Due Diligence: Finding The Right Manufacturer In China
1. Do a site visit and look out for possible problemsWhether you are looking for an investment opportunity or a business partner, you can’t go wrong by starting with a site visit and talking to personnel from different departments to understand the business and to look for abnormalities. During site tours, key issues are often identified and could become deal breakers. Look out for idle or outdated machinery and equipment that may require repair or replacement; this may indicate required spending in the future to maintain technology competitiveness or to increase production capacity - all of which may impact ROE. Similarly, aged or damaged inventory that should be written off and the condition of the plant and building are all potential red flags that can be picked up.
2. Do not underestimate environmental issues Technology manufacturing companies often need to dispose of materials that could be harmful to the environment during the manufacturing process. Investors need to be cautious as the company could be heavily fined by the authorities. This may require significant future capital expenditure on waste treatment facilities; the company may be forced to shut down until the issue is properly addressed.
3. Take note of inventory provisions From a financial perspective, a typical area of concern for investors in the technology manufacturing sector in China is inventory provision. Although we have seen improvements over the past decade, we still encounter companies that do not have proper inventory management policies to identify obsolete or long aged inventory. Hence, understating the inventory provision continues to be a focus area.
For example, some companies only require the accounting and finance department to estimate inventory provision but the production personnel, who is in the best position to assess the usability of inventory, is not involved in the process. Alternatively, the accounting policies applied may not have been recently updated, despite rapid changes in the business and industry. In addition, some companies keep their inventory at offsite warehouses or have consignment inventory at distributors – neither are regularly monitored.
It is not uncommon to see that many companies do not have formal policies to assess the condition and salability of their products on a regular basis. As a consequence, those products are no longer saleable (particularly those high-technology products that easily become outdated or prone to damage) and cannot be identified in a timely manner.
4. Warranty provisions could be complicated Technology or electronic products often come with a warranty period. Many manufacturing companies in China do not have the experience or sophistication to properly estimate the warranty provision at year end. The exercise could be time consuming and challenging, depending on the product range, warranty period and historical records of faulty products, such as the frequency of returns and average repair costs. Potential investors of such manufacturing companies should spend time to understand how the warranty provision is being calculated to assess its adequacy as of the closing date. Liabilities related to warranty provision are often considered and addressed in the sales and purchase agreement.
5. Do not forget the labor force. While technology-focused manufacturing companies are generally not as labor intensive as traditional manufacturing companies in China, the labor force still remains a crucial part of operations. All companies need to comply with the local regulations and contribute social insurance and housing fund at rates that may vary from one city to another. Under-contribution is a common issue. The labor cost base may increase considerably if fully compliant with the regulations. It is best to seek professional advice on the adequacy of social insurance provision as the advisors will need to check with the local authorities on the applicable contribution rates for the various social benefits. In addition, other areas such as severance payments (if there are plans to close part of the business) and underage labor are also areas of concern, especially with foreign investors.
6. Understand the working capital requirements of the company Similar to overseas-based manufacturing companies, those in China may have a relatively high working capital requirement, especially if capital is tied up in inventory, prepayments for inventory and materials, and long outstanding receivables (especially with domestic customers). It is not surprising to find companies with a cash conversion cycle exceeding 100 days. As part of the efforts to understand the business, investors should spend time to understand the real working capital requirement of the company, possible improvement measures, and consider whether further working capital finance might be needed post completion.
As with doing transactions in western countries, investing in Chinese companies in the technology manufacturing sector (or any sectors) requires a skeptical mind, patience and knowledge of the company and the environment in which it operates. Investors should conduct sufficient due diligence and not be afraid to walk out of a bad deal.
About the Author Bernard Poon is the Transaction Advisory Services Leader at Ernst & Young. EY recently released the 16th edition of Global Capital Confidence Barometer in April, which gauges corporate confidence in the economic outlook and identifies boardroom trends and practices in the way companies manage their Capital Agenda.
* The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.