A Fair Alternative for Boto
28 April 2002
It's nearly four weeks since Boto International Holdings Ltd (Boto) proposed a sale of its core festive products and leisure furniture businesses, accounting for 100% of last year's turnover, to a Buy-out vehicle controlled as to 30% by Boto Chairman Michael Kao (Mr Kao) and 70% by the funds of Carlyle Group (Carlyle).
We announced our opposition to this back-door privatisation at a huge discount to fair value, and have since been joined by numerous investors, large and small, including Templeton, Martin Currie Investment Management and other institutions.
Since then, more details have been emerging, about the financing of the Buy-out and the ownership structure of Boto. As we will show, several parties have a material interest in the Buy-out and should be prohibited from voting. We call on Boto to withdraw the proposal, and instead, we have offered an alternative proposal which would be fair to all shareholders, would achieve the same net result for Mr Kao, and would retain a great industrial company in the Hong Kong Stock Exchange with over 7 years of unbroken growth in both sales and profits.
On the Register
Webb-site.com has obtained and analysed a copy of the register of members, better known as the share register. This is always somewhat challenging in HK, because most of the public shares (other than those of management, directors and controlling shareholders) are held through banks, brokers and custodians in the clearing system and in turn through a single registered shareholder, HKSCC Nominees Ltd (HKSCC Nominees), a fellow subsidiary of SEHK. More about that problem another time.
The first surprise was that the number of shares in issue had increased by 1m to 3,439,925,000, probably due to the exercise of share options.
Note to Regulators
Believe it or not, in HK there is no requirement for a public filing to be made whenever shares are allotted and listed on the SEHK. This contrasts with the treatment of the opposite direction, share buy-backs, which must be notified to the SEHK by 09:30 the next business day. It is high time that the SEHK fixed this - electronic disclosure costs a minimal amount, and investors have a right to know how many shares are in issue at any time - in other words, how big their companies are. For one thing, if they don't know that figure, then they cannot know whether they have breached the legal disclosure threshold, which is soon to be reduced from 10% to 5% of the issued shares.
Material interests
Justice will only be done on connected transactions if those parties who are involved in the transaction, or have a material interest in its outcome, are prohibited from voting. It should be up to the truly independent shareholders, who have no other interest in the transaction besides their shareholdings, to determine whether a transaction should proceed. The SEHK rules on this are very messy, and in fact they mention the "material interest" concept in the context of "Major Transactions" (big ones) rather than connected transactions.
Under Listing Rule 14.10 for Major Transactions:
"The Exchange will normally require that any shareholder shall abstain from voting... if such shareholder has a material interest in the transaction."
Fortunately, the Buy-out is both a Major Transaction as well as a connected transaction. We will show you why various parties are conflicted by their material interest.
What the register shows
As we already knew from his latest filed disclosure, as of 28-Dec-01, Mr Kao has a total voting interest of 56.91%. Of this, 53.02% is held through Sunni International Ltd (Sunni), a company which is 51% owned by Happy Nation Ltd (Happy Nation), which in turn is ultimately owned by HSBC International Trustee Ltd (HSBC) as trustee of a family trust established by Mr Kao. Happy Nation also has a direct holding in Boto. Mr Kao has a direct holding in his own name and other shares held by Kessuda Consultants Ltd, a company wholly-owned by Mr Kao. All this makes his economic interest in Boto about 30.93%.
"Latest Tx" means the latest change in registered holding. Not all of Sunni's and Mr Kao's shares are on the register - we could only find a total of 52.05% for Sunni, and 1.47% for Mr Kao, which implies that another 0.97% and 0.34% are held by nominees, probably through HKSCC Nominees Ltd. These are marked "unknown" in our column for registered holder. Mr Kao should be required to disclose who holds these shares so that they can be excluded from voting.
Note to regulators
All conflicted parties should ensure that an independent party is appointed as proxy in respect of all of their shares with instructions to abstain. The proxy will then confirm the total number of shares which are not voted, and it reduces the risk of HKSCC unknowingly voting stock on behalf of a nominee of a conflicted party.
Other directors
The other directors, through various holdings, have the following shares:
All of these executive directors would have been involved in the board decision to propose the transaction and probably in negotiations too. In addition, as Mr Kao, through Sunni, controls the composition of the board by outright majority, the other directors in effect report to him.
Again, in this table, Philip Lam Pak Kin's registered holding differs from his latest disclosed shareholding, so part of its must be held by nominees, marked "unknown" in our table. Francis Kao is Mr Kao's son and presumably a beneficiary of his trust, which is a party to the Buy-out.
Pleasure International Ltd and Golden Jungle Ltd are ultimately owned by HSBC as trustee for family trusts of Ms Liliana Tsen and Mr Kui Yiu Ngok respectively.
Other co-founders
One of the three co-founders of Boto, Mr Law Pun Leung, passed away some time before Boto's IPO. A company called Silverbay Group Ltd (Silverbay) is on the register with 140,491,890 shares, or 4.08% of Boto. The register records Silverbay's address as the head office of Boto in HK. We don't know who opens its mail. Silverbay is ultimately owned by HSBC, as trustee of The Law Pun Leung Family Trust.
The role of HSBC
According to an article on FinanceAsia.com, HSBC Group said it is arranging debt finance for the Buy-out vehicle comprising HK$764m of long term debt and $40m of working capital finance, or a total of $804m. This amounts to some 80% of the total $1,007.5m purchase price for the Buy-out. HSBC Group would expect to earn arrangement fees and profits on the loan from its interest spread, so it has an obvious material interest in the transaction. Clearly then, it has a conflict of interest in voting shares in Boto as a trustee.
Senior Managers
SEHK rules require Senior Managers of listed companies to be identified in the annual report. This allows us to identify the following shareholdings from the register as being held by Senior Managers:
Note: the law does not require Senior Managers (which is a Listing Rules term) to disclose their shareholdings, so we do not know whether they have any indirect holdings through HKSCC Nominees Ltd.
Vivian Kao is a daughter of Michael Kao and presumably a beneficiary of his family trust, which is a party to the Buy-out. Terry Tse Chi Man will, if the deal is completed, be promoted to a Directorship of the listed company, so he also has a material interest in the Buy-out. In the case of all Senior Managers, since they are on the register, the Chairman is likely to know how they vote, because they will have to send in proxy cards in their own names or attend the meeting.
Clearly, since Mr Kao is their boss, it would not be a good career move for a Senior Manager to vote against the Buy-out. Furthermore, most of them will be working for the privatised core businesses, and may in future receive bonuses, profit-sharing or other equity-like incentives which depend on the performance of the privatised group, giving them a material interest in the Buy-out.
Because of all these material interests which create a conflict of interest, we believe the Senior Management are not independent shareholders and should be prohibited from voting.
Share Options
Notice that nearly all the Senior Managers' holdings last changed on 12-Dec-01. There's a probable reason for this. On 15-May-01, a round of share options was granted, including 3m to Mr Kao and 9m to the other directors, exercisable for two years starting six months after the date of grant, that is, between 15-Nov-01 and 14-Nov-03. Normally, option holders would not exercise options until near the end of their period, partly because that involves putting up cash and triggering tax liability. However, between 3-Dec-01 and 12-Dec-01, the directors exercised all of these options, less than a month after they became exercisable and nearly two years before expiry. Based on the identical register dates, it is a fair guess that Senior Managers (whose dealings are not required to be disclosed) all exercised options on the same day.
Note to Regulators
We don't know how many options were granted in total, because amazingly, the SEHK does not require companies to file disclosures when they grant options. That is another problem the SEHK should fix - currently it is impossible for an investor, or a takeover offeror, to know how many shares (and hence votes) would be in issue after all outstanding options are exercised. A classic example of this was on 22-Apr-02 when Pacific Challenge disclosed that, unknown to a hostile offeror, it had purportedly granted 23.888m share options way back on 4-Feb-02, equivalent to 8.3% of the current share capital.
Shanghai Industrial
A company called GEM Capital Investment (BVI) Ltd, which is wholly owned by Shanghai Industrial Investment (Holdings) Co Ltd (SIIC) owns 5.83% of Boto. SIIC, which is wholly-owned by the Shanghai Municipal People's Government, is also the parent of HK-listed Shanghai Industrial Holdings Ltd. Mr Zhuo Fu Min (Mr Zhuo), an Executive Director and Vice President of SIIC, is a non-executive director of Boto, having joined the board after SIIC subscribed for the shares in September 1997, at a split-adjusted $0.34 per share.
As a director of Boto, Mr Zhuo should have full access to the latest management accounts, 3-5 year projections and other material which were provided to Carlyle during the Buy-out due diligence. This would show him just how strong the prospects are, and why SIIC should join other minority shareholders in voting against the Buy-out.
Voting Summary
According to an article in the SCMP on 25-Apr-02, quoting a source who was clearly aware of the details, the SEHK has ruled that HSBC will be allowed to vote the shares it holds through Silverbay, which gets its mail through Boto's head office. As stated above, we strongly disagree with this decision as we believe HSBC Group has a material interest in the transaction from its lending business.
According to the same article, SEHK has decided that "all directors would be barred from voting". However, the article also says that "some senior management shareholders would be allowed to [vote]". We disagree - anyone whose boss is Mr Kao clearly has a conflict of interest, as shown above. We don't know what is meant by "some" senior managers, but we would guess that it at least excludes Mr Kao's daughter and probably Mr Tse, who is expecting a promotion if the deal proceeds and has been instrumental in presenting the Buy-out to the media.
We urge the SEHK to reconsider, but if they allow HSBC to vote the deceased co-founder's shares, and allows Senior Management to vote too, then we can assume that these conflicted parties will vote in favour, presenting a vote of up to 5.12% in favour of the deal.
Mr Kao and the directors (including some of their shares held through unknown nominees) together have 64.84% of Boto. If HSBC (4.08%) and Senior Management (1.04%) are excluded, then that leaves independent shareholders (including SIIC), who own 30.04% of the company, to decide the outcome, on a simple majority of votes cast. Not all independent shareholders will vote, of course - so the turn-out will play an important factor.
The independent shareowners, large and small, who have told Webb-site.com they will vote against the Buy-out, hold between 10% and 15% of the votes (we are not releasing an exact figure for obvious reasons). Tellingly, not a single shareholder has contacted us to say they will vote in favour, despite Boto's claims of support, which we frankly do not believe. Anyone who thought this was a good price would have already sold their stock at the higher prices prevailing before the deal was announced. So unless there are some hidden undisclosed shareholdings loyal to Mr Kao, it appears very likely that this deal will be voted down.
A Great Business
One thing that everybody agrees on is that Boto has great core businesses of festive products (Christmas trees and decorations) and leisure furniture. The latter business grew sales at an estimated 100% in the year ended 31-Mar-02. Boto should announce the audited results as soon as possible.
Mr X. D. Yang, a Managing Director of The Carlyle Group, said in a statement announcing the deal:
"Boto is a very solid company with strong cash flows. It is the world leader in the artificial Christmas tree business."
He went on to describe it as:
"one of the best run manufacturing companies that we have seen in Asia."
He continued:
"Carlyle is well positioned to work with Boto to further capitalize on its predominantly U.S. and European customer base and accelerate the growth of its leisure furniture and other related businesses"
Remember, this and the festive products side are the principal products which Boto described in its announcement as "relatively mature with low growth prospects". Quite a contrast! Carlyle's Mr Yang also appears to agree with us that US retailer Kmart's restructuring will not be more than a blip in the distribution of Boto's products to end customers. He told Reuters on 4-Apr-02:
"We think Boto has a very strong and diverse customer base. The foundation is very strong and we hope and expect Kmart will come back in some fashion".
HSBC's loan implies greater business value
For a second opinion, we turn to HSBC, who told FinanceAsia.com:
"We view this as a good business. We have banked this company for a long time. We have a great deal of confidence in the way it has grown."
Indeed, so strong are the cash flows that HSBC is willing to lend 80% of the purchase price of the deal, which we believe is because it is worth a lot more than Carlyle is paying for it.
We say this, because any sane banker, lending money against a business with factories in mainland China, would not expect much in the way of real recoverable security - and would lend against projected cashflows, discounted back to net present value.
This loan would not exceed 40-50% of the fair value of the business. This translates to a debt:equity "gearing" ratio of 40:60 (67%) or 50:50 (100%). No way would HSBC provide 80:20 (400%) gearing for a business of this type. This can only mean one thing: based on the loan facilities of $804m, the business is actually worth between $1,600-2,000m, rather than the $1,007.5m that they are paying for it, so that the loan-to-value ratio is between 40% and 50%. If you take the mid-point of that range, or $1,800m, then that just happens to be 10x the estimate of $179.6m by Kim Eng brokerage of what Boto made in net profit for the year to 31-Mar-02.
This is a figure which we have previously stated would stand a fair chance of success if it was made in the form of a general cash offer at around $0.52 per share for all outstanding shares in the company.
Withdraw Now
We urge the board of directors, in the best interests of the company, to withdraw the Buy-out proposal rather than publish a circular convening a general meeting. They may feel they had a duty to announce the proposal in order to seek investors' views, but it is quite clear that independent shareholders overwhelmingly disapprove. To push on in the face of this opposition would simply damage the reputation of the company, since the terms of the deal are beyond any justification. If that circular goes out, they and their advisers can expect a classic analytical shredding exercise on Webb-site.com.
Boto would set a shining example of accountability if it listened to the market, thanked us for our support and agreed that remaining public, and not privatising the core business at a huge discount to fair value, was the way forward.
The agreements for the Buy-out are conditional, amongst other things, on independent shareholders' approval, a condition which cannot be waived by the purchaser. If that condition has not been satisfied by 31-May-02 then the deal automatically lapses without liability to any party. Carlyle has a reputation to preserve too, but if it is unwilling to sign an early termination agreement, then the most graceful way out for Boto is simply to run out the clock and allow the deal to lapse.
A Fair Alternative
Due to the HSBC loans, it is clear that one side-effect of the Buy-out is that Mr Kao would receive a substantial amount of net cash, being the difference between the dividend of part of the sale proceeds, versus the equity that he would need to subscribe for the Buy-out. We have not been told whether he is paying the same price as Carlyle for the equity in the Buy-out vehicle, but it is very unlikely to be more and may well be less.
Based on an estimated $243m of equity, he would need to put in up to $73m for his 30% stake. Boto has indicated to some investors that it will only pay out about 70% of the proceeds of the Buy-out, or about $0.22 per share, retaining the rest (about $0.10 per share) to play with in the start-up Imagi animation business. The market would apply a heavy discount to this, and the shares might trade at only 40-50% of net asset value, or $0.04-$0.05 per share. That means they are only worth about $0.26-0.27, including dividend, if the Buy-out proceeds. That compares with $0.34 before the Buy-out was announced.
This dividend would give Mr Kao, with his 30.93% interest, about $234m, so after investing in the Buy-out vehicle, he would extract about $161m of cash while keeping a geared 30% stake in the future of the core business. That's great for Mr Kao, but terrible for all the minorities, who would be replaced by Carlyle and lose all the upside of this business.
A fair alternative would be as follows:
- Withdraw the Buy-out proposal, or allow it to lapse on 31-May-02;
- Boto, which has almost zero net debt, could borrow $520m from HSBC as a long-term loan;
- distribute the $520m as a special dividend of about $0.15 per share; and
- make a renewed commitment to remain listed in Hong Kong and to the highest standards of corporate governance.
That would treat all shareholders equally and fairly. As a shareholder, Mr Kao would receive 30.93% of $520m, or $161m, exactly what he would extract from the Buy-out, and retain a 30.93% economic interest in Boto, almost the same as the 30% he would have in the Buy-out. Boto would retain its listing, and all investors would receive a dividend and participate in a geared upside for the core business. Our proposal is fair to all shareholders, not just Mr Kao. HSBC is obviously happy to lend $520m if it would lend $764m against the same cash flows.
At current interest rates, with a premium of say 2% over HIBOR (4% total), the loan interest would be about $20.8m per annum. Ignoring any tax benefit, at the current Mar-02 P/E of around 6x, this would reduce market value by about $125m, or around $0.036 per share, which is much less than the $0.15 dividend, adding $0.114 per share to shareholder returns.
More importantly, if Boto acts responsibly now, then we would expect it to participate in the general re-rating of industrial stocks that has taken place. Hong Kong's Stock Exchange needs good companies that are committed to developing the quality and depth of this market. Companies like Techtronic Industries, Johnson Electric and Esprit Holdings have shown what can be done. Remember, Boto has grown both sales and profits for 7 years in a row, and is expected to announce an 8th year for Mar-02. Not many HK-listed companies have achieved that!
If the Buy-out proceeds, then like any private equity firm, Carlyle would hope to exit in a few years time. They would probably look for earnings to grow at an average rate of around 20% for the next 4-5 years, doubling earnings in the process, and then refloat Boto on another market such as Nasdaq with a P/E of say 11x, double the purchase price of 5.6x. Double the earnings and double the p/e and you get a $4b valuation. Profits in the next 4-5 years would be enough to repay the loan, leaving a return of $4bn on a $243m equity investment. But like we said, this is not going to happen, because we will vote it down if they push ahead.
We believe such earnings growth and P/E re-rating can take place in Hong Kong, if Boto recommits to the Hong Kong market and to treat its investors fairly. Hong Kong's market needs to retain and nurture success stories like Boto.
© Webb-site.com, 2002
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