Interchina Bubble

Pop quiz: what's the largest stock in the Hang Seng Small-cap Index? It's mainland property investor Interchina Holdings Ltd - at HK$7.11bn (US$912m). But not for long, we think. At 16.4x net asset value, this stock shows classic signs of being manipulated, and the SFC has investigated twice - you have been warned.

Interchina Bubble
23rd October 2001

What's the biggest stock in the new Hang Seng Small-cap Index? Interchina Holdings Ltd (Interchina) with a 6.69% weighting. We are talking about a $7.11bn bubble fit to burst. After you've read this article, you'll understand why.

Interchina is the second incarnation of Burlingame International Co Ltd (Burlingame), a property investor which got into deep financial difficulties. At 31-Mar-00, Burlingame had a negative net worth of HK$437m (US$56m) and total indebtedness of $1.23bn. Here's the history, for all you lovers of value destruction.

The Downfall of Burlingame

Burlingame had bet heavily on mainland property projects in the mid-1990s. On 3-Mar-98, it agreed to sell off some HK properties to a company called Garsan Investment Ltd (Garsan) for HK$238m, to repay bank debt. We don't know who owns Garsan, but the deal basically became a call option, because completion was scheduled for 1 year later, and only $38.8m was paid up front in Mar-98. All but $1m was refundable if the purchaser failed to complete. Sure enough, the property market headed on down, and on 23-Oct-98 Burlingame announced that it had in fact already refunded $11m of the deposit, and had been sued for the balance. The deal was off, and the purchaser wanted its money back.

Meanwhile, in Jun-98, with the Garsan deal still open, Burlingame agreed to buy a company called Go Gold Ltd (GGL) from Wealth Land Development Corp (WLDC) for HK$352.8m in cash instalments. WLDC was wholly owned by Mr Zhang Yang (Mr Zhang). You'll read more on him later.

GGL was set up as part of a pre-acquisition restructuring to own parts of Highness Garden in Shanghai (the Properties). Along with the Properties, GGL also had 85% of the estate management company and 100% of the operator of the clubhouse in the development.

Originally, Mr Zhang founded a company called Winton Bright (Groups) Ltd (WBL) in HK in 1993. Mr Zhang owned 80% of WBL while two individuals named Zhang Chen and Tong Wan Ching owned 10% each. WBL owned 85% of Shanghai Winton-Bright Real Estate Co Ltd which developed the Properties, the remaining 15% being owned by a PRC third party. Development commenced in Aug-93 and finished in Jan-98.

By the time of the interim results announcement on 29-Dec-98, Burlingame had paid $90.6m in deposits for the acquisition of GGL, but reported that:

Burlingame was looking for a way out of the deal, and expressed uncertainty that they could recover any deposit paid, so they made a provision for loss of the whole amount. Meanwhile, on 23-Oct-98 Daiwa Bank had filed a writ seeking repayment of $31m. The creditors were closing in.

On 19-Mar-99, bankers HSBC petitioned the court to wind up Burlingame on the grounds of insolvency, with $390m owing to HSBC and $970m to all banks. The company also said it had written to WLDC rescinding the agreement to purchase the Properties on the basis that the vendor had failed to deliver vacant possession and clean title.

Restructuring

On 15-Jun-99, Burlingame announced it was in negotiations with an unnamed potential investor for a possible restructuring, and on 19-Jul-99 announced that the investor was a company owned by Mr He Xue Chu (Mr He), and gave outline details of the proposal, which also involved the revision of the Properties transaction, so that Mr Zhang and Mr He would become the largest shareholders of the new company.

The restructuring negotiations carried on until 29-Nov-99 when a full proposal was announced, in which each of the existing 425m shares of Burlingame was swapped for a new share in Interchina. The bank creditors were essentially in two classes: secured creditors, who were to get their money back by a programme of property disposals, and unsecured creditors, who suffered a sharper haircut than Tung Chee Hwa's famous stubble, losing 80% of their loans, getting 10% in cash and the rest in Interchina shares. As a result, in the year to Mar-01 Interchina recorded a gain of $401.95m on "liabilities waived by bank creditors".

In the restructuring, the deal to buy GGL was scrapped. It now turned out that the $90.6m deposit for the acquisition comprised HK$22.6m in cash up to 27-Aug-98 along with 42 apartments in Beijing which had been valued at US$8.77m (HK$68m) in a deal on 21-Sep-98. All of this was forfeited by Burlingame. Meanwhile, GGL had managed to sell off part of the Properties (except for the clubhouse) for RMB218m (HK$205m).

That gave Mr Zhang the money to subscribe $200m for 2,000m new shares in Interchina, of which 1,300m were to be subscribed on completion of the restructuring, and 700m within one year afterwards, all at HK$0.10 per share. Mr He agreed to subscribe $100m for 1,000m shares at HK$0.10 per share.

After much ado and 9 months of gestation, the restructuring was completed on 30-Aug-00 and the next day Burlingame was replaced by Interchina on the Stock Exchange. The original public shareholders of Burlingame had been diluted from 63% to 9% of the new company. According to dealing disclosures, Mr Zhang subscribed the additional 700m shares 2 days later on 1-Sep-00, not waiting a whole year to put the money in. Mr Zhang and Mr He now had a total of 79.57% of Interchina.

Interchina is born

On 28-Sep-00, Mr Zhang placed 175.595m Interchina shares through Shenyin Wanguo Capital (Hong Kong) Ltd at $0.35 per share to increase the public float back to 25%. The next day, Mr He resigned as Chairman but remained as an Executive Director, while Mr Zhang became Chairman, and a new executive director, Anthony Tsang Hin Fun (Mr Tsang) was appointed.

At the same time, Mr Billy Kan Che Kin, who had been inherited from Burlingame and put on the board of Interchina, also resigned, and under his 3-year contract signed with Burlingame in Dec-98, he got a $5.2m pay-off equal to one year's salary.

Price takes off

Next, the price began to take off, rising from $0.31 on 13-Oct-00 to $0.91 on 14-Nov-00. The SFC began investigating, and on 19-Jan-01 Interchina announced their findings (passed through the SEHK) that as of 9-Nov-00, 16.56% of the company was in the hands of 6 "major public shareholders", leaving just 8.53% in the hands of other public shareholders. This is known as a "concentration warning".

Several months ago, we asked the SFC and SEHK to establish a page on their web site where all such concentration warnings could be gathered in one place, so that investors might have fair warning by checking that page. No action yet.

By the time of the concentration warning, the price had begun to slide, and was down to $0.28 on 1-Mar-01 when the company announced a placing of 614m new shares at $0.26 each on 1-Mar-01, through Makindo Securities (Hong Kong) Ltd (Makindo), raising net proceeds of $157m for debt reduction and working capital and diluting Mr Zhang to 41.61%. On the same day, Mr He sold 44m shares at the placing price.

On 22-Mar-01 Mr Zhang disposed of another 224.28m shares (5.11% of Interchina) at between $0.192 and $0.212 each, reducing his holding to 36.50%. Five days later, Mr He followed suit by selling 950m shares (21.67% of Interchina) at $0.19 each to "five independent third parties", leaving him with just 0.14% of Interchina. That deal must have been done "off-market" because volume that day was only 12.2m shares.

In summary, Mr He had invested $100m in Aug-00 and come away with $192m and 6m shares in Interchina.

Options granted - spectacular timing

In what proved to be an amazingly inspired piece of timing, around the end of Mar-01 the board granted to three directors options to subscribe 139m shares at $0.16 exercisable between 1-Apr-01 and 31-Mar-05, of which 109m went to Mr Zhang, 15m to Mr He and 15m to Mr Tsang. Like most listed companies, the options can be granted at up to a 20% discount to the 5-day average price, so that implies a benchmark of 20 cents. Looking at the price chart of Interchina, the lowest 5-day average before 1-Apr-01 was on 22-Mar to 28-Mar, at $0.2008. They got the exact bottom of the chart, the lowest point that Interchina has reached since it was, well, since it was Interchina.

Today, with the shares trading at $1.62, those options are worth a cool $189.8m.

It is impossible to tell from the SDI disclosures the date on which options were granted. The SFC/ SEHK should remedy this. We first raised this point some years ago.

Interchina Securities

On 11-Apr-01 Interchina announced that it had on 30-Mar-01 acquired 70% of Makindo for an undisclosed sum. It had bought its own broker, later renamed Interchina Securities Ltd. The company also announced "a possible joint venture in the area of environmental protection business in China" which would "offer a total solution for water treatment". Nothing firm has yet been announced on this.

The price closed on 10-Apr-01 at $0.245, and immediately began its run up to the current price of $1.62, up 561% in six months.

On 2-Aug-01 Mr Liu Shunxin and Mr Richard Lam Cheung Shing were appointed as executive directors. Mr Lam had been a director of Burlingame from 5-Aug-98 to 28-Apr-99. We don't know anything about Mr Liu

Listed companies should be required to give the same biographical information in announcements of board appointments as they do in the annual report. Otherwise investors don't know who is running their company, and may never see a biography if the director resigns before the next annual report is published.

Convertible Notes

On 3-Aug-01 Interchina announced a proposed issue of a $200m convertible note to a BVI company called Capital Champion Ltd, whose owner was not disclosed.

The notes bear interest at 3% per year and have an unusual structure; they convert at the higher of (i) $1 per share and (ii) the 10-day average price prior to conversion. In practice, that means the latter, because no sane holder would convert if the market price were less than the conversion price, unless the company was in severe financial difficulty with no hope of repayment. Conversion can take place in the 12th, 24th, 30th and 36th months, 25% each time, with carry-forward of unused conversion rights.

If the share price in the last 20 days of the first year averages less than $0.80, then the noteholder can redeem the note at 106% of par. At the end of the second year, if the average is less than $0.90, the noteholder can redeem at 112%. Finally, at the end of the third year, if the average is less than $1, then the noteholder can redeem at 118%. This basically ensures that, if the company is solvent, after 3 years the subscriber will either get shares near market price (with a 3% yield until conversion) or about a 9% yield on his note until redemption.

Half of the proceeds were for use in expanding Interchina Securities, and the rest for funding potential investment projects.

When the deal was completed on 23-Aug-01, the subscriber nominated Yan Liyan (Mr Yan) to join the board of Interchina that day. As a director, Mr Yan's holdings had to be disclosed, and it then emerged that he owned 295.705m shares, or around 6.74% of Interchina. We don't know anything about Mr Yan's background.

Stock Borrowed

According to a dealing disclosure, on 24-Aug-01, the day after he joined the board, Mr Yan lent 290m shares to Mr Wang Changda (Mr Wang). Under the agreement, the borrowed securities shall be returned at any time by Mr Wang or upon the lender giving notice to Mr Wang. Why would Mr Wang want to borrow stock, do you think? We don't know, but one common reason for borrowing shares is in order to sell them, creating a short position. We don't know anything about Mr Wang or what he's doing with the stock.

New Investor

On 8-Aug-01, at the AGM, Mr He and Mr Tsang did not offer themselves for re-election, contrary to the statement in the directors' report of 11-Jul-01 that they would do so. For whatever "personal reasons", they had changed their minds.

On 9-Aug-01, Mr Zhang sold a 15% interest in WLDC (which holds his shares in Interchina) to a company called A-Jex Investment Ltd for an undisclosed price. No word on who owns that.

Mr He and Mr Zhang both had service contracts for a fixed term of 3 years from 1-Jun-00. It is not known whether Mr He received any compensation for the early departure.

Property Sale

On 10-Sep-01, Interchina announced the sale of one of the old Burlingame mainland property projects for $151m to a company owned by Zhang Jin Shui, an "independent third party", with completion due by 29-Sep-01.

Second Concentration Warning

On 14-Sep-01, the results of another SFC investigation were announced (again, via the circuitous route of the SFC telling the SEHK, and the SEHK telling the company, and the company telling the market). This time, with Mr Zhang holding 36.46%, another 53.77% was held by "15 major public shareholders", leaving 9.8% in other public hands at 10-Aug-01.

In addition, the company said that the SFC is conducting an enquiry into the dealings in the shares from 31-Jul-01 to 6-Sep-01 (during which, the price doubled from $0.65 to $1.30), and based on information provided to the SFC, 13 of the 15 holders had been involved in active buying and selling and their trades accounted for approximately 40% of the total market turnover during the period.

Second Convertible

The same day, Interchina announced another convertible bond issue, this time for $100m, to be placed on a best endeavour basis (i.e. not underwritten) by Guotai Junan Securities (Hong Kong) Ltd, a subsidiary of a mainland brokerage.

The terms are almost the same as the first convertible, except that the minimum conversion price has been raised to $2 per share, with correspondingly higher target prices, below which the holders can redeem.

On 15-Oct-01, the deadline for completing the placing was extended to 13-Nov-01.

What's Really Going On?

At 31-Mar-01, Interchina had net assets of $435m (or about $0.099 per share) , but at $1.62 per share, it now has a market capitalisation of $7,114m. Yes folks, this is an asset based company trading at 16.4x net assets. Normally, mainland property stocks trade at a discount to net asset value.

Many of these "major public shareholders" as the SFC euphemistically puts it, are likely participants in a syndicate aimed at sucking in either ignorant investors, or simply knowledgeable investors who know that the stock is massively over-valued but like to gamble on someone else paying more for it.

If you hold this stock, ask your broker or investment adviser about getting out.

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