Dilution City

We take a look at one of the worst connected transactions of 2000, in which Century City International Holdings proposed to spend US$317m on 27% of a fibre optic project from a company controlled by its Chairman. The share swap, priced at 712 times net assets, is hanging over the company and the Chairman has the option to complete it whenever he likes, to avoid dilution if and when the company seeks to reduce its 193% gearing with fresh equity.

Dilution City
10th July 2001

In Aug-97, Century City International Holdings Ltd (CCIH) was at the peak of its fortunes. The shares reached HK$2.95 and it was worth some US$971m. At 31-Dec-00, the company controlled 60.4% of listed Paliburg Holdings Ltd (Paliburg) which in turn owns 73.8% of Regal Hotels International Holdings Ltd (Regal). In other words, a classic ownership pyramid. Don't ya just love their web site with its naff rendition of Vivaldi's "Spring"?

At the apex of this pyramid sits Lo Yuk Sui (Mr Lo), the Chairman, Managing Director and 58% shareholder of Century City. He is the son of Lo Ying Shek, the 88-year old Chairman of Great Eagle Holdings Ltd, and his brothers include Lo Ka Shui, Chairman of the GEM Listing Committee and Deputy Chairman of Great Eagle, as well as Vincent Lo Hong Sui, Chairman of Shui On Construction and director of Panda-Recruit.

CCIH, through Paliburg, was highly exposed to the Hong Kong property market having, amongst other things, paid a fortune for a development site in Stanley, on the South side of Hong Kong Island. When the stock market crashed, so did the property market, leaving the group highly leveraged. Now that may have been bad strategy, but it is not a corporate governance problem in itself. Property was Paliburg's core business and investors could take their choice as to whether to own it.

The net result of that exposure was a highly leveraged balance sheet, with the group facing net debt at 31-Dec-00 of US$1,278m or 193% of net assets, and in default on certain bonds. The group is in an "informal standstill" with its bankers while it tries to sell off assets.

The normal outcome of a situation like this is that a company either goes bust, or works its way out of trouble with asset sales, fresh equity injections or conversions of debt to equity. Either way, existing shareholders (including the controlling shareholder) are likely to be diluted and the controller may lose control.

With this in mind, you will begin to understand a transaction first announced on 15-Aug-00, well after the Nasdaq bubble had burst. In this deal, CCIH proposed to buy a 27% interest in Beijing Century Union Digital Technology Ltd (JV), a PRC company which prior to the deal was beneficially owned through a chain of companies as follows:

Name	%
Mr Lo	51.7968
Other unnamed shareholders	30.6000
Regal	5.7024
CCIH	1.9008
Total foreign investors	90.0000
Beijing CSU Digital Technologies Ltd (PRC Partner)	10.0000
Total	100.0000

We don't know who owns the PRC Partner or who the unnamed shareholders are. The 27% interest in the JV is to be acquired from a company jointly owned by all the investors other than the PRC Partner.

So What is the JV?

The 20-year Project was defined as the provision of these services "in connection with a broadband national railway fibre optic network in the PRC".

Reading between the lines, what this appears to say is that an existing but "dark" (unused) fibre pair would be converted by the JV into an operational network. The JV is not the only player in this game - CITIC Pacific has a similar project, but that's story will have to wait.

The estimated total capital expenditure needed to achieve this (presumably including the rights to the fibre) would be RMB2.5bn (US$300m), so CCIH's 27% share would be US$81m, although it was hoped that equipment financing could be arranged by the JV to avoid shareholders having to pay anything.

The JV was incorporated in the PRC on 24-Apr-00 and by the time of the announcement less than 4 months later it had paid up capital of just US$1.65m. Up to 31-Jul-00 the JV had recorded an unaudited loss of about US$7,000. Despite this, American Appraisal Hongkong Limited valued the JV on 31-Jul-00 at RMB12.6bn (US$1,513m) or 917 times the capital invested at that time, "by adopting the methodology of discounted cash flow".

We are asked to believe that a project with a future (then unfunded) capital expenditure of US$300m has a net present value of US$1,513m after financing costs. That kind of return is way out of line for any normal utility project, and at the end of the day, that is what it is.

The Price on The Deal

Here's the shocking part. For the rights to 27% of the Project, CCIH was to pay HK$2,475m (US$317m), a 22.3% discount to the above valuation. Don't reach for your cheque book! That compares with the share of invested capital of US$445,000. In other words, the price was set at 712x net asset value.

This wasn't a straight sale. CCIH was granted a call option to make the purchase in one or more tranches, within a 24 month period which eventually began on 16-Feb-01 after conditions were satisfied. At the same time, Mr Lo's vendor company had a put option to make the sale in one or more tranches in the same period. Not only that, but if CCIH managed to receive proceeds of at least HK$1,500m (US$192m) from the issuance of new shares or other securities in the future, then it would be obliged to exercise the call option and complete the purchase.

The purchase price was payable in 4,500m new CCIH shares valued at $0.55 each, which was the same as net asset value per share of CCIH at 31-Dec-99. As a result, the new shares would be equal to a whopping 135.3% of the existing shares, or 57.5% of the enlarged company. The effect would be to dilute the public investors from 42% of CCIH to just 18%.

Now you get the picture. In the event that Mr Lo's existing 58% stake in CCIH starts to get diluted by the future debt-equity restructuring of the company, he can start exercising the put option over the JV stake, and complete the deal or tranches of it. Those 4,500m new shares will allow him to keep control even as the public gets diluted. For example, if a restructuring were to involve the issue of another 5,000m new shares for cash, or in return for the waiver of debts, and the put option were fully exercised, then the result would be:

Name	Before	After restructuring%	After the put exercise%
Mr Lo	58	23	50
Public	42	17	11
New investors		60	39
Total		100	100

It is interesting that the agreement provides an automatic trigger of the call option in full if CCIH raises more than HK$1,500m of fresh equity, resulting in the issue of 4,500m shares to the vendor company controlled by Mr Lo, and insulating him from dilution.

Shareholders are also faced with the following fact: Mr Lo controls both CCIH and the Vendor. So although it seems unlikely, if for some incredible reason it turns out that the JV is worth more than the price proposed, he can simply get CCIH not to exercise the call option, which would then lapse after 2 years.

Note to regulators

This "put-and-call" arrangement was subject to minority shareholders approval at a meeting which took place on 22-Sep-00, and the deal was approved.

Believe it or not, in HK there is no specific requirement to announce the dispatch of a shareholders circular, the outcome of shareholders meetings, or the number of members attending, or the number of votes cast in each direction, either on a show of hands or a poll, so we have no way of knowing from public data how that approval was reached. In many such cases, the resolution would not go to a poll (a count of shares voted), because the main board listing rules still do not require one.

So often deals like this are passed on a show of hands by those people present in person, including employees, with a solitary hand in the air from the Hong Kong Securities Clearing Company, a subsidiary of HKEx, representing almost all the public shareholder base.

Writing on the Wall

Today, the shares of CCIH trade thinly at $0.083, down 97% from their Aug-97 level. Century City has become Century Hamlet, valued by the market at US$35m. Although the official net asset value stands at $0.468 per share, investors have discounted the stock for the likelihood of a massively dilutive share issue.

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Dilution City 10th July 2001

So What is the JV?

The Price on The Deal

Note to regulators

Writing on the Wall

Dilution City
10th July 2001