Fructivore Investments

As I stated yesterday, American Lorain has announced that they have sold stock and warrants totaling 5 million shares for $2.40, 1.75 million shares worth of warrants at a price of $3.70 that become exercisable six months after the transaction closes and have a term of 5 years thereafter, and 500 thousand shares worth of additional warrants with the same terms except that they only run for two and a half years, all for the price of $12 million.

As anyone can see, though, $12 million is simply 5 million shares times $2.40; the warrants seem to have been thrown in for free. These warrants, which are essentially call options, according to the Black Scholes formula using a high volatility assumption, and based on $3 a share, are worth $1.16 and 76 cents respectively. Now, of course writers smarter than I ( as well as less smart) have criticized the Black Scholes, since it is inaccurate for valuing options that are long-dated or far from the strike price and is based on an unrealistic view of asset price behavior, but it is undeniable that the warrants are worth more than nothing. In fact, I believe the consensus is that the Black Scholes tends to undervalue such options, in which case this was definitely a poor arrangement for American Lorain. And, since I think the company was undervalued before the deal was finalized, this price is even more indefensible.

Of course, since I think that a price of $5 is minimally adequate for the company, I see it more that the firm has just given away more than $1 per warrant. I can only assume that the price was negotiated around a month ago when the stock was trading at less than $2.40, since at $3 before the announcement it seems like a ridiculous deal.

Even going by market prices, at $3 a share, the company loses 60 cents times 5 million shares, $1.16 times 1.75 million in the 5-year warrants, and 76 cents times 500 thousand in the 2-1/2-year warrants, total $5.41 million. Before the deal was announced, the firm was trading at  $3 a share with 25 million shares outstanding, total $75 million. After the announcement yesterday, the share price dutifully retreated to $2.70, total market cap $67.5 million. It fell further today, of course, but what didn’t?

Now, the company will receive $12 million from the sale proceeds, but be diluted by 5 million additional shares. If the warrants are not exercised, there will be no further dilution, so ($75 million plus $12 million sale proceeds – $5.41 million in discounts), divided by 30 million shares, comes to $2.72 a share.

If the warrants do get exercised, as I think they will be, the company takes in an additional $3.70 per warrant, or $8.325 million, at the cost of further dilution. It also suggests that the share price of $2.40 was an even bigger discount, so I’ll just use the warrant price of $3.70 instead of $3 (for making this modification I am relying on no financial authority but myself, but it seems to me to have a certain logic). So, (75 million + 12 million + 8.325 million – 5.41 million in old discount – 3.5 million in new discount)/32.25 million shares comes to $2.68. So, with the warrants exercised or without them this new equity offering has diluted the company by 30 cents a share.

(It is curious, though, that the closing price $2.69, settled right between the above-calculated diluted values; I would never imply that the markets are efficient, but at the very least they are paying attention).

Si Chen, the firm’s CEO and majority shareholder (at least for now (unless he has an interest in the buyers of this offering in which case some shareholder derivative lawsuits would be in order, so I doubt this is the case)), is “very pleased with our ability to acquire this type of equity financing given the nature of the tight global markets. It speaks well of how the investment community views American Lorain.”

However, since the firm’s P/E ratio was 4.67 as of yesterday, this represents a cost of capital of 21.4%. Although I commented before on the high interest rates they get in China, the worst one in their last report was a “mere” 13.1% and curiously their cost of long-term financing is much lower than their short-term financing (although there could be subsidies at work; I’m not an expert on China’s internal investing environment). Of course one expects the cost of debt to be less than the cost of equity, but this year’s earnings to date are on par with last year’s,  and last year their interest payment was covered 7.5 times; it was covered 6.2 times the year before that, and year to date it is covered 4.5 times for a company that claims to see higher demand in the second half of the year. This coverage ratio, although not iron-clad, is consistent with investment-grade credit and it seems to me that raising the capital by borrowing, even though the firm would be pushed to the lower end of investment-grade, would be preferrable to giving up 8% in cost of capital and submitting to dilution.

Nor, to my knowledge, has American Lorain stated what they intend to do with the proceeds. As of last year their return on assets was 15.3% and their return on equity was 23%, so at a 21.4% cost of capital even if they did realize these results from their new capital (which is questionable because of diminishing marginal returns) they hardly produce any benefit that would justify this level of dilution. Even paying off their debt would significantly improve their already fairly strong credit profile.

Accordingly, I think this offering was entirely ill-priced, and should constitute a black mark on the market’s perception of the talents of American Lorain’s current management.

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Investing by grocca