Friday, November 30, 2012

Trade Idea: Suntech Power Bonds vs Equity ($STP)

Executive Summary
The Chinese photovoltaic solar firm Suntech Power (STP, which I've mentioned before on the blog) has a market capitalization of $165 million. However, its bonds due March 15, 2013 currently trade at around 33 cents (a yield to maturity of almost 700 percent). There's $541 million of notes due at the March maturity, so at market value that is $179 million. The current market capitalization of the company is 92% of this. Clearly there is a market inconsistency when you can make double your money in five months if a company with a significant market capitalization meets its bond maturity.

Capital Structure and Organizational Structure
The best view of the organizational and capital structure is available in the recent November 14 presentation to bondholders. Suntech Power Holdings Co., Ltd., the U.S.-listed publicly traded entity, is a Cayman Islands corporation. The $541 million of notes are holding company debt, and there is a fair amount of other debt at the holding company, plus the holding company guarantees the Chinese domestic bank debt of the subsidiaries. The holding company had only $3.3 million in unrestricted cash as of August 31.

The bank debt totals $1,441 million, which is mostly at the Chinese subsidiary level. The holding company owns a British Virgin Islands holding company, which in turn owns three subsidiaries: Suntech Power Cyprus (Cyprus), Wuxi Suntech Power (Chinese) and Suntech Power Investment PTE (Singapore). The Wuxi Suntech subsidiary is the real deal as far as operational assets are concerned, and it has $359 million in total cash as of August 31 (but over $1 billion in debt).

Equity vs Bonds Due 2013
There are options traded on Suntech equity, and the March contract expires the same day the bonds mature. The $1 strike put is $0.40 and the $1.50 strike is $0.80. Buying them outright is equivalent to shorting the stock at $0.60 or $0.70, respectively, which is expensive considering the $0.89 share price.

More interesting is what the March options are implicitly saying about the likelihood that the company defaults on its bond obligation. Assuming that the stock is worthless in the event of a default and worth more than $1 in the event of survival, then the implied probability of default is only 40%. [The market price of the put should be the expected value of a $1 payoff.]  

Meanwhile, I estimate (conservatively) that the bonds would also be worth zero in a default. With that assumption, you can estimate the probability implied by the market that the bonds default is 66%. [Bond investors probably think these bonds would have some recovery, which means they are more optimistic than I am about recovery but actually more pessimistic about the likelihood of default.] That means that the default, recovery, and valuation opinions implied by the bonds and stock are significantly different, as we saw above.

Three Cases
The inconsistency between implied probabilities that I described above doesn't sound like much, but it's glaring. Here's why - consider the three possible scenarios for how this upcoing maturiy crisis plays out:

  • Bonds zero, stock zero ("stubborn founder refusing to accept bailout or rational government leads to free-fall")
  • Bonds pay, stock diluted ("bailout/restructuring jackpot")
  • Bonds pay, stock rallies ("miraculous return to profitability")
Assume that you bought one bond for $350 and also bought 15 of the $1 strike put contracts for $600. Under scenario one, you would lose $350 on the bond but make $900 on the puts for a net of $550 (roi of 58%). Under scenario two, you would make $650 on the bond and breakeven or make money on the puts for a net of at least $650 (roi of 68%). Under scenario three, you would make $650 on the bond and potentially lose the entire $600 in puts for a net of $50 (roi of 5%). I estimate the probability of these scenarios as 70/25/5, so the bulk of the probability distribution is highly profitable.

The biggest concern is any sort of edge case, like the bonds going to zero while the stock is unexpectedly halted so that you don't make money on your put options. 

Industry Fundamentals
So why is this company so distressed? Let's take a step back and look at the fundamentals. We have successfully shorted two prior PV solar companies, Evergreen Solar and Energy Conversion Devices, because of a collapse in profitability in the entire PV solar industry.

This Greentech Media article on PV consolidation in 2013 has a good summary of how the PV industry got here and where it is going. As they put it, "overly aggressive capacity build-up in 2010 and 2011, along with severely curtailed subsidies in major feed-in tariff markets resulted in a massive supply-demand imbalance that manifested itself in early 2011, and is not expected to abate until at least 2014."

In other words, photovoltaic firms had a few good years when they were capacity constrained and tons of firms could make money, but those times are not going to come back. [There was a shortage of polysilicon coupled with fixed demand from subsidized buyers that drove high profit margins. Both of those conditions have gone away.] Margins have totally collapsed, as you would expect in an industry that is operating at around half of capacity.

Greentech Media thinks that China will prop up some of its domestic firms (including Suntech) by extending more loans, and possibly be acquired by state-owned Chinese firms. However, they note that "it would require a massive expansion in Chinese installations (to the tune of 15 gigawatts in 2013), considerably beyond what we expect to occur, to keep the entirety of existing Chinese capacity in business," meaning that a number of Chinese PV solar firms will have to be liquidated. 

Company Fundamentals
The solar industry downturn has resulted in puny gross margins for Suntech (under 1% in Q1) and large operating losses. The company does not have any current prospects of servicing its debt - to avoid liquidation, it will need to be kept afloat on the chance that attractive margins someday return to the industry.

You can see in the bondholder presentation (slide 10) that Suntech is more expensive per watt than its Chinese competition - not good when the industry is operating well below capacity. We are still waiting on third quarter financials, so we do not have a very good picture of how bad the situation has been recently.

The company also got itself into a big mess with its investment in Global Solar Fund S.C.A. Sicar (GSF), which was founded in 2008 to make investments in private companies that own/develop solar projects. Suntech invested E156 million and more importantly guaranteed E493 million in loans provided by China Development Bank to an investee company of GSF.

The company sought to sell its GSF stake in order to meet its upcoming debt obligations, but it discovered that E560 million in German government bonds that were pledged as collateral for its guarantee obligations... didn't exist. A Reuters article gives a good summary,
"Suntech said it had obtained the German bonds from Romero's private firm, GSF Capital. It said it needed the paper as security because it had guaranteed CDB's loan to Solar Puglia II. If the loan soured and Suntech was forced to pay up, Suntech could do so by selling the bonds and using the proceeds.

But the bonds did not ultimately belong to Romero, according to Suntech, which revealed on July 30 that Romero's firm had actually borrowed the paper from another, unnamed European company. Suntech has not disclosed the name of the fictitious bonds' original owner, nor said why it relied on Romero for this sum of paper and not the GSF fund's own assets."
It is a convoluted story, but the key implication is that one of the subsidiaries is worth much less than previously thought, and that its value if any will not be realizable in time to address the 2013 note maturity.

More Detail on Legal Structure and Capital Structure
These are holding company notes:
"The notes are unsecured, are effectively subordinated to all of our existing and future secured indebtedness, to the extent of the assets securing such indebtedness, and are structurally subordinated to all liabilities of our subsidiaries, including trade payables. [...] All of our operations are conducted through our subsidiaries. None of our subsidiaries has guaranteed or otherwise become obligated with respect to the notes. Our right to receive assets from any of our subsidiaries upon its liquidation or reorganization, and the right of holders of the notes to participate in those assets, is structurally subordinated to claims of that subsidiary’s creditors, including trade creditors. Even if we were a creditor of any of our subsidiaries, our rights as a creditor would be subordinate to any security interest in the assets of that subsidiary and any indebtedness of that subsidiary senior to that held by us. Furthermore, none of our subsidiaries is under any obligation to make payments to us, and any payments to us would depend on the earnings or financial condition of our subsidiaries and various business considerations. Statutory, contractual or other restrictions may also limit our subsidiaries’ ability to pay dividends or make distributions, loans or advances to us. For these reasons, we may not have access to any assets or cash flows of our subsidiaries to make payments on the notes."
This is as we noted above: holding company notes that are probably worthless unless China finds it convenient to bail them out. The most recent Form 20-F (2011) has more detail on the domicile of the holdco/subcos and the location of the assets,
"Most of our production, storage, administrative and research and development facilities are located in close proximity to one another in the city of Wuxi in Jiangsu Province. [...]  

Dr. Zhengrong Shi, our founder, chief executive officer and chairman of our board of directors, beneficially owned 30.2% of our outstanding share capital as of December 31, 2011. [...] 

We are a foreign private issuer and, as a result, we are not subject to certain of the requirements imposed upon U.S. domestic issuers by the SEC. For example, we are not required to issue quarterly reports or proxy statements. We are allowed six months to file our annual report with the SEC, and we are not required to disclose certain detailed information regarding executive compensation that is required from U.S. domestic issuers. Further, our directors and executive officers are not required to report equity holdings under Section 16 of the Securities Act. As a foreign private issuer, we are also exempt from the requirements of Regulation FD (Fair Disclosure) which, generally, are meant to ensure that select groups of investors are not privy to specific information about an issuer before other investors. We are, however, still subject to the anti-fraud and anti-manipulation rules of the SEC, such as Rule 10b-5. [...]

Our corporate affairs are governed by our second amended and restated memorandum and articles of association, the Cayman Islands Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as that from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws than the United States. In addition, some U.S. states, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law than the Cayman Islands. [...]

We are a Cayman Islands company and substantially all of our assets are located outside of the United States. A substantial portion of our current business operations are conducted in the PRC. In addition, a majority of our directors and officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons are located outside the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It may also be difficult for you to enforce in U.S. court judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, many of whom are not residents in the United States and whose assets are located in significant part outside of the United States. In addition, there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state. In addition, it is uncertain whether such Cayman Islands or PRC courts would be competent to hear original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state. [...]

Our predecessor company, Wuxi Suntech Power Co., Ltd., or Wuxi Suntech, was incorporated in January 2001 and commenced business operations in May 2002. To enable us to raise equity capital from investors outside of China, we established a holding company structure by incorporating Power Solar System Co., Ltd., or Suntech BVI, in the British Virgin Islands on January 11, 2005. Suntech BVI acquired all of the equity interests in Wuxi Suntech through a series of transactions that have been accounted for as a recapitalization. In anticipation of our initial public offering, we incorporated Suntech Power Holdings Co., Ltd., or Suntech, in the Cayman Islands as a listing vehicle on August 8, 2005. Suntech became our ultimate holding company when it issued shares to the existing shareholders of Suntech BVI on August 29, 2005 in exchange for all of the shares that these shareholders held in Suntech BVI."
The most important conclusion from all of this is that the 2013 notes and stock are both issued by the Cayman Islands holdco, and so we can anticipate what CI restructuring rules are.

I also found a useful article called Failed PRC Reverse Mergers: Strategies to Maximize Stakeholder Recoveries. The article notes one case involving a NASDAQ-listed BVI holding company that owned five Chinese subsidiaries. When an internal investigation conducted by a special committee discovered evidence suggestive of fraud, the Chinese controlling shareholder implicated in the wrongdoing tried to add directors to the board to obtain a majority. In order to prevent this shareholder from dissolving the special committee before it could complete its investigation, the special committee filed a chapter 11 petition in U.S. Bankruptcy Court in Nevada, and the court enjoined the shareholder from interfering further.

Hires UBS For Restructuring
On October 9, Suntech announced that it had hired UBS as an adviser to look into "alternatives" for the 2013 note maturity. The Bloomberg article about it quoted an analyst who said that "converting the notes due in March into common equity isn’t a good option because it would be 'enormously dilutive'". Although it is not a "good option" for shareholders, it is the only option short of a bailout by the Chinese banks. A default would be even worse for shareholders. But most importantly, the current share price does not price in the two high probability outcomes for shareholders: debt exchange or default.

Chinese Bailouts
One of the paths to survival for Suntech has been the possibility of a bailout by Chinese banks or governments. On October 26, the company received a $32 million loan from government entities including the state-owned China Development Bank.

One might suspect that the Chinese government and banks are now "in for a penny, in for a pound." If they don't redeem the bonds due in March, then STP goes under and the latest decision to put in money looks dumb too. But if they prop it up by refinancing the bonds with Chinese bank loans, the whole thing can be spun as a success that just hasn't quite materialized yet. However, a recent Forbes article mentioned that there were other behind the scenes machinations taking place,
"A report by 21st Century Business Herald on Oct. 26 quoted a bank source in Wuxi as saying that the government has offered to give Shi the funds he desperately needs. But the paper said a key condition would require Shi to provide his own personal assets to guarantee that those bonds would be repaid. That means Shi would probably lose the 30% of Suntech shares he owns. Another proposal by the government would see Suntech Power delist from New York Stock Exchange and become a state-owned company. Shi reportedly refused the two government proposals and wanted to protect the New York-listed Suntech Power by letting its core subsidiary in Wuxi go bankrupt..."
This account is light on specifics, but the first proposal implies that government funds would repay the 2013 notes, possibly at the expense of (at least Shi's) common stock. The second proposal just sounds like a liquidation where the holding company securities wouldn't receive any proceeds.

The result at the note maturity in March is binary: they are either paid or not. The recent presentation to noteholders mentions three "possible alternatives" for addressing the 2013 maturity: "restructure convertible notes, convertible notes exchange offer, or strategic investment in connection with one of the above."

Notably, the presentation mentions "alternatives considered but not available." It says that domestic (Chinese) loans "may be available to refinance existing bank debt as it matures," which is good news, but "credit support to repay offshore debt is not available."

The notes have tanked since that presentation was released, as it appears that the government bailout is not on the table. At this point, the "convertible notes exchange offer" seems like the most realistic possibility. I don't see why the 2013 notes would settle for less than ~95% of the equity in the company if they were to exchange.

In any case, the valuation of the stock and bonds is inconsistent.


Unknown said...
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GZ said...

Thanks for the very detailed blog. I have been watching this one for a few months now. One thing I am not so sure is if the stock will be wiped out after bankruptcy. I know it sounds crazy, but I saw some stocks still trading near 1.00 after chap 11 (sorry I forgot the name I was looking at). If that happens, you lose on both sides of this trade.

CP said...

That happens in the short run, but in the long run if the bonds don't get paid the stock will be worthless.

GZ said...

Another thing that is uncertain is what happens to my short stock position. By the time the put is exercised, the stock might have been delisted and traded on the pink sheet. I am not sure if we are required to cover immediately because it won't be shortable, or we can still short but pay dearly on the borrow. If we have to immediately cover, then one leg of the trade would be closed at a loss, but the long bond will stretch out for months and eventually be worthless.
Although they eventually do converge at 0, we might still have lost money on both legs.

An even horrifying thought just came to me -- they might just default on the bond without filing for bankruptcy. There is very little one can do about it. I am not sure it can actually happen, but if it happens, people wouldn't have to go to Cayman island to file a law suit?

CP said...

Let's imagine that the stock only falls to 20 cents after a missed principal payment on the bond. That's a pretty realistic scenario. (And that the bonds go to zero.)

In that case, the puts are worth 80 cents (2x), so you lose $350 on the bond but make $600 on the puts, a net of $250 which is 25% roi.

There are $541 million in bonds outstanding - I'm not worried about an involuntary petition being filed if the company misses the payment and doesn't file one itself.

GZ said...

I hope you (we) are right. I actually have this exact trade on since the August. It was a little early and I lost tons of premium. Fingers crossed.

CP said...

Interesting! You own the March puts?

GZ said...

Yes I do.

CP said...

Have you looked at the 50 cent puts? Those might be an even better hedge to owning the bonds.

GZ said...

In retrospect I think an in the money put might be better.

CP said...

I think ITM puts are good too.

That sort of implies that you think the equity is going to do OK, though.

I really think the whole holding company capital structure goes to zero.

GZ said...

The problem is both 1.0 and 0.5 puts are expensive. Like today, both the put and the stock lost value.

CP said...

Maybe earlier, but they are both up now. Just not as much as the stock is down, which is to be expected since delta <1.

We care about the terminal outcome anyway: the debt maturity.

GZ said...

It's kind of interesting that the stock rallies but bond does not change much. Sometimes I suspect that I missed something and in the end the stock will not go to zero but bonds will default. But if the conviction remains, this might be a good entry point.

CP said...

hey GZ,

I think that's a good sign for the trade.

I'm adding to the short. If you read between the lines of the article, they are going to let the firms BK and the survivors will pick up the pieces.

I'm not aware of a Cayman Islands bankruptcy where shareholders received hundreds of millions in value when bondholders received nothing.

CP said...

You can read the bond indenture here:

They are NY law bonds.