Posted by: donmihaihai | April 5, 2009

Road closed?

Hi Hoegaandit, since I have not been writing much lately, I use this opportunity to lengthen my reply. Writing something that I have no or little knowledge, hopefully I can reduce the amount of traffics.
Convertible bond is bond bounded by contract terms first follow with equity kicker if share price of the company, Celestial in this case is higher than the conversion price. So, it must not be view as equity in bull market and bond in bear market but rather be view as that the company must fulfills their obligations on both bond and equity at all time.

Part 1. Problem on transferring funds out of China, or to Singapore in this case.

I don’t know where I can look for such information but my understanding, just like many out there is that while it is not easy, there is no “NOT ALLOW” regulation. And it has been widely published so let me quote Pfood 2009 annual report as an example.

“RMB is not freely convertible into foreign currencies. Under the PRC’s Foreign Exchange Control Regulations and Administration of Settlement and Sales and Payment of Foreign Exchange Regulations, the Group(Pfood) is permitted to exchange RMB for foreign currencies through banks that are authorised to conduct foreign exchange business.”

Next, rather than asking around or speculating, the followings should provide a sound standing that it can be done.

1) The easy one.

CB was borrowed(or raised) in 2006, Singapore dollar. The intention of any borrowing is for usage so it was being converted into RMB and transferred. All operations of Celestial are in PRC and it is straight forward that all or part of CB may not be exercised in the future. Which mean money for repayment in case of non conversion must be from Celestial operations in PRC unless further borrowing(or equity) must be done outside PRC. Borrowing(equity) is subjected to market condition in which there is risk itself of not able to do it but it will always be part of the equation.

So by saying that it cannot be done, we are saying that all parties involved — management(include board of directors), CB holders, investment bank(or banks) and shareholders are STUPID. They don’t know that fund cannot be transfer out of PRC. Put the issue of refinancing out of the picture 1st, end of the day, the ability of repaying is through cash generated from business. Everyone can be stupid by not knowing, but bank can’t especially when currencies restriction/conversion is the most basic for bankers

2) Regulation changed. If that is the case, it doesn’t need to wait until now for the fear to emerge.

3) Differences of regulations in different province and nature of the transfer.

I do not know anything about any regulations differences in different provinces so I leave it out.

Nature of transfer. I do not know the reason behind restricting the conversion of RMB into other currencies but it is likely to be the case of control. But if the restriction of conversion is the case of for what, then borrowing in RMB, convert and transfer out of PRC should be the least concern of regulator as compare to 1) dividends payment and capital return, 2) investment and businesses.

And the amount RMB 1.3 billion is “big” or “significant” only to the case of Celestial market capitalisation and the average market capitalisation of China stocks listed here but not in the case of Celestial Assets, shareholders equity, earnings, relative to all China stock listed overseas and bank size.

Part 2

Talking about bankruptcy, financial status of Celestial must be taken into consideration.

(RMB million)

Operating cashflow(last 5 years) — FY2004 : 90M, FY2005 : 230M, FY2006 : 274M, FY2007 : 450M, FY2008 : 540M.

Total and average operating cashflow — 1, 587M and 318M

Total repayment of CB – 1,300M(estimated)

Net cash/(debt) include CB — FY2004 : 118M, FY2005 : 211M, FY2006 : 320M, FY2007 : 333M, FY2008 : (414M)

Shareholders equity — FY2004 : 465M, FY2005 : 968M, FY2006 : 1,398M, FY2007 : 1,751M, FY2008 : 2,185M

5 years number show that 1st Celestial is healthy and generating good cashflow. At any point of time, Celestial can borrow 2 to 3 time more than CB. And since refinancing is for CB, Net debt to equity for FY2008 will remained at 0.2X and debt to equity at 0.6X

Next to the question buring question of refinancing. It is worthwhile to look into recent announcement by Celestial on the “Independent Auditor report FY2008” by PricewaterhouseCoopers. It highlighted few major points.

1) Emphasis of matter without qualifying opinion.

So other than CB issue, others are OK. This is significant because there is always a risk of fraud. While it is hard to fake the kind of cashflow Celestial is generating, but there is always a possibility of faking cashflow as long as cash is not flowing out of the company. That is the case for Celestial — mid size working capital, little debts and insignificant dividends payout. With huge amount of Capex, I always fear that Celestial is capitalising “nothingness” into assets. Since this Capex is part of the issue in “emphasis of matter” and material, at least that fear doesn’t emerge.

2) Redemption amount = RMB 1.3 billion. Cash and cash equivalents at 31/12/08 = RMB 812 million. Capital commitment : RMB 718 million.

3) Celestial is in discussion with several financial institutions for refinancing in case of early redemption and directors believed that the required refinancing will be in place if the early redemption of bond materialise.

It seem like no one(excluding auditor as they are not in the position to express an opinion on this) is believing board of directors which consist of executive, non executive and independent directors.

4) If refinancing does not materialise, operation may be ceased and assets may worth much less if it is sold not under normal situation.

With enough information, it is time to play different scenarios as at current situation, redemption is certain

1) Refinancing being done. Great, case closed.

2) No refinancing, not in PRC or outside PRC. A quick take over by someone appointed by CB holders to shut down everything sell assets in speed.

The worse for this scenario, liquidation of working capital and left over cash will get RMB453million(according to B/S at 31/12/08 at fullvalue) plus RMB70million of land right(according to AR2007), CB holder need another RMB777 million by selling the RMB2,249million of Fixed Assets. While RMB777million is just about 35% of Fixed Assets, in fire sale with no regards on anything, Fixed Assets that Celestial owned can worth little. It may worth even lesser as only RMB1,200 million of the total RMB2,249million are completed and being utilised, the rest belong to current expenditures.

It is highly uncertain how much CB holder will get back, but it may range from 35 cents on a dollar to full amount. So unless all CB holder bought their CB at much lower price, this is not a workable.

3) No refinancing/ late refinancing/ unable to transfer money out of PRC. CB holders take the fundamental of Celestial into consideration, even in the case of bankruptcy which should be the correct scenario rather than 2). Directors, shareholders, employees, state government and whatever parties come into the picture.

Here it will be like game theory. The fight between all players in the game and everyone can benefits even with no refinancing because of Celestial fundamental. But if CB holder want to get most of the benefits by itself, all other parties can play “do not cooperate”. With Celestial fundamental and the CB amount, the longer its drag, the more shareholders will get in return. At $0.1, Celestial is worth around $60 million. Another $0.1, investor will almost get 100% return and that is just $60 million or about RMB300million.

In this scenario, one must also take the possibility of CB holder taking over and become the equity holders(one of the outcome). And this is also a special case as Celestial unable to refinance and transfer money out of PRC BUT CAN PAY DIVIDENDS LIKE WHAT HAPPENED FOR THE LAST FEW YEARS — strange right.

CB at par worth about 4X Celestial average cashflow. 2X Celestial 2008 cashflow. 0.6X BV. But that is also 4X market capitalisation of Celestial. Celestial defaulted. CB holder should buy Celestial shares but that is only workable if all CB holders agree to whatever further plan for refinancing. And there is also a question of how much shares they can buy. But with CB, there are chances that they become the sole equity holders. Now, it looks even better if they are not paying a full price for CB — 50, 60 or 70 cents on the dollar.

Why CB holders want to become equity holder?  Let not goes back and start look at CB as equity in bull market and bond is bear market. CB by itselfs already has an equity component attached. So if A decided not to become, B may want to come in and buy CB from A.

Sorry to disappoint you, Hoegaandit that I didn’t put down all outcomes. But I believe putting them into 1), 2) and 3) is good enough.

 

 

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Responses

  1. Hi Donmihaihai

    Thank you for your thoughts. If your heading “Road Closed” implies you think any further time spent speculating (without full information) on outcomes may be counterproductive and not worthwhile, I understand.

    I agree with your basic premise that given the cashflow generating abilities of Celestial (albeit I am suspecting that sales and profits may be under quite severe pressure in the shorter term), it would pay for the bondholders, should there be a default, to keep the business operating. This sort of reasoning is important, because, it seems to me, one is dealing here with a situation where we have inadequate information. For instance, my understanding is that rights of convertible bond holders can vary from simply being a borrower secondary to other borrowers (and only superior to equity holders) (“weak CB holders”), to having the right to immediately wind the company up in the event of default (“strong CB holders”).

    Who as a practical matter is in the superior position – the bond holders or Celestial? As you indicate even in the event that the CB holders are strong CB holders, it will not pay them rationally to wind Celestial up. So by that token, the CB holders seem as a practical matter to be in a more vulnerable position. They are I think going to have to compromise, as did the bondholders with eg Promos. Will this affect the existing shareholders? Well, a deal could be agreed with management where the CB holders had substantially increased rights vis a vis the existing shareholders eg rights to significantly more shares at a much lower strike price. But why would Ming Dequan agree to this? Presumably in general his position as the major shareholder is not that different from us minor shareholders?

    I tend to think there is ground for very cautious optimism.

  2. Hoegaandit sounds just like MusicWhiz.
    Gutless to leave remarks as another nick.

  3. nicknick

    I only know one Hoegaandit and one MusicWhiz and I don’t care whether you have a problem with them or not. This is not a place for you to start the fire.

  4. Hoegaandit,

    I use “Road closed?” as I am wondering if Celestial has a future. If it is about other investor or speculator, it won’t be a nice one.

  5. Don’t worry I can assure that I always post as “musicwhiz” and do not have so much free time on my hands to create multiple nicknames to post under or to criticize. In addition, dealing with my own companies is already time-consuming enough without taking other people’s companies and also reveiwing and criticizing them, which some people seem to be fond of. I believe others have their reasons for investing in the companies they invest in, and I don’t question their analysis because of circle of competence. There is some stuff which I, as an investor, cannot understand well so I avoid it. If others can understand it, good for them. But it is NOT my tendency to question and demand answers from another with regards to their investments (which personally have no bearing to me as it is NOT my money).

    Perhaps the one thing I should point out is whether one has enough margin of safety to protect oneself if one is “wrong” about a company or if the company has cooked the books. For companies like Oriental Century and JEL which cooked the books, no amount of analysis can save you as a shareholder when the company implodes. If one thinks that they can detect subtle fraud or hidden items from analyzing the financials, then I have to say you have to be quite an expert or close to being a forensic auditor to be able to do that, as no one has access to the detailed accounting records of the Company unless you are in their accounting department !

    As investors, we take the financials at face value and we do our analysis based on the numbers given. It is OK to have doubts but just because you cannot explain something does not mean it is unexplainable. This is a general statement and is not meant to relate to other companies.

    Maybe one day I should just follow the “curt” style of talking about companies and people will somehow show “support” for it as it is no-nonsense, rather than the polite way of addressing issues. Apparently, people seem to see more sense in being curt than in being polite, for whatever reasons.

  6. Musicwhiz,

    If these are your intention when your tempers is boiling, this is not a place for your to start your fire too.

  7. deleted

  8. Deleted

    Enough. Don’t act like a kid.

  9. Deleted.

    Enough

  10. Hi Donmihaihai,

    I enjoy your analysis. I am a shareholder in Celestial as well and I feel that the convertible bond situation is over blown.

    With its current assets and cashflow, (verified by PWC) banks will be most willing to lend. There are news that China banks have been increasing lending last few months. And the transfer of funds out of China, while tricky is not impossible. MNCs who do business in China for eg. may need to buy materials overseas, they will definitely need to pay out of RMB.

    From how I see it why Celestial went into net liabilities despite the impending potential bond conversion is that they see a tremendous opportunity window to capture the milk market with their protein milk product. In business, one must strike quickly before the opportunity window closes.

    At the price now, the chance of a multi-bagger potential is much higher. Is this the road close or more highways for Celestial, I believe it is the latter.

  11. littlecupid,

    Thanks but I don’t consider that as analysis but rather what I think.

    To me net current liabilities or net current assets are just technical terms. And if Celestial really goes down with this CB, I don’t know how to invest anymore because the differences between financial weak and strong is no longer determine by fact but rather what banker feel like having for lunch.

    But lets not forget about the risks involved.

    Market capitalisation may has a role to play here as bank may not lend due to its current capitalisation.

    There are many ways to gain return other than trading and investing. At current valuation and situation, may invite lot of different kind of players trying to get their hands on it.. shareholders like us may not in a good position to defend..

    Lastly must always beware of the management and possible including independent directors. While I haven’t received Annual reports, I saw their “Notice for AGM” at BT last week with resolutions that must be voted down. Celestial has a history of issuing share or option cheaply. And there is no resolution for share buy back. At the current price, share buy back is the best use of capital.


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