I was surprised when I was unable to track down any news coverage on the recent announcement by BYD Electronic (BYDIF.PK) regarding management’s intention to lend RMB 1 billion to its parent company BYD (BYDDF.PK). Not even one single article or blog post. The proposed loan agreement still needs to be approved by independent shareholders (excluding BYD’s 65% vote) on 14 Oct 2011, but the fact that management is prepared to put this forward has me worried.
You can find the details of the proposed loan here (pdf), but the gist of it is that BYD Electronic is lending RMB 1 billion to its parent BYD for three years at 7.3% per annum. BYD, which owns 66% of BYD Electronic, is using its shares in BYD Electronic as collateral. BYD Electronic’s management thinks the deal makes sense for BYD Electronic shareholders, because the 7.3% yield compares favorably with that which can be earned from a regular savings account.
Questionable capital allocation decision
On the face of it the above argument makes sense, but not when you consider the following. BYD Electronic is currently valued at about RMB 3.5 billion; it has net cash of roughly RMB 2.5 billion (pdf) which gives it an enterprise value of RMB 1 billion. Therefore, the RMB 1 billion loan makes up almost 30% of the current market value! Apart from the fact that RMB 1 billion in itself is a big number; in context it is equally significant.
Furthermore, BYD Electronic’s share price decreased by over 80% from HKD 10.75, since its IPO in 2007 to around HKD 1.90 today. Neither is the company paying dividend nor is it buying back shares. Why not? Maybe management does not think BYD Electronic is trading below its intrinsic value. However, if management does not consider BYD Electronic International Co Ltd ’s shares undervalued when trading on a PE [as reported on Reuters Knowledge] of 3.3, an EV/NI of 1.1 or a P/BV 0.46, then at which valuation would management consider it undervalued? How can management be comfortable with lending excess cash out at 7.3%, when it can equally well repurchase shares which would yield 30% (inverse of PE of 3.3)? Obviously it is not practical to apply all of the RMB 1.1 billion this way, but what about a special dividend to ALL shareholders?
BYD needs capital
The real reason seems obvious; BYD needs the cash, because it is a company in need of capital. It had mixed success in raising some with Bloomberg reporting the June 2011 equity raise of RMB 1.42 billion being 35% below target. The same article goes on to say BYD recently received shareholder approval to sell as much as RMB 6 billion of bonds. It has RMB 16 billion of bonds and loans outstanding with a RMB 15 billion term loan maturing next year. Borrowing costs for the bonds are estimated to be at least 8.89%.
In itself it should not necessarily be of concern, but what should have the alarm bells ringing is that it appears management of BYD Electronic is willing to raid the piggy bank to help BYD borrow at 7.3%.
Consider Buffett’s view on share repurchases
BYD does not seem to miss an opportunity to capitalize on its most famous investor’s name, Mr. Warren Buffett. Management even referred to Mr. Buffett in the regulatory filing announcing the intended RMB 1 billion loan. It is interesting to note what Mr. Buffett wrote in his letter to shareholders in 1984 about management’s behavior in the context of share repurchases. I highlighted the last paragraph, which I find particularly instructive.
The companies in which we have our largest investments have all engaged in significant stock repurhases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons - one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.
The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer. (To make the point extreme, how much would you pay to be a minority shareholder of a company controlled by Robert Wesco?)
The key word is “demonstrated”. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth - and, after a while, neither will the market.
Mr. Wang Chuan Fu
We hear very little from majority shareholder and chairman of BYD and director of BYD Electronic, Mr. Wang Chuan Fu, but the talk we are getting from notable backers like Mr. Charlie Munger, Mr. David Sokol and Mr. Buffett is remarkable.
However, it is not the talk, but the walk that matters. What is Mr. Wang Chuan Fu “demonstrating” to his shareholders at BYD Electronic? Is he, to paraphrase Mr. Buffett, turning his back on repurchases? Based on the previously low market multiples how can one not come to that conclusion? This of course raises many questions. Can BYD Electronic shareholders expect all future cash flows to be conscripted to BYD? Is this a harbinger of what BYD shareholders, including Mr. Buffett, can expect from the hands of Mr. Wang Chuan Fu?
It will be interesting to see which way the independent shareholders vote on 14 Oct.
Disclosure: I am long BYDIF.PK.