Bailout ideal for Citic Pacific, less so for shareholders

Citic Group agrees to buy FX "hedges" with mark-to-market losses of HK$10.4 billion from its Hong Kong-listed unit in exchange for an interest equity stake.
The management at Citic Pacific is no doubt breathing a sigh of relief after being thrown a lifeline by its controlling shareholder, state-owned Chinese investment company Citic Group. Having shocked shareholders a few weeks back with the revelation that contracts entered into by its finance chief to hedge an exposure to the Australian dollar had turned sour and cost the company close to $2 billion in losses, Citic Pacific has struck an agreement to sell the majority of the ôtoxicö contracts to Citic Group, effectively eliminating any further losses from this exposure.

In return, Citic Group will get an increased equity stake in the Hong Kong-listed conglomerate by way of a HK$11.625 billion ($1.5 billion) convertible bond that will be automatically converted even if it is out of the money. Until the CB can be issued and the contracts transferred û both require shareholdersÆ approval û Citic Group will provide a standby facility of $1.5 billion to Citic Pacific to cover potential further liabilities arising on the hedging contracts.

According to a company announcement, Citic Pacific will sell certain Australian dollar target redemption forward contracts with a current mark-to-market loss of HK$10.4 billion û and the potential for further downside û to Citic Group for $9.3 billion. However, Citic Pacific will retain its AUD leverage foreign exchange contracts which will continue to serve as a hedge for outlays in connection with its iron ore business in Australia. These contracts are currently carrying losses of HK$5.1 billion but, contrary to the contracts that are being transferred to Citic Group, they are viewed as ôrealö hedges and qualify for hedge accounting. This means the company doesnÆt have to mark-to-market and put the gains or losses through its profit and loss account.

The agreement was seen as something of an ôidealö solution for Citic Pacific, although analysts acknowledged that it was also pretty much a last resort for the firm, which had been generating additional losses on the contracts in question since the positions were first announced on October 20. Bearing all the marks of a bailout û Citic Group is essentially taking over positions that could face significant further declines û the agreement is not too dissimilar from the government capital injections into troubled financial firms around the world. It also continues a trend seen over the past couple of months whereby controlling shareholders have been forced to step in and provide the necessary funds for companies in dire need of capital for whatever reason û typically through the use of fully- or partially-underwritten rights issues that have been shunned by minority shareholders.

The Citic Pacific bailout is different in one important aspect though û the minority shareholders did not get a chance to reduce the dilution that will be the result of the CB issuance to Citic Group. And the dilution is significant as the total number of shares will be increased by 66.3%. As a result of the bailout, Citic GroupÆs direct ownership in the company will increase to 57.6% from 29.4% and its ownership together with concerted parties, including chairman Larry Yung, will increase to 70.5%.

Thus, it would be understandable if minority shareholders werenÆt too keen on the package, especially since they have already lost 58% of their investments since the hedging contracts were first announced, due to a drop in the share price.

However, the share price gained 9.2% yesterday to HK$6.62, having risen as much as 17% in early morning trading. Billy Ng, an analyst with J.P. Morgan, attributed the gains to relief that a solution had been found and said the transfer of the contracts to the parent company will remove a major overhang on the stock caused by the fact that the potential downside on these contracts was unlimited.

While the loss-making contracts remained on Citic PacificÆs books, investors who wished to buy the companyÆs shares were also ôforced to take a major position on the Australian dollarö, he says. That said, investors will be more cautious about investing in this company in the future, having been alerted to the potential foreign exchange issues that arise from its investments in Australia, he adds.

Indeed, the magnitude of the loss, which has so far resulted in a profit warning, the resignation of financial director Leslie Chang and a formal investigation into the company by the Hong Kong securities regulator, has led to a de-rating of the stock. Out of the 10 analysts who cover the company, according to Bloomberg, six have a sell recommendation on it. The four analysts who have a buy have not revised their recommendations since the FX contracts were revealed. According to an investor, Merrill Lynch has dubbed Citic Pacific the ôleast preferred stock in the Greater China conglomerate spaceö.

In its 26-page announcement, Citic Pacific noted that it would have been difficult to obtain additional banking facilities at this time in light of the current volatility and lack of liquidity in the equity and credit markets globally and financial support from its largest shareholder is ôthe most feasible optionö.

However, the $1.5 billion standby facility, which is unsecured and repayable on demand, is intended to be a backup measure only and the funds will no longer be available if they are not drawn down before the CB is issued (which is currently expected to be by the end of this year). At the moment the management doesnÆt believe that it will have to draw down on the facility, but if it does, it will be at a cost of 280bp over Libor.

The intended objectives of the standby facility, the CB and the contract transfer, according to the company announcement, is to demonstrate Citic GroupÆs continuing support for Citic Pacific, to resolve its commitments and/or liabilities under the hedging contracts and to enhance the liquidity of the group.

ôWe believe that the agreement and arrangements with Citic Pacific will help restore confidence in the company,ö Chang Zhenming, Citic GroupÆs vice-chairman and president, said in a written comment. ôCitic Pacific is a strong company with solid assets and a highly experienced management team. With this financing in place, it can move forward and continue developing its business.ö

The CB will be convertible into Citic Pacific shares at a price of HK$8 per share, which represents a 32% premium to the closing price of HK$6.06 on October 31, when the shares were suspended from afternoon trading pending the announcement of this agreement. The shares only resumed trading yesterday. Based on the close on the last full day of trading, the conversion premium is 60%. However, the share price had been trending upwards from the October 27 low of HK$3.66 on speculation that Citic Group would come to the aid of its Hong Kong-listed unit û although initially it was believed that it would only provide a loan.

The sharp deterioration in the share price û it peaked at close to HK$43 in February û is evident by the fact that the initial conversion price is at a 71% discount to the companyÆs unaudited consolidated net asset value per share of HK$27.80 as of June 30 (which obviously doesnÆt take into account the forthcoming dilution).

The CB will pay an annual coupon of 2% until it is converted, although this is of little significance since the bonds will be automatically converted once the deal has been approved by independent shareholders. The deal is conditional upon, among other things, approval of a whitewash waiver that will enable Citic Group to increase its stake in Citic Pacific without having to make a general offer to other shareholders. However, this isnÆt expected to be an issue.

Citic PacificÆs troubles began in July when the Australian dollar suddenly changed direction and started plunging against the US dollar. This turned contracts set up by finance director Chang and his team with a view to minimise the currency exposure of the company's iron ore mining project in Australia into virtual loss-making machines. And the losses were quickly spiralling out of control.

And closer inspection, the contracts werenÆt really hedges at all, but highly leveraged FX bets taken to profit from the Aussie dollar's gentle rise against the US dollar. The contracts committed Citic Pacific to buying the Aussie dollar at $0.87 even as its value collapsed to $0.65 and the holder of the target redemption contracts û soon to be Citic Group û will have to keep doing this until October 2010. The potential downside is unlimited.

As of Wednesday this week, Citic Pacific had incurred a total loss of HK$16.8 billion ($2.2 billion) from these trades, including the mark-to-market losses of HK$10.4 billion and HK$5.1 billion and an already realised loss of HK$1.3 billion.

¬ Haymarket Media Limited. All rights reserved.
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