We issue a bubble warning on Hon Po Group (Lobster King) (0228), and dig into the background to its apparent transformation into the next big thing, coal mining in Inner Mongolia.

Stir-Fried Lobster
19 April 2006

We love a good lobster, but restaurant group Hon Po Group (Lobster King) Ltd (Hon Po, 0228) is one of those dishes that would be better sent back to the kitchen. We think it is being stir-fried and heavily overcooked.

History

Hon Po's IPO was co-sponsored by the now-defunct International Capital Network Ltd, which itself was a GEM disaster. The sponsor was Anglo Chinese Corporate Finance Ltd, the lead manager was Kingston Securities Ltd and a co-manager was Ever-Long Securities Ltd, itself owned by Styland Holdings Ltd (0211). We wrote a series of stories on the Styland network in 2002. Styland's listing has been in the deep-freeze since 21-Apr-04.

The Hon Po prospectus ran with an audit date of 30-Jun-01, 7 months before it was published, and the 3.5 year track record showed a steadily declining turnover and net profit - hardly inspiring.

IPO Expenses - who paid?

30% of the 50m shares1 sold at HK$1 were existing shares sold by the controlling shareholder, while Hon Po raised $35m gross. Page 97 of the prospectus states that the estimated expenses of $16m would be split 30:70 between the vendor and Hon Po (in proportion to the old and new shares), leaving the company with $23.8m net, but the 2001 accounts show that the company shouldered the entire costs, and only received $19.64m net of expenses, leaving them $4.16m short. We hereby ask the Stock Exchange to investigate this.

Plunged into loss

The stock listed on 18-Feb-02 and the company then plunged into loss and had a series of accounting delays. It wasn't until 6-Nov-03 that it finally reported an audited loss of $77.1m for 2002. Auditors Ernst & Young qualified their audit report due to a lack of "sufficient documentation and explanations" relating to transactions with the controlling shareholder.

The late reporting eventually earned Hon Po and its executive directors the usual slap on the wrist from the Stock Exchange, although in all that huff and puff, Hon Po's payment of the vendor's IPO expenses went completely unnoticed.

On 19-Sep-03, ICEA tried to arrange a takeover of Hon Po at $0.25 per share by a private company 50% owned by Mr Cheung Kam Foo and 50% by Mr Lam Lui Ming. Mr Cheung was an Executive Director of Vanda Systems & Communications Holdings Ltd until 13-Mar-01, and then went on to be CEO of a "renowned beverages group in China" so investors may have expected a back-door listing was in the offing. However, the deal was scrapped on 1-Dec-03. Two weeks later, Ernst & Young quit as auditors.

Fund raising

The losses continued, with Hon Po having negative net assets of $21.6m on 30-Jun-04. Other than a gradual closure of restaurants and sale of related assets, not much happened until 20-Jan-05, when Hon Po announced a top-up placing of 25.2m shares (enlarging the issued shares by 20%) through Yicko Securities Ltd (Yicko) at $0.312 per share, a 20% discount to market, raising a net $7.6m for working capital. Then a month later, on 21-Feb-05, Hon Po announced a placing through Yicko of $40m convertible notes with a deep-discount conversion price of $0.10 per share, 70% below market. The proceeds of $39.4m were said to be for general working capital.

But they weren't finished. On 9-May-05, with the first note issue not yet completed, they announced another placing through Yicko of HK$100m of convertible notes, this time convertible at $0.05, a 95% discount to market. The proceeds of $97.5m were supposedly for use in future investments in food and beverage related industries and/or property investments, although they had nothing in mind.

The stock exchange "requested" that the company get an independent financial adviser to opine on whether the note issues were fair and reasonable, and put it to a vote of independent shareholders. So the company hired Kingston Corporate Finance Ltd (yes, Kingston, as in the Lead Manager of the IPO), who said the note issues were indeed fair and reasonable, and both issues were approved by shareholders on 30-Jun-05. Apparently the Stock Exchange regarded Kingston as independent, but we don't.

Making the issues in reverse order, on 25-Jul-05, half of the second convertible notes was issued and immediately converted into 1,000m shares, or 86.9% of the enlarged capital. Then on 11-Aug-05, the first convertible notes were issued and immediately converted into 400m shares. Finally, on 22-Aug-05, the other half of the second notes was issued and immediately converted into 1,000m shares. At this point, Hon Po said it was engaged in "preliminary discussion" regarding a possible acquisition of an investment in PRC natural resources. Obviously this was neither food and beverage nor property investment, so we are asked to believe that they hadn't been planning this when they asked shareholders to approve the note issues 2 months earlier.

After the last note conversion on 22-Aug-05, the company had 2,551.2m shares in issue with a market value (at $1.20) of $3,061m, even though it only had about $103m of net assets, based on the 30-Jun-05 figures and adjusted for the note issues. So it was already in a bubble, at about 30x NAV, and the 2,400m shares issued to note holders represented 94.07% of the company. A week later, on 29-Aug-05, the stock was suspended, and there it stayed for 7 months, until....

The Deal

On 7-Apr-06, Hon Po finally announced that on 28-Dec-05 it had conditionally agreed to acquire a 60% stake in Newsummit Investments Ltd (Newsummit), a BVI shell which owns a 51% stake in China West Gas and Oil Ltd (HKCo), incorporated in HK, which in turn holds (through subsidiaries, PRC1 and PRC2) two agreements to exploit a purported Peat Moss Mine and Coal Mine in Inner Mongolia. The price of the acquisition is a deposit of HK$81.6m in cash plus the issue of convertible notes with a face value of $5bn, convertible at $5 per share.

Hon Po and the Vendor also agreed to put cash into Newsummit pro rata to their holdings, with Hon Po putting in $18.4m. It won't have escaped your notice that the entire $100m raised in the second note issue has been spent on these deposits.

Regulatory note
Although the deal is subject to shareholders' approval and numerous other conditions, both cash "refundable deposits" totalling $100m have already been paid, and all that Hon Po has in return is security over the shares of Newsummit, so if the deal is not approved, and Hon Po wants its cash back, then it may end up with the shares it didn't want, effectively completing the acquisition. In our view, the Stock Exchange should treat such deposits in themselves as transactions, which cannot be made without the relevant shareholders' approval, but that's not how they see it.

Hon Po also gets a 2-year option to acquire the other 40% of Newsummit for HK$45m in cash and the issue of a convertible note with a face value of $3,955m, convertible at $8 per share.

The vendor of Newsummit is an unnamed individual independent third party, and as Newsummit is incorporated in the BVI, we have no way of finding out who owns it.

Regulatory note
The Stock Exchange should require the disclosure of counterparties to acquisitions and disposals and (in the case of companies) their beneficial owners, but it doesn't.

The other 49% of HKCo is owned by a Mr Tsui Man Sang (Mr Tsui) (48.99%) and his wife (0.01%). We know nothing about him.

Dig, dig

We did a little mining of our own, by digging up the records of HKCo from the companies registry. We discovered that until 29-Aug-05, the capital was just HK$10,000, entirely owned by Mr Tsui (99%) and his wife (1%). But on 29-Aug-05 (the day dealings in Hon Po were suspended), the capital of HKCo was increased by HK$40m from $0.01m to $40.01m, of which $20.4051m was subscribed by Newsummit, giving it 51%, and $19.5949m was subscribed by Mr Tsui, giving him 49%. By coincidence, this $40m is equal to what Hon Po raised a few days earlier from the first convertible note issue, but the subscription by Newsummit and Mr Tsui came 4 months before Hon Po's deal to buy a stake in Newsummit, so on the face of it, HKCo had no connection to Hon Po at that stage.

But wait, there is a connection. The filings show that on the same day as Newsummit bought into HKCo, Mr Chan Shi Yung (Mr Chan) was appointed as a director of HKCo. But the strange thing is, Mr Chan was appointed as CEO of Hon Po on 5-Jul-05, so what was he doing on the board of HKCo 4 months before Hon Po signed the deal to buy into the project?

At 30-Sep-05, the net assets of Newsummit were just HK$7,451,254, and it had a loss since incorporation on 30-Mar-05 of $325,751, which implies that it has received equity capital of just US$1m (HK$7.77m). So where did it find the money to invest HK$20.40m in HKCo? It must have borrowed at least some of it, but from whom?

Another director of HKCo, also appointed on 29-Aug-05, is Mr To Yuet Sing, who in the filings gives the same address as Newsummit. The only thing we know about him is that he once filed a petition for the winding up of Codebank Ltd, a GEM company which holds the record for the shortest trading on the GEM or main board (144 calendar days) before going bust. According to Codebank, Mr To's petition claimed damages for his investment loss on 180,000 shares, but he later withdrew the petition.

The Mine

The Coal Mine, which has an area of 40.08 sq. km, has a purported reserve of a massive 800m tonnes, equivalent to about 16% of global output in 2003. Think about it, that is almost 20 tonnes per square metre of surface area. One of the heaviest forms of coal, anthracite, is about 1.5 tonnes per cubic metre, so that means the coal depth must average at least 13 metres, the height of a 4-storey house. Imagine a block of coal half the area of Hong Kong Island and at least 40 feet deep. Very impressive, if it is true.

The deal is subject to numerous conditions, including the obtaining of a valuation of HKCo of not less than a whopping $40bn, valuing Hon Po's effective 30.6% stake at $12.24bn.

Stay clear

In our view, this is yet another bubble in a frothy market. Ask yourself this:

Yesterday's closing market price of $3.325 values the existing shares of Hon Po at HK$8.48bn, and all that Hon Po has at this stage is a conditional agreement and whatever remains of its restaurant business, having paid away virtually all its cash as a deposit for this deal. If the deal completes, then the bonds will, upon conversion, create another 1bn shares, expanding the market cap to $11.81bn, and that's for just the 30.6% stake in a project which has yet to be funded.

The face value and conversion price on the bonds to be issued, of $5bn and $5, might make you think that is where the shares are heading, but the reality is that after paying out the cash, Hon Po has no material net assets of its own, so redemption of those bonds is currently out of the question, and it could have put any price it liked on the bonds - it could just as easily have been $1bn convertible at $1 or $10bn convertible at $10. Either way, you get the same number of shares. Don't be misled by the headline figures - this is a project which has only had HK$40m of equity funding into HKCo. The only difference from a larger face value is that, until conversion, the notes represent a larger claim on any future assets of Hon Po.

Notes

1. All prices and shares are adjusted for a 5:1 consolidation effective 12-May-05

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