|Shares Out. (in M):||27||P/E||na||na|
|Market Cap (in $M):||67||P/FCF||na||na|
|Net Debt (in $M):||207||EBIT||0||0|
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Recommendation: Short CMED to $0, with an attractive probability that the investment thesis plays out in the next 3 months. The current stock price is $2.57, implying a market cap of $70m, and we think there’s an attractive chance that both figures find their way to zero in the near future.
This investment idea is relatively simple. China Medical Technologies didn’t pay its last coupon payment due on December 15, 2011. Yet it had reported $206 million of cash on its balance sheet as of September 30, 2011. Why didn’t it make the payment? Our belief is that all or most of the cash isn’t there, and that CMED is misrepresenting itself in its SEC financial statements.
The attractiveness of the CMED short is that we have a good catalyst: a missed coupon payment and an impending debt restructuring. It’s a bit of an obvious point, but when a company misses its coupon payment, it typically signifies that a looming Chapter 11 or some other nasty development for equity holders is around the corner. Bonds are currently trading at 25 cents on the dollar. The company has two separate tranches of convertible notes, and we believe that it’s a somewhat widely dispersed investor base. There will probably be holdouts. Any restructuring transaction will certainly be difficult and time-consuming to negotiate.
In the case of U.S.-listed Chinese companies, a missed coupon payment may furthermore indicate that management is tired of dealing with foreign investors, has drained the company’s bank accounts, transferred assets to private entities owned by related parties, and the management team is planning on disappearing.
We have spoken with the Wilmington Trust (the indenture trustee), the counsel working with bondholders, and the Company’s Cayman counsel. All parties have indicated that the company has been relatively passive and not very communicative. Richard Thorp of Thorp Alpirga, who is the Company’s Cayman legal representative and is in charge of forwarding noteholder inquiries to the company via the email address firstname.lastname@example.org, has not been privy to any bondholder restructuring plans nor has been informed of the company’s restructuring intentions, saying that he doesn’t “know what their intended line is at all.”
At this moment, we can only conjecture what is actually going on. The Company did not issue a press release when the nonpayment occurred on December 15th, nor when the 30-day grace period expired on January 14th. As an aside, this is an obvious violation of SEC disclosure rules, given that a coupon nonpayment is a material event, and a further sign that the company is going dark.
Most of CMED’s equity holders found out about the nonpayment on January 26th, when Fitch announced that it had reduced the company’s rating to Restricted Default due to the missed coupon. The stock declined 20% on the day, and we think it has further to go. S&P has also downgraded the company to “SD”, which stands for selective default.
The indenture trustee is Wilmington Trust, and the contact there is Suzanne MacDonald. She confirmed that the coupon was not paid and wrote that Wilmington Trust “will be sending a Notice of Default very shortly.” Bondholders have been working with Hogan Lovells, who represents the ad hoc bondholders committee. From our discussion with Hogan Lovells, they have had trouble getting in touch with the management team, ostensibly because it’s the Chinese new year. Naturally, that’s a silly notion, and given that the Chinese New Year is the best excuse for management’s lack of communication with bondholders, we think that there is plenty to be concerned about for equity holders. Chris Donoho, Cathy Yu and Neil McDonald are the contacts at Hogan Lovells. Donoho and McDonald are working on the Shengdatech bankruptcy, as well as bondholders of Sino Forest and Hong Kong-listed China Forestry.
In terms of the evidence for financial misrepresentation at China Medical, it’s best to read the 23-page Glaucus report issued last month and available at:
Glaucus summary points:
One of our theories for the coupon non-payment is that the Glaucus report was enough to trigger the beginnings of a deeper audit by PriceWaterhouseCoopers, and that CMED management therefore thinks there is a high chance they fail their audit for fiscal year 2011. Last year’s audit was completed in July, so conceivably their next audit will be due mid-year. The company has a March 31st year-end. Based on experience with other U.S.-listed Chinese companies, the resignation of a top-4 auditor like PWC would trigger a large price decline as well as a potential trading halt. Given the potential for this, management may have decided to forego paying bondholders their interest, and instead drain the company’s bank accounts and begin transferring operating assets to private related parties.
We could also envision that the Glaucus report may have triggered inquiries from the company’s independent board members, particularly its non-Chinese directors Iain Bruce and Lawrence Crum. Mr. Bruce is a retired KPMG accountant and Dr. Crum is the director of the Center for Industrial and Medical Ultrasound and a research professor in electrical engineering and bioengineering at the University of Washington. These aren’t the types of guys with much to gain from a cover-up. It’s possible that they’ve urged for an independent investigation, and that the management team sees the writing on the wall and has decided to disengage foreign claimholders. Again, the thesis would be that management realizes the likelihood of a trading halt, and has begun looting the public company’s assets.
Finally, we’ll mention that a coupon non-payment at a time when a Chinese company is reporting plenty of cash is nothing new. We haven’t seen it much in the United States because there are not too many U.S.-listed Chinese convert issuers. But the Singapore Stock Exchange has seen this plenty before.
According to a 2010 article in South China Morning Post:
“Since late 2007, a spate of so-called S-chips – mainland companies listed on the Singapore exchange – have borrowed money then failed to repay the debts, with some becoming mired in fraud scandals. Of the 11 S-chips that issued convertible bonds between 2005 and 2008, six have declared themselves unable to repay […] Another five S-chips failed to repay bank loans during 2008-9. The effects on their share prices have been, predictably, crushing.”
Companies that defaulted despite having substantial cash on their balance sheets include China Milk Products, Celestial Nutrifoods, Neo-China Land Group (Holdings), etc. At this point, most VIC readers are pretty familiar with Chinese frauds that have made up their cash balances, like CCME, LFT and CHBT, so I probably need not continue.
Risks / Variant View:
The risk here is fairly straightforward. If the company decides to make a payment, the bondholders will likely withdraw their notice of default, and the stock will pop. It's conceivable, given that $5 million is not an overly onerous amount (the company has another $5 million payment due on February for its 4% converts). There’s one line of thinking among stockholders that the company is merely trying to swap its current 30 to 50 cent paper into lower principal value bonds. This sounds good in theory, but I’d assume that it would take a long time in practice, and that bondholders will demand that the equity be wiped out in order for them to take their haircut. So as they go down the path of a restructuring, maybe management realizes the difficulties involved with effecting a bond restructuring with fragmented investor bases of two tranches of converts, and decides to just make their coupon payments and forget this whole non-payment episode. With the company’s current $70 million market cap, it wouldn’t necessarily take a lot to double the stock price. As a result, it’s important to keep this position small.
The other risk is that the borrow rate creeps up above 50% and the stock price doesn’t collapse in the next six months.
Overall though, we like the trade.
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