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AutoChina makes a sop to investors but its business model remains a mess

|Includes: Ford Motor Company (F)

The removal of AutoChina International's (AUTC.NASDAQ) earn-out provision is nothing more than a cosmetic action designed to appease investors. If they looked harder at the financials, they would find a company living on borrowed money.

AutoChina International (AUTC.NASDAQ), a leading commercial vehicle leasing company in China, has axed the controversial system under which its CEO gained shares each year while existing investors saw their shareholdings diluted.

It’s a positive step, but it doesn’t resolve fundamental problems with the company’s business model.

The earn-out provision, introduced in 2009, was supposed to remain in place until 2013, diluting shareholders’ stock by 5-20% each year. The size of the earn-out is based on growth in AutoChina’s EBITA – the more the growth rate exceeds 30%, the higher the proportion of total outstanding shares awarded to CEO Li Yonghui. In 2010, this dilution reached the full 20% as Li was issued over 2.6 million shares.

Following a spate of bad publicity as investors expressed concerns about further dilutions, the company agreed to terminate the provision from 2012. For the fiscal years 2010 and 2011, the earn-out will only occur if EBITDA growth tops 70%, as opposed to 30%.

This about-turn was driven by a report by The Forensic Factor, which denounced AutoChina as “the most preposterous Chinese reverse merger yet.” Accusations leveled at the company included the use of inappropriate accounting methods, artificially inflating the balance sheet, a reliance on related party transactions, and “the most dilutive, and shareholder unfriendly, earn-out that we have ever seen.”
The day the report was published AutoChina’s share price dropped 17% to US$23.09 and it is now trading at US$20.40, a 52-week low.

Despite AutoChina management’s timely effort to respond to TFF’s accusations. This is the lowest price in 52 weeks. Therefore, we think the earn-out termination is used as a tool to retain investors’ confidence.

Investors may feel they have cause to celebrate: Had this vulpine earn-out remained in place – and had, Li could have gained 19.5 million shares between now and 2013, diluting existing shareholders by about 50%. (This calculation is based on AutoChina’s EBITDA growth remaining above 90%, which would entitle Li to the maximum 20% earn-out.)

There are two reasons why this “victory” is overstated. First, EBITDA growth was 426% in 2009. Under the revised earn-out provisions for the fiscal years 2010 and 2011, if AutoChina crosses the 70% threshold, Li walk away with enough shares to dilute existing investors’ holdings by 15-20%.

Second, the earn-out climb-down is nothing more than a compromise solution devised by AutoChina management to avoid further scrutiny that would expose its unsustainable business model, and send the share price spiraling downwards.

We have made our case several times before (see here, here, and here), and The Forensic Factor said much the same in its report. Put simply, AutoChina is living on borrowed time. Its primary business line – buying trucks which are then leased to customers – is hemorrhaging cash, to the point that the only thing standing between AutoChina and bankruptcy is support from internal and external financing sources.

In the first three quarters of 2010, AutoChina raised US$367 million in capital from banks (US$190 million), affiliates and related parties (US$101 million), warrants (US$10 million) and secondary offering (US$66 million). This was US$250 million more than in the same period in 2009. Link

Most of the capital went to new vehicles leasing activities (US$176 million) and loan repayment (US$173 million), but operational cash flow for the first three quarters remained US$8.9 million in the red. Link

Since its inception in 2007, AutoChina has failed to report even a single quarter of positive operating cash flow. It has absolutely no value to investors and probably never will.

This is a classic case of a healthy balance sheet hiding a multitude of sins. And the company has offered no explanation as to how it plans to extricate itself from its debt-dependent position.

The investor takeaway is simple: Stay away from this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.