I noticed an article in The Globe and Mail, a newspaper in Toronto, describing the efforts in Vancouver to become a Gateway to China.  The article is well written, and contains several interesting bits of information, including:

“But it is impossible not to see the growing gap as a symptom of the kind of complacency that Mr. Woo decries. Consider also the disturbing fact that Canada is losing ground in Asia. Two decades ago, Canadian business had a market share of 2.5 per cent, a robust amount considering the size of this country’s economy. Ten years later, Canada’s market share had fallen to 1.7 per cent. And today, as opportunities in China mushroom, Canadian business has less than 1 per cent of the market, and is fading to the point of irrelevancy.”

I wonder why Canada’s market share of China exports is shrinking by so much.  I also wonder who is benefiting.

Anyway, the globalization aspect that hit closest to home for me was the following:

“Times are good in booming B.C., so it’s easy enough to let that long-term peril, however serious, slip off this quarter’s to-do list. There are exceptions, one of the most notable being Next Level Games Inc., a Vancouver video game developer that has made expansion into China a cornerstone of its strategy for dealing with the overheating labour market in B.C., the threat of a rising Canadian dollar and the increasing demands of the newest gaming platforms.

The company has set up a 12-person operation in Beijing to produce the art for its video games, the animation that meshes with computer programming. After a year, CEO Douglas Tronsgard says his firm sees it as an unqualified success. The firm’s latest video game for Nintendo, Mario Strikers Charged, is a bestseller in Japan. And the relatively cheap salaries of the Chinese artists - half the cost of their Canadian counterparts, even though they’re being paid top wages in China - means that the dollar’s surge past parity is of no great concern to Next Level.”

While I was happy to see that they were successful, it does poke a hole in part of my story that western companies will find significant challenges in setting up small captive labs in China.  Normally, I would strongly advise someone like Mr. Tronsgard to consider outsourcing to one of the excellent game development art studios in China.

I continue to be stunned by Longtop’s announcement.  According to the latest news, they expect to raise approximately $136M from this offering.

Before I go any further, I should take a moment to distinguish between investing, which I define as buying an asset, or a portion of an asset, with the expectation that it’s value will increase over time, and gambling.  Gamblers put their money on the table and hope that chance will favor them.  Investor’s buy an asset with value and expect that market forces (and sometimes hard work) will increase the value of the asset.  I respectfully submit that westerners who buy the ADS based offering from Longtop are playing the lottery. They are not investors.  They are not leveraging their resources to create more value.  Here’s why…

When you’re buying into a software outsourcing company, and you remove all of the good will, you’re basically left with four primary asset categories:

• Real estate
• People
• Client lists / Books of business
• Processes & reusable IP

Let’s think about each of these within the context of Longtop Group / Longtop Financial Technologies.  We need to carefully consider what we’re actually buying when we pick up these shares:

• Real Estate - While they talk about using some of the investment to purchase commercial real estate, let’s not forget that property rights in China are quite different from what we are accustomed to in the west.  There was a time, not too long ago, when the government simply took all of the real property.  The government is currently promising to respect property rights, but it is a risk, so the value must be discounted for the risk.  Finally, it will be important to verify that title to the land and buildings actually remains with Longtop Financial Technologies, rather than getting registered with one of the other group companies.
• People - While well run Chinese outsourcing companies are able to control attrition, one would need to have access to insider level HR data to really know whether the current staff are likely to stay.  I do not want to be plunking down my portion of $136M for staff that will happily go to work for a competitor offering fifty cents more per hour.  Another unknown is the actual staffing level within Longtop Financial Technologies.  Many of the outsourcing organizations that are subsidiaries of established Chinese companies take massive liberties when it comes to counting employees.  It’s not uncommon for them to claim to have thousands of engineers, because they count the engineers in the parent company and any sister companies.  The, admittedly weak, rationale goes something like, “Well, those people would be available to us if we needed them for projects…” Unh-hunh.  I would want to look carefully into any headcount numbers that they claim.  Early in my dealings with Chinese software outsourcing companies, I tried to represent a subsidiary of a large Chinese software outsourcing company that claimed to have 5K employees.  Strangely, they never seemed to be able to respond to RFI’s/RFP’s, and they never seemed to have people available for interviews.  A couple of years later I found out that the division actually had no engineering staff - 0.  They had management and marketing, with an agreement that the parent company would “put the resource in” after they won some projects.
• Client lists / Existing business - I recognize that there are costs associated with switching vendors, but clients aren’t endlessly patient.  They can switch to other vendors, especially if service deteriorates, or costs increase.  High turnover can also push clients into looking for an alternative.  While existing business is good for cash flow projections, I would want to have very good insight into the company’s current client satisfaction and the degree to which clients are actually “locked in” before I relied too much on future projections.
• Processes - We all claim to have state of the art processes, as verified by our ISO and/or CMMI certifications.  I would want to ask Longtop’s clients about the company’s adherence to strict process discipline.  I would also want to find out whether all of the delivery teams, as well as the internal project teams, followed some sort of process discipline.  I’ve seen many organizations that have convinced the examiners to certify them for very high levels of process maturity, while concealing the fact that most of their delivery teams operate with very little process.  I’m afraid that this is one of the consequences of the current state of the industry in China, where many of the companies are competing as low cost suppliers.

Of course, the largest questions are:

• When I buy an ADS, what percentage am I getting of which exact legal entity?  How much equity does the parent company retain?  How carefully separated are the legal, business and asset issues from the parent company, as well as the other sister companies within the Longtop Group?
• Who are my co-owners?  Many established Chinese companies like the Longtop Group have very close ties to the state.  Even if there is not direct ownership by the state, it might be very interesting to see which current, and former, government officials are among the owners of Longtop and will subsequently become my new business partners?  Do you care to hazard a guess regarding who will prevail in any disputes?
• What kind of transparency, reliable reporting and recourse can I expect as an owner of an ADS?  Remember that American Depositary Shares represent indirect ownership.  While theoretically you’ll have “full rights of ownership”, the underlying security is actually traded on the Shanghai stock exchange and is governed by the rules there.  I don’t know enough about the regulations and policies affecting registrations on the Shanghai exchange to even have the illusion that I have an edge there.  Further, I suspect that we won’t see very many westerners prevailing in legal action for securities fraud in Shanghai listed companies, at least not in this decade.
• How do I feel about the money that I invest being used to “pay a previously declared dividend?”  I can’t help but wonder how much control an owner of an ADS will be able to exert if the company decides to use the money raised for something really inappropriate.

I am not claiming to have any underlying insight into Longtop Financial Technologies’ actual business and operations.  They could very well be a great company.  I’m just urging caution and consideration before we put real money into this.  I know that investing in China is all the rage right now.  I read about a time when investing in tulips was the big thing.  I was working in Silicon Valley at a time when plowing money into Internet companies with no business plan, no revenue and some vague notion about “aggregating eyeballs” was the brilliant investment thesis (”eThis” & “iThat”).  I’m ashamed to even it, but I wrote business plans that stated our objective was to drive page views and monetize site visits by… Sigh…

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