Time to Vote Against Boto Sale
4 August 2002

It's been four months since Boto International Holdings Ltd (Boto, 0585) announced it was proposing to sell all of its core businesses of Christmas trees, accessories and leisure furniture (Businesses), comprising 99.9% of its turnover, to a management buy-out vehicle owned 70% by Carlyle funds and 30% by Boto's Chairman Michael Kao Cheung Chong (Mr Kao). In early July, the proposal was restructured (the Revised Transactions) to make it 75% owned by Carlyle and 25% by Boto. 

The Revised Transactions include 2 share option schemes in which Mr Kao and other management would be entitled to participate, giving them 15% of the vehicle, diluting Boto to 21.25% and Carlyle to 63.75%.

Of the 15% options, 10% would be exercisable at the same entry price as Carlyle and Boto, granted within one year and exercisable within one year. So they are in effect a direct stake in the vehicle. The other 5% is to be granted within 18 months, then exercisable within 10 years at a 70% discount to the buy-out, subject to financial performance targets.

The price on the sale was increased by HK$70m, or about 7%, but that increase basically just covers the earnings which the Businesses have made during the delay to the transaction, as last year Boto made $160.7m in the 6 months to Sep-01. The transaction was originally due to complete by 31-May-01, but is now targeted to complete three months later, at the end of August. So in effect, there was no increase at all.

Anglo Chinese advises shareholders to vote AGAINST

On Friday 2-Aug-02, the circular to Boto shareholders (Circular) was posted. Click here to download it. The circular contains something which is unique in recent Hong Kong history. The independent financial adviser, Anglo Chinese Corporate Finance Ltd (Anglo Chinese), has recommended that shareholders vote against the sale. It has been many years since an independent financial adviser has not called an acquisition or disposal "fair and reasonable". Director Dennis Cassidy wrote in their advisory letter in the Circular (p54):

"we consider that the terms of the Revised Transactions do not adequately reflect the value of the Businesses to be sold and we therefore do not consider the terms to be fair and reasonable. Accordingly we advise the Shareholders to vote against the resolution to approve the Revised Transactions set out in the ordinary resolution to be considered at the First Special General Meeting."

This advice, and the rarity of such a recommendation to vote against management, to us underlines how bad the terms of this deal are.

How Boto depressed its 2002 profits

You may recall that on 18-Jul-02 Boto's annual results showed a surprising drop in profits in the second half of the year ended 31-Mar-02, with net profit falling 9.6% from HK$156.4m to $141.4m. This of course was in the middle of the proposal to sell the Businesses, and we commented at the time:

"we take it with a large pinch of sodium chloride, because it would be in the interests of management to paint a gloomy picture, and there are  plenty of legally acceptable ways in which figures can, at least on a short-term basis, be depressed."

We were right. Anglo Chinese revealed in the Circular (p39) that as part of Carlyle's initial negotiations, Carlyle had "required" $12.4m of provisions in respect of slow-moving stocks in respect of the closing stock position at 31-Mar-01. However, the 2001 accounts had already been published. In the Mar-02 accounts, rather than restate, or adjust, the Mar-01 results to include the required provision, Boto included this provision in the Mar-02 results instead. We think that was misleading.

In addition, the Mar-02 results included "transaction costs" of $1.6m relating to the current proposals for the sale of the Businesses, which obviously is not part of Boto's core profits. We guess that includes things like legal and advisory fees.

Finally, Boto has estimated (p60) that the net loss contributed by the animation business of Imagi (the only business of Boto group if the deal proceeds) was $8.0m in the year ended 31-Mar-02. No figure was given for 31-Mar-01 but it is probably negligible as Boto did not invest until Oct-00 in its first 65% of Imagi (now 82.5%). The animation firm was in development for most of the year to Mar-02 and only booked its first sale near the year-end.

So adjusting for the stock, the transaction costs, and Imagi, we see that the core Businesses looked like this:

So in fact, rather than a reported drop of 9.6% in net profit for Boto as a whole, the Businesses grew core earnings by 12.7%.

The stock adjustment and the other adjustments were not visible in the annual report, and are only publicly known thanks to the letter of Anglo Chinese. We don't know whether Boto made any other adjustments which may have  depressed its earnings.

Anglo Chinese also pointed out that although Boto's gross profit margin originally appeared to have fallen from 37.7% in 2001 to 33.9% in 2002, if you adjust for the 2001 stock provision in 2001, then gross profits would have grown from $330.5m to $375.9m, up 13.7%, while the gross margin only fell from 36.3% to 35.0%.

This much smaller margin drop is probably accounted for by the increase in contributions from leisure furniture, which is lower margin than festive products. Sales of leisure furniture grew 131% in the year to Mar-02, and even by the Directors' projections, which may be conservative, they expect furniture sales to grow 23% in the current year and 21% in the year to Mar-04.

Strong market position

Anglo Chinese also reported (p39) that the Directors estimate Boto's market share of artificial Christmas trees is over 40% in the USA, about 60% in the UK and some 25% in continental Europe. Clearly Europe offers long-term growth potential and the USA and UK are strong market positions. Boto is the World's largest manufacturer of Christmas trees which brings great economies of scale.

Anglo Chinese wrote (p45), in relation to net assets:

"Given the performance of the Company, its reputation and position in the market and prospects, we consider...the consideration of the disposal to be inadequate"

In relation to the p/e based on the sale price of the businesses, the adviser wrote

"If the adjustments to the results for the year ended 31st March 2002 referred to on page 39 of our letter... are eliminated, the price earnings multiple based on a consideration of $1,064 million would be 6.55 times" (emphasis added)

With the festive products expected to be flat, but with leisure furniture growing, this would be an even lower p/e for the current year.

Don't be misled by the "effective consideration" of $0.34 per share which appears in the Circular, because that includes pre-completion dividends which are money already earned by the Businesses since 30-Sep-01, which you haven't received. Due to the current proposals, Boto did not pay a dividend for its 31-Mar-02 results, but we expect them to pay a higher interim dividend for the 6 months to 30-Sep-02 if the deal does not proceed.

Management's position

Mr Kao, in his "Letter from the Board" writes (p32):

"The original structure of the Disposal Agreement did, on the face of it, put me in a position of a perceived conflict of interest.....The Revised Transactions place my interest on the same footing as all Shareholders"

We disagree with the second part of that statement. Independent shareholders are not being offered share options over a direct stake in the Businesses, while Mr Kao and his management will receive up to 15% options, of which 10% would be granted within one year and exercisable within a year after grant without any financial targets.

Mr Kao's economic interest in Boto is about 31.0%, including a 53% controlling block owned by Sunni International Ltd (Sunni) of which Mr Kao owns 51%. So after all the options are exercised, his interest in the Businesses via Boto will be about 6.6% (31% of 21.25%). While we haven't been told how the options will be allocated, the size of his option stake, as the most senior of management, could easily be comparable to this.

Furthermore, Independent Shareholders would have only an indirect 21.25% stake in the Businesses via Boto, and there are a number of "events of default" in which Boto could be forced to sell that stake at the price it paid for it, to other shareholders of the buy-out vehicle, including Carlyle, Mr Kao and management after the exercise of their options.

These events of default have been clarified in the Circular (p23) since the announcement of revised terms, but an event of default would still be triggered in several circumstances, including if:

• Mr Kao resigned from Boto or was declared bankrupt, forcing his resignation; or

• Mr Kao sold 1% of Sunni; or

• Sunni  was dissolved or distributed its Boto shares to its shareholders; or

• Mr Kao ceased to control more than 50% of Boto. Currently, he has 56.9%.

If for example, Boto were to issue 20% new shares  for funding requirements in the future, that could trigger a loss of control by Mr Kao as his stake would be diluted to 47.4%. Meanwhile, management's direct stake in the Businesses might even be enhanced if they take up their share of the stake which Boto was forced to sell.

We note that the views of the Independent Non-executive Director(s) are not stated in the circular.

Selling in a down market

Let's be clear. We would not object to selling the Businesses for a fair price. This is not a fair price, and Anglo Chinese agrees that it is not "fair and reasonable". Mr Kao writes:

"The global equity market is experiencing another period of turmoil"

He is quite right about that. Now is not the time to be selling a prime business with a leading market share. If he really wants to sell, then we would get a much better price when the economy stabilises and the market confidence returns. Mr Kao also writes:

"after 33 years' experience in the industry, I believe I am best placed to understand the future needs and prospects of the Businesses"

Mr Kao, we certainly respect your expertise in building and running the Businesses - that is why we own a piece of Boto. You are a great industrialist and Boto is a great business. But in return, please respect the fact that we are experts at investing and the stock markets, and have more experience in financial valuation than you do. Expertise in manufacturing does not equate to expertise in financial valuation, or in cartoon animation for that matter.

Pro forma net assets

Boto has included in the Circular a pro forma balance sheet at 31-Mar-02 (p15) and calculation of net assets per share (p14). This shows that if the deal proceeds, net tangible assets (NTA) would be $191.1m or $0.056 per share, after payment of a dividend of $0.26 per share. Included in the NTA, there would be cash (net of borrowings) of about $152.7m, or around $0.044 per share. There would also be intangible assets comprising Imagi animations in production and goodwill, totalling $0.007 per share.

The 25% initial stake in the buy-out vehicle, after deducting the goodwill (premium over net assets) which it is paying for the Businesses, would be carried at just $6m, but the investment cost is $88m. If you add back the goodwill in the venture, then NTA rises to $0.079 per share.

If the deal proceeds

Historically, HK-listed companies which have sold their core businesses and whose balance sheets consist of a large proportion of cash, tend to trade at a discount to the value of that cash, because minority shareholders have no control over what the management might do with it. 

For example, consider City e-Solutions Ltd (0557) which sold its core hotel businesses to its parent in 2000 and was left with a small hotel reservations business. It had NTA per share of $1.396 at 31-Dec-01, including cash of $1.310 per share. It paid no final dividend, and now trades at $0.53 per share, a 62% discount to NTA.

Another example is  Hongkong Chinese Ltd (0655) which sold Hongkong Chinese Bank just after the end of 2001 and was left with a small brokerage. It had pro forma NTA at 31-Dec-01 of $2.24 per share (after payment of a special dividend of $1.45 and final dividend of $0.03). That includes cash of about  $1.29 per share and a lot of other liquid assets. It now trades at $0.46 per share, a 79% discount to pro forma NTA.

If the Revised Transactions proceed, Boto will consist of a loss-making start-up animation business, a 21.25% stake in its old business (after dilution by the options) and a dwindling pile of cash. It therefore seems quite reasonable to estimate that if the deal proceeds, Boto shares will trade around 50% discount to NTA, or around $0.04 per share at best. In that case, the dividend of $0.26 only brings total value to $0.30 per share. And that's being optimistic.

The day before the sale was announced, Boto was trading at $0.34 per share, and on Friday 2-Aug-02 it closed at $0.31 per share.

How to Vote Against the Sale

The Revised Transactions and the dividend are subject to two shareholder meetings. The first one, to consider the Revised Transaction, is on Monday 19-Aug-02. Mr Kao and certain of his management colleagues, who together control 60.6% of Boto, are required to abstain, leaving 39.4% who can vote.

Despite our appeals, the Listing Committee of the Stock Exchange ruled that the shares which can be voted include shares held by an executive director of Boto, Liliana Tsen, with 5.5%, and shares held by a deceased co-founder's trust held by HSBC as trustee, with 4.1%. HSBC is a lender to the buy-out vehicle, and the widow of the co-founder is a non-executive director of two Boto subsidiaries.

Other minorities include Shanghai Industrial Investment Corporation (parent of HK-listed Shanghai Industrial Holdings Ltd), with 5.8%.

The voting intentions of these 3 shareholders are unknown, but we hope that they will listen carefully to the advice of Anglo Chinese and vote against the sale or at least abstain. If they vote in favour, then this could be a close vote. Webb-site.com has been contacted by holders of over 13% who intend to vote against the sale, including Templeton and ourselves, so that leaves another 11% whom we have been unable to contact.

The second meeting, to facilitate the dividend, is on Friday 30-Aug-02. It is a special resolution requiring 75% approval of those who vote. Everyone can vote on this, including Mr Kao. Obviously if the sale is voted down at the first meeting, then there is no need for the second meeting. However, shareholders should note that even if the sale is approved in the first meeting, there is no guarantee that Mr Kao and his colleagues will vote in favour of the dividend, although they have "indicated" that they will vote in favour. Even if they do, the resolution could still fail to pass. So you could end up with no dividend.

To keep things simple, we recommend that investors vote AGAINST the resolution to be considered at the first meeting on 19-Aug-02. Don't worry about the second meeting unless the sale is approved at the first meeting, in which case there will still be time to send in votes for the second meeting. Do not confuse this meeting with the Annual General Meeting, which is on 16-Aug-02.

Webb-site.com has today launched a new step-by-step guide called How to Vote for all your shares in HK-listed companies. Most investors are "non-registered shareholders", and the process is explained in the guide. In the case of Boto, if you are a registered shareholder (which is unlikely), you should use the PINK proxy form to vote AGAINST the resolution, then follow the procedure in the guide.

Do not delay voting. Banks, brokers and custodians impose cut-off deadlines several days before the meeting, and CCASS imposes a deadline too. So this cannot wait. We need your votes.

© Webb-site.com, 2002

Organisations in this story

• Imagi International Holdings Limited

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