On Wednesday A123 Systems (AONE) announced the execution of a non-binding Memorandum of Understanding with the Wanxiang Group that will, if successfully implemented, restore A123 to sound financial footing. Since the basic deal terms are a good deal more complex than the reports one reads in the mainstream media, I think a drill down into the details may be helpful for investors who want to understand what a restructured A123 will look like. The critical document for this analysis is the MOU included as Exhibit 99.2 to A123's recent report on Form 8-K.
The basic business deal has three distinct structural elements:
- A $75 million senior secured bridge loan facility with associated warrants;
- A $200 million senior secured convertible note financing; and
- A block of warrants that will, if exercised, generate up to $175 million of additional equity.
The bridge loan facility will be secured by substantially all of A123's assets and has been separated into two tranches. The first $25 million, which includes $15 million in cash and a $10 million letter of credit, will be immediately available to A123 upon execution of definitive agreements. The $50 million balance will be funded when certain first tier conditions are satisfied, including:
- receipt of a favorable determination from the Committee on Foreign Investment in the United States;
- receipt of Chinese government approvals;
- retention of the R&D and engineering teams; and
- other usual and customary conditions.
Barring a mass exodus of the R&D and engineering teams, I think there's a high probability that the entire $75 million bridge loan facility will become available to A123 over the next couple months; Wanxiang will obtain a reasonable level of de facto control; and A123 will get enough breathing room to finish a more comprehensive restructuring.
The senior secured convertible note financing will be more complicated and time consuming. Wanxiang's commitment to buy $200 million in notes is subject to several second tier conditions, including:
- reasonable assurances that A123's government grants and tax credits will remain available;
- stockholder approval of the restructuring transaction;
- conversion or repurchase of at least 90% of $143.8 million in convertible notes that were issued in April 2011;
- conversion or redemption of the $50 million in convertible notes that were issued in May 2012;
- an increase of the number of directors from seven to nine and the election of four directors designated by Wanxiang;
- compliance with Hart-Scott-Rodino and other antitrust laws; and
- continued listing of the Common Stock on Nasdaq.
It's clear from the MOU that the retention of A123's government grants and tax credits is a critical valuation issue. If the grants and credits remain in place, the exercise price of the bridge financing warrants will be $0.425, but the exercise price will be reduced to $0.17 if the grants and tax credits are lost. Similarly, the conversion price of the senior secured notes and the exercise price of the related warrants will be $0.60 per share if the grants and tax credits remain in place, but they'll both be reduced to $0.24 if the grants and tax credits are lost.
Under the circumstances, I think A123 will probably get the necessary government assurances and approvals. It should also be able to negotiate the redemption or repurchase of its outstanding debt on reasonable terms. While investors may grumble, particularly if the proxy statement for the required stockholder approvals includes a reverse split to solidify A123's Nasdaq listing, there really isn't an alternative so they'll eventually go along.
While the series of transactions have been described as a $450 million rescue in media reports, the only funds Wanxiang will be required to invest are $75 million for the bridge loan facility and $200 million for the senior secured convertible notes. If one assumes that no additional shares will be issued in connection with A123's outstanding convertible debt, the bridge loan warrants will give Wanxiang the power to obtain 51% voting control by tendering that debt in payment of the exercise price. While conversion of the notes would increase Wanxiang's voting control to 75% if it chose to exercise its rights, a reasonable risk manager could conclude that voting control, coupled with $200 million in secured debt, was a more advantageous position for Wanxiang given the uncertainties of A123's business.
I've always believed that prudent investing begins with a worst case analysis. In the A123 - Wanxiang transaction I believe the worst case is a $75 million equity infusion that will increase A123's book value to $188.8 million, or $0.544 per share, and give Wanxiang voting control. While the $200 million senior secured convertible note financing will increase A123's liquidity, a substantial portion of the cash will be used to redeem or repurchase A123's other debt securities.
I believe it's safe to assume that the holders of the $143.8 million in convertible unsecured subordinated notes that A123 issued in April 2011 will be willing to accept a haircut in connection with an early redemption. I don't, however, have any basis to predict what the haircut might be. While holders of the $50 million in convertible unsecured senior notes that A123 issued in May 2012 might also be willing to accept a haircut in connection with an early repayment of the $39.6 million balance, I'd expect their negotiating position to be more aggressive. In a worst case scenario, the bulk of the $200 million in proceeds from Wanxiang's senior secured convertible note financing will be used to retire junior debt.
On balance I believe the Wanxiang transaction is a positive development for A123's stockholders because it will stop the issuance of additional common shares under the 2012 notes and help alleviate the intense selling pressure that's resulted from the issuance of 23.4 million new shares since June 26th. It will also restore A123's stockholders equity to a more reasonable level and give the company time to restructure its affairs. The transaction is not, however, a permanent solution to A123's problems and any number of uncertainties are yet to be resolved.
While I don't see anything in the deal structure that would justify a rush to the exits, I believe investors who decide to hold or buy A123's stock must pay careful attention to future releases that quantify the current uncertainties. This is not a good time for irrational exuberance.