A123 Systems Announces Dilutive New Financing to Distract from Horrible Earnings ($AONE)

This morning, AONE started before announcing earnings by announcing a "Non-Binding Memorandum of Understanding With Wanxiang Group Corporation". These are the terms which were disclosed:

"Under the proposed terms of the strategic agreement outlined in the MOU, Wanxiang would provide A123 with up to $75 million in initial debt financing under a Senior Secured Bridge Facility, with an initial credit extension of $25 million and $50 million to be funded after the satisfaction of certain closing conditions, and, subsequently, upon satisfaction of certain closing conditions, purchase $200 million aggregate principal amount of A123's Senior Secured Convertible Notes. The agreement would also include the potential for Wanxiang to invest up to an additional $175 million if it exercises the warrants that would be issued in connection with the Bridge Facility and the Convertible Notes for cash. Incurrence of the remaining $50 million of loans under the Senior Secured Bridge Facility would be subject to the satisfaction of certain approvals and conditions, including receipt of favorable determination from CFIUS and receipt of Chinese government approvals. Issuance of the Convertible Notes and the related warrants would also be subject to additional conditions, including approval from A123's shareholders, termination of the Hart-Scott-Rodino waiting period, the conversion or redemption of all the outstanding six percent Convertible Notes and relevant warrants and the repurchase or retirement of at least 90 percent of A123's outstanding 3.75 percent convertible subordinated notes due 2016.

According to the proposed terms of the strategic agreement, if the entire amount of the initial debt financing is provided to A123 and the full amount of the warrants and Convertible Notes are issued and exercised for cash, Wanxiang's total capital investment in A123 from these agreements would total approximately $450 million. The total amount of shares of A123's common stock issuable upon exercise and conversion of the warrants and Convertible Notes would represent approximately 80 percent of the then outstanding common stock of A123. While the MOU is non-binding and the execution of definitive documentation is subject to negotiation and, among other items, the amendment of agreements with certain of A123's existing lenders, A123 and Wanxiang are currently negotiating definitive documentation and intend to close the full transaction by the end of 2012."

This disclosure is light on terms and heavy on headline numbers. Because of this, the initial market reaction was to incorrectly interpret this as bullish. Notice that there is no disclosure of the conversion price of the new notes or of the strike price of the warrants.

By the way, the news articles claiming that WX is paying $450 million for a majority stake are completely out of their minds. This looks more like a hard money convertible loan where the lender can short the stock at the money (thanks to the conversion options and warrants) to protect its position.

But the most amazing part is that it is contingent on redeeming the existing subordinated notes! These are the ones we own (paired against the equity) that have been trading in the low 20s.

That raises two questions: why and how. Why does WX care about having these be redeemed? Their new financing will be senior to the sub notes, so they could conceivably just ignore them. On the other hand, it is nice to have a cleaner capital structure, and it has always been embarrassing that AONE is trying to sell expensive capital goods when its debt trades at a 50 percent yield.

Second major question is how the sub notes are going to be repurchased/retired to satisfy that part of the MOU. Obviously, AONE isn't going to be calling them at par! They could do open market purchases at the current distressed price. However, that would still cost about $50 million, and cashing out other creditors presumably is not what WX signed up for. That leaves a distressed exchange / debt for equity swap. A big clue is that the MOU calls for 90% of the subs to be retired, which is a common threshold in exchange offers. I could see these notes being given something like 10 cents of cash plus stock to induce them to tender.

The stock component of the distressed exchange would need to basically wipe out the existing equity, though. If the entire WX deal needs to happen by the end of the year, than the distressed exchange needs to happen really soon. This could be why the stock tanked at the end of the day and the subs rallied from low 20s to 31.

Conclusion: the relative valuations of the subs and stock are still inconsistent. In order to bring in the new capital, the subs need to be given a tip to go away, and the current equity needs to get totally shafted. At a $50 million market value of the bonds and $75 million market cap, the market prices don't reflect this.