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A CFO bridges the gap between U.S. investors and a Chinese manufacturer in a key environmental business.
David M. Katz, CFO.com | US
March 3, 2009
As the CFO of China Wind Systems, a small U.S.-based company that makes forged rolled rings - an essential part of wind turbine gearboxes - for companies in China, Leo Wang is well acquainted with two of the biggest potential growth engines in the currently growth-challenged world.
On one hand, there's China, which is increasingly viewed as the motherlode of future global consumer demand. On the other, the company's a key player in the supply chain for the production of a source of clean, renewable energy - and on the list of currently used catch-phrases in conversations about the environment, "clean renewable energy" surely ranks high.
At the same time, Wang, a native of China with an MBA from MIT and a PhD in economics from the University of Oslo, bridges two worlds. Working for a company that raises capital exclusively in the United States but manufactures its product and distributes it only in China, he must communicate the ways of U.S. investors to his boss in China, while conveying the conservative financial outlook of a Chinese operation to markets here.
Formed in 2007 through a reverse merger, China Wind Systems used private placement funds to join with a U.S.-listed, Delaware-registered company with little in the way of operations called Malex. The ring manufacturer spawned $39 million in revenue in the 12 months between the third quarter of 2007 and the third quarter of 2008. (The company plans to report on the fourth quarter of 2008 and the entire year in early April).
The company has just completed what it calls its "phase one expansion." The $15 million project - about half of which was funded in two rounds of private- investment financing -allows China Wind to shed its outsourcers and become a full-fledged, in-house maker of forged rolled rings and other components. The rings, about 9 feet across, are a key component of the gearbox, which enables wind to power the turbine's generator. (Phase two, involving the manufacturing of other gearboxes and other parts, is expected to take two years.)
Wang was the company's senior vice president of finance from August to December 2008, when he became CFO. In February, just a few days after China Wind Systems begun producing forged products at its new facility in Wuxi City, he sat down with a group of CFO editors to discuss the challenges of spanning two worlds of finance. An edited version of the conversation follows.
Do you think the investors in the United States get more excited about opportunities in China than Chinese investors get about investing in their own country?
It may well be. Investors in China and U.S. investors may have different perspectives about investing in a Chinese company. For the Chinese it's a domestic company. It may not be as sexy. And more importantly, they may not fully appreciate the growth potential in the company because they look around - plenty of Chinese companies abound. But U.S. investors look to China. Here [in the U.S.], the market is very mature. Especially in the current market condition, opportunities are not very many and they're not very good. Whereas, if you look at China, the growth potential is much higher compared to here.
How has your capital raising in the United States been going?
It went pretty well, I would say. Simultaneously with the reverse-merger transaction, a U.S. private equity investment firm put in the bulk of $5.5 million, aligned with a couple of small investors. It allowed us to [fund] the company's phase-one expansion.
Now, we did do another round of fundraising in the past quarter - and then we certainly could feel some of the impact of the credit crunch. The company was doing very well. But investors who previously were very enthusiastic about investing in the company were a little bit scared by the overall market conditions here in this country. So they became a bit more hesitant. But we still managed to raise $2.1 million from U.S. based private investors to complete the phase-one expansion.
What was your goal in performing the phase-one expansion?
The goal of the phase one expansion was to allow us to produce forged rolled rings in-house. Until then we had been outsourcing a part of our production processes to other companies. But with the completion of the phase-one expansion we were able to do all production in-house.
You must hold some pretty important patents.
We don't. The manufacturing of forged rolled rings is actually not as complicated as gearboxes. Typically a gearbox is where you will have patents and your own designs. Our product is essentially a ring which is manufactured from a piece of steel. So the whole production process involves putting the steel through a heating process. You heat it up, and then you can, with the use of a ring roller, roll it larger and larger into a ring. With, of course, precision. Because we're talking about parts that are eventually going to go into a gearbox.
If you don't have a patent, what protection do you have against competition?
Well, there are a couple of things we think will allow us to compete against other companies. One is that we have experience and the skill sets in industrial equipment manufacturing deriving from our previous business. Through that we have acquired more expertise that can be easily transferred to our current production process. So we'll be more proficient at doing this and more experienced.
We have been able to use part of that expertise to design — in-house — a key piece of equipment through our phase-one expansion. It's a ring roller. This is a key part of the production process. So in case you have a breakdown of equipment, because we have the expertise in house, we can get the repair maintenance done immediately, minimizing production staff and revenue loss. Not every manufacturer can do that.Did you choose to stop outsourcing and bring your manufacturing in-house because it gave you operating flexibility?
Yes, and it also shows on the bottom line, because the growth margin will then immediately go from 22 percent with outsourcing to about 28 percent initially when we bring everything in house. And then when we finish our production ramp-up and everything is fine-tuned and is going smoothly we expect our gross margin to rise to 34 percent.
What metrics do just you check every day?
We have to keep a close eye on the company's cash flow. Steel prices, certainly, because that has an impact on our cost, and ultimately our bottom line. It also has an impact on how demand from customers will be affected. But now we also increasingly watch how the global financial markets evolve on a day-to-day basis because that has implications for how investors react. We've noticed very clearly that it's not enough for a company just to do well by itself for everything to go smoothly.
In our case, the business was doing well, but because of the market turmoil we had trouble with our second round of fundraising because investors just were scared. They were scared and that sometimes defies any rational reasoning.
There may be no rationale. They look at the fundamentals of the company and everything is fine. They may have been very enthusiastic about this deal a few months ago when the market was OK. But now, with everyone hiding away, they start to hesitate. And that's without regard to the fundamentals.
And I think we are not alone. That's what often characterizes a recession, a downturn. It's more psychological than economic. here is a hurt mentality in the market out there. Typically investors move in crowds. And when the market is bad everyone goes away, and then when the market recovers everyone rushes back. And I think we've noticed that a lot, especially in the last few months, related to our own business.
What have you learned from the crisis and how has it changed your strategy going forward?
We've started to be very careful with our cash-flow management. We learned that when the market shies away, it's very important that you have plenty of cash to sustain your operations, to pay all the bills, and that in a market downturn, typically there will be good opportunities if you look carefully. And then cash wins. So that is one of the key lessons we learned, early on: Be very careful with cash management in good times, but even more so in bad times.
So how's your cash position? Are you satisfied with it?
This company has over the years had a pretty healthy cash-flow situation. [The company's net operating cash flow to about $5 million for the nine months ended September 30, 2008, to about $6 million for the nine months ended September 30, 2007.] It's been pretty profitable, and we have been able to plow back the cash generated from operations to fund our phase-one expansion. I mean the $5.5 million dollars initial investment from investors was not everything we put into the phase one expansion. We plowed in a lot of our own cash, and we fully intend on doing the same thing going forward. With the phase one-expansion completed and with the wind business doing OK given the current climate in China, we expect that we will be able to continue to generate a healthy cash flow.
What's the outlook for the wind farm business in China? You don't usually think of that kind of a green industry in China — or do you?
Well, increasingly we do. It may be surprising, but with the rapid economic growth over the last decade, energy demand has increasingly become an important issue in China, and the government has realized that. Obviously, we cannot rely on the import of oil forever. Concerning the fossil fuel supply, the resources are limited. And it's not renewable. So once it's gone, it's gone.
So in order to sustain our pace of growth to meet the demand for energy we will have to go and look for other alternatives. That's the thinking behind the push into renewable energy by the Chinese government. There was a renewable energy bill enacted in 2005, and the push into renewable energy has been really serious. To give you an example, installed wind capacity has been growing at an average of 46 percent per year over the last 10 years. And that pace has actually accelerated over the last few years. In 2008, it doubled, so that means the growth was 100 percent. And this year it's expected to double again.
Where does China Wind Systems fit into the wind turbine supply chain.
If you look at the industry value chain we are upstream. We produce the forged rolled rings, the gear rings, the shafts, and flanges. Next come the gearbox manufacturers: they take our rings and shafts and gear rings and put them into their gearboxes. And then they turn around and sell the gearbox to a turbine manufacturer, which buys the gearbox and other components and puts them all together in a turbine. And then they sell the turbine, the finished turbine, to a wind farm developer or a utility. And then [the developer or utility] puts up the towers, puts up the turbines and start generating electricity.
How do you view President Obama's stimulus package and his ideas about expanding alternative energy and green projects in the United States? How does that affect you?
Well, to the extent that the stimulus package and the renewable energy initiatives encourage imports, it may have an effect on demand for our products, indirectly, through the turbine-industry value chain. But my personal experience is that each country tries to promote its own domestic growth of renewable energy. Many states here typically try to promote the development of that business within the state or the federal government tries to promote it within the country at the federal level.
Because of that I'm not very optimistic about an immediate impact. But hopefully over time, if [U.S. companies] realize that for the same wind turbine you can get cheaper components from elsewhere as compared to domestic manufactured components, maybe that will spill over.
Have you had to do much bank borrowing?
We haven't had any long-term bank borrowing, so we don't have any long- term debt on the company's books. People always ask about that. But we do have some short-term borrowing to pay for raw materials, basically working capital.
Why not long-term debt?
If you look at most Chinese companies listed here in the States — and it's astounding to someone from here — a company may be doing very well, but more often than not there's no long-term borrowing on the company's books. One guess [as to why that is so] is probably the Chinese mentality. When I was little, I was told borrowing was bad and that you should always have savings to cover your expenses. And if you look at the Chinese economy, for decades it has been around [a] 40 percent [savings rate]. In the United States, the savings rate increased a little bit, but I think it's still 1 to 2 percent. That's after an improvement, right. So I think it has something to do with the mentality — a habit, you know.
What has been your biggest leadership challenge as CFO?
I guess the biggest one has been to really bridge the gap between two business cultures. Being based here, I deal with U.S.-based investors as well as accountants, lawyers, and the market in general. There is a different way of doing business here, very different from the way business is done in China. And I'm sort of in the middle. I deal with both sides. It's probably a bit more challenging communicating the cultural differences in the United States to the China side. But it has also been challenging conveying the Chinese way of doing business to the U.S. investors.
For example, you ask about borrowing. U.S. investors kept asking me the same question over and over again: Why isn't the company taking on more borrowing? And why can't you as the CFO tell the CEO that it would make more sense for him to take on more borrowing? People think you can just tell a CEO to do that and he will listen. But that's just not the way a Chinese company is run. The CEO is the single largest shareholder in the company. Before it was listed here, this company was run as a family business. This again, is typical of Chinese companies. Most of them are family owned businesses or started out that way, at least.
So it's a very subtle balancing act for someone like me to try to address the issues and concerns from both sides and still make sure that the really important things get done at the end of the day. And that has been the most challenging aspect of this role.