Tech Market WatchBy Perry Wu
An observer of American politics once said that the scandal is in what is legal, not in what is illegal. The same can be said for the U.S. investment banking business and its dealings with publicly-listed Chinese technology companies.

At Internet cafes, at homes, at offices, and at schools across China every day, millions of Chinese–mostly male–spend countless hours absorbed in Internet games. Many of these games are free to play and many others are networked versions of counterfeit "daoban" versions, which are basically free too. But some really good ones cost money and require prepaid cards to play the online networked versions (i.e. the cards enable a player to play alongside dozens or thousands of other netizens).

The self-proclaimed largest Chinese seller of online games is Shanda, a company well-known among these game players. Shanda has been doing a brisk business selling these prepaid cards, as the company currently distributes China's most popular Chinese-made (as opposed to more popular American or Japanese-made) network game, "Legend of Mir".

In the last couple of weeks, Shanda filed a preliminary prospectus with the U.S. SEC with the intention to do an IPO. The Goldman Sachs-led issue intends to raise upwards of US$300 million, valuing the company at a jaw-dropping US$1.2 billion.

The company is a compelling story to investors because Shanda's basic business is to spend the money to develop or license a game. If it becomes as popular as its "Legend" game has become, the marginal cost of adding additional players is next to nil. Printing up new prepaid cards is like printing money. And with the recent release of Shanda's financial statements printed in its preliminary prospectus, there is now concrete evidence that Shanda is indeed making a mint off its games.

Shanda's games might be virtual but its profits are anything but: Shanda's cash from operations were about US$33 million for the year ended 2003. With net income of also about US$33 million on net revenues of US$72 million, its profit margin was a ridiculously high 45%.

So with the ability to generate so much cash at a high rate, you might think that Shanda would be worth something, but is it really worth US$1.2 billion? With 2003 net income of around US$30 million, that sets Shanda's price-earnings multiple at around 40. A p/e ratio that high is indeed appropriate for a fast-growing company.

The key is that there has to be some high probability that Shanda will continue to grow in the future as much as it has done in the past. For that you need a track record. In this regard, Shanda is a failure. Its entire growth and success thus far is based on one very popular game, "Legend of Mir". There is no reason to expect that this game will continue to be as popular in the future. When its popularity wanes, how does an investor know that the company will come up with something equal or better? There is simply no basis. Only a few multinational game companies like Infogrames have the broad base to hiccup a few gaming failures.

China's finicky gamers will sooner or later move on to another game–games lasting longer than a year are few indeed. With Shanda's short operating history (the company only started in December 1999), it has yet to prove it can continually innovate year after year to produce what its customers want. Check the shelves of software stores and there will be at least 20 unknown games for every game that sounds familiar. Making a hit game, it seems, is harder than making a decent feature film.

Additionally, Shanda's major legal problem thus far is its popular "Legend of Mir" game was actually developed by a South Korean games company and licensed to Shanda. Probably because of the game's overwhelming success, Shanda and this Korean company have been in a prolonged arbitration dispute over licensing issues. Fortunately, this is probably why Shanda wised up and developed its latest game, "World of Legend", in-house.

But the most troubling part about this company is what it did just a couple of months ago as it was preparing its IPO with Goldman Sachs. On March 5, 2004, Shanda declared a special cash dividend of US$23.2 million, which represented all of its distributable profits at the end of 2003. Basically, the chairman of Shanda, Mr. Tianqiao Chen, and his cohorts (including the Softbank Corporation) are going to pocket all the distributable profits that Shanda has earned thus far, and then sell the company to the public!

Now, paying this dividend is completely legal but just think about what this action says. The whole point of an IPO is that a company presumably needs to raise cash to develop its business. If the company is declaring a large dividend to its owners right before it goes public, then it seems the company never needed cash in the first place.

Have any of the journalists who fawn over Shanda and cover Asian business figured this out yet? Who's blowing the whistle on this charade and why can't journalists these days be schooled in basic business fundamentals? It seems they are more intent on uncovering Chinese worker exploitation than exploitation of investors. But let's get off the soapbox and return to the harsh reality:

With such high profit margins and profitability, you would think that Mr. Chen et al would want to keep their money in the company rather than take it out. Surely with such a successful, high-growth business, Mr. Chen can earn a higher return on his money by keeping it in the company, no?

If Mr. Chen wanted to cash out of his investment, then this is fine. He could have just sold the whole company to a willing buyer. So why didn't he? Well, it's obvious that in the still-current hysteria over Chinese stocks, he knows he can get a higher price if he sells the company's stock to gullible investors through an IPO, rather than sell the company to a private investor. China's hot right now–even Morgan Stanley's Mary Meeker seems high on Mono Sodium Glutamate in her newly published look at Chinese tech companies–and Shanda wants to rape and pillage the market while it can.

The other truth is that Mr. Chen knows better than everyone that Shanda is probably little more than a one-trick pony. One or two popular games should not give a reasonable investor confidence that Shanda can keep it up, far in to the future. From that point of view, Mr. Chen is simply acting rationally for his own benefit.

So this outrageous dividend is a most blatant example of how differently company executives act when it is "other people's money," and Shanda has not even gone public yet. If Mr. Chen is not willing to keep his own money in the company, why should an investor?

Goldman Sachs, that pillar of Wall Street, is acting completely legal by deciding on a ridiculous US$1.2 billion valuation for Shanda, and by allowing Mr. Chen and his friends to deplete the company's cash accounts right before going public. But investors should ignore what is legally correct, and ask themselves what makes sense.

As Warren Buffet has said, Wall Street has never been a place where quality control is practiced. That will always be the job of common-sense investors.

About the author:
Perry Wu is a writer and correspondent for ChinaTechNews.com and can be reached here at the site. Perry Wu does not hold any positions, long or short, on any of the Chinese or American company securities mentioned in this article.

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