Investors need to evaluate motives for a merger in order to asses whether the newly formed entity is likely to create long-term value or not. There are numerous questions concerning motives for any merger that need to be asked and answered when evaluating the new company. Among others, investors need to know if a merger makes sense and what are the chances of the new company making it in the tough world of capital markets.
On 15 January 2008, it was announced that JGL shall sell and Powerplus shall buy 50% of the fully paid ordinary shares of China Steel Australia held by JGL. Powerplus is currently in the process of acquiring 142,450,000 China Steel Australia shares from JGL, representing a 46.25% stake in China Steel Australia at the Consideration (RMB 155,302,000).
The payment can potentially increase another RMB 11,419,000 if the audited FY2008 consolidated net profit after tax of China Steel Singapore Pte Ltd is greater or equal to
RMB 48,000,000. Currently, China Steel is listed on the Australia Stock Exchange.
In my point of view, this is a lousy acquisition. Below are the reasons:
1) The net profit for FY2008 will surely exceed RMB48 million due to the non-recurring and non-cash financial income of the convertible loan it is holding on its accounting books. For FY2008, this will amount to RMB41.7 million. For evidence, please read up the prospectus of China Steel.
2) Powerplus have grossly overpaid for the acquisition. Please refer to my earlier posting on “What is synergy?”. I will demonstrate with some calculations why this is so.
Powerplus has paid RMB155.3 million for a 46.25% stake. This means the valuation of China Steel is RMB335.78 million. This figure excludes the “extras” that they will pay if the profit exceed RMB48 million. Let’s look at what is the amount of premium they have paid in this deal. After the listing in Australia, the total book value of China steel is expected to be AUD$7.813 million (RMB50.39 million). Powerplus has paid an astonishing high 6.6 times book value for a 46.25% stake. Whatever synergy and cost benefits that one can reap from such an acquisition disappears with such a high purchase price.
3) Chances are that in total, Powerplus will pay RMB166.7 million. Assume that the true earnings (without exceptional items) for FY2008 is RMB38 million. For that, Powerplus is able to claim RMB17.6 million by virtual of its shareholdings. This translates to a return of 10.5%. This kind of investment hardly inspires any confidence considering the ROE of Powerplus for FY2007 is 15.5%. If we take out the cash component, the adjusted ROE is an excellent 35.5%.
4) Shares in JGL is owned by Dr Lim Seck Yeow’s wife and son (Mdm Tan Geok Bee & Mr Hung Lim). Conflict of interest is present. Enough said.
5) Potential dilution of Powerplus’s stake as China Steel seek to raise funds for the new plant in year 2009.
6) Convertible loan agreement with an individual called Zhang Guangxia. He may get in the region of 130 million shares. Potential stake dilution.
The whole deal smacks of bootstrapping. When a company’s earnings increase as a result of the merger transaction and not due to the allegedly created economic benefit from the merger, this is called the bootstrapping effect or bootstrapping earnings.
Below are some of the factors that will impact the earnings of China Steel in the near future:
A) Barriers of entry not exactly high. China Steel has developed its own internal know-how which has contributed to the success of that company. This know-how is not protected by patent or similar rights. There is a risk that competitors may copy this know-how or develop similar or better know-how and produce better or less extensive product that currently produced by China Steel. There is also a risk of employees leaving the China Steel and disclosing know-how to competitors.
B) Reliance on a single key customer and supplier and contract with Huaguang expires on 8 October 2010.
C) High raw material prices. Coke is one of the main raw materials used by China Steel in the production of Nickel Pig Iron. The ever rising coke prices have caused China Steel to get customers to supply their own coke. There is no guarantee that this arrangement will work out.
D) Taxes will be incurred from 2009 onwards.
Monday, March 24, 2008
Friday, March 7, 2008
Structured warrants - Love or hate them?
A few days ago, the local newspaper reported that despite the current bearish sentiments in the Singapore stock market, financial institutions are still continuing to issue structured warrants on the exchange. The reasons these institutions give to encourage investors to buy them include leverage, hedging of risk...... blah, blah.
Make no mistake, the issuing of these structured warrants are cash minting machines for these financial institutions. For those that are unconvinced, pls talk to friends or relatives working in the structured warrants department of these institutions. I believe it will be interesting to find out if the top management of these companies make use of such warrants in their own investment plans. But that is another story for another day.
There are a few reasons why these structured warrants generate income. Firstly, they are being issued at a premium. Generally, one could use the black-scholes formula to calculate the warrant's fair price. So strictly speaking, if one buy the warrants on its listing day, one is overpaying for it. Would you pay $1.3 for a dollar note?
Secondly, the financial institution's risk are fully hedged using the dynamic delta hedging process. Of course there are variations of how this can be carried out. In short, the institution will go out on the open market to buy and sell the underlying share in order to maintain a delta neutral position. It doesn't matter whether the price of the underlying share goes up or down. Under ideal conditions, the income earned will be equal to the premiums charged. However, in reality, this amount can fluctuate too. But not to worry, at the end of the day, the institutions will still collect their cheque.
To sum up, issuing of structured warrants, which picked up over the past few years, are new methods of generating income for these institutions. Please open your big eyes to understand the big picture before putting in your hard-earned money.
Make no mistake, the issuing of these structured warrants are cash minting machines for these financial institutions. For those that are unconvinced, pls talk to friends or relatives working in the structured warrants department of these institutions. I believe it will be interesting to find out if the top management of these companies make use of such warrants in their own investment plans. But that is another story for another day.
There are a few reasons why these structured warrants generate income. Firstly, they are being issued at a premium. Generally, one could use the black-scholes formula to calculate the warrant's fair price. So strictly speaking, if one buy the warrants on its listing day, one is overpaying for it. Would you pay $1.3 for a dollar note?
Secondly, the financial institution's risk are fully hedged using the dynamic delta hedging process. Of course there are variations of how this can be carried out. In short, the institution will go out on the open market to buy and sell the underlying share in order to maintain a delta neutral position. It doesn't matter whether the price of the underlying share goes up or down. Under ideal conditions, the income earned will be equal to the premiums charged. However, in reality, this amount can fluctuate too. But not to worry, at the end of the day, the institutions will still collect their cheque.
To sum up, issuing of structured warrants, which picked up over the past few years, are new methods of generating income for these institutions. Please open your big eyes to understand the big picture before putting in your hard-earned money.
Tuesday, March 4, 2008
Intelligence is over-rated, really!
A short quiz:
What is the difference between investing, speculating and gambling?
Ans:
In investing, the probability of winning is >90%
In speculating, the probability of winning is 50%. You lose when brokerage fees are factored in.
In gambling, losing probability is >95%
Definition of investing:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
As in most countries, those people who call themselves “investors” are not investors at all. They are speculators. In the short run, particularly while capital markets are rapidly developing, speculators may be able to earn high returns by rapidly trading stocks without doing thorough analysis. But in the long run, you cannot earn sustainably high returns from mere “gut feelings.”
People like to speculate because they become addicted to their own belief that they are about to make money. And when they do make some money, they turn greedy as their actions have been justified by a positive result. In terms of brain chemistry, the anticipation of profits activates the dopamine system in the brain, flooding our neurons with a signal of excitement.
Greed is generated in the same regions of the brain that produce pleasure when we find food or shelter or love. These basic reward circuits are among the oldest systems in the human brain.
Geniuses have them, too. Brilliant people are better at generating great ideas than the rest, but they are no better at controlling their own emotions than you or I.
Luck has a great deal to do with it. Whenever a stock trades, the buyer thinks the seller is making a mistake. The seller thinks the buyer is mistaken. Only one of them can be right. After they both pay their dealing costs and any taxes on the transaction, neither may show any net profit for his pains. In the short run, almost anyone can be right a few times in a row, by luck alone. Even in the long run, luck can rule the day. It can take years, even decades, to determine whether an investor has genuine and repeatable skill or is just lucky. The danger comes when you believe you are skillful and, in fact, you turn out to be merely lucky.
If one do not put policies and procedures in place, in advance, to control one's emotions, one will never be able to resist the siren song of the markets when the markets go mad. Common sense and good judgment are vastly more valuable than intelligence.
What is the difference between investing, speculating and gambling?
Ans:
In investing, the probability of winning is >90%
In speculating, the probability of winning is 50%. You lose when brokerage fees are factored in.
In gambling, losing probability is >95%
Definition of investing:
An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.
As in most countries, those people who call themselves “investors” are not investors at all. They are speculators. In the short run, particularly while capital markets are rapidly developing, speculators may be able to earn high returns by rapidly trading stocks without doing thorough analysis. But in the long run, you cannot earn sustainably high returns from mere “gut feelings.”
People like to speculate because they become addicted to their own belief that they are about to make money. And when they do make some money, they turn greedy as their actions have been justified by a positive result. In terms of brain chemistry, the anticipation of profits activates the dopamine system in the brain, flooding our neurons with a signal of excitement.
Greed is generated in the same regions of the brain that produce pleasure when we find food or shelter or love. These basic reward circuits are among the oldest systems in the human brain.
Geniuses have them, too. Brilliant people are better at generating great ideas than the rest, but they are no better at controlling their own emotions than you or I.
Luck has a great deal to do with it. Whenever a stock trades, the buyer thinks the seller is making a mistake. The seller thinks the buyer is mistaken. Only one of them can be right. After they both pay their dealing costs and any taxes on the transaction, neither may show any net profit for his pains. In the short run, almost anyone can be right a few times in a row, by luck alone. Even in the long run, luck can rule the day. It can take years, even decades, to determine whether an investor has genuine and repeatable skill or is just lucky. The danger comes when you believe you are skillful and, in fact, you turn out to be merely lucky.
If one do not put policies and procedures in place, in advance, to control one's emotions, one will never be able to resist the siren song of the markets when the markets go mad. Common sense and good judgment are vastly more valuable than intelligence.
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