China Water & Drink Favors Institutional Investors

China Water & Drink (CWDK.OB) announced Friday that it has successfully closed a $50 million private placement of convertible notes to a small group of investors include Goldman Sachs (GS), the bluest of all blue-blooded investment banks. The company's CEO describes this transaction as a "tremendous opportunity for us to expand our market penetration", mainly through acquisitions.

This looks great, until you realize the company is setting the conversion price at $4.25 per share, a whopping 75.4% discount from Thursday's closing price of $17.25. Why is the conversion price so low, with the knock-on effect of a greater-than-necessary dilution? I thought I would look at other recent OTCBB convertible deals for comparison.

First, in December, China Biotics (CHBT) completed a $25 million offering with a conversion price of $12.00. And what were the shares trading at the time? $12.00. This was a deal done at market price, at 0% discount, despite a 10.9% dilution. Why would the investors do that? Clearly, they are getting interest income off the convertible bonds. But more importantly, given the rise of Chinese stocks, by the time conversion rolls around, the shares could be trading at much higher than the conversion price. So a small or 0% discount is doable.

Let's look at another example. In November, China Recycling Energy (CREG.OB) closed a $5 million deal (first tranche of a larger transaction) with a conversion price of $1.23. This was a 59.3% discount from its previous close of $3.02. At first sight, this resembles CWDK's deal. But when you scratch the surface a little, you will realize that the share price doubled in the three trading sessions before this announcement. In other words, news leaked. Taking the pre-rally price, the discount would only be 12.1%, for a 16.1% dilution.

Was there a rally in CWDK's case? Were there unusual trading volumes in the past few days? Not really. But even if you were to say that CWDK's post-Christmas rally could be attributable to this transaction, this is still a 38.0% discount from its 12/24 closing price of $6.85, versus a dilution of only 11.1%. Still very rich.

Finally, I want to look at Huifeng Bio-Pharmaceutical (HFGB.OB). This company closed its convertible transaction on 12/31, raising $2 million in proceeds. And what was the conversion discount? There was no discount. In fact, the conversion price was set at a PREMIUM to its closing price - $1.00 versus a closing price of $0.75. I looked at the deal and thought: Why not? Conversion happens in the future, and if the investor buys into the company's growth story, a premium like this is very possible.

So where does that leave us with CWDK? The bottom line is, this is not just a case of the share price being over inflated, which it is. It is, more egregiously, a question of favoring institutional investors over retail investors like us. In other words, CWDK is telling us: "Sorry, since you're not Goldman Sachs, you can't buy our shares at $4.25. But I can offer you at $17.25 if you like". And this is not even a PIPE deal. The institutional investors are, additionally, earning interest in the meantime, while having the option of deciding if they want to convert in the future.

So I ask: why would one support a company like that? I certainly wouldn't.

My Position: None.

Comments

[megiddo666:]

This is one way to see it. Another way is that Goldman, etc. Are going to make a ton of money. There will be share dilution at some point, which will create additional trading liquidity and possibly drop the price. However, there is much to the story untold above.

The current PE is only 24x earnings, the company is opening a huge production expansion in 2Q 08. Additionally, its nine months performance and business outlook, even without expansion via acquistion is strong. If any share dilution takes place, if acquisitions are accretive in 08. It seems good news. Also the Chinese govt. has already said it is restricting capital inflows and Chinese bank lending in 08 to cool the economy. As one holding CWDK shares, I am not particularly concerned about the share price or the deal...However someone wanting to get in at a lower entry price might have reason to question this deal.

2008 Jan 28 11:53 AM

[megiddo666:]

Why this article came back up on Oct. 31 a day after the Hekmann deal closed is erroneous. The Goldman PIPE was done in January.

2008 Oct 31 09:11 AM