Description

Investment thesis

We are presenting a merger arbitrage opportunity. Management of China XD Plastics (CXDC) is attempting to close the deal to take the company private at $1.20 per share. At the current level of $1.01 per share, the upside is around 19%. The closing date has been extended to February 7, 2021, we believe due to pending class action lawsuits by shareholders against the sale. We believe it is a spectacular deal for the management, so it is likely to close one way or another.

Business description 

Founded in 1985, CXDC is a supplier of automotive plastics in China under the business name Xinda. It also has a smaller operation in Dubai. It was listed on Nasdaq in 2009 through reverse merger. The stock reached a high of $11.25 in the fourth quarter of 2009 and as an opaque Chinese reverse merger stock it never gained favor with investors, battled some short-sellers along the way and has declined ever since.

Business performance and valuation

Despite significant financial leverage of just over $1 billion in net debt, of which $500 million is due within the next three years, credit remains widely available to CXDC. It pays a weighted average interest rate of around 5%. In December 2019 CXDC announced yet another $135 million facility agreement with a bank consortium led by ICBC, China’s leading state-owned bank. Several other financing deals were announced throughout 2019. Tangible book value is $12.20 per share.

Table: earnings record. *adjusted to reverse doubtful debt later collected

Business has grown and performed well with the exception of 2020. However, 2020 had a number of one-off items included in operating expenses totaling at least $28.6 million in addition to the one-off effects related to the pandemic. Otherwise the business seems healthy and showing some pricing power. The business may seem commodity-based but there is a limited number of competitors in this space. CXDC is also moving into more specialized and higher margin products. For 2019 the company reported an overall increase of 45.9% in the average RMB selling price of its products.

Even among some of the most lopsided Chinese deals it is rare to see a business that earned over $5 per share since 2015 being sold off at $1.20. Needless to say, it is a very attractive deal for management and less so for exiting shareholders.

Deal background

In February 2017, Chairman & CEO Mr. Jie Han teamed up with an affiliate of Morgan Stanley to submit a non-binding offer to take the company private at $5.21 per share. There was a big uproar from shareholders, such as a CFA who posted a thoughtful article on Seeking Alpha estimating the fair value of CXDC “under conservative assumptions at $58.32”. The deal then got held up due to difficulties in finding debt financing. Lenders were keen to provide credit for business purposes but less so to help take the business private. $100 million in debt financing was finally obtained in October 2019 from ICBC but Morgan Stanley pulled out shortly thereafter. 

In 2018, Mr. Han’s son, Mr. Tiexin Han, tried to subscribe for shares worth $75.6 million in the Chinese operating business at the valuation of $3.46 per CXDC share. The deal failed and the investment was refunded. It was probably nixed by Morgan Stanley which had two board members (who lost their seats in September 2019) and a say over material events.

Mr. Han, effectively going it alone, made his initial offer on May 11, 2020 of $1.10 per share. The company then received emails from a number of individual shareholders all saying the price is too low. After intense negotiations Mr. Han increased it to $1.20 and the board accepted, without disclosing as to what the following emails may have said.

The transaction was approved by shareholders in November 2020 because Mr. Han had the voting power to unilaterally approve the deal.

China XD Plastics is incorporated in Nevada, which affords a high degree of immunity to its directors and officers from actions arising from non-arms-length or related-party transactions. It also offers no rights of dissent to shareholders.

Litigation

The transaction was originally estimated to close in Q3 2020. On December 13, 2020 the merger agreement was amended to extend the termination date to February 7, 2021. We believe closing is being held up by pending shareholder class action lawsuits. Some have already been dismissed but a few remain. Statistically litigation with respect to transactions is dismissed by the court 28.4% of the time. The other 71.6% of transaction litigations result in some type of settlement (Cain & Davidoff), with the vast majority being disclosure-only settlements and only 5% involving payment to shareholders (and 100% involving payment to lawyers). Any changes prompted by settlement to the merger agreement are very unlikely to result in a higher deal price. While the baseline statistics are favorable for near-term resolution, a factor that calls for caution in this case is we have gone far beyond the expected timelines of such litigation as the median time between lawsuit filing and settlement is 44 days.

Management vs minority shareholders

As a familiar theme from the field of Chinese take-private transactions in US markets management has had a blocking position and not allowed any serious consideration of selling out to anyone else but his group. Mr. Han’s buyer group holds a combined 69.7% of voting power and 50.1% of share capital. CXDC did not attempt to get any alternative offers and “the Special Committee determined that there was no viable alternative to the proposed sale of the Company to the Buyer Group”. 

Typically these types of Chinese buyouts end with management getting their way anyway, just with a slight delay even if a competing bidder emerges. For example in the case of eHi Car Services management was able to leverage its controlling position despite a powerful minority shareholder offering a higher price. They eventually joined forces and lowered the offer price.

Downside

CXDC’s closing price prior to the deal announcement was $0.96, only 5% below the current price. If the deal were to fail, at that hugely undervalued level value may seem trapped but management will probably keep working to buy out minority shareholders. The risk is management may start to engage in self-dealing to help itself to the company’s assets but in our view the risk is mitigated by how easy and cheap it is for Chinese management teams to carry out lawful buyout transactions at bargain prices. 

The stock of CXDC’s biggest competitor, Kingfa Sci&Tech Co Ltd (Shanghai 600143), has more than quadrupled since Mr. Han made the buyout offer. Indirectly it is likely CXDC’s value has also increased since it would be more even more valuable for Mr. Han to re-list in Mainland China, for example.

Financing

The total amount necessary to take the company private is $42.8 million. Of this amount $37.8 million will be paid from the company’s own offshore cash and $5 million by the chairman as an equity contribution. 

We have been involved in various and analyzed scores of Chinese buyout situations over the years and found that buyouts led by management where they have majority ownership that become binding tend to close at a high rate. Odds are stacked in the buyout group’s favor and when it’s an incredible deal for them it should motivate them even more.

Catalyst

Closing of transaction.