China unpegs yuan; HQ Sustainable unpegs health products

June 29, 2010

No doubt all of you have noticed that China has recently unpegged their currency to the US dollar, preferring to key it instead to a basket of foreign currencies. Of course, having a fully floating yuan is pegging it to a basket of foreign currencies; it’s just that the peg is to every currency in the world at whatever weight the international market allows. At any rate, this has caused the yuan to become slightly stronger, although the Chinese government is still in control of all currency exchanges and is keeping volatility clamped down, but it is a positive development for those of us who like domestically-focused Chinese stocks, as the same amount of yuan now translates to more dollars.

China has said all along that they will not be bullied by complaining foreigners, and that if they unpegged their currency it would be to serve their own interests. And this unpegging may indeed have nothing to do with Western agitation and everything to do with China’s needs. We are told that the Chinese economy is expanding and some policymakers are becoming more domestically focused, and this means that China needs concrete, steel, copper, coal, petroleum, and all manner of things, which will be consumed internally rather than be worked up and re-exported. These things are, of course, much cheaper to buy with a strong currency than a weak one. Unfortunately, since the dollar and other currencies become weaker as the yuan becomes stronger, we in the US may find them to cost more, although our own exports will become more competitive as well. In any case, those of us who own companies that have cash flows in yuan should make out very well.

Speaking of which, HQ Sustainable announced Friday that they intend to spin off their marine health and bio-products line, representing about 1/4 of the firm’s total sales but more than half of its gross profits, into a separate company, although the board claims that it will retain 65% ownership. This segment has been the recipient of the bulk of the firm’s marketing expenditures, and much of the firm’s allocations to bad debt reserves has gone to the fish farm business last quarter, although the health products division received most of the reserve increases last year. It has not escaped my notice that many domestic Chinese firms have high and increasing receivables, so it is reasonable that bad debt reserve allocations will be higher than historical levels. I’m not sure if receivables reserve against chargeoffs can be viewed as nonrecurring; on the one hand a weak global economy will mean that chargeoffs are higher than they would be on a normal footing, but with higher levels of receivables come higher levels of reserves naturally, so I’m not convinced that these chargeoffs are nonrecurring enough to be ignored.

As I stated in my last article, the market tends to punish conglomerates of unrelated businesses, on the grounds that diversification for its own sake is generally practiced on the portfolio level and it is superfluous to practice it within a company. The market reacted positively to this spinoff, and the stock went up 10% on Friday, although it gave that back up entirely on Monday. I do like spinoffs, although with the company theoretically giving up 35% of an entirely domestically-focused business the cash flows in yuan may be going to another party. Furthermore, since I view the entire company as dramatically undervalued I worry that the spinoff will result in the firm giving away the new shares too cheaply, thus paradoxically destroying value in a move intended to enhance value. However, if the sales go well, the firm will receive the premium associated with the spinoff and retain control and a large interest in an entity that has its premium unlocked, and 35% of that premium will be in cash.

On balance, then, I think that both China’s liberalization of the yuan and the HQS spinoff  are positive developments for the strategy proposed on this blog.

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