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EDINBURGH — Naspers is a stock market darling that few dare to criticise. A company that is built on the foundation of a media business, its recent successes have come from a shrewd investment in Chinese tech company Tencent. Sean Peche, portfolio manager of the Ranmore Global Equity Fund, has tackled the elephant in the room: China may have the hallmarks of a capitalist country, but it is not democratic and the rules are different there from other countries. Peche has prised open the finer details of how Chinese multinationals operate in a globalised world while being constrained by Chinese government policy. His findings are scary and disappointing if you’re a Naspers shareholder. Or, indeed, if you’re a South African with a heavy weighting of your portfolio in the domestic market. Naspers dominates the Johannesburg stock market. Here’s Peche’s analysis, followed by a reply from Naspers – which was offered the opportunity by BizNews to respond to a worrying picture set out by the fund manager. – Jackie Cameron
By Sean Peche*
As any shareholder in the Russian companies, Yukos or Sistema, or MTN in Nigeria or Acacia Mining in Tanzania may tell you: Be very careful of owning companies in countries with all powerful governments where allegations around judicial independence exist and property rights may not be respected if the Government isn’t a co-shareholder.
When an investor buys an equity, they inherently rely on: the property rights of a country, the listing requirements of the stock exchanges and the corporate governance of directors to safeguard their investment.
Arguably the riskiest companies are those with: questionable legal rights to operating businesses, which exist in an all-powerful country and have weak corporate governance structures – Chinese technology companies.
Today, Tencent, Alibaba, Baidu and JD.com are collectively valued at more than $1 trillion. Tencent is listed on the Hong Kong Stock Exchange and the others are listed as American Depositary Receipts / Securities on the NYSE and Nasdaq.
As Chinese President Xi Jinping tightens his grip on China by removing the 10-year limit on the Presidency, how concerned should investors be about these high flyers? Especially since unlike some other Chinese companies, the Government is not a shareholder.
Firstly, all these companies are incorporated in Cayman Islands and use “VIE” (Variable Interest Entity) structures* (refer to Naspers note below). This is where the Cayman Islands company is a shell company with nothing other than a few “structure contracts” with the underlying operating Chinese company/ies. These contracts allow the results of these operating companies to be consolidated into their financial results but as Tencent discloses in note 46 (e) of their 2016 Annual Report, “the Company has consolidated the operating entities within the group without any legal interests.” This is because as Alibaba disclose in their 2017 Annual Report, “foreign ownership of certain types of Internet businesses is subject to restrictions under applicable PRCS laws, rules and regulations.” So the registered ownership of these operating businesses often rests in the personal hands of the Chinese founders, primarily the CEOs of these listed companies.
But it may be even worse than that, for as Tencent discloses in their Directors’ report, “Circular 13 ..expressly prohibits foreign investors from gaining control over or participating in domestic online game operators through indirect ways such as establishing other joint venture companies or entering into contractual or technical arrangements with the Chinese licence holders.”
Furthermore, that “the Company’s legal advisers believe the Structure Contracts do not violate PRC laws and regulations but that there are substantial uncertainties regarding the interpretation and application of the currently applicable PRC laws, rules and regulations. Accordingly, the PRC regulatory authorities and PRC courts may in the future take a view that is contrary to the position of the Company’s PRC legal advisers concerning the structure contracts”
So are all the profits from these Chinese operating companies paid out to these listed Cayman island shells? “It doesn’t seem so”, because on page 226 of Tencent’s Annual Report, in note in note 46 (d), entitled “Significant restrictions”, Tencent discloses that “RMB86,250 million were held in Mainland China and they are subject to local exchange control and other financial and treasury regulations. The local exchange control, and other financial and treasury regulations provide for restrictions, on payment of dividends, share repurchase and offshore investments, other than through normal activities.
What’s the point of growth if you can’t get your hands on the cash?
Baidu disclose in its 2017 Annual Report, “The PRC government has broad discretion in determining penalties for violations of laws and regulations. If the PRC government determines that we do not comply with applicable law, it could revoke our business and operating licenses…”
What seems clear to me is that these companies and their VIE structures exist at the total mercy of the Chinese State and control over the State is tightening. Forget that these Chinese CEOs have large stakes in the companies, this is no safety net when things go wrong beyond the CEO’s control – it wasn’t for Mikhail Khodorkovsky, who at one point was worth $15bn, and it wasn’t for Christo Wiese when Steinhoff unravelled.
Worse still, China is now involved in a trade war with the US and what better way to flex their muscle on the US (without impacting their domestic economy) than by making life difficult for the foreign investors in Chinese technology companies.
Of course, that’s apart from the obvious questions of what happens to these contracts if something unexpected happened to CEOs, Jack Ma or Ma Hauteng, or they act contrary to the interests of ordinary shareholders? In 2005, Jack Ma, founder of Alibaba, transferred ownership of Alipay from the group to himself reportedly without the knowledge of major shareholders Yahoo or Softbank (although Alibaba itself disputed this account), but since the control of the operating Alibaba businesses rested with him, ordinary shareholders were powerless.
Unfortunately, the risks don’t stop there because the corporate governance rules in the Cayman Islands, the home of these listed (not operating) companies, are generally considered to be less stringent than in many areas of the world. Indeed the Council of Institutional Investors wrote in December 2017 “the VIE structures themselves create significant management conflicts of interest, complicating, if not foreclosing, the ability of outside shareholders to challenge executives for poor decision making, weak management, or equity-eroding actions. VIEs lead foreign investors to believe that they can meaningfully participate in China’s emerging companies, but such participation is precarious and may ultimately prove illusory.” Cayman island companies are not required to hold AGMs (Baidu doesn’t hold them) and unlike New York Stock Exchange Standards, a majority independent board is not required, the remuneration committee does not have to be composed entirely of independent directors and a material change to the compensation plan does not require shareholder approval.
And by their own admissions, these companies do not always comply fully with their Stock Exchange Corporate Governance codes.
Under the more onerous UK Corporate Governance rules, a board member would not be considered “independent” if they received remuneration apart from their director’s fee or if they served on the board for more than 9 years from the first election.
In Tencent’s case, 3 of the 4 independent non-execs were appointed 14 years ago and have become fabulously wealthy through generous share awards over this period – in 2016, 61,474 “Awarded Shares” were granted to independent non-executive directors (worth $3m today) and at year end there were 192,724 outstanding Awarded Shares to the independent non-execs worth over $10m today (not all of which had vested). In total, the Independent Non-Execs owned shares and awarded in December 2016 worth nearly $50m at today’s value. One can see the logic behind the UK rules – it must surely be very difficult standing up to a CEO who has made you so fabulously wealthy and who holds power over your unvested Awarded Shares.
But Tencent’s significant shareholder, Naspers, arguably has little moral authority to lecture Tencent on good corporate governance.
Nasper’s discloses in note 17 of its 2017 Annual Report that they have “an obligation in terms of their Memorandum of Incorporation to maintain its control structure”. This is done via the use of their unlisted A shares which have 1000 times the voting power of the ordinary N share traded every day. However, the exact ownership of these A shares is not immediately clear and in June 2017, the Business Day reported that Caxton’s legal team claimed to the Competition Tribunal that “Naspers had not been forthcoming about the details of the ownership structure”. Ultimately Caxton’s application to intervene in the Tribunal case was rejected as the control structure was not relevant to the transaction in question, so Naspers were not required to respond to this allegation. Nevertheless, in Naspers’ 2006 20F (A version of a company annual report required by foreign companies listed in the US and last reported by Naspers in 2006), Naspers disclosed with reference to these A shares “As a result, the controlling shareholders and these directors significantly influence the outcome of any action requiring approval of shareholders.) So in essence it seems to me that the company is controlled by directors who control (not own) just 0.21% of the total shares in issue.
Which they do to an eye watering effect.
Naspers’ share award scheme is so generous that in 2015 the new shares being issued threatened the company’s control structure so 194,997 new A shares were issued to the A share shareholders to ensure this control structure was maintained (note 17 of 2017 Annual Financial Statements)
And in 2016 and 2017, the Diluted weighted average number of N shares in issue increased by 3.5% and 3.2% respectively, a rate at which exceeds even Amazon’s dilution at 1.5% and 1.9% respectively.
Unfortunately, this dilution is also on top of the ~0.7% p/a dilution at a Tencent level for their employees (note no additional dilution at Amazon is suffered at a subsidiary level)
Naspers’ share price performance has been entirely thanks to Tencent over the years so if you thought that all the extra shares to Naspers executives was because of all the cash generated by their non Tencent businesses, you’d be wrong. Very wrong.
Naspers only generated a combined $38m in cash flow from operating activities in 2017 and 2016 but if you exclude the $339m of dividends from investments (largely Tencent), its other businesses haemorrhaged $301m of cash (and that’s before any capex). No wonder the company needed to raise over $2bn last year.
But yet in note 17, Executive Director and key management emoluments over these 2 years is disclosed as totalling $94m. And this excludes the Non-Executive remuneration of $4.4m in 2017 alone and which is even higher than the $3.5m paid to Microsoft’s “Non-employee directors” in Fiscal year 2017.
Furthermore, I calculate that 68% of the N Shares present at the AGM voted against Directors Remuneration but because the A shares* (refer to Naspers note below) carry 1000 votes, the motion passed. Given the control structure, it is surprising to me the A shares are able to even vote on this motion.
So today Naspers trades for $40bn less than its Tencent shares alone. This is a direct cost that pensioners and savers in South Africa are suffering apparently due to management. But they seem far from concerned and in the 2017 AGM they seemed even dismissive of this “obsessing with the so-called discount to the sum of the parts value” and expressed no interest in unlocking this value through buybacks or selling Tencent shares, mainly because it would have been a poor decision historically – “we are really not interested in fads and funnies to make a quick buck.” Given the extent of executive remuneration, I think we all know who is making the “quick buck” but I respectfully suggest they take a more humble approach and read any financial product disclosure: “Past performance is no guarantee of future returns.”
It would be easy to unlock value for the benefit of South African savings industry – sell Tencent shares and use the proceeds to re-purchase the Naspers shares for as long as a discount exists but following their recent sale of Tencent shares, the Board have committed to selling no more for 3 years – essentially taking the unlocking of value off the table for this period.
Management seem blind to the layered and very real risks that exist with their Tencent holding. Indeed, I couldn’t find any reference in Naspers’ 2017 annual report or website to the specific risks disclosed by Tencent and outlined above. Perhaps it is also somewhat telling that Naspers’ Risk Committee Report takes up one page and their Remuneration Report 12 pages.
Due to exchange control and Naspers’ 20% weighting in the JSE Top 40, the South African savings industry is totally exposed to this company. Practically every fund manager owns it already, in size, and given the share price’s 26% fall since November 2017 and widening discount there seems to be little more local demand for the share. Foreigners may be dissuaded by the messy and difficult to decipher control structure. South Africa cannot afford a collapse in the Naspers share price, and surely being aware of the layers of risks inherent in its Tencent holding is a step towards mitigating this.
Naspers’ board has more than just a responsibility to its shareholders, it has a responsibility to the savings industry of South Africa. If it cannot see that, the PIC, ASISA, the asset management industry, and the Johannesburg Stock Exchange should consider lobbying Government to amend the Companies Act and prohibit variable voting rights and control structures of publicly held companies.
Let shareholders have more ability to hold management to account. Poor corporate governance is not in the interests of society, especially not when it’s a company the size of Naspers.
As Mark Goyder, the British author and Governance expert said “Governance and leadership are the yin and the yang of successful organisations. If you have leadership without governance you risk tyranny, fraud and personal fiefdoms. If you have governance without leadership you risk atrophy, bureaucracy and indifference.”
- Sean Peche is the portfolio manager of the Ranmore Global Equity Fund which has no direct or indirect holdings or positions in any of the companies mentioned.
From Meloy Horn, Head: Investor Relations, Naspers
I believe everyone is entitled to their own views, which includes investment opportunities and where people choose to invest. Similarly, Sean is welcome to his own persuasions.
However, perhaps important to also be careful not to come across as changing facts to support a specific view.
In working through the article, I have come across the following important facts that are wrong:
- Various countries have unique features to their corporate set-ups and VIE structures happen to be common to Chinese companies. There is nothing mysterious about them, and mainland Chinese companies listed abroad or in Hong Kong typically use them. Those that prefer to see only defects in China are welcome not to invest there, but one marvels that it became the second biggest economy in the world. We are entirely comfortable with our Tencent investment.
- The reference to a 3% share dilution as a result of the Naspers share schemes in comparison to Amazon is completely wrong, the correct figure in 2017 was 0.08% (0.13% in 2016). Sean seems confused by shares issued to acquire stakes in assets like Avito and Takealot.
- He portrays the value of the then A share award to maintain the Naspers control structure as huge, when in fact it was trifling – i.e. only $0.3m. The control structure, which has been in place since the original listing of the Naspers group in 1994 and which every shareholder is aware of, secures our independence and serves to prevent a foreign take-over of Naspers. (We are actually in the process of uploading it onto our website for easy reference – should be there in the next few days).