Honworld May 6, 2015 Cheap Financing or Something Else?
On May 6, 2016, Honworld Group announced a RMB133 million investment in its wholly owned subsidiary Lao Heng He from CD Fund in exchange for an estimated 3.5% of Lao Heng He’s capital. The actual percentage that CD Fund receives will be determined by a valuation report that will be released over the next three months. The funds will be used to construct a natural ecological brewing production base in Wuxing Area, Huzhou City, Zhejiang Province, PRC (the investment project).
The transaction is conditional upon the satisfaction of the following conditions:
- from the date of the Investment Agreement to the date of the Completion, there is no material adverse event that will adversely impact on the business prospects, assets, and financial condition of Lao Heng He;
- the articles of association of Lao Heng He has been amended according to the terms of the Investment Agreement;
- all internal approvals of Lao Heng He, Huzhou Chen Shi, Honworld, and Huzhou Nantaihu with respect to the entry of the Investment Agreement have been obtained;
- Lao Heng He has obtained the relevant undertaking documents from Huzhou City Wuxing Finance Bureau for the Investment Project;
- Lao Heng He has obtained the approval from the relevant local government authorities for the Investment Project; and
- CD Fund completing its due diligence on Lao Heng He. Use of Proceeds Lao Heng He shall ensure that all proceeds of the Capital Investment to be used in the implementation of the Investment Project.
Honworld’s wholly owned subsidiary, Huzhou Chen Shi agreed to repurchase the equity interest of Lao Heng He to be owed by CD Fund within 8 years after the payment of the Capital Investment. CD Fund is according to the repurchase schedule under the Investment Agreement. Under the agreement, the CD Fund with receive minimum returns of a dividend at an annual rate of return amounted to 1.2% of the Capital Investment. No dividend payments need to be made by Lao Heng He until 20 March 2018. On 20 March 2018, the CD Fund shall be paid the total dividend accumulated then the CD Fund will be paid a yearly dividend on or before 20 September every year after 20 March 2018.
Lao Heng He is a wholly-owned subsidiary principally engaged in the manufacturing of cooking wine, soy sauce, vinegar, soybean sauce products and other condiments products. Lao Heng He’s unaudited key income statement accounts are below.
In 2016, the company accounts for 97% of Honworld’s revenue, 97% of its net profit before tax, and 89% of its total assets.
CD Fund, a wholly-owned subsidiary of China Development Bank, was established on 25 August 2015 and is principally engaged in the investment of financial bonds.
The investment will be reported as a financial liability on the company’s balance sheet as there will be no gain or loss as the company can repurchase the equity interest.
Assuming it was a straight investment in the company, it values Lao Heng He at just over 14 times pre-tax profit. The deal seems like a very cheap way of funding the company’s investment assuming it can repurchase the investment at a cost in eight years. It also avoids diluting the company’s existing shareholders through rights issues or issuing additional shares to raise capital needed. The company provided no additional details about the investment project.
As highlighted before, the company’s focus on maintaining such a high inventory level is not allowing the company to self fund its growth. The vast majority of the company’s inventory is work in progress and the gross margin generated on aged products does not cover the cost of ageing products leading to a lower ROIC for the company, as illustrated in our initiation report.
This event has little change on our view that Honworld has a strong brand and economies of scale giving it a very strong competitive advantage. The company is growing very rapidly and is run by a passionate owner operator with the only downside being the allocation of capital to inventory. We are in the process of decreasing our position size but as stated we are not selling below HKD5.00 per share.