CHINA HOLDINGS ACQ CORP HOL
November 13, 2009 - 2:41pm EST by
elehunter
2009 2010
Price: 9.57 EPS $1.32 $1.50
Shares Out. (in M): 20 P/E 7.3x 6.4x
Market Cap (in $M): 187 P/FCF NM 37.3x
Net Debt (in $M): -48 EBIT 32 38
TEV ($): 139 TEV/EBIT 4.3x 3.7x

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Description

Background:
After experiencing one of the biggest bull runs in history, I am surely not alone in my pursuit of investments with well defined catalysts and low correlations with the market. Over the past several months, there have been a number of China-related SPAC acquisitions which have offered such an appeal: deep value-oriented special situations with well defined catalysts (the deals themselves) that at least in theory have low market correlation. The most successful of these deals have had a common thread: solid growth potential and very compelling valuations. These small cap stocks have no Wall Street research coverage and typically undergo a process of investor turnover (from the original SPAC arb hedge funds to fundamental investors) - conditions which create fertile opportunities to invest in companies at significant discounts to intrinsic value.


2 examples of recent SPACs follow: while the underlying stocks of both of these deals have provided short term upside...

EDS up 54% in 4 days post shareholder vote
TMI up 48% in 6 days post shareholder vote

... the warrants have provided the real firepower (the best trade in these 2 instances has been to buy well before the vote and hold until the following week)


EDSWW up 155% from one week before to one week after vote
TMI/WS up 920% from one week before to one week after vote


New Idea:
An upcoming SPAC deal which possesses some of the similar above-mentioned characteristics is China Holdings Acquisition Corp ("HOL" - AMEX). HOL is a special purpose acquisition company which raised approximately $121 million in November 2007. HOL recently announced its intention to acquire JinJiang Hengda Ceramics Co ("Hengda"), subject to a shareholder vote on November 20, 2009. If greater than 33% of current common shareholders vote against the deal, HOL will be liquidated and the trust redeemed at $9.79 per share. As mentioned in a later section, I am highly confident that the shareholder vote will be a success.


Recommended Trade: Buy HOL stock and warrants (HOL/WS)

 
HOL is acquiring Hengda, a company experiencing strong secular tailwinds, at a very attractive valuation. The stock, currently at $9.56 trades at about 6X FY08 EPS and 4X FY08 EBITDA. This compares against the China construction materials peer group average of 40x and 19x, respectively. At 10-12x conservative FY10E EPS (see valuation section below), which I deem fair given my conservative assumptions of high-teens EPS growth, I get fair value of $15-16 per share.


At the current share price, if the deal gets approved, investors will likely see significant upside from the company's strong fundamental growth. If the deal does not go through, investors can lock in a gain of greater than 10% in a week, as the stock will rise to the trust value of $9.79 per share (with confidence, as arbs will move into the stock if there's a disparity).


The warrants, currently at $0.89, trade at a deep discount to intrinsic value: using the current price of $9.56, with a strike price of $7.50, expiration of 11/16/2012, an implied vol of 30% and the 10 yr yield of 3.4%, I get an intrinsic value of $3.40. At fair value for the underlying stock of $15, the intrinsic value of the warrants would be over $8 but for technical reasons (HOL warrants are callable by the company at $13.50) upside of the warrants is capped at $6.00.


Investing in warrants of SPACs has somewhat of a binary outcome. If the deal is not approved by shareholders, the SPAC trust is liquidated and common stock holders are redeemed at $9.79 per share; warrants, in this scenario, will be worthless.


Summary Company Description:
The investment target, Hengda, was founded in 1993 and is a leading regional manufacturer of ceramic tiles located in Fujian province, in the southeastern region of China. The company estimates that it maintains an approximate 3-4% market share in the $5 billion ceramic tile industry in China. Hengda mainly caters to the domestic Chinese market (95% of revenues) and its products are available in over 2,000 styles, colors and size combinations and are used for exterior siding and for interior flooring and design in residential and commercial buildings. Currently, porcelain tiles account for about 80% of company revenues with glazed ceramic, rustic, and ultra-thin tiles rounding out its product base. In China, exterior ceramic tiles are widely used in commercial and residential buildings. These buildings are considered to be more modern and are generally regarded as being better constructed.


Hengda's manufacturing facility is located in JinJiang city, Fujian province with an aggregate annual production capacity of 28 million square meters using nine production lines. The company is in the process of building a new production facility, which will increase production capacity by 42 million square meters (for total of 70 mm sq meters) by 2012. Hengda primarily sells its products through an exclusive distributor network (currently 31 distributors) and directly to property developers. Furthermore, the company has maintained long-term relationships with its customers with nine of its top ten clients having purchased products for the past 9-11 years.


Hengda attempted to go public in Singapore in 2008 but subsequently withdrew its offering due to poor market conditions. As part of the IPO process, the company retained Grant Thornton as its auditor and hired a CFO with auditing experience at a publicly listed company in Hong Kong as well as at a Big 4 accounting firm.

 
The Ceramics industry in China has the following key characteristics:

  • Ceramic tiles industry has grown approximately 20% (by revenue) over the past 3 years and is expected to grow 10-15% over the next 5 years.
  • The industry is fragmented with hundreds of small mom and pop factories with varying quality levels. The top 10 manufacturers account for only 20% of industry revenues.
  • Ceramics are widely used in the PRC as a construction material for both residential and commercial buildings given its durability and ease of maintenance.
  • Rapid growth of construction materials sector in China has been driven by:  
  1.  Population growth and urbanization - 350 million people (equivalent to entire population of USA) are expected to be added to China's urban population by 2025. Currently only 45% of the Chinese population live in urban areas. This compares to about 50% for Indonesia, 70% for Malaysia, 81% for the US, and 90% of the UK
  2. Increase in living standards - per capita living space in urban population has nearly doubled from 13.7 square meters in 1990 to 27.1 sq meters in 2007. This compares against 30-50 sq meters in European countries.
  3. Government stimulus - central and provincial governments plan to invest approximately $130 billion in current stimulus plan to build affordable housing and promote the construction industry.


Investment Thesis:
An investment in Hengda has the following merits:

  • Hengda will be a beneficiary of positive secular growth trends affecting the Chinese construction materials industry: urbanization, increasing rate of home ownership, continued population growth, and developing mortgage market.
  • Hengda operates in a fragmented industry with opportunities for consolidation and gain market share from smaller mom and pop operators.
  • The company plans to spend nearly $80 million in capex over the next 3 years to expand capacity by 150% to meet increasing demand (current capacity utilization is 115% as Hengda outsources some production). Most manufacturers do not have the financial resources to take on such expansion
  • The company's products are recognized for its quality and innovation. New products, such as the ultra-thin tile, have approximately 50% higher gross margins than corporate average.
  • Increased capacity should allow company to expand geographically and target new distributors in northern and western provinces in China which will further enhance growth.
  • Attractive valuation - while there are no pure-play public comps, Hengda is being acquired at approximately 6X my 2010 EPS estimates and 3X EBITDA (see more at valuation section below). This compares against average of 26X P/E and 9X EBITDA for Chinese construction materials and cement companies.
  • Approximately 60% of the deal consideration (8.1 mm additional shares) is in the form of earnouts related to earnings growth. I view this as an extremely solid incentive system for management to achieve its financial goals.

 
Risks:

  • Hengda's management team has provided very aggressive guidance for the next 3 years. Given its capacity expansion plans, new distribution strategy and underlying construction spending growth, management expects approximately 20-25% topline and nearly 35% bottom line growth from 2009-2012. I am using more conservative assumptions, but there is risk that the market may be disappointed if the growth rate is less stellar than management anticipates.
  • There is a potential bubble brewing in the Chinese property sector, especially in Tier 2 and 3 cities. Bubble deflation could be exacerbated by potential government mandated slowdown in bank lending.
  • Ceramic tiles are largely commoditized products. Price competition could be prevalent if residential and commercial construction slows significantly. Mitigating factor: tiles only account for 2% of total expenses in a construction project so pricing pressure may be lower relative to other building material products.

 
Valuation:
My estimates assume mid-teens topline growth and flat to modest margin expansion. Under such a scenario, 2010 EPS and EBITDA would be about US$1.50 and US$40mm. Applying a 10-12x forward P/E multiple and 5-6x EBITDA multiple (which seems fair for a mid-teens grower) yields in a $15-16 share price.


This deep value opportunity exists because there is no Street coverage, it is below the radar screen, and it exists because this is below the radar screen (market cap of $140M pre-dilution) and as with any SPAC, there is deal risk. Opportunities like this are rare, especially after wild run-ups in the market such as this.

 

Catalyst

  • Shareholder vote on November 20, 2009. The SPAC sponsors have done a good job of communicating with fundamental investors and the current stock price volatility is likely as a result of some investor turnover (risk arb funds and smaller shareholders selling out).

 

  • Release of preliminary 3Q operating and financial data sometime before shareholder vote.
    sort by    

    Description

    Background:
    After experiencing one of the biggest bull runs in history, I am surely not alone in my pursuit of investments with well defined catalysts and low correlations with the market. Over the past several months, there have been a number of China-related SPAC acquisitions which have offered such an appeal: deep value-oriented special situations with well defined catalysts (the deals themselves) that at least in theory have low market correlation. The most successful of these deals have had a common thread: solid growth potential and very compelling valuations. These small cap stocks have no Wall Street research coverage and typically undergo a process of investor turnover (from the original SPAC arb hedge funds to fundamental investors) - conditions which create fertile opportunities to invest in companies at significant discounts to intrinsic value.


    2 examples of recent SPACs follow: while the underlying stocks of both of these deals have provided short term upside...

    EDS up 54% in 4 days post shareholder vote
    TMI up 48% in 6 days post shareholder vote

    ... the warrants have provided the real firepower (the best trade in these 2 instances has been to buy well before the vote and hold until the following week)


    EDSWW up 155% from one week before to one week after vote
    TMI/WS up 920% from one week before to one week after vote


    New Idea:
    An upcoming SPAC deal which possesses some of the similar above-mentioned characteristics is China Holdings Acquisition Corp ("HOL" - AMEX). HOL is a special purpose acquisition company which raised approximately $121 million in November 2007. HOL recently announced its intention to acquire JinJiang Hengda Ceramics Co ("Hengda"), subject to a shareholder vote on November 20, 2009. If greater than 33% of current common shareholders vote against the deal, HOL will be liquidated and the trust redeemed at $9.79 per share. As mentioned in a later section, I am highly confident that the shareholder vote will be a success.


    Recommended Trade: Buy HOL stock and warrants (HOL/WS)

     
    HOL is acquiring Hengda, a company experiencing strong secular tailwinds, at a very attractive valuation. The stock, currently at $9.56 trades at about 6X FY08 EPS and 4X FY08 EBITDA. This compares against the China construction materials peer group average of 40x and 19x, respectively. At 10-12x conservative FY10E EPS (see valuation section below), which I deem fair given my conservative assumptions of high-teens EPS growth, I get fair value of $15-16 per share.


    At the current share price, if the deal gets approved, investors will likely see significant upside from the company's strong fundamental growth. If the deal does not go through, investors can lock in a gain of greater than 10% in a week, as the stock will rise to the trust value of $9.79 per share (with confidence, as arbs will move into the stock if there's a disparity).


    The warrants, currently at $0.89, trade at a deep discount to intrinsic value: using the current price of $9.56, with a strike price of $7.50, expiration of 11/16/2012, an implied vol of 30% and the 10 yr yield of 3.4%, I get an intrinsic value of $3.40. At fair value for the underlying stock of $15, the intrinsic value of the warrants would be over $8 but for technical reasons (HOL warrants are callable by the company at $13.50) upside of the warrants is capped at $6.00.


    Investing in warrants of SPACs has somewhat of a binary outcome. If the deal is not approved by shareholders, the SPAC trust is liquidated and common stock holders are redeemed at $9.79 per share; warrants, in this scenario, will be worthless.


    Summary Company Description:
    The investment target, Hengda, was founded in 1993 and is a leading regional manufacturer of ceramic tiles located in Fujian province, in the southeastern region of China. The company estimates that it maintains an approximate 3-4% market share in the $5 billion ceramic tile industry in China. Hengda mainly caters to the domestic Chinese market (95% of revenues) and its products are available in over 2,000 styles, colors and size combinations and are used for exterior siding and for interior flooring and design in residential and commercial buildings. Currently, porcelain tiles account for about 80% of company revenues with glazed ceramic, rustic, and ultra-thin tiles rounding out its product base. In China, exterior ceramic tiles are widely used in commercial and residential buildings. These buildings are considered to be more modern and are generally regarded as being better constructed.


    Hengda's manufacturing facility is located in JinJiang city, Fujian province with an aggregate annual production capacity of 28 million square meters using nine production lines. The company is in the process of building a new production facility, which will increase production capacity by 42 million square meters (for total of 70 mm sq meters) by 2012. Hengda primarily sells its products through an exclusive distributor network (currently 31 distributors) and directly to property developers. Furthermore, the company has maintained long-term relationships with its customers with nine of its top ten clients having purchased products for the past 9-11 years.


    Hengda attempted to go public in Singapore in 2008 but subsequently withdrew its offering due to poor market conditions. As part of the IPO process, the company retained Grant Thornton as its auditor and hired a CFO with auditing experience at a publicly listed company in Hong Kong as well as at a Big 4 accounting firm.

     
    The Ceramics industry in China has the following key characteristics:

    1.  Population growth and urbanization - 350 million people (equivalent to entire population of USA) are expected to be added to China's urban population by 2025. Currently only 45% of the Chinese population live in urban areas. This compares to about 50% for Indonesia, 70% for Malaysia, 81% for the US, and 90% of the UK
    2. Increase in living standards - per capita living space in urban population has nearly doubled from 13.7 square meters in 1990 to 27.1 sq meters in 2007. This compares against 30-50 sq meters in European countries.
    3. Government stimulus - central and provincial governments plan to invest approximately $130 billion in current stimulus plan to build affordable housing and promote the construction industry.


    Investment Thesis:
    An investment in Hengda has the following merits:

     
    Risks:

     
    Valuation:
    My estimates assume mid-teens topline growth and flat to modest margin expansion. Under such a scenario, 2010 EPS and EBITDA would be about US$1.50 and US$40mm. Applying a 10-12x forward P/E multiple and 5-6x EBITDA multiple (which seems fair for a mid-teens grower) yields in a $15-16 share price.


    This deep value opportunity exists because there is no Street coverage, it is below the radar screen, and it exists because this is below the radar screen (market cap of $140M pre-dilution) and as with any SPAC, there is deal risk. Opportunities like this are rare, especially after wild run-ups in the market such as this.

     

    Catalyst

     

    Messages


    SubjectRE: confidence in deal approval
    Entry11/13/2009 11:30 PM
    Memberelehunter

    A few reasons I believe the deal will go through:

    1) The sponsors have reduced their promote by 50% (from 3.2mm shares to 1.6mm) in order to sweeten the deal for existing shareholders

    2) Management incentive structure provide a layer of investor protection.  Earnouts based on fairly aggressive assumptions (~25% topline growth and ~35% earnings growth) represent an additional 60% of deal consideration.  I am modeling a more reasonable (in my opinion) 15%ish topline growth with flat margins.  I believe the stock still works if it hits my estimates with significant upside if mgmt hits their numbers (even assuming additional share dilution).

    3) I have spoken with a few 1mm+ original share holders that are actually staying in the deal

    4) Mgmt is likely to announce forward sale agreements (SPAC will repurchase shares from investors in exchange for "yes" vote) sometime before the vote next week.  In fact, management is targeting a 75% redemption and repurchase of existing shareholders as Hengda does not have a great need for cash.

    5) Lastly while this isn't perfect, where the warrants trade is typically a good indicator of potential for deal approval.  With about a week left until the shareholder vote date, the warrants would seem to imply that investors at least believe a deal will be going through.

    Some other recent SPACs adopted features which virtually assured shareholder approvals.  While the HOL deal is not ironclad, I believe it has a strong likelihood of success.


    SubjectWarrants
    Entry11/20/2009 11:55 AM
    MemberCoyote05

    Are the warrants mis-priced at $1.50 now that the deal has been approved and the stock is at $9.80?


    SubjectRE: Warrants
    Entry11/20/2009 01:17 PM
    Memberjamal
    seems that way... Also, HOL common is available to short--in contrast to TMI.

    SubjectRE: RE: Warrants
    Entry11/20/2009 01:41 PM
    MemberSeastreak

    Where can you get a borrow?


    SubjectRE: RE: RE: Warrants
    Entry11/20/2009 02:31 PM
    Memberjamal

    was better earlier..just checked and at interactive brokers there are 8,000 available but 12bp indicative rate...looked around at others and can't find much...so basically tough pickings


    SubjectRE: RE: confidence in deal approval
    Entry11/20/2009 03:13 PM
    Memberrasputin998

    Is there some aspect of the warrants that we don't appreciate?  Why would they trade so far below intrinsic value?  More importantly, why wouldn't an investor gobble up a levered way to play this equity with such strong secular tailwinds and such a low valuation?


    SubjectWarrant valuation
    Entry11/23/2009 04:03 PM
    Memberelehunter

    Regarding the warrants - the company needs to register the warrants and the SEC must subsequently issue an effectiveness order.  This needs to be done in order for investors to exercise the warrants.  The Company has no real incentive to do this immediately, although all managements say that they will use best efforts to do so.

    A registration statement could take up to 3 months (sometimes more).  This probably partially explains the discount to intrinsic value.  Also, most of these SPACs common shares cannot be easily borrowed.  So investors cannot efficiently arb away the discount.

    In my experience with SPACs, it seems like warrants typically discount any time value as well as imply a fairly low volatility.  Bottom line - this is not an efficient market and therefore you get a wide range of discounts to intrinsic value.


    SubjectRE: Warrant valuation
    Entry11/23/2009 05:56 PM
    Membercarbone959

    So in your experience what are the catalysts going to be going forward (other than registration)?


    SubjectRE: RE: Warrant valuation
    Entry11/23/2009 11:18 PM
    Memberelehunter

    This stock is undergoing a turnover of the investor base to value-oriented investors.  As for catalysts, it will be more fundamentally driven (earnings, comps reporting, etc) but this will take time.

    As for technicals, the company can tender for the warrants (like EDS just did), which could provide a floor valuation for the warrants.


    SubjectRE: RE: Delisting Notice
    Entry12/15/2009 10:25 AM
    Membercarbone959

    These delisting notices are common with SPACs but what is less frequent is the lack of desire to stay listed. I'm not sure if that in itself is a bad thing (maybe they plan on staying on OTCBB to save money and then go to Nasdaq.

    However what is more important for anyone following this idea is that the most common reason for this is failure to have enough shareholders (I think the minimum is 400 or sometimes 800). So if you just own warrants, go buy yourself 100 shares and be counted as a shareholder.


    SubjectUpdate
    Entry12/18/2009 09:48 AM
    Memberelehunter

    12/18/09: Quick update: Spoke with Mark Wilson on his cell (914) 815-3027. He says the China Ceramics management team is working on setting a calendar for news releases in 2010. Highest on the priority is addressing the public float, maintaining listing requirements, and registering the shares and warrants (only upon registration will the warrants be exerciseable). He wouldn't pinpoint a date, but it sounds like there will be a big push to get a lot of this done, including reporting earnings, by February 2010.

    With 1.0M of the 1.6M share float locked up by one shareholder, there is an effective float of just 600K shares, which reinforces my view that shorts are playing with fire. Note the press release today showing that the company has initiated the acquisition of a new production facility in Gaoan, China (as previously disclosed in the F-4 dated 11/10/09). China Ceramics paid $21M in cash and took on $15M in debt (5.3% interest) and will invest $4M for a total acquisition cost of $40M. The first 3 of 7 production lines have been operational for 2 weeks, and finished products are expected to ship from the factory to distributors in early January 2010.

    All told, production capacity will increase from 28M sq meters in 2009 to 70M sq meters in 2012 at an incremental cost of about $80M, or $1.90 per sq meter. The company should generate about $0.50 per sq meter of incremental free cash flow so that's less than a 4 year payback.

    Finally, there have been concerns of a secondary issue - to address the float, registering shares to allow for warrant exercising should get us most of the way there, but there may be a small secondary sometime in 2010. I do not believe it will be very dilutive, and the increase in liquidity will ultimately be beneficial to the stock.

    For another contact, try (203) 226-6288 and ask for Paul Kelly, a carryover director of China Holdings. He will likely be the most useful contact in the US.


    Subjectcurrent capitalization
    Entry12/18/2009 04:52 PM
    Memberheffer504

    can you just lay out the current capitalization, ie shares, warrants, earnout potential, pro forma cash post the factory acquisition, etc?  thanks...


    SubjectRE: Update
    Entry01/16/2010 05:23 PM
    MemberSeastreak

    it seems like this is now trading at 2x ebitda is that right?

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