KHD rights: The Big Disappointment
On December 23rd KHD announced that a Chinese entity, CATIC, would become an investor in KHD. That was the extent of the good news. Everything else about the announcement, from its timing to the way in which the ‘investment’ would be made, was a disappointment. At the very least it was a reminder that in non-US jurisdictions, shareholder interests are not always safeguarded in the same way as they are in the US.
The proposed operation (‘proposed’ only because it has not yet been effected, though I fully expect it will be) is as follows:
- KHD is making a rights offering whereby shareholders of KHD as of Jan. 4, 2011 will receive one non-transferable right for each 2 shares of KHD stock owned
- Each right entitles the owner to purchase 1 restricted KHD share (i.e. it cannot be traded for 29 months) for 4.53 Euros
- The rights, however, can only be exercised by shareholders of KHD in Germany and Luxembourg and accredited investors elsewhere (though this latter is not explicitly stated in the prospectus)
- CATIC will purchase a 20% interest in KHD by subscribing to the rights which are not exercised (for example yours, if you are a small investor and live in the US or Canada) at, you guessed it, 4.53 Euros per share.
- If too many rights are exercised to allow CATIC to purchase a 20% interest in KHD, the whole transaction may be scrapped.
I’m having a hard time swallowing some of these terms. My quick and dirty interpretation is that KHD management, who by the way have almost no ownership interest in the company, have solicited a Chinese partner in order to facilitate KHD’s entry into the highly desirable Chinese market by selling them an interest in KHD at a below market price. Worse, they are shifting ownership away from certain current shareholders to these new shareholders without giving all current shareholders a say in the matter. Now, bringing in Chinese partners to get a crack at all that cement business in China may turn out to be a great strategic move (even if it is a little late), but does anyone on the KHD management team have any idea what this transaction looks like to a small North American investor? Rape, pillage and torture would be an understatement! I don’t have a handle on how many small KHD shareholders are based in North America, though I would bet it is the vast majority, as the original KHD (from which the new KHD was spun off in March of last year) was a Canadian company listed on the NASDAQ. This kind of ‘taxation without representation’ no matter how well-meaning is anathema to US shareholders, well, at least to me. Plus, small North American shareholders are being unfairly treated vis-a-vis their German and Luxembourg (and accredited) counterparts. My first reaction was ‘Maybe its time to sell my KHD shares’. But I quickly thought better of that (never sell on bad news!), and concluded that perhaps I should dig deeper into the company’s announcement, like, say, read the official offer prospectus. There, of course, was the next rub; the prospectus, while available on the KHD website, is not meant to be read by North American shareholders because the rights and the shares which they represent are not registered under US securities laws. Luckily, I’m not a North American-based shareholder, though I do hold these shares in a US brokerage account. That obstacle surmounted, the more I read, the more I began to wonder about European securities regulations. Is it really possible that under German law, foreign shareholders of a German company can be discriminated against, even partially expropriated? Can management and directors disenfranchise and run roughshod over shareholder rights in the name of a strategic corporate goal? Yes, these are rhetorical questions. I don’t expect an answer. The rights will expire before I could even get a chance to begin delving into German security regulations, so I just might as well accept it all at face value.
So it looks like the terms of the rights offering will allow Peter Kellogg, who owns about 6% of KHD is a North American investor, to participate in the rights offering, while other small North American investors will be excluded. When I first looked at the offering terms I was wondering how management would dare exclude such a large shareholder from this offer. They took the easy road, it seems, and provided the loophole.
My take on the share ownership pre and post rights exercise (assuming P. Kellogg exercises his rights and there is the maximum rights exercise among other shareholders) is laid out below:
|Gr./Lux rights shares||5,590||11.2%|
Ownership issues aside, the question remains whether this is a good strategic deal for current shareholders or not. The ownership interest of current KHD shareholders who cannot exercise their rights will be diluted by up to 1/3 under this rights plan (if all rights are exercised there will be 3 KHD shares outstanding for every 2 KHD shares outstanding before the rights exercise), but the company will (theoretically) get a facilitated entry into the vast infrastructure building market in China. Furthermore, KHD will receive 75 million euros in cash if and when all the rights are exercised. The proposed operation will actually increase per-share book value from about Euro 4.24 to Euro 4.34 ($5.51 to $5.64), give or take. But from a cash flow perspective, it looks more like dilution, at least for the first year or two. The incremental Euro 74.5 million from the rights issue is going to be used “.. for research and development activities in relation to grinding and pyro process equipment as well as for development of standardizations of plant equipment for packaged complete solutions for grinding and pyro-processing applications. Moreover, the Company intends to use a certain amount of the net proceeds for a co-investment together with CATIC into a design institute and a manufacturing entity in the PRC as agreed in the Cooperation Agreement between the Company and CATIC..”. So the funds raised are not going to be used for immediate investment to generate additional returns. Rather, it looks like they will be setting up a slush fund for some research in China. In other words, the whole operation appears to be simply a financial maneuver to allow the Chinese partner to buy a 20% ownership interest at below-market rates, no more, no less. And with little or no chagrin this appears to be explicitly stated in the offering prospectus. (Vergogna!)
I will be exercising my rights, if possible, and will continue to hold my KHD shares, but mainly because I would have a short-term gain if I sold. As my holding period approaches 1 year for each tranche of shares purchased or acquired in the spin-off from Terra Nova, I will be revisiting the question of why I am holding these shares. Unless there is a very compelling reason to hold, I will have a hard time forgetting management’s treatment of small shareholders. For me, this was a good reminder of the extent to which non-North American companies can disregard shareholder interest. Make sure that on your investment checklist you include ‘reasonable level of management ownership’. I, for one, wonder if this operation would have been undertaken if current management had a significant ownership interest in their company and they were forced to treat all shareholders equally. Certainly if they had, I would feel much better about this rights offering. But they don’t and I don’t!
So as always, caveat emptor!
[updated January 13, 2011]