The decision to merge Harbin Electric, Inc. (NASDAQ:HRBN) with Tech Full Electric Company, Ltd. (TFEC) involves an acquisition of 59.34% of HRBN. The total purchase price, according to SEC filings (Schedule 13D, 6/20/2011), is $463.8 million, or $25.04/share. This investment adds $98.9 million of goodwill to HRBN’s existing balance sheet and generates a pre-interest, pre-tax marginal return of about 11%, based off of the last couple of years of audited financial statements.
Financing for this merger involves a $400 million term loan being supplied by China Development Bank to TFEC, payable over 7 years, along with both a $38.8 million equity position and $25 million secured note supplied by Abax Global Capital, Abax HK (see schedule 13D 5/2/2011, in addition to that filed on 6/20/2011), and their affiliates (all apparently related to each other through ownership and the Director position held by Xiang Dong Yang of HK, schedule 13G filed 12/9/2010 and schedule 13D filed 1/10/11) to Tianfu Investments, a Cayman Island firm owned by the CEO of HRBN, Tianfu Yang. The secured note is due in 2018, basically over the same period as the term loan, and is contingent in part upon the receipt of warrants. Thus, the secured notes appear to have a feature that makes the cost of this component of financing variable (schedule 13D, 6/20/2011 ex. 7-05).
Investors have significant doubts about this merger being realized, as reflected by the significant discount to the $24/share shareholders will receive should this be completed. I have decided to put myself in the shoes of the buyers to try and determine whether I find the buyout a good use of capital. Knowing this should be useful in forming an expectation as to how committed the buying parties are to the offer. First, we know the buyout offer is far above book value of $13.87/share. We also know, assuming the financials are accurate, that HRBN’s assets return operating income at a rate of about 15%. Given this is marginal analysis, we have to include the cost of the Loan Facility, which is LIBOR plus 3.5% for the first three years and 4.5% thereafter until the loan is paid off.
Figure that LIBOR will average about 1%, and we can see that the investment returns less than the interest incurred to complete the buyout yield, about 7% the first year, assuming the ability of HRBN’s assets to generate earnings continue going forward (Implied interest of LIBOR plus margin on $400 million, for $463.8 million is about 3.8% the first three years and 4.7% thereafter. All of the above ignores the portion of interest on pre-existing debt being purchased, 59.34% of $112 million with an implied rate of about 7% per annum. This works out to 1% of the buyout the first year, yielding about 6% before taxes, but this is irrelevant in the analysis at hand and I include it merely as a reminder about the effects of pre-existing debt.). The secured notes present an additional cost, but given the variable nature of this component of financing, I will ignore its effects.
This leads to some natural questions concerning use of that capital to purchase 59.34% of HRBN. The $463.8 million in capital might be better utilized through another investment decision within HRBN that yields something greater than 7% before interest and taxes (BIT) over the next 7 years. At the very least, it is worth consideration. Let’s get a rough idea on the severity of diminishing returns on marginal assets. For the periods 2008, 2009, and 2010, one can see that EBIT as a percent of assets have been 18.69, 15.67, and 14.82 percent, respectively. Additional assets for each period have, on average, added 0.10, 0.09, and 0.77 in operating income per dollar. Assets have expanded over this period and we can see that the additional assets have all yielded greater than 7% BIT on average, with a minimum of 9%, along with increasing revenues.
The buyers are sacrificing this higher return if they follow through with the buyout, making the buyout inferior to expansion if all of this is accurate. How committed is anyone to a decision that makes themselves worse off? Clearly, the buyers can choose to not follow through on this offer for any number of reasons. In addition, even after the loan is paid off there remains a permanent 4% cost BIT on the current 59.34% of the existing assets as a result of the decision to buy out the company at an inflated price relative to asset valuation on the books when other uses of that capital appear to have offered better returns at the time. Of course, the secured notes reduce the aforementioned returns through either dilution or additional interest expenses. Thus, the expectation that the buyout offer will be realized is less than certain and a rational person cannot be blamed for finding it lacking in credibility; not due to the parties involved, but strictly based upon the opportunity cost suggested by the audited financial statements.
A credible offer seems to be anything under $383.5 million for 59.34% of HRBN, using the 9% threshold. This would translate to an offer of roughly $19.66/share, assuming the other costs remain unchanged, and make all parties better off rather than one party better off and the other worse off. The buyers may have reasons unrelated to returns on investment for purchasing 59.43% of HRBN, but when the opportunity cost of the decision is greater than the benefit by an identifiable quantity of about $80 million, I think changing one’s mind is not at all out of the question and that is what anyone long HRBN needs to worry about.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.