In the Gome: Going public case study. What was the structure of the deal?

Gome: Going Public

Mr. Wong Kwongyu, founder and chairman of Gome Appliance (Gome), was at another crossroads in early 2004. Gome, started in 1987 as a humble 100 square meter single shop in Beijing, had grown to reign supreme in Chinas home electrical appliances retail sector. The companys fiercely competitive prices, along with high-quality customer service and aggressive expansion, made it the Wal-Mart of China. Gome boasted 139 retail stores throughout China and an annual sales turnover of RMB 17.8 billion (US$2.1 billion1) in 2003. Now Mr. Wong faced the challenge of charting the ideal course to take Gome public. He could float Gomes shares in Chinas domestic stock

markets in Shanghai or Shenzhen, or seek an overseas listing in Hong Kong, NYSE or NASDAQ. Furthermore, he had the option to bypass the traditional IPO process through a so-called reverse takeover, no matter where he decided to go public. Reverse takeover was an unusual route to public company status but could suit Gomes needs well if ably implemented.In evaluating these different options, Mr. Wong knew he would have to carefully balance key factors such as eligibility, length, and execution and regulatory risks. His final decision would undoubtedly impact Gomes growth for a long time to come. The Young Entrepreneur behind Gome : Wong Kwongyus entrepreneurial career started on the New Years Day of 1987, when he borrowed RMB 30,000 to open a modest electronics retail store in Beijing. He picked an auspicious name Guo Mei, meaning beautiful nation in Chinese for what would in due time become a sprawling commercial empire. As a native of Shantou in the southern Guangdong Province, a town renowned in China for its residents business acumen, Wong went to Beijing at a tender age of 18 to strike his first pot of gold. By that time, Chinas nine-year old economic reform was being pushed at full throttle in major industrial cities and Wong saw great potential in the retail trade. Wong spent almost seven years fine-tuning his model to grow Gome. From 1987 to 1993, he kept opening new outlets selling mostly imported household electronic products but under different store names. He innovated as he went along from placing advertisements in newspaper centerfolds to negotiating directly with manufacturers and importers, both considered first in China by industry observers. By 1993, Wong had six stores in Beijing under his direct control. He decided to unify them under a single umbrella brand Gome and structure all future expansions in this centralized retail chain model. Gomes main book of business focused on brand-name electronics from overseas, which were under-supplied in the Chinese market and hotly sought after throughout the 1980s. Unit prices stayed high and loyalty from Chinas newly-awakened urban consumer class was almost presumed. As an ambitious upstart, Gome revolutionized the home electronics supply chain by eliminating multiple layers of third-party distributors and entered the market with a deliberate never-to-be-undersold pricing strategy. But gradually, relentless competition eroded profitability and smuggled foreign goods posed a growing challenge to procurement. In 1997, Wong Kwongyu made a momentous decision: Gome was to shift its product mix to indigenous and joint-venture brands locally manufactured in China.

Household Electronics Industry in China

Consumer Demand Chinas household electronics market enjoyed explosive growth since the early 1980s. As per capita GDP increased 23-fold from RMB 463 in 1980 to RMB 10,542 in 2003, demand for household durable goods long regarded as high-value amenities during Chinas heavy industrialization period up to the late 1970s skyrocketed. Retail market for home and consumer electronics in China grew from RMB 134 billion in 1992 to RMB 394 billion in 2002, representing an annual compounded growth rate of 11.4%. Structurally, the market shifted from the traditional audio-video products to personal computers, communication products (such as cellular phones) and small household appliances (such as microwave ovens, electric shavers and air purifiers), driven by evolving consumer needs and tastes. Brand loyalty to both manufacturers and retailers was low relative to the more mature markets in the U.S. and Europe. However, reliable after-sales services were valued by Chinese consumers. Price wars among retailers routinely broke out during four extended holiday periods: the three Golden Weeks (Chinese New Year in January/February, May Day in late spring and Chinas National Day in early October) and the Christmas-New Years Day period.

Manufacturing :

As demand multiplied, supply of electronics in China changed dramatically. In the early days, foreign brands such as Panasonic and Philips dominated. But their dominance was short-lived. Local firms, taking full advantage of their lower cost structure and the technical expertise gained Wong Kwongyu was also substantially involved in property development in China. His real estate business was consolidated into China Eagle (Pengrun) Real Estate Co., Ltd., parallel in structure to Gome and under a group holding company directly controlled by Wong himself. Media reports indicated that Wong saw real estate as complementary to retail in cash flows and a crucial long-term development area for his portfolio companies. The central government in China instituted new harsh penalties against smuggling in the mid-1990s. Historically, a large proportion of smuggled goods into China were foreign consumer products such as electronics and cosmetics. National Bureau of Statistics of China, China Statistical Yearbook 2006(Beijing: China Statistics Press, 2006). Gome, quoting data from th

e State Information Center. through joint ventures, rose to the challenge. After over ten years of brutalcompetition unseen in the history of consumer durables industry, Chinas household electronics market reached full saturation by the late 1990s. Quality improved substantially while prices plummeted, pushing down industry profitability across the board. Chinas home-grown giants, such as Haier, Changhong and TCL, had grown to control the mainstay of the market and even begun to export products overseas. In 2003, China produced 65.4 million television sets, 48.2 million air-conditioners and 22.4 million refrigerators, all ranked among the worlds top three. Gomes decision in 1997 to source directly from local companies reflected this seismic change in electronics manufacturing.

Competition:

Consumer electronics retail in China was an RMB 440 billion market in 2003. As many as 30,000 companies, including dedicated chains like Gome, traditional department stores and single-store operators, competed intensely in this vast market. In recent years, electronic retail chains had grown rapidly in size and importance. From 1998 to 2003, the proportion of the overall market sales accounted for by them increased from 5% to 30%.7 Gomes closest competitors were the chain operators who had already achieved national scales and distribution networks. If ranked by sales revenue in 2003, the top three chains were: Gome (Guo Mei, RMB 17.8 billion), China Paradise (Yong Le, RMB 8.8 billion) and Suning Appliance (RMB 8.5 billion). China Paradise was the leading player in Shanghai while Suning enjoyed advantages in Nanjing (its home base) and the surrounding areas in Jiangsu Province. Exhibit 1 gives more information on the top seven electronics retail chains in China. In addition to domestic competitors, Gome also faced the potential threat from global titans. Historically, retail had been one of the most protected industries in China. But the government made the commitment to fully opening the market to foreign competition by the end of 2004, as part of Chinas WTO ascension agreements signed in 2001. Already, foreign retailers such as Carrefour had built robust on-the-ground presence in China thanks to cleverly structured local partnerships designed to circumvent regulatory barriers. After 2004, many more overseas giants including Wal-Mart and Best Buy, the largest electronics retailer in the U.S. with a 13% market share in 2003, were expected to swarm in with high ambition and deep pockets.

Gome Went National

After a brief period of disruption, Gomes transition to local brands helped boost its profit margins and brought about more control in the procurement process. Within two years, Gome consolidated its presence in Beijing and appeared ready to go national. The Tianjin Boycott Mr. Wong picked Tianjin, a booming port city only 150 kilometers to the southeast of Beijing, as the first expansion target. In July 1999, Gome opened two stores in Tianjin and soon a nasty price war ensued. The citys ten entrenched department stores formed a united front and demanded that large electronics manufacturers stop supplying Gome immediately. In addition, they accused Gome of malicious price cutting and dumping. Before long, the local media took sides and published the department stores grievances in a series of high-profile articles. Paradoxically, the media exposure created free publicity for Gome and a backlash among local consumers, who came to appreciate Gome: Going Public Gomes lower prices and defected en masse. Mr. Li Juntao, Gomes General Manager for North China and another Shantou native, remembered vividly that when Gome opened two new outlets in Tianjin within the following year, throngs of eager shoppers, lured by opening day sales prices, formed long queues outside the stores during the wee hours. The boycott staged by the local retailers quickly faded and Gome gained market leadership in products ranging from air-conditioners to washing machines.

Expansion, Expansion, Expansion : With the victory in Tianjin secured, Gome drastically accelerated the pace of expansion. In December 1999, Gome entered Chinas largest electronics market Shanghai. In the following three years, Gome opened more than ten regional branches and scores of new retail stores in cities such as Chengdu, Chongqing, Zhengzhou, Xian, Shenyang and Jinan. In October 2002, Gome forayed into the affluent Guangdong market, hoping to establish a troika of strong presence in Chinas northern, eastern and southern regions. Backed by growing brand recognition and rich chain store operating experience, Gome built scale in Guangdong at a breakneck speed. New stores were being opened at a rate of one per month at the minimum, radiating strategically from the two anchor cities, Guangzhou and Shenzhen. In order to speed up expansion and relieve the pressure on cash flow, Gome also started setting up franchise stores. By the end of 2003, Gome controlled 139 retail stores throughout China (see Exhibit 2 for a map of Gomes major regional branches and outlets) and had sales revenue of RMB 17.8 billion for 2003 (see Exhibit 3 for Gomes historical performance). With a national market share of 4.1%, Gome had become Chinas largest household and consumer electronics chain store operator by a significant margin. Gomes national strength was broadly mirrored in all key regional markets except the Yangtze River Delta, where other scaled players competed effectively. In November 2003, Gome surprised the industry again with another pioneering move: opening a 25,000 square feet mega-store in Hong Kongs bustling Mong Kok District, the first ever by a Chinese mainland retailer.

Business Model :

Competitive pricing from high volume, customer service comes first. Gome Corporate Mission Statement Low cost and high volume represented the cornerstone of Gomes business model. Prices of similar products were typically 10-15% lower at Gomes stores than those at department stores. In 2002, Gome also instituted lowest price guarantees and offered to give shoppers their money back if they found lower prices elsewhere. Known widely in the industry as a price killer, Gome used pricing aggressively to build volume and expand scale. As a major electronics retailer, Gome had significant bargaining power over top manufacturers in China. To ensure competitive prices, Gome did not charge mark-ups over sourcing costs. In other words, the average gross margin of a typical sale was zero. Sometimes, Gome even allowed its regional affiliates to price below costs of good sold during targeted promotional campaigns. Instead, Gome made money in rebates from manufacturers, who agreed to send back a certain percentage of their total sales to Gome over a period of time. Since 1999, this rebate ratio for Gome had risen from 3-4% in 1999 to close to 10% in early 2004. Another pillar of Gomes competitive strategy was customer service. Dedicated call centers and

hotlines handled customer complaints and other product-related requests. For larger appliances, Gome promised free door-to-door delivery within an 80-kilometer radius. Gome also hired mysterious shoppers to regularly monitor the quality of customer service. These initiatives, only a small part of Gomes overall customer relationship-building program, were an indicator of Mr. Wongs personal belief in business integrity and constant innovation.Gome was meticulous in managing its chain of capital (zi jin lian). It invested heavily in IT infrastructural projects including a group-wide ERP system to improve inventory turnover and centralize distribution. In procurement, 60% of Gomes transactions with suppliers were carried out using bank acceptance drafts, which were supported by the issuing banks credit and usually cleared within three to six months by Gomes suppliers. There were only minimal transaction fees and no interest charges. In China, banks provided this service to their most important clients usually state-owned enterprises (SOEs) as a privilege. Private companies that had gone public were also preferred by banks in extending acceptance draftsand normal loans due to their better reputation and access to liquid capital. In 2003, Gomes trade and bills payable days stood at an impressive 106 days.

Going Public

From 1999 to 2003, Gome achieved an annual compounded growth rate of 90% in sales turnover and solidified its leadership position in Chinas electronics retail market. Moreover, margins were up as well. Chairman Wong Kwongyu had been considering making Gome a public company since 2002 but now he felt the opportunity warranted making a decision on this as soon as possible. He regarded going public as a cornerstone event that would sustain Gomes growth in the long-term. First, Gome needed cash to expand its retail network. Opening a new outlet from a core standard store at 4,000 square meters to a flagship store over 8,000 square meters required RMB 5 to 10 million in upfront costs including lease advances, store infrastructure and working capital. Being a public company could also help Gome maintain its financial flexibility, even if the near-term funding needs were limited. Second, going public could well be a competitive necessity for Gome. Suning Appliance had already filed for an IPO on the Shenzhen Stock Exchange and expected an approval soon. China Paradise was rumored to be seeking an overseas listing most likely on the Hong Kong Stock Exchange by the end of 2005. On the horizon, the government would allow direct market entry by foreign retailers after 2004. To survive the initial frontal assault and compete against the generally much better capitalized global players, Gome may have to go public and secure a platform for future financing. Third, as Chinas retail industry became more deregulated, Wong Kwongyu expected swift consolidation. Without market traded shares as M&A currencies, Gome would lose out on critical acquisition opportunities or worse, get swallowed up by a publicly traded competitor. Finally, going public would enhance Gomes prestige within the industry and among the general public, particularly if the listing occurred outside of China. Additionally, an IPO process could bring sophisticated, value-add overseas institutions to invest in Gome, thereby improving its shareholding structure, upgrading its corporate governance, and even infusing world-class retail industry operating best practices into Gome. Wong Kwongyu had thought about continuing torely on trade credits and bank loans for financing. But they may not be enough for Gomes next phase of development. Plus, both Gomes Gome Corporate Presentation, July 2004. Bank acceptance drafts were included under trade and bills payable on Gomes balance sheets. suppliers and banks valued public status highly. Another potential source of capital was private equity (PE), still in its infancy in China in 2004. Wong feared that Gome may not be in the right industry for PE and that investors in any case would push for an IPO within one or two years. Gome had several options in going public. Mr. Wong focused his thoughts on two critical

questions: where and how.

Listing Venue

Gome could list its shares either on a domestic exchange or in an overseas market. Domestic listing options included Shanghai and Shenzhen while overseas listing options included Hong Kong, NYSE and NASDAQ. Exhibit 4 compares key statistics of these five listing alternatives. Domestic Listing China had two stock markets: the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Both were established in the early 1990s and had since seen highly volatile trading through three major boom-and-bust cycles. In early 2004, Chinas domestic equity prices were still in a slump, compared to the most recent peak attained in 2001. Investor confidence was depressed and the market suffered from an overhang of non-tradable shares. These shares were owned primarily by the state and entitled the holders to corporate cash flows and voting power, but not trading rights in the secondary market. In 2003, non-tradable shares accounted for almost 70% of the total market capitalization. Chinese stock markets were in general closed off to investors from abroad and initial listings were put under strict reviews and quota-setting by the China Securities Regulatory Commission (CSRC), the main regulatory body for equity dealings in China. The CSRC had been green-lighting more private businesses for IPOs but SOEs were still the priority. Among the 1,223 Chinese companies listed in Shanghai or Shenzhen at the end of 2002, only 113 (9%) were private firms.

Hong Kong Listing Hong Kong was an attractive financial market for Chinas SOEs and private companies alike, due to its access to major global institutional investors, lack of government interferences, transparent regulatory requirements, and geographic and cultural proximity. In addition, accounting and disclosure rules were rigorous and compatible with global standards. Specifically for Gome, Hong Kong was far more open to private Chinese companies and had deeper capital markets than China, enabling listed firms to more easily raise follow-on financings. If Gome wanted to list in Hong Kong, it needed to choose between two different models: H shares or red chips. H-share companies were incorporated in China while red-chip companies were incorporated off-shore but had substantial business activities within China and controlling Chinese shareholders. Because red-chips were legally foreign firms, they were subject to fewer regulations by the Chinese government. As of December 31, 2003, there were 64 H-share and 72 red-chip stocks listed on Hong

Kong Stock Exchanges Main Board and an additional 28 H-share companies on the Growth

Enterprise Market (GEM).12

U.S. Listing

For listing in the U.S. (NYSE or NASDAQ), Gome would have to issue American

Depository Receipts (ADRs). ADRs carried ownership claims on a specified number of foreign securities and enabled the holders to become the de-facto owners of overseas securities without suffering high transaction costs and low liquidity typically associated with directly investing abroad. ADRs were hosted by brokerage houses in the U.S. and traded on U.S. domestic stock exchanges in dollars. Chinese companies listed in the U.S. were perceived to be the best-in-class and most well-run among their peers. Historically, listing in the U.S. through ADRs was popular with large Chinese

SOEs in traditional industries (mostly on NYSE) and high-tech firms (mostly on NASDAQ).

However, Gome had virtually no operations outside of China and no natural investor base in the U.S. Besides, a U.S. listing would involve greater costs and highly stringent post-IPO disclosure standards due to the Sarbanes-Oxley Act of 2002. Still, this option could be appealing as Gome and Wong Kwongyu himself would benefit from the positive media exposure following a high-profile IPO making Gome the first Chinese consumer goods company to be listed in the U.S. Wong Kwongyu knew that the choice of listing venue would also be influenced by two additional considerations. First, initial listing hurdles differed markedly across different exchanges (see Exhibit 5 for detailed requirements by market). Gome had to determine whether it would be eligible to go public according to these criteria. Second, the regulatory landscape for the industry could play a role as well. If there were uncertainties around the path to full retail market opening in late 2004, Gome might not be able to receive foreign investments even if it were to be listed overseas. In this scenario, the extent and mode of equity holdings in Gome by entities abroad would beintensely scrutinized by the Chinese government. It was clear to Wong that in the end, a decision would be made only after carefully weighing the pros and cons inherent in each option.

IPO or Else

In most cases, a private company went public through a well-structured IPO process, during which professional intermediaries such as investment banks, accountants and legal counsels helped the company meet onerous regulatory requirements and generate demand among potential investors. While procedural details may differ, the general contour of this process was remarkably consistent across most equity markets in the world. The advantages of a conventional IPO were self-evident but in Wong Kwongyus mind, its drawbacks to Gome were perhaps just as clear: the process could drag on past 2004 and market volatilities could significantly increase the execution risk. A possible alternative to an IPO would be a reverse takeover, also known as a backdoor listing, accomplished by a stock merger between a private and a public company leading to the private company taking a controlling position in the public company. After the transaction, the private company would be automatically transformed into a new publicly held company, under its own name and with a new board of directors. Typically, the original public company, referred to as a shell, was either operationally dormant or financially defunct. Its practical value lied in its status as a listed company. As such, it had to contribute a substantial majority of its shares in exchange for all the shares in the private company, rendering the latter effective control of the merged entity. The whole process was structurally akin to a normal merger and acquisition, but could be subject to much lighter government scrutiny and disclosure requirements if the shell company had already been reviewed by regulators when it initially went public. Reverse takeovers were relatively rare in the U.S.13 but more common for small- and medium-sized private Chinese companies, who faced long and unpredictable IPO screening at home and tight listing requirements abroad. By the end of 2003, 13A recent example of a reverse takeover in the U.S. was the New York Stock Exchange, a privately owned non-profit company, being acquired by Archipelago Holdings, a public company, to form the NYSE Group in 2006. The NYSE Group became a for-profit corporation and began trading publicly on its own stock exchange on March 8, 2006.

208-001 Gome: Going Public 8 31 Chinese companies had gone public in the U.S. via backdoor listings while 40 followed the IPO path.14 Backdoor listings on the two Chinese domestic stock markets were thought to be even more prevalent. Indeed, public company status, along wi

th all the advantages and privileges it conveyed,

was a much scarcer commodity in China.

If Gome chose to seek a backdoor listing, it woul

d not need to start from scratch. Known among

his peers as a capital market whiz, Wong Kwongyu had already managed to gain control of a Hong

Kong-listed shell company through a series of dazzling financial transactions: December 28, 2000 Capital Automation Holdings Limited (Capital Automation, 0493.HK),

a public company listed on the Hong Kong Stock Exchange, agreed to purchase three office properties in Beijing for HK$12 million (US$1.5 million

15) in cash from China Eagle Real Estate

Co., a private company controlled by Wong Kwongyu. Capital Automations principal business was in computer-aided design (CAD) systems and equipment sales but the company had been losing money since 1995. In conjunction with the real estate purchase, Capital Automation also issued 36 million new shares, representing 19.15% of the existing share base,

16 at HK$0.38/share to Wong. After the tr

ansaction, Wong owne

d 16.07% of Capital Automations total shares outstanding.

September 12, 2001 Capital Automation issued

44.3 million new shares, representing 19.78%

of the existing share base, at HK$0.18/share to other investors.

February 5, 2002 Shinning Crown, a British Virgin Islands (BVI)-incorporated company

wholly owned by Wong, purchased 1.35 bil

lion new shares of Capital Automation at

HK$0.10/share. After the transaction, Wong

controlled 85.65% of Capital Automations

outstanding shares.

April 26, 2002 Shinning Crown sold 180 million shares of Capital Automation at

HK$0.425/share to several institutional investors.

17

July 23, 2002 Capital Automation was re

named China Eagle Group Company Limited

(China Eagle). China Eagle took on Capital Automations old stock ticker (0493.HK). Now that Gome had a publicly listed shell (China Eagle), Wong Kwongyu needed to make two critical decisions. First of all, should he push through with the backdoor listing strategy or shift gears to go public via a traditional IPO? Structuring these elaborate deals had, over the past four years, consumed tremendous amounts of Wongs energy and ingenuity. But he was only half way through. Completing the second half of the process could demand even more attention from Wong and his senior team, all at a time when their undivided focus on key operating issues was imperative. It was a valid question to ask whether this unconventional path was really worth all the trouble. Second, if Wong decided to move ahead with a backdoor listing, he may have to engineer a restructuring of Gomes current assets. Gomes financial advisors proposed taking the following sequential steps:

1 US dollar = 7.8 HK dollars. According to Hong Kong Stock Exchanges regulations, any new stock issuance under 20% did not require trading suspension and general shareholders approval. The Hong Kong Stock Exchange defined 75% shareholding by any single entity as a trigger point, above which the entity was required to either: (1) make a tender offer for the remaining shares and de-list, or (2) reduce holding to less than 75%. Gome: Going Public Select a subset of the 139 retail outlets under Gome at the end of 2003. These outlets should enjoy higher profitability, greater market shares and less competition. They represented Gomes best retail assets and should be packaged into a holding company (Gome Listco) which would go public through a reverse takeover. Exhibit 6 contains the restructured historical financial statements for Gome Listco. 2.Wong Kwongyu himself should hold 35% of Gome Listco while the remaining 65% could be sold off to an off-shore private company controlled by Wong (BVI Co.), thereby qualifying Gome Listco as a joint-venture retailer in China. 183.Let China Eagle, the shell company, acquire the 65% Gome Listco stake from BVI Co., consummating the reverse takeover. As a result, Gome Listco would formally gain the listing status from China Eagle and become a publicly traded company on the Hong Kong Stock

Exchange (see Exhibit 7 for a summary of the proposed reverse takeover process and Exhibit 8 for information on relevant peer companies for Gome Listco). Mr. Wong liked this plan but he wondered if there were too many moving pieces here. For competitive reasons, he would like to have Gome listed through front door or back door by the end of 2004. Any delay would force him to play catch-up, financially and strategically, with major competitors within and outside China.

Conclusion

Throughout his career, Wong Kwongyu took great pride in being a maverick. His fateful decision to go to Beijing as a teenager to sell foreign electronic products on borrowed money foreshadowed

his legendary rise later. At several crossroads in Gomes corporate history, such as the choice to switch Gome to domestic brands, Wong opted to be the pioneer in his industry. So far, both his company and himself had been handsomely rewarded. Now, it was time again to decide. Wong was firmly convinced of the merits of taking Gome public as soon as possible. But he needed a coherent, well-considered plan to make it happen. Should he follow his usual instinct and go public through a highly innovative but potentially risky backdoor listing? Or should he leave the shell company already acquired alone and move on toward an IPO in either Hong Kong or the U.S.? Was a domestic IPO even an option for Gome? Finally, he had to understand better the implications of each listing choice for future financing and operating decisions. He remembered that one of Gomes company mottos, which he created years ago, read courage to be innovative, making progress together. But for such a pivotal decision as going public, was the less traveled path the way to go? 18 As of early 2004, Chinas Ministry of Commerce limited foreign stake in any retail joint-venture to 65%. Joint-ventures may be eligible for certain tax incentives provided by local governments in China.