We have been adamant that in order for the ChinaHybrid space to flourish, companies need to abandon silly capital raises at asinine P/E multiples. Instead, during 2010 and into 2011 many ChinaHybrids have scurried to the deal flow ticket window to take a ride on the dilution train that left the station in 2009 – even companies like Telestone Technologies (NASDAQ:TSTC) and Zst Digital Networks(NASDAQ:ZSTN) that had clearly hinted they wouldn’t.
Let’ take a look at TSTC commentary issued before the company’s secondary offering:
On October 4, 2010 Telestone Technologies Corporation announced that it has secured a 300 million RMB ($44 million USD) line of credit from Bank of Beijing.
The new bank line for approximately $44 millionwas entered into on September 27, 2010, which has a five-year term. Telestone is under no obligation to utilize any part or all of the credit line.
“We are pleased Bank of Beijing is providing the Company with a sizable line of credit,” stated CEO and Chairman Mr. Daqing Han. “Obtaining funding from an established lender further validates Telestone’s strong operating model and attractive growth outlook. We believe this credit line will provide invaluable support for our continuing business expansion and meet our working capital needs over the next several years. With additional financial flexibility from this line and a backlog of $106 million, we remain confident we will achieve our $129.4 million revenue target for the full year 2010.”
Statement from 2010 third quarter 10Q clearly indicates that an equity raise was not on the table:
We believe that the combination of present capital resources and unused financing sources are more than adequate to meet cash requirements for 2010 and the following years. We intend to meet our liquidity requirements, including capital expenditures related to market expansion, research and development for new products and technology, through cash flow provided by operations and additional funds raised by short-term loans. We are an enterprise with good credit and our relationships with these banks are in good standing. We believe that adequate cash flow will be available to fund our operations and additional needs in the future
Now here is commentary from a conference call explaining why they chose to complete an equity raise about two months later:
As many of you are aware, on November 24, we completed a secondary offering of 1.675 million shares, raising approximately $18.9 in net proceeds for the company. There is also a 15% over-allotment that is valid for 30 days. I would like to state clearly that the purpose of the secondary offering was to raise capital primarily for a facilities expansion, which should greatly improve our future margins, rather than to enhance our balance sheet.
Call me ignorant, but I am pretty sure most would agree that a facility expansion falls into a category of TSTC’s outlined liquidity requirements. I guess the company meant it literally when it said “ it was under no obligation to utilize any part or all of the credit line.”It will be interesting to see if TSTC has utilized any of its bank line of credit. A lesson to be learned here is that we need to take China RTO commentary like TSTC’s with a grain of salt, especially when S-3 filings are present.
I get the sense that many Chinese RTO’s want to attempt to raise funds before the completion of year end audits, private due diligence investigations and SEC probe activities that could potentially expose less than savory company behavior. Shengda (NASDAQ:SDTH) is a case in point. On December 9, 2010 the company announced a convertible note offering, despite the fact that it allegedly has $120 million in the bank. Well just yesterday, the company issued a press release announcing that it had appointed a special committee of the Board of Directors to investigate potentially serious discrepancies and unexplained issues relating to the Company and its subsidiaries’ financial records identified by the Company’s auditors. The stock is halted. China Integrated Energy (NASDAQ:CBEH) tapped the equity market as it headed into 2011, despite a “healthy” cash balance. Sinohub (NYSE AMEX:SIHI) just jumped on the dilution train this morning. The SEC needs to define a new set of rules that govern the Chinese RTO capital raise process.
TSTC is not the only case of a company racing to the deal flow window despite having what appeared to be contradictory intentions
Despite a healthy cash balance Skypeople Fruit Juice (NASDAQ:SPU) completed an offering in late 2010 after promoting strong insinuations that a near-term equity raise was not in the cards. Zst Digital Networks (NASDAQ:ZSTN) caught investors by surprise when it filed an S-3 in early January. But we consider the private placement of Kingold Jewelery (NASDAQ:KGJI) on January 13, 2011 as one of the most egregious Chinese RTO capital raises in recent history, one so disturbing that it forced a member of the Board of Directors to resign:
On January 28, 2011. Dr. Orza resigned from the Board due to a disagreement over Kingold’s equity offering which he did not support at the $3.19 per share offering price. He felt that Kingold was undervalued at such price. Kingold’s previously announced US$22.9 million equity offering closed on January 13, 2011.
I published an article on December 2, 2010 that went largely unnoticed, highlighting our findings that KGJI’s attempt to IPO in China was rejected. We found articles where the Chinese media had speculated that the reason for this rejection was partly due to misleading financial disclosures. It is assumed that some of this would have been disclosed in the company’s risk disclosure sections of its filings, including an open S-3. I believe that potential investors in the private placement would liked to have known? The stock was $8.87 at the time of that article. Like clockwork, the stock eventually free falled close to the private placement offering price of $3.19, supporting a P/E in parity with where most ChineseHybrids climb aboard the dilution train. Now that is what I call efficient…and in my opinion a show of extreme desperation supported further by due diligence we recently completed.
When it comes to raising money, RTO’s just do it differently than Quality U.S or Chinese ADRs that follow the finance 101 rule of thumb – buy back stock when it’s undervalued and offer stock when it is overvalued. Even U.S. companies that exit Chapter 11 perform offerings at better multiples.
The reasons that many RTO firms give to raise money include:
“We need to carve out a position in our markets before our competition does” or “we need a cash buffer as we draw down our current balance through expansion.”
While true to an extent, you will be hard-pressed to convince me that companies with the enviable cash balances can’t find more efficient ways to reward their shareholders. With $36.4 million in cash, China Electric Motor (NASDAQ:CELM) may soon fall into this category. Analysts project 2011 EPS to grow 41% to $1.07 . While CELM has not recently raised money, ask yourself why it recently filed an S-3. CELM is an FIE and its SAIC filings do not match SEC filings. We had actually embarrassingly coded this stock as a GeoBargain not too long ago.
I thought about this topic long and hard and came to a conclusion. There is something fundamentally wrong with a company sporting a healthy cash balance that can not execute a growth strategy without constantly tapping the equity market, especially when current estimates show EPS growing over 30%.
Frankly, I believe it is some combination of the three motivations.
- Chinese Philosophy where the company’s goals take significant precedence over shareholder objectives.
- Management is not comfortable risking company capital due to an uncertain view of its market environment or a weakened financial position it may not be disclosing.
- Fraudulent motives, where small companies lie about their size to raise capital to help a dream come true.
What percentage of motivations takes precedence has yet to be determined, but I do believe that there are more companies than investors like to admit that are living in a field of dreams: Real companies, just smaller than claimed, with their eye on the American dream and believe with a little help from generous foreign investors they can become giants. We call it fraud. They call it a means to an end.
Nevertheless, I still am hanging on to the belief that a portion of the Chinese RTO space can emerge stronger than ever, aided by the ongoing cleansing process. Many firms where SAIC filings do not match may be the result of tax avoidance schemes as opposed to outright fraud. Supported by strong on the ground DD, I believe the stage could be set for a significant rally in select ChinaHybrids that complete 2010 audits using top auditors, have internal controls in check and are forecast to grow 2011 EPS at least 30%. I am just not sure how many will qualify.
Furthermore, deeper due diligence performed by investors will provide an additional vetting out process, ultimately leading to the attainment of higher P/Es. I am aggressively searching for companies that can pass our more stringent quality litmus test. The GeoTeam is pulling filings and performing on-the-ground DD with the hopes to identify inefficiently priced stocks before the masses do. Gladly, we are beginning to find some.
Disclosure: Short CELM, ZSTN, CBEH. no positions in other stocks mentioned at time of article.