We think China Medical Technologies (CMED) is an attractive short at current levels, and that its missed interest payment supports Glaucus Research's report arguing that CMED's equity will end up being worthless. Most ominously, CMED's non-payment may indicate that the company is no longer interested in meeting its obligations to foreign shareholders and is preparing to go dark, following in the footsteps of many other troubled U.S.-listed Chinese companies whose management teams simply disappeared into the sunset after fraud was discovered at their companies.
China Medical's payment default was made public last week, when Fitch Ratings announced that China Medical Technologies had missed the coupon payment on its $125 million 6.25% convertible senior notes due 2016, and it downgraded the company's rating to "Restricted Default." Standard & Poor's has subsequently downgraded the company to "SD", which indicates that a company has selectively defaulted on some obligations. As of yesterday, both the 2013 and 2016 convertible notes traded at a bid price of 25 cents on the dollar.
I contacted the company's bondholder trustee at Wilmington Trust, who confirmed that "the company did not pay its 12/15/2011 coupon nor did it pay it in the grace period which expired 1/14/2012." The trustee said that Wilmington Trust "will be sending a Notice of Default very shortly."
I also reached out to Richard Thorp of Thorp Alberga, who is the company's Cayman legal representative and is in charge of forwarding noteholder inquiries to the company via the email address cmednoteholders@thorpalberga.com. Thorp has not been privy to any bondholder restructuring plans nor has been informed of the company's restructuring intentions, saying that he doesn't "know what their intended line is at all".
Interestingly, the company did not bother to report the missed coupon payment. It has been more than two weeks since the grace period ended on January 14th, and China Medical has still not issued a press release or 8K explaining the missed payment. As an aside, this is a violation of SEC disclosure regulations, given that a missed coupon payment on a company's bond securities is certainly a material event.
An Ad Hoc Bondholder Committee has been formed and has been working with legal counsel Hogan Lovells to negotiate with the company. Neil MacDonald of Hogan Lovells, who is one of the partners on the case, currently represents the official committee of unsecured creditors (comprising primarily bondholders) in the Chapter 11 bankruptcy of ShengdaTech, Inc. (SDTH.PK). He and other lawyers at Hogan Lovells also represent a large bondholder group in relation to Sino-Forest (SNOFF.PK) as well as a bondholder group for China Forestry Holdings Co Ltd., the halted Hong Kong-listed Chinese forestry company.
Equity holders in ShengdaTech, Sino-Forest and China Forestry have been virtually wiped out.
From our discussions with Hogan Lovells and Wilmington Trust, the company has not reached out to bondholders to begin negotiations on a debt restructuring. On December 14th, the eve of the coupon payment, the company surprised the market by announcing the following:
The Company intends to implement a debt restructuring plan to improve its balance sheet. The plan may include, without limitation, a debt-for-debt exchange with existing holders of the Company's convertible notes maturing in August 2013 and December 2016, which may potentially involve holders receiving new debts with different interest rates, maturities and principal amounts compared to the existing debts or other alternatives to be agreed.
Given the company's large reported cash balance, this release was unexpected. China Medical's should not need to restructure its debt if its balance sheet is anywhere near as liquid as the company claims.
CMED reported $206.5 million of cash on its balance sheet as of September 30, 2011. The company's missed coupon payment would have amounted to less than $5 million of cash outflow. It's difficult to believe that the company would voluntarily decline to make its scheduled payment if it did in fact have $206.5 million of cash. Instead, similar to many prior U.S.-listed Chinese companies like China MediaExpress (CCME) and China-Biotics (CHBT.PK), it is far more believable that the large reported cash balance does not actually exist and that China Medical Technologies is misrepresenting itself in its financial statements.
The missing payment naturally bodes very poorly for China Medical's equity holders. We'd be surprised if bondholders willingly took haircuts to their claims while equity holders stood by unaffected. More likely, bondholders would demand equity or dilutive securities if they're being required to take writedowns on their security claims.
Missed Interest Payments: This Never Ends Well
China Medical is far from the first Chinese company listed outside of the mainland to stiff bondholders on a required payment. And the range of outcomes for equity holders in these scenarios has been between, at best, quite poor, to at worst, a complete loss of all value in the common equity. During the previous spate of Chinese scandals, when a wave of Singapore-listed Chinese companies failed in the so-called S-Chip scandal, numerous mainland Chinese companies listed in Singapore suddenly lost interest in servicing their debt, despite the fact that they appeared to have large cash balances and substantial cash flow. A 2010 article from the South China Morning Post reported that:
Since late 2007, a spate of so-called S-chips - mainland companies listed on the Singapore exchange - have borrowed money then failed to repay the debts, with some becoming mired in fraud scandals. Of the 11 S-chips that issued convertible bonds between 2005 and 2008, six have declared themselves unable to repay […] Another five S-chips failed to repay bank loans during 2008-9. The effects on their share prices have been, predictably, crushing.
The majority of these tainted S-chip companies have gone on to see their shares delisted and shares have ended up worthless. For example, look at the case of China Milk Products Group, a company that produced bull semen and cow embryos for sale to cattle breeding operations. When investors in the company's convertible debt used an option attached to the bonds to demand immediate repayment of the debt, China Milk's balance sheet seemed to indicate that there was plenty of cash available to repay creditors.
China Milk's last annual report, for fiscal year 2009, claimed that the company had $239 million of cash versus $150 million of convertible notes. Furthermore, the company claimed to have generated $51 million of cash flow from operating activities in the previous year. The company's balance sheet appeared to be sufficiently strong to service its debt with cash to spare.
The company blamed its failure to repay creditors on foreign exchange regulations that had trapped its funds outside the country, and claimed that it would pay bond holders as soon as possible. However, the debt was never repaid, and the company went dark. Management disappeared, and finally, in July 2011 - 18 months later - liquidators were put in charge of the company. It is unclear what, if anything, bond holders will recover. Equity holders suffered a complete loss.
China Milk Products is just one example out of many where a bond default precipitated a complete collapse of the company with equity holders completely wiped out. Celestial Nutrifoods is another that failed to pay off its debt and entered liquidation within 18 months after with shareholder equity entirely destroyed. FTI Consulting, the liquidator of the remains of Celestial Nutrifoods, believes that Celestial Nutrifoods' management team fraudulently transfered money out of the company just prior to that company's debt default.
In 2008, before the management allegedly began stripping assets, Celestial Nutrifoods had $119 million of cash to support $180 million of debt, according to its annual report. When the company defaulted on its debt in 2009, it still claimed to have $53 million in its cash reserves. There is no reason to believe this company needed to default voluntarily. Like China Milk and now China Medical, it claimed to have sufficient cash on its balance sheet at the time it defaulted.
The list goes on and on. China Sun Bio-Chem, China Enersave, China Printing & Dyeing and numerous others have stiffed bondholders, engaged in alleged accounting irregularities, and ended up leaving shareholders with nothing. And even in the few situations where the defaulted debt has eventually been serviced, the results have not been pretty.
Take, for example, the case of Neo-China. The company is a Hong-Kong listed property developer in Mainland China that failed to make a coupon payment in 2009. Neo-China claimed to have more than HK$2 billion in cash and that its payment was merely delayed due to China's Spring Festival (see here). Nonetheless, Moody's slashed Neo-China's rating to its second lowest level possible after the late payment.
Neo-China's stock plunged 45 percent when its stock was finally reopened for trading after a long halt, and the stock (now renamed Shanghai Industrial Urban Development) has dropped an additional 50 percent in the subsequent 18 months. The former chairman of Neo-China has become a wanted man by Hong Kong's anti-corruption authorities for making illegal property transactions with the goal of "artificially inflat[ing] the profit and assets of Neo-China."
Even in cases such as Neo-China where bondholders get their money eventually, equity holders still lose. Well-run companies just do not voluntarily default on debt. Missing debt payments - in Neo-China's case supposedly due to a holiday - is usually a sign of fraud or malfeasance.
Does the Missed Coupon Payment Confirm the Glaucus Fraud Allegations?
This non-payment is suspicious especially in light of the Glaucus report issued last month. In December, Glaucus issued a 23-page report that alleged the following:
- CMED paid $28 million for an acquisition from a seller who [Glaucus] believes was secretly related to CMED's chairman. Evidence also shows that CMED radically overpaid for the acquisition: a few months before selling the company to CMED, a company controlled by parties related to CMED insiders bought out minority shareholders at prices suggesting that the business was worth $5-$8 million, not the $28 million paid by CMED for the acquisition.
- Despite a purportedly profitable business, CMED is a serial capital raiser and has not generated free cash flow for most of its history. The company has spent twice as much on "investing activities" as it has purportedly generated from operations, so much like a typical Chinese fraud, it relies on debt or equity financing as its primary source of cash generation.
- CMED's balance sheet presents numerous highly suspicious red flags. CMED's receivables account for a much higher percentage of net revenues than its Chinese competitors and its Day Sales Outstanding are on average 141.9 days longer than a leading Chinese competitor, despite the fact that both companies sell similar products to similarly situated customers.
- In 2009, an anonymous letter to the audit committee accused senior management of committing fraud with respect to the company's financials and its acquisitions. After an investigation by the audit committee, CMED's auditor, KPMG, resigned.
In the context of Glaucus' evidence for financial misrepresentation, the company's missed coupon payment makes more sense. The company may be misrepresenting itself in its financial statements, and therefore may not have sufficient cash to pay its near-term debt obligations.
One explanation for the coupon non-payment is that the Glaucus report triggered the beginnings of a deeper audit by the company's auditors at PriceWaterhouseCoopers. If CMED management came to believe that there would be a high chance the company fails its audit for fiscal year 2011, management may have begun draining the company's bank accounts and transferring operating assets to private related parties. Under this scenario, management could deem that it wouldn't make sense to send cash to foreign noteholders, when the bonds would default upon a PWC resignation and likely equity trading halt anyways.
A similar stock trading halt could occur if independent directors forced the company to undergo an independent inquiry. As we have seen with companies like ShengdaTech and Jiangbo Pharmaceuticals, independent directors can play a critical role in forcing companies to open their books to outside third parties. As such, we could envision a scenario where the Glaucus report triggered inquiries from the company's independent board members, particularly its non-Chinese directors Iain Bruce and Lawrence Crum. Mr. Bruce is a retired KPMG accountant and Dr. Crum is a research professor in electrical engineering and bioengineering at the University of Washington. They likely do not have much to gain from a cover-up. It's possible that they have urged for an independent investigation, and that the management team has seen the writing on the wall and decided to disengage foreign claimholders. Again, the thesis would be that management has realized the likelihood of a trading halt, and has begun looting the public company's assets.
Conclusion
Looking back at what has happened when other Chinese companies have voluntarily defaulted on their debt, we think the outcome with China Medical is somewhat predictable for equity holders. In most cases with S-Chips that skipped convertible note payments, the default was not the only issue with the company; usually fraud, embezzlement, and other unethical activities were being engaged in by the management teams. With Glaucus having already laid out a compelling argument to suggest that China Medical is engaged in questionable activities, we view this debt default as a sign that the company is following the path of many S-chip companies. We fear that the company will soon go dark, with management disappearing and the company ending up in liquidation, leaving equity holders with nothing.
Disclosure: I am short CMED, CHBT.PK, SNOFF.PK.
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