The Chronological Progression of China Medical's Debt Woes
Despite reporting over $200 million in cash, China Medical Technologies (CMED) is going through the familiar cycle of a company lacking in liquidity and is forced to ask its bondholders for a debt restructuring. This has led to a halt on February 7th by the NASDAQ until the company can supply additional information. It's uncertain when the halt will be lifted or what will happen to the stock at that point, but a look at the problems brewing in CMED will help us make a decision once trading resumes. Reportedly, CMED will be added to the OTC-BB exchange tomorrow on 2/28 as shown here. The new symbol is CMEDY.
Newly public companies don't start out in trouble, but get there over time. A company's actions and a look at the liabilities section can often tell the crux of the story. Although CMED originally started trading on US exchanges in 2005, its troubles didn't start becoming apparent until 2008. We'll start there. The following is a timeline of CMED's debt holdings and related actions:
Click to enlarge:
China Medical was apparently a healthy medical device company with a market cap of over $1 billion. Its earnings and cash flows were stellar. It only had $150 million of debt with a low interest rate of 3.5%. This was an understandable amount of debt to use for acquisitions and to expand its distribution to hospitals all over China. Interest expense was a modest $1.3 million for the quarter. The company also paid a nice, juicy dividend of $12.656 million. CMED planned on continuing with an annual dividend.
Quarter ending 9/30/08:
This quarter CMED took on another $276 million worth of debt at a 4% interest rate to total $426 million. This was quite a bit of debt, but the company was growing fast and was ambitious. It wanted to dominate the competition with the best products and the best, most widespread sales force. Interest expense was $2.7 million for the quarter.
Quarters ending 12/31/08 thru 9/30/09:
China Medical kept the same debtload and tried to grow the company. It was paying anywhere from $4.1 million to $5.2 million in interest expense. CMED paid its 2009 annual dividend of $17.740 million in quarter ending 9/30/09.
Quarters ending 12/31/09 and 3/31/10:
CMED wasn't too happy with its share price averaging around $13 or $14 a share. It had reached over $50 a share in 2008. So management decided to take action:
From the 12/31/09 quarterly report:
"In September 2009, the Company's board of directors authorized a share repurchase program, under which the Company may repurchase up to US$30 million worth of its outstanding ADSs from the open market or in block trades for a period of one year, commencing on October 1, 2009. As of December 31, 2009, the Company repurchased about 390,000 ADSs at a cost of approximately US$5.0 million (or $12.82 average per share). The Company will continue to repurchase issued and outstanding ADSs depending on market conditions, the trading price of its ADSs and other factors."
From the 3/31/10 quarterly report:
"As of March 31, 2010, the Company repurchased a total of 500,000 ADSs at a cost of approximately US$6.4 million, (or $12.80 average per share). The Company has terminated the program."
There are a couple things I find interesting from the above quotes. First, the average price per share that CMED repurchased the ADSs in both the 12/31 quarter and the 3/31 quarter are almost identical at $12.80 a share. Looking at CMED's chart, it doesn't seem to have ever traded that low during that time period. I'm wondering if they got a special bulk deal on the share buybacks. Second, CMED terminated the buyback program.
In the 3/31/10 report, Mr. Sam Tsang, Chief Financial Officer of the Company commented, "To address certain concerns raised by some of our shareholders and potential investors regarding our high level of leverage, we have taken various measures during the past few months including the purchases of our 3.5% tranche as well as 4% tranche of convertibles notes from the open market at significant discounts on the face value of the convertible notes, the termination of our share repurchase program and the suspension of our annual dividend. We intend to continue to reduce our leverage by accumulating cash generated from our operations. When we reduce our leverage to an appropriate level, we will resume our annual dividend. Nevertheless, we will not reduce our investment in the expansion of our direct sales network serving top tier hospitals and the internal product development on our three technology platforms which will sustain our growth in the mid to long term."
The suspension of their dividend and termination of their stock repurchase program is typically the first step that companies make when their leverage gets too high and starts becoming a problem. CMED also reduced part of its 4% interest bearing notes at a discount.
Quarter ending 12/31/10:
As CMED's 3.5% interest bearing loans will come due in November, 2011, it took on $150 million in 6.25% interest bearing loans and paid off the majority of the 3.5% notes. At this point, CMED had evolved to higher interest bonds on its book, swapping out the 3.5% interest loans for ones that require 6.25%. When companies are in debt trouble, the borrowing costs increase.
Quarter ending 9/30/11.
After three straight quarters of buying back convertible notes at a big discount, CMED didn't buy back any this quarter. This change of pace is a sign of liquidity issues. CMED also was getting ready to retire its remaining 3.5% bonds in the following quarter.
Quarter ending 12/31/11:
CMED paid off its 3.5% interest bearing notes for a total of $16.7 million. CMED shocked investors by announcing a "debt restructuring" and began negotiations with bondholders. Because of the debt restructuring, it didn't pay the interest owed on the 4% coupon bonds which should've been paid on December 15, 2011. The company then had a grace period of 30 days to make the bond payment, or it would be in default.
In general, debt restructuring is never a good sign for shareholders. The bondholders never take a haircut if they don't have to, but if they do have to, the equity holders will take a hit first. The hit to the equity holders is usually either an allowed delay in payments but an increase in the debt, or a debt to equity swap for the bondholders, massively diluting the equity.
Current Quarter ending 3/31/12:
CMED didn't pay the semiannual coupon payment for its 4% bonds during the 30 day grace period and didn't file a 6-K or issue a press release. Both Fitch and S&P downgraded CMED to "Selective default." Management cut off all communication to shareholders by not filing a 6-K or press release, and isn't answering emails or phone calls.
Upon my questioning, one of its independent directors, Dr. Lawrence Crum, told me he quit being a director a couple months ago. He said he "hasn't heard from the company the last couple months, doesn't know what's going on, and doesn't care." This probably is a bad sign for the company. On CMED's annual report for the fiscal year ended June 30,2011, Dr. Crum has served on the board of directors since February 2005, and was a member of the audit committee, compensation committee, and nomination committee.
On February 2nd, Fitch dropped its rating and is no longer following the company due to inadequate explanation by management. On February 15th, Wilmington Trust, the trustee for the bondholders, reported that CMED again failed to pay its coupon payment due on its 6.25% bond. Upon the news, S&P downgraded the company to "Default" and discontinued coverage due to inadequate information from the company. CMED's shareholders are still in the dark. On February 7th, the NASDAQ halted trading on CMED for "additional information requested" from the company.
What comes after this is almost always either a forced bankruptcy by the bondholders, and/or a delisting from the NASDAQ to the pink sheets. Some CMED investors are hoping that CMED will come out with successful negotiations with the bondholders. The reality is that businesses usually don't operate like this, not even Chinese businesses. A company's management wants the share price to be as high as possible partially because share based compensation is more effective with a higher share price. These kinds of games hurt the share price and erode investor confidence, and hurts the company's bottom line.
What about all that cash on the balance sheet?
Companies that take the actions that CMED is taking, going through a debt restructuring and defaulting on bond payments, almost always have little to no cash. If there was cash, it would be used to at least make the minimum payments and avoid the trouble that CMED is going through now.
However, CMED reported $206 million in cash on its statement ended 9/30/11. For years, its cash balance has been reportedly between $100 million and $200 million. For the quarter ended 6/30/11, $191.7 million was reported, for 3/31/11: $171.6 million, and for 12/31/10: $169.6 million. CMED has said in its shareholder meetings that the cash would be used for growing the business. However, only a minimal amount has ever been used for that. CMED's cash balance of around $200 million isn't used for acquisitions, paying off debt, share buybacks, or dividends. So far, it is just numbers on a piece of paper with no real power. One can either make the assumption that the money isn't there and CMED is making it up, or the funds are tied up somewhere. I'm guessing it's the former, as there are quite a few Chinese companies trading on American exchanges for pennies with millions of dollars of cash reported on their balance sheets. This wouldn't be the first time this has happened. But we shouldn't have to guess here, the company should give us the answer.
Disclosure: I am short CMED.