Fiducia China Focus Newsletter

• State Assets and Companies for Sale is Official Policy
  
  
• Event Announcement
  
  

• About the Development Zones in the Yangtze River Delta
  
  
• Tidying up China’s market is the goal of new Ministry of Commerce
  
  
• Intellectual Property Trend in China
  
  
• Shanghai Industrial Holdings Ltd.
  
  

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Patrick Kriegeskorte
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All liabilities excluded. This Newsletter is based on information obtained from sources (government, business associates, companies, publications, etc.) believed to be reliable. However Fiducia Management Consultants does not make representations as to it's accuracy, completeness or correctness.

Fiducia Management Consultants is China Partner of Corporate Development International, a global partnership specialising in mergers, acquisitions and divestitures.   www.cdiglobal.com

State Assets and Companies for Sale is Official Policy

The State Council (equivalent to the ruling cabinet) has formally approved the interim rule for dealing with the state sector in China. It is now official government policy for many of the state enterprises to be either shut down or sold off.

Under the newly established State Asset Management Commission (SAMC), the government would only retain direct management over 196 state enterprises (excluding the financial institutions). The rest of the 170,000 state companies will be under the responsibility of the regional and provincial authorities. They could deal with the companies the way they think fits.

This is a major step forward in restructuring the Chinese economy.

The 196 large and strategic state-owned enterprises include well-known entities such as China Mobile, China Shipbuilding Industry Group, COSCO, Sinopec, Minmetals, COFCO, China Resources, China Merchant Ship Navigation, Baosteel, China Eastern Airline, China Southern etc. The list consists of enterprises which are major market leaders in China, collectively these 196 state companies controlled asset value of RMB 6.9 trillion (EUR 713 billion) at the end of 2002 of which RMB 2.5 trillion (EUR 258 billion) belonged to the state.

SAMC role as the caretaker would be to improve the efficiency of these major corporations while ensuring the state's interests are protected. The 196 enterprises would gradually be transformed into industrial conglomerates capable of competing with the multinationals in domestic and overseas markets. Because of significant government investment in the past, these conglomerates will receive priority in nurturing their future development.

For foreign investors interested in acquiring Chinese companies, this is the clearest signal that the Central Government is in favor of a faster pace in privatization. Merger and acquisition activities would play an increasing important role in the process of enterprise reform. Now the remaining task will be to find a consistent approach in company valuation for the state enterprises not under SAMC control.

Direktinvestitionen in China
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Fiducia Speakers: Jürgen Kracht, Heiko Bugs
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A Reality Check and a Valuation Guide for Intangible Assets

In an age of knowledge-based economy, no one can deny the importance of intellectual property (“IP”). However, these assets rarely show up on the balance sheet. The difference of market to book value reflects the ability of companies to successfully convert intellectual property into profits.

IP Development in China
For many years, Chinese companies have overlooked the importance of IP. This changed when China joined the Paris Convention for the Protection of Industrial Property in 1985. Since then, IP development has generally been at the same pace with the economic development: The number of patent applications and patents granted in China has been growing at 15% p.a. from 1994 to 2001.

But taking a closer look at the authorized patents from 1985 to 2001 in China unveils a difference: Domestic applicants in China focus more on utility models and designs patents, while foreign applicants concentrate on inventions patents, especially in their key technical fields. Besides, domestic patent applications and foreign patent applications accounted for about 85% and 15% respectively.

New approach to Intellectual Property management
The investment climate for technologically advanced industries in China has improved greatly in the past few years owing to the promulgation of a series of intellectual property legislation. On top of, that China has acceded to a number of international treaties and conventions related to the protection of intellectual property rights. IP is no longer just a bunch of legal documents and research results to be locked away in company vaults.

A new approach to IP-management involves more aggressive and active “indirect exploitation” of intellectual property value. Apart from internal use, IP may also be commercialized through a joint venture, outright sales, franchising, or licensing. The last years have seen several successful business cases in China using the valuation of IP as non-cash equity contribution to a Sino-Foreign joint venture. Although the value attributed to intangible assets injected to an equity joint venture is expected not exceeding 20% of the registered capital as a general rule, some local governments, e.g. Shanghai, have increased this to 35% for hi-tech ventures.

Measuring the True Value of Intellectual Property
The best way to measure the value of IP is generally to calculate the present value of the estimated future economic benefits that can be derived from its ownership. Such a proceeding corresponds to the income approach, which is also acknowledged in China.

Major steps in IP-valuation by the income approach are as follows:

• Identify the specific application of the intellectual property (How will it be commercialized?)
• Estimate the size of the chosen market and the potential market share for the product or service that employs the intellectual property (What sales can be expected?)
• Quantify the economic benefits that can be expected from exploiting the intellectual property (How much incremental profit can be enhanced?)
• Assess the risk of achieving those economic benefits and adequate return to compensate the risk (What are the returns of alternative investment with similar risks?)
• Determine the period of time over which the benefits will occur (What is the economic life of the IP?)

Intellectual property must always be valued within the context of the operation it is part of. A brand is valued based on the saving in royalty payment from associated products due to the ownership of the brand against licensing it from others. Likewise, the value of a proprietary technology stems from incremental profit enhancement brought to a business or operation.

Conclusion
As intellectual property is increasingly important, business managers must understand the value of IP, must know the value’s origin and should be aware of associated risks. Additionally managers should be aware of making the best use out of their IP. Valuation theories are easy to learn but it may take life long to practice.

China’s newly established Ministry of Commerce (MoC), the merger of MOFTEC and SETC, has now been in operation for several weeks. Minister of Commerce Lu Fuyuan has stated that the MoC’s policies were clear in their orientation to develop a uniform and open market with a “sound order of competition”. This means that the China market should, in theory, be an equal playing field for both local and foreign companies.

Yet it remains to be seen what lies underneath these words. According to Lu, the MoC is in the midst of drafting some important measures for the next few months such as fighting protectionism and counterfeiting, “rectifying and regulating market order” as Lu calls it.

Good news for foreign business then? Maybe. The MoC is a powerful organization at least in size. But integration of the two state ministries into one will take time. Both of them were dealing with different clientele and possess differing expertise. There are indications that although there is only one Minister of Commerce, there now exist two departments for each sector. China’s multiple market nature with strong local protectionism is another worry. It remains unclear if the MoC has authority over provincial governments to enforce a more open and equal market approach.

For the time being, a wait-and-see approach to the true intentions and capabilities of MoC is the only option. It is still too early to decide whether the new bureaucracy will make life easier by being the force behind a more liberal implementation of WTO-regulations and thus in favour of foreign business.

Twenty years ago, China set up the Special Economic Zones (SEZ) in order to experiment with Foreign Direct Investment (FDI) in a controlled yet attractive environment for foreign companies. Later, the State Council approved other forms of development zones that offered similar tax incentives as the SEZs.

Even though investing outside these zones is possible, many foreign enterprises prefer their advantageous tax and infrastructure environments. Shanghai has been very successful in attracting foreign companies with its world famous investment zones, such as Waigaoqiao Free Trade Zone (FTZ) and Zhangjiang Hi-tech Industrial Development Zone (HIDZ). But what led to the development of the area on the one hand, has also resulted in an increase in overall prices on the other. As a result, an increasing number of foreign investors are paying attention to the lower cost development zones in Shanghai’s neighboring provinces of Jiangsu, Zhejiang and Anhui. These provinces, which together with Shanghai comprise the Yangtze River Delta (YRD) Region, are one of the most important powerhouses of China’s economy. The YRD Region accounts for more than a quarter of China’s GDP and a third of its FDI.

The infrastructure outside Shanghai has improved in the last years. Highways, railways and the Yangtze River itself offer infrastructure that enables access to the main logistic hubs in Shanghai (airport and port) and Ningbo (port). These conduits are also facilitating increasing integration between the different cities within the region as well. Furthermore, many development zones outside Shanghai have reached a similar level of development as those in Shanghai. Wuxi New District, a merger of several industry parks, and Singapore Industrial Park in Suzhou, a government-to-government cooperation, are two notable examples.

Development zones outside Shanghai offer significant cost advantages. The average salaries for unskilled labor in Singapore Industrial Park are as much as 18% lower than in Shanghai. Labor regulations such as social security benefits and minimum wage levels also differ from city to city, and thereby further increase the investor’s choice of investment locations. The increasing competition between municipal governments for FDI has meant that many industrial parks have been established without central government approval. These parks cannot offer the same tax incentives, but try to compensate by offering subsidies and lower land prices instead. Xishan Municipal Development Zone with a land price of 7.25 USD/m2 is more than sixteen times cheaper than Waigaoqiao FTZ.

Apart from cost considerations, of course other issues like infrastructure, availability of labour and services are also important criteria for investors when evaluating and choosing a zone. Requirements and priorities vary with the size being made and also depend on the type of industry and the underlying strategy. Thus determining the optimum zone requires shopping around. Generally speaking, there are no good or bad zones, but rather zones that are more suitable for a particular purpose.

Shanghai Industrial Holdings (SIHL) is the flagship in a conglomerate of 4 listed companies, 9 subsidiaries and 270 associated and affiliated companies, combined under the roof of Shanghai Industrial Investment (SIIC), Shanghai Government's sole "window company" in Hong Kong. SIIC is currently the largest and most resourceful overseas enterprise under the control of the Shanghai Municipal Government and following the principle “based in Hong Kong, backed in Shanghai”.

Incorporated in 1996 and listed on the Stock Exchange of Hong Kong in the same year, SIHL became a blue chip stock in January 1998. The SIHL group consists of five main units: Infrastructure/Logistics, Consumer Products/Retailing, Automotive Parts, Information Technology, Medicine and Bio-technology. SIHL owns 16.2% of Semiconductor Manufacturing International Corp., the first contract chip maker in China, which produced the first silicon wafers at a plant in Shanghai at the end of 2002.

For 2002, Shanghai Industrial reported a worse than expected net profit of EUR 123 million, caused by a big loss at its start-up semiconductor unit. With half of its customers from overseas, it was influenced by the weakness of the global semiconductor industry.

But investors are even more concerned by the development of SIHL’s core operations: Shanghai Industrial has been enjoying huge profits from two road projects, Yanan Road and Inner Ring Road in Shanghai. Analysts estimate that the Shanghai government guaranteed an annual return of around 15 per cent of the invested capital for both projects. But last year, Central Government issued a directive ordering regional governments to settle with foreign investors on the cancellation of previously guaranteed returns on infrastructure projects.

Shanghai Industrial will be paid outstanding investment in the projects in cash but it is expected that new projects will see lower returns. The returns from the toll-road projects accounted for about 60 per cent of its total profits last year.

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