While US stock markets stagnated on Monday, Harbin Electric (HRBN) was away and sprinting. The shares of the China-based manufacturer of electric motors ended the day up 16.3% on news that its chairman, Tianfu Yang, in partnership with the major private equity firm Baring Partners, was bidding to take the company private at $24 per share.

While most investors in the broader US markets might ignore a privatization bid for a small Chinese company, investors in Harbin Electric and in its broader sector should see it as a landmark event – and not a particularly welcome one.

Harbin Electric belongs to a select group of companies that is composed of small Chinese firms that came to be listed on American stock exchanges using an alternative to an initial public offering (IPO) called a reverse-merger. A reverse-merger is a transaction whereby a shell company (an incorporated legal entity with no business operations) that is already listed on an American exchange “buys” the Chinese company that is seeking to go public. After becoming listed, the company usually undergoes a capital raise. With the reverse merger and capital raise completed, the Chinese company has essentially completed an IPO.

Harbin Electric underwent this reverse-merger process in 2005, when it was a small player in the electric motor market in China. Using the capital it has raised through its domestic listing and other secondary share offerings, the company’s growth over the past five years has been nothing short of spectacular. In 2005, the company boasted revenues and net income of $24 million and $10 million, respectively. For the fiscal year 2010 the company is expected to post $430 million in revenue and $90 million in net income.

Investors who have held a stake in Harbin Electric since its listing in 2005 have been richly rewarded. Over this period, the company’s share price has appreciated almost eight times over (as of its 10/12/10 closing price) – generating a 48.5% compound annual return.

Given Harbin Electric’s success, it should come as no surprise that a great number of small Chinese firms have followed its path into the US capital markets through the reverse-merger method. The firms that have done so greatly vary in terms of size and industry. They include China Security and Surveillance Technology (CSR), a firm engaged in the manufacture and installation of surveillance products that boasts revenue of almost $800 million, and Soko Fitness (SOKF.OB), an owner and operator of fitness centers and beauty salons that does $30 million in business.

While many firms have followed in Harbin Electric’s footsteps, not many have found its success. Firms like jewelry wholesaler and retailer Fuqi International (FUQI) and oil driller China Northeast Petroleum (NEP) have experienced accounting and corporate governance issues that have led to SEC compliance issues. Other companies like the paper manufacturer Orient Paper (ONP) and pro-biotics producer China Biotics (CHBT) have been accused of outright fraud.

As a result of these issues, a great pall currently lies over the entire Chinese reverse-merger sector. The discussions surrounding these stocks have devolved from debates over proper valuation to shouting matches regarding whether or not these companies actually exist. Unfortunately, as the intellectual level of discourse has fallen, so too have company stock prices.

The malaise in the Chinese reverse-merger sector has even affected companies with clean corporate histories and upstanding reputations like Harbin Electric. Where the company was once awarded a price-to-earnings (P/E) ratio of 25 at the end of 2007, its shares can now barely muster a P/E ratio of 12 – despite exponential growth in revenues and operating income. As of its close, today, Harbin Electric boasts a tiny price-to-earnings growth (P/EG) ratio of 0.5 and a petty forward P/E of 7.9.

These numbers are shocking when one considers the valuation of some of Harbin Electric’s peers. Chinese companies that listed on American exchanges through the traditional IPO route using bulge-bracket investment banks as underwriters command valuations many times greater than Harbin Electric’s. Firms like New Oriental Education  (EDU) and Ctrip (CTRP) garner P/E ratios of 44, and 57, respectively, despite the fact that their revenue and earnings growth rates trail Harbin’s. Chinese firms that trade on China-based exchanges in Shanghai, Shenzhen, or Hong Kong receive valuations that are similar to or higher than those given to New Oriental or Ctrip. For instance, firms that trade on ChiNext, a recently launched Nasdaq-style exchange for small Chinese companies, command an average P/E ratio of 64.

The issue of valuation is at the core of Harbin Electric’s privatization bid. While Harbin Electric’s reverse-merger listing has given the company capital to support its massive growth, it has not given it a fair and proper valuation. If Harbin Electric were to be given a valuation that is consistent with that which is given to US-listed Chinese companies like Country Style Cooking (CCSC) and Sohu.com (SOHU), the firm would be reasonably priced at $50 per share (equivalent to a P/EG ratio of 1.0) – and even that might be conservative. For instance, if Harbin Electric were given a P/E ratio equivalent to that which is given to the average company listed on ChiNext, its share price would be $192 based on 2010 earnings-per-share projections.

Thus, with their privatization bid, Harbin Electric chairman Tianfu Yang and private equity firm Baring Capital seem to have a highly compelling arbitrage play on their hands. For a meager price of $24 per share, they can purchase the company and then list it again on the rapidly evolving markets in China at share prices potentially two to eight times higher than present. While Mr. Yang and Baring Partners will likely profit exorbitantly, current Harbin Electric shareholders and other American investors will miss out on the tremendous potential that the company holds. However, given the conditions that currently exist in the Chinese reverse-merger sector, these latter two groups may only have themselves to blame.

If American investors continue to allow stock prices in the Chinese reverse-merger sector to be dictated by xenophobia, unproven accusations of fraud, and excessive fears over corporate governance issues, Harbin Electric will not be the first promising Chinese company to flee American stocks exchanges through privatization and then relist in friendlier markets. If a large exodus does ensue, American investors will miss out on a tremendous amount of potentially once-in-a-lifetime investment opportunities. Given the American economy’s stagnant performance over the past few years and its likely continued underperformance, these opportunities are ones that American investors should not relinquish without a fight.

Disclosure: Author holds long positions in HRBN and in a number of companies in the Chinese reverse-merger sector.

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