Mengniu unlocks share value through EB

By issuing an exchangeable bond into China Modern Dairy, the dairy maker can potentially offload unwanted shares accumulated through a mandatory offer earlier this year.

China Mengniu Dairy provided some relief for equity-linked investors on Thursday by selling $194.8 million worth of bonds exchangeable into shares of Hong Kong-listed China Modern Dairy, bringing just the fourth equity-linked deal in Asia ex-Japan this year.

The transaction followed deals from Nanya TechnologyZhejiang Expressway and Ennoconn worth a combined $1 billion. That is only 21% of the $4.7 billion sold throughout last year — although it should be noted that investors enjoyed a bumper 2016 after bond sales by investment grade issuers such as CRCC as well as rare high-yield names like Sunshine 100 China Holdings.

It is clear that, even after Mengniu’s deal, the market still has plenty of catching up to do if bankers are going to hit the same level of issuance in 2017. But the new deal is a good start. It gives a classic example of how equity-linked products can help achieve objectives that neither a share sale nor a structured financing could achieve.

Mengniu's dilemma

Mengniu was stuck in a tricky situation with its stockholding in China Modern Dairy that originated from a 14.5% stake purchase from private equity firm KKR in January this year.

China’s second-largest manufacturer of dairy products was forced to make a mandatory general offer for all China Modern Dairy shares after the $242 million stake purchase, since it had accumulated a 39.9% stake after the deal. According to Hong Kong listing rules, an owner holding over 30% of a listed company is required to make an offer for all the remaining shares it does not already own.

In March, Mengniu announced China Modern Dairy shareholders had tendered 21.4% of the company’s outstanding shares, increasing its shareholding to 61.3%. Unsurprisingly, Mengniu wanted to offload this additional stake since it had never intended such a large ownership.

But Mengniu’s exit option was limited by the fact that the stock has plunged since it acquired the stake. The company acquired the shares at HK$1.94 per share but they were quoted at HK$1.66 by the end of trading on Thursday. This suggests that it will have to bear a 14.4% loss — more if it offered a discount — if it chose to sell the shares through a direct block sale.

Another option for Mengniu was monetising the stake through share-backed financing — in other words, using the stock as collateral for bank loans. This is a good way to refinance at an extremely low cost, but it does not help if the company wants to eventually offload the stake.

More importantly, the company would want to avoid running into a liquidity crunch in case China Modern Dairy shares plunge. It would not have to look far to find an example of what can go wrong. Huishan Dairy, one of Mengniu’s key rivals in dairy production, suffered a catastrophic 85% crash in its share price in late March amid a liquidity crisis that involved share pledging by its controlling shareholder.

As a result, executives at Mengnui opted for an exchangeable bond — sending a clear signal that the company ultimately wants to sell the additional stake.

The company can reduce an 11.24% stake in China Modern Dairy if the bonds are fully exchanged into shares, bringing its shareholding to around the 50% mark.

And instead of a loss, the exchangeable bond also allows Mengniu to potentially sell the stake at a 32.5% premium to market price.


Mengniu — rated BBB+/Baa1 — launched the Reg S-only deal with largely fixed terms, including a zero coupon and a 1.25% yield-to-maturity. The only variable was the exchange premium, which was being pitched at between 30% and 35% over China Modern Dairy’s Thursday close of HK$1.66.

According to two sources familiar with the situation, the terms were largely fixed because the bookrunners had good visibility on demand after sounding out the bond sale since the beginning of the week. In the end the bulk of the bonds were allocated to wall-crossed accounts, according to one of the sources.

The EB came with a standard five-year structure, a three-year put option and a call option subject to 130% trigger. There is also full dividend pass-through for all bondholders.

One bond trader said the stock lending facility attached to the deal helped offset the relatively low daily turnover of China Modern Dairy shares, which was only about $1.3 million on a three-month average basis. The bookrunners arranged a total of 363 million shares for lending, which is slightly over half of the 698 million shares exchangeable through the EB.

In the end the exchange premium was set at the mid-point of the guidance at 32.5%, translating to a final exchange price of HK$2.1995. China Modern Dairy shares have never reached that level for over 19 months since October 2015.

Underlying assumptions of the deal include a 95% bond floor and an implied volatility of 24% based on a credit spread of 125 basis points and stock slippage of 5%.

DBS served as global coordinator for the exchangeable bond sale, and also a joint bookrunner with BOC International.


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