Webb blocks WKK privatisation
5 June 2007
Webb-site.com notes the announcement this evening by Wong's Kong King International Holdings Ltd (WKK, 0532) and confirms that its editor, David Webb, holds sufficient shares in WKK to veto the proposed privatisation of the company by its Chairman and CEO, Senta Wong (Mr Wong), and will do so. We explain why.
Background
WKK is involved in two complementary businesses: the trading and distribution of materials and equipment used in electronics manufacture through WKK Distribution Ltd and WKK Engineering Service Ltd, and its own manufacturing of electronic products for customers through WKK Technology Ltd (nice video, by the way). It also owns a travel agency.
On 4-Aug-06, WKK announced a proposed privatisation by its Chairman Senta Wong, at $1.38 per share, by way of a Scheme of Arrangement under the Takeover Code. This was voted down by independent shareholders on 18-Oct-06.
It is natural during privatisation attempts for the management of targets to downplay the prospects of the company they are trying to privatise. During the offer period, on 11-Sep-06, WKK announced its interim results for 30-Jun-06, which showed a 26% increase in turnover but almost no change in net profit at $85.5m. However, that was after a provision of $28.4m for impairment in the value of its PRC and overseas premises and also a then-unexplained increase in the provision for HK tax from $7.1m to $22.4m.
When the final results for 2006 were announced on 17-Apr-07, the full year's HK tax charge included a provision of $8.1m for tax they should have charged in prior years - that is, it did not relate to 2006 profits. Also, the impairment on the properties was slashed by almost half to $15.7m. These two items still add up to non-recurrent items of $23.8m. The reported net profit was $250.1m, but adding back the non-recurrent items takes it to $273.9m, an increase of 52% on the previous year. This translates to basic EPS of about $0.392 per share, or diluted EPS (allowing for share options) of $0.379 per share.
Full-year turnover grew by a more modest 8%. Looking at the two main segments, external sales on the equipment and materials side grew by 18%, with operating profit up 20%, while the OEM side saw 2% growth but increased operating profit by 75% on higher margins. WKK has put together an impressive track record. In the last 4 years, turnover has risen 108% from $2,405m to $5,012m, while net profit has surged from $22m to $250m, or $274m if you adjust for those non-recurrent items.
Year-end headcount has risen 45% from 4,284 (including 3,714 in the mainland) to 6,217 (including 5,674 in the PRC). The customer and supplier base is diversified, with 16% of turnover and 14% of purchases attributable to the largest customer and supplier respectively.
In the last quarter of 2002, WKK relocated all of its manufacturing facilities to the new WKK Technology Park in Changping, Dongguan, built at a cost of $400m. It has been paying down debt since then, reducing the net debt:equity ratio from 95% at the end of 2002 to a modest 28% at the end of 2006, and at that rate it should be near debt-free by the end of 2007. Net tangible assets at 31-Dec-06 were $1,060m, or $1.50 per share.
The Sunday Route - a backdoor privatisation
Under Rule 31.1 of the Takeover Code, Mr Wong was prohibited from making another offer within the 12 months after 18-Oct-06 when the previous offer was rejected. 5 months later, on 19-Mar-07, the stock was suspended pending a "very substantial disposal". You can't get more substantial then selling everything. After a month on ice, on 16-Apr-07, the day before the 2006 results were announced, the suspension was lifted and WKK announced a back-door privatisation offer, in which WKK would sell all of its assets to Mr Wong and then distribute the proceeds to shareholders, leaving WKK as an empty, worthless shell which would be delisted and wound up. This structure has become known as the "Sunday Route" after PCCW Ltd (0008) first used it to privatise Sunday Communications Ltd.
In our view (note: your editor is a member of the Takeover Panel), such transaction structures should be regarded by the SFC as "Offers" within the definitions of the Takeover Code, and hence the SFC should apply the Code to them. The Code defines an Offer as follows:
"Offer includes takeover and merger transactions however effected, including schemes of arrangement which have similar commercial effect to takeovers and mergers.." (emphasis added)
Rule 2.10 also talks about alternative offer mechanisms, where it says:
"where any person seeks to use a scheme of arrangement or capital reorganisation to acquire or privatise a company...."
The Sunday Route and the current WKK privatisation involve a reduction of the share premium and share capital, which are a form of capital reorganisation, in order to distribute the proceeds of the disposal. But even if they didn't touch the capital, the transactions should still be captured within the meaning of "Offer" because they have a similar commercial effect to a takeover. WKK shareholders would end up with cash in exchange for their shares, and the offeror would end up with 100% of the business. If that isn't a takeover, then what is? The definition makes clear that it is the end result that matters, not how it is effected.
If the Takeover Code is not to become a document of purely historical interest, routinely avoided with the Sunday Route, then the SFC must interpret the Code to include it.
The Second Offer
Although there has been no change to the relevant Stock Exchange Listing Rules since the Sunday deal (and the SFC has not applied the Takeover Code), there has been a change to the way the Listing Rules are applied. In the Sunday deal, the company split the transaction into a sale and a distribution, so that after Sunday had sold all its assets to its parent on a simple majority vote, shareholders were forced to choose between holding a suspended cash shell, or approving the distribution and delisting, which is like asking a chicken whether it prefers to be roasted or fried. By contrast, in the WKK deal, the Exchange has required the whole thing to go to a single vote with the standard of approval that normally applies to privatisations under the Takeover Code.
The announcement states:
"The Stock Exchange has requested the Company to apply the voting standard imposed by Rule 6.12 of the Listing Rules to all Proposals. To comply with Rule 6.12...the Board...will apply the Required Voting Standard to such resolution." (emphasis added)
This voting standard is the one adopted by Listing Rule amendments on 31-Mar-04, which mirrored amendments to the Takeover Code on 17-Jan-02, which in turn followed our article Hobson's Choice when Webb-site.com brought the issue to regulators' attention on 14-Jan-01. The Voting Standard applies the same threshold to delistings as is applied to compulsory purchases of shares after a general offer. That is, if 10% of the independent shareholders (to whom the offer applies) reject the proposal, then it fails. So investors at least have this protection, although they do not benefit from all the other rules of the Takeover Code that would normally apply.
According to the privatisation circular dated 4-Jun-07, as of 29-May-07, WKK had 708,795,964 shares in issue, of which 476,657,458 shares are held by the "Interested Shareholders". Between the announcement of 16-Apr-07 and the circular, another shareholder, Shanghai Holdings Ltd, controlled by the Wong family's trust, has been unearthed, which holds (including a subsidiary) 7,950,628 shares. So in total, 484,608,086 shares will abstain from voting. There are a further 112,000 vested employee options which could be exercised before the vote and might be regarded as independent. That takes the total shares which could vote to 224,299,878 shares, or 31.64% of the enlarged share capital.
It therefore takes 10% of these, or 22,429,988 shares, to veto the privatisation. David Webb holds more shares than this (but less than the 5% legal disclosure threshold), and will veto the bid.
Note: in tonight's announcement, WKK noted that David Webb does not appear on the share register. That is true for nearly all public shareholders in HK-listed companies, because they hold their shares through banks, brokers and custodians, who in turn hold them through CCASS, the Central Clearing and Automated Settlement System. CCASS also allows investors to participate directly. CCASS then holds all these shares through HKSCC Nominees Limited, the de facto depository, so that is the name which appears on the share register of listed companies.
Why we are blocking the offer
The offer at $1.65 per share values WKK at a P/E of only 4.4 times its adjusted diluted 2006 EPS, and at only 1.1x its net asset value. Electronics manufacturing companies of comparable size trade on much higher valuations without any privatisation offer on the table. For example, Fujikon Industrial Holdings Ltd (0927), of which David Webb holds over 5%, trades on a P/E of 8.6x Sep-06 trailing earnings and 1.98x NAV. Its market capitalisation is $857m. Alco Holdings Ltd (0328), also in electronics manufacturing, of which David Webb holds under 5%, is on a P/E of 8.1x Sep-06 trailing earnings and 1.60x NAV.
It is true that WKK had a great year in 2006, and there may, depending on market conditions, be some pullback in 2007, but we are quite prepared to accept some earnings fluctuation in return for long-term growth, and so, obviously, is Mr Wong. With a second offer after 5 months, he is obviously in a hurry to privatise the company before its value becomes more apparent to the market.
We met with Mr Wong on Friday afternoon (1-Jun) at the offices of his adviser, Standard Chartered, and communicated our intentions to him. We can appreciate, from his perspective, that there are costs involved to remaining public, including retention of independent directors, listing fees, producing and printing interim and annual reports, and other disclosure costs. We also accept that the market has been slow to recognise the value being built in the business since its trough in 2002. Industrial stocks in general have been ignored in the last two years as the market focussed on hyping Chinese consumer stocks, gambling stocks, and natural resources plays.
He told us that although he had no plans to do so, one of his future options is to sell the business and, in his view, this would be easier if the company were private. We disagree. It would destroy the value of the listed status and hand to Mr Wong the upside on a sale of the business.
The offer at this level is nothing more than a cry for attention to this overlooked and undervalued stock, and as we told him, if he is just seeking attention, then he's got it. Mission accomplished. On the other hand, if he really wants to privatise WKK, then he should make a fair and reasonable offer that we and the other shareholders could support. Having two failed offers would stretch his credibility if he were to make a third offer in the future after investors had again been proven right to hold on. So if he really wants to privatise, we said, then now is the time to do it.
We note that Mr Wong has stated in tonight's announcement that he will not increase the offer. He also stated that he will not make another offer within 12 months. Of course, if the Takeover Code applied to this offer, then that statement would be true anyway, because as noted above, the Code prohibits another offer within 12 months of a failed offer. However, this statement doesn't rule out a takeover by a third party, should one come along. A buyout led by a private equity firm would be one way for Mr Wong to manage his exit.
We estimate that fair value of this stock to be around 8x trailing earnings, or over $3 per share, although in these particular circumstances, we would be prepared to leave a modest discount on the table. Let's make that clear - based on all current information, we would reject an offer below $2.50, and even at that price, we would be surrendering some value. Whether other shareholders would accept that price we cannot say.
While we don't expect this stock to reach fair value overnight, if Mr Wong commits to keeping WKK public and improves investor relations, treating them as well as WKK treats its customers, suppliers and employees, then there is no reason why it should not do so in the medium term. In the short-term, the shares may come under selling pressure from hedge funds and others who had expected to exit at $1.65, but this is not a consideration in our decision. We are acting to preserve long-term value for all shareholders.
The circular
Not being a document under the Takeover Code, the circular dated 4-Jun-07 falls short of the disclosure that would be required by the code. It does, however, contain a letter from "independent" financial adviser DBS Asia Capital Ltd (DBS). This is the same firm which advised shareholders the last time to accept the offer at $1.38. Those who rejected that advice have been proven right. Parent DBS Bank Ltd, incidentally, is a banker to WKK group. You might think that constitutes a conflict of interest, but they don't.
Webb-site.com warned DBS some weeks ago (without disclosing the amount of our then shareholding) that we would be opposed to the offer. Interestingly, last time around, DBS came up with 15 companies which they regarded as comparable, including 5 loss-makers. This time, there are only 7, of which 2 are loss-making. Vast chunks of the electronics manufacturing industry, including the companies we mentioned above, are omitted. None of the 7 is currently under privatisation offer, so their share prices do not reflect any bid premium which would be needed to secure a privatisation, and DBS does not analyse previous successful privatisations.
Even then, the mean P/E of the 5 profit-makers is 9.64, and the median 8.84. which justifies the comments we made above. Indeed, at 8.84-9.64x basic EPS (the measure they used), WKK would be at $3.16-$3.45 without a bid premium, so our valuation is conservative.
Even DBS grudgingly admits that it has a problem:
"If solely based on the PER of the Comparable Companies, the Proposed Distribution per Share may not be seen to be entirely fair and reasonable"
and
"it should be highlighted that the Proposed Distribution per Share does not compare favourably to the prevailing valuations of the Comparable Companies on a PER basis."
In a comparison of price to Net Asset Value, DBS finds the mean of the comparable companies to be a rather inconvenient 1.58, compared with 1.10 in this offer. So instead, it takes the median of 0.87 and concludes that the P/NAV is fair and reasonable. We disagree, but in any event, we accord greater weighting to the earnings.
DBS also trots out the old chestnut about the "limited liquidity" in the shares, which has been in every privatisation document since paper was invented. We don't know of any company which has unlimited liquidity, do you?
On the specific issue, though, the circular (outside of the DBS letter) notes that in the 180 days prior to the offer, the average daily turnover was 798,388 shares or "only 0.1%" of the total issued shares. In fact, that should be 0.113%, or 13% more than they suggest, but in any event, there are about 240 trading days per year, so that equates to 27.1% per year, or almost the entire free float. To put this 0.1% in perspective, Johnson Electric Holdings Ltd (0179), a company 15 times larger, had turnover of 0.205% per day in the same period. So yes, small caps are less liquid then blue chips, but WKK is not unusual in this respect.
After all that, DBS concludes that despite the P/E being far below all of the comparable companies, none of which is under offer, the proposals are fair and reasonable. What did you expect them to say?
© Webb-site.com, 2007
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