Nearly everyone who’s paid attention to the US-listed Chinese stock sector is familiar with Harbin Electric (HRBN). HRBN has been relentlessly attacked by short sellers since its announcement nearly one year ago of a proposed management buyout at $24. These periodic attacks have produced large stock price volatility, and undoubtedly certain short sellers have made terrific returns by closing out their positions on sharp price drops.
But the remaining short sellers -- the True Believers who haven’t closed out their positions -- are now left in a very unpleasant position. Their fates were sealed when HRBN obtained final SEC approval of its proxy and set a meeting date of Oct 29 to approve the buyout.
The stock still has quite attractive upside potential. Assuming you purchase stock on Oct 10 at $21.75, and the trade settles on Oct 13, and the deal closes and funds at $24 on Nov 7, your annualized return would be over 150%. An even more compelling trade is to sell puts on HRBN – from a common sense point of view, the puts are way overpriced, and present an even better risk/reward ratio than owning the stock.
Opportunities in selling the puts:
- The puts can be grouped into 2 categories. In the first category are the puts that expire on Oct 21. From a risk/reward standpoint, these October puts are particularly compelling, because all hurdles to closing the buyout have now been surmounted except for the shareholder vote and then the actual funding and closing, none of which will occur prior to the Oct 21 expiration. So, October 21 should “come and go” without any events occurring, and at such point we would only be one week away from the shareholder meeting. Logically, between now and Oct 21, the current price ($21+) should be a floor, and more likely, the stock should rise to the $22+ level. Here are some examples as of late in the day on Oct 6 – logically, all of these puts should expire worthless (or in the case of the $23 put, close to worthless) in under 2 weeks:
|11 Oct 17.00||$ 0.55||$ 0.80||$ 0.25|
|11 Oct 18.00||$ 0.75||$ 0.95||$ 0.20|
|11 Oct 19.00||$ 0.95||$ 1.00||$ 0.05|
|11 Oct 20.00||$ 1.00||$ 1.25||$ 0.25|
|11 Oct 23.00||$ 1.90||$ 2.25||$ 0.35|
- In the second category are all options expiring after the shareholder vote – the November, December, January and March series. These options have a higher risk than the October options since it’s theoretically possible that shareholders don’t approve the buyout, or that the funding sources vanish at the last minute. However, that seems like a pretty remote risk considering: (i) the financial strength of the parties involved, (ii) the opportunity for Abax to have pulled out of the deal back in June, before the definitive documents had been signed when the stock fell to $6 (they did not pull out, leading one to believe that they really want to close this deal), and (iii) the substantial funds the company and Chairman Yang have spent on blue chip bankers and lawyers over the past year on this deal (why in the world would he spend that kind of money if he didn’t intend to close the deal?). Nonetheless, it’s a theoretical risk. To compensate for that risk, the Nov-Mar puts have higher premiums than the Octobers of course, some of which seem downright stupid. Below are some examples. Assuming the buyout closes as scheduled, the maturities of all these puts will be accelerated, and will expire worthless in about 4 weeks:
|11 Dec 9.00||$ 0.90||$ 1.00||$ 0.10|
|11 Dec 14.00||$ 1.75||$ 1.90||$ 0.15|
|11 Dec 17.50||$ 2.25||$ 2.45||$ 0.20|
|12 Mar 5.00||$ 0.25||$ 0.55||$ 0.30|
|12 Mar 8.00||$ 0.80||$ 1.15||$ 0.35|
|12 Mar 10.00||$ 1.05||$ 1.50||$ 0.45|
|12 Mar 16.00||$ 2.00||$ 2.55||$ 0.55|
|12 Mar 19.00||$ 2.60||$ 3.20||$ 0.60|
|12 Mar 22.00||$ 3.30||$ 3.60||$ 0.30|
Why are there still great opportunities in HRBN stock and puts even though the company is literally on the verge of closing the deal?
- The True Believer short sellers are likely only now beginning to process their fate. It’s basic human psychology that we initially deny an unexpected and totally unwanted outcome, whether of a personal or financial nature. Despite the final nail in the coffin late last week, it’s likely that many of them just don’t believe that this “bad outcome” could be happening. They were so certain they were going to win, and they kept trying all the way up until in the last minute to crater the company and the stock price. But with Oct 29 right around the corner, that denial will probably give way pretty quickly to resignation.
- The “denial factor” is likely exacerbated by the very high cost that short sellers have had to pay to borrow the stock. HRBN has a huge short interest ratio, is often on the naked short sale “Threshold Security list” for failures to deliver, and short sellers have been paying around a 100% annualized rate to borrow the stock from lenders. For example, assume a short seller established his position on the last day of trading in 2010. The average closing price of HRBN over all trading days in 2011 has been just under $18. At a cost to borrow of 100%, that short seller has paid fees of roughly $18 x 100% times 9/12, or $13.50, just to keep that short in place through the end of September. What a financial beating many of them have taken so far on this trade! You would have to convince yourself that the stock was literally going to zero (and quickly) to justify establishing and continuing to hold that position for such a long time, which is all the more reason for the “denial” reaction.
- Additionally, the put premiums have been pushed sky-high for 2 reasons: (i) volatility has a huge impact on option pricing models (but with the deal only weeks away from closing, the relevance of historical volatility is questionable), and (ii) the very high cost to borrow the stock made it mathematically justifiable to push premiums into the stratosphere as an alternative to shorting the stock (but again, with the closing so near, these premiums should collapse, just as they quickly did in the weeks prior to the shareholder vote on the recent CSR buyout).
- As well, it’s likely that a lot of “me-too” short sellers have gotten into this name. The negative stories sounded so believable, and making money being short US listed Chinese stocks has been such easy pickings. It’s probable that a very large percentage of those who still hold short positions in HRBN have done no independent research on the company, and have little personal knowledge of China. When you do very little of your own research but keep making money, you tend to develop a misplaced sense of confidence, which doesn’t dissipate overnight.
The big picture that short sellers seem to have misunderstood:
- Despite the fine work done by the shorts in uncovering true fraud in certain Chinese companies, it’s also clear that certain “enterprising” (to be kind) short sellers also figured out how to make any Chinese company look bad, and unleashed a viral contagion upon the entire sector – painting all US listed Chinese stocks with the same nasty brush, and scaring investors to death with their stories.
- But if a large percentage of Chinese companies were truly frauds, as the shorts would have us believe, how could there be a huge and fast-growing private equity industry in China? In the last 6 months alone, BJGP, CPC, CSR, FTLK, SNEN, SOKF, TBV, and TCM have been taken private by management and PE firms, or purchased by strategic acquirers. Bain Capital is in the final stages of completing its buyout of CFSG. YONG and CXDC have recently obtained large equity infusions from Morgan Stanley. Many more US listed Chinese companies will likely go private in the next year or so. All the PE firms involved in these deals are able to conduct due diligence on a scale and to a level of detail that the short sellers can never even dream about.
- What is the strategy of the PE firms? They know that they can take these companies public again in Hong Kong in a fairly short period of time, for huge profits. A recent example is Hongguo International (a footwear company) which completed its Hong Kong IPO late last month, raising about $150mm USD, and valuing the company at about $600mm USD. The company was taken private (it had been listed in Singapore) in 2010 at a valuation of only $130 million USD, so these clever guys made a 4-5x return in under 2 years, not including the effect of leverage.
- Specifically in the case of HRBN, the short sellers ignored the fact that multiple highly sophisticated parties were invited into the inner circle to conduct due diligence, far more due diligence than the most sophisticated outside short seller could ever conduct. Most likely, the objective with HRBN is to re-IPO it in Hong Kong within a couple of years for a big profit. These parties include:
- The PE firm Abax Capital, which is rolling its current holdings of HRBN stock into the buyout, and also providing fresh equity and subordinated debt, totaling to a commitment of over $100mm USD. Note that Hong-Kong based Abax is backed by Morgan Stanley, and run by Donald Yang, the former head of Hong Kong and China Capital Markets for Merrill Lynch.
- The China Development Bank, which is an arm of China’s national government, responsible for carrying out national economic policy objectives, and which has assets totaling 5 trillion RMB (over $800 billion USD).
- The incredibly costly team of bankers and lawyers providing advice to the various parties, including Goldman Sachs, Lazard, Morgan Stanley, Skadden Arps, and Gibson Dunn.
Below is a table which suggests a logical price path for HRBN, if it follows the example of how CSR traded prior to the completion of its buyout a few weeks ago. CSR is a good comparison in that it was very heavily shorted, had a high cost to borrow, and its buyout was also financed by the China Development Bank (interestingly, the bank financed 100% of the buyout, with no new equity money coming in to support the buyout). Also interesting is the fact that CSR had actually been subject to a formal and ongoing SEC investigation (presumably regarding its accounting) for over a year at the time that the SEC approved its proxy. By contrast, HRBN has never been subject to a formal SEC investigation. Yet the short sellers were trying very hard in September to get the SEC to halt the proxy approval process (they nearly “demanded it” in their most recent published reports). Their self-serving efforts failed of course, because in the proxy approval process, the SEC is primarily concerned with adequate disclosure to investors of the events concerning a buyout, so that investors can make their own fully informed decision about whether to vote for the merger. Of course, maybe the guys who wrote those reports knew that, and instead they were really just trying to knock the stock price down, to be able to cover.
|Key Event||Announcement made||Closing price prior to such announcement |
|As a % of Merger Price of $6.50||Closing price on 1st day of trading after announcement||As a % of Merger Price of $6.50|
|CSR announced that Definitive Proxy Statement was filed||8-11-11 at 7:03am EST||$ 5.73||88.2%||$5.95||91.5%|
|Shareholder mtg commenced 9-13-11 at 10pm EST||na||na||na||na||na|
|CSR announced that Shareholders approved merger||9-14-11 at 7:00am EST||$6.18||95.1%||$6.40||98.5%|
|CSR announced that the merger was completed||9-16-11 4:30pm EST||$6.40||98.5%||N/A - no further trading||N/A|
|HRBN announced that Definitive Proxy Statement was filed||9-29-11 at 5:00pm EST||$19.20||80.0%||$20.65||86.0%|
|Shareholder mtg will commence 10-29-11 at 9am EST||na||na||na||na||na|
|Projected: Results of vote likely to be announced prior to market opening on 10-31-11||Projected, using same ratios as CSR:||$22.82||95.1%||$23.63||98.5%|
|Projected: Likely merger closing prior to Nov 4||$23.63||98.5%||N/A - no further trading||N/A|
|All data is based on regular (not extended) trading hours only|
Disclosure: I am short HRBN puts