TPG invests in Chinese shoe retailer

The private equity investor buys $80 million of CBs with warrants in Daphne International that could give it a stake of up to 14.5% in the Hong Kong-listed company.

TPG Asia, the Asian arm of private equity firm Texas Pacific Group, has agreed to buy Rmb550 million ($80 million) worth of convertible bonds in Chinese shoe manufacturer and retailer Daphne International Holdings, which will give it a 9.8% stake in the company once fully converted. The deal also includes 100 million warrants, and if they too are exercised, TPG's holdings will increase to 14.5%.

The company will use the money as working capital and to expand its retail network in China. However, the deal has wider implications than just a fund raising tool. Daphne will treat TPG as a strategic investor and will expect the US company to share its business vision and add "considerable value" by bringing in international best practices within both business strategy and corporate governance. In a statement issued to the Hong Kong stock exchange, Daphne noted that TPG is "an experienced partner to entrepreneurs and high-growth companies".

While TPG didn't comment specifically on its tie-up with Daphne yesterday, the following statement on its website says something about its investment approach: "While we do not seek to become involved in the daily operations of our portfolio companies, our wealth of experience, deep industry expertise and large global network of affiliated partners position us as a vital resource from which management can draw strategic, financial and operational guidance."

A source noted that the private equity firm has been very bullish on the Chinese consumer retail sector for some time and has been looking for suitable investments.

TPG will get one seat on Daphne's board, which, according to the same source, is expected to be taken up by Mary Ma, the former chief financial officer of Chinese computer manufacturer Lenovo and, since September 2007, a managing director with TPG. The private equity firm will also use its international contact network to help Daphne find a new CFO -- a position that has been vacant for quite some time -- as well as a head of supply chain management.

Daphne is not your typical target for a private equity firm as it isn't exactly a young start-up without other fundraising options, but a well-established mid-cap stock with a market capitalisation of about $670 million. The company was set up as far back as 1987 and has been listed on the Hong Kong stock exchange since 1995. Initially an original equipment manufacturer, it launched its own Daphne brand in 1990 and has gradually been expanding this side of the business even since. It currently has over 3,000 retail outlets in China and Taiwan. In 2008, only 12% of its revenues came from the OEM business and in June last year it changed its name from Prime Success to better capitalise on the Daphne brand.

However, as the financial crisis has taken a toll on share prices, private equity investors and hedge funds have become increasingly interested in buying stakes in publicly listed companies where they see upside potential. These so called Pipe [private investments into public entities] deals are also a way of avoiding the difficulty of obtaining approvals for traditional buyouts in certain countries, China included.

By selling CBs to the strategic investor, the target company is able to maximise the capital injection since the funds will be raised at a future share price. So far this year, there have been at least two other such private CB deals in Asia, which compares with only three public CBs. Last month Techtronic Holdings sold $125 million worth of CBs with warrants to a group of six investors, and earlier this year KCC sold $58 million worth of bonds exchangeable into auto parts manufacturer Hyundai Mobis to one single investor.

The Daphne bonds sold to TPG have a five-year maturity with no put and will pay an annual coupon of 3.125%, resulting in low-cost funding for the company. The bonds are denominated in renminbi, which allows the company to avoid accounting for the equity option on a mark-to-market basis, but settled in US dollars to make it more attractive to international investors such as TPG.

The bonds can be converted into Daphne shares at any time at a price of HK$3.50 per share. The conversion price translates into a modest premium of 7.7% over Friday's closing price of HK$3.25 (Daphne was suspended from trading yesterday pending details of TPG's investment). However, one source noted that when TPG and Daphne started to negotiate the conversion price, the share price was significantly lower and since the discussions were focusing on an absolute price, rather than the premium, the final premium ended up being a bit tighter than initially may have been intended. Based on the average closing price for the past 30-days, the conversion premium would be 28.5%.

The HK$3.50 conversion price values the company at 11.7 times its 2008 earnings and a similar valuation for 2009 as earnings are expected to rise only marginally this year due to a slowing growth in same-store sales.

Daphne's share price has almost doubled since the beginning of April (+94%) amid improving sentiment for Chinese footwear and sportswear retailers in general. That said, it still has some further ground to make up before it is back to the levels of around HK$4.80 where it traded 12 months ago. The stock hit a record high of HK$9.69 in April 2007. Supporting the notion that the share price will continue to trade up, 13 of the 15 analysts who cover the stock have a "buy" recommendation in it. However, this could be partly due to the fact that analysts haven't had a chance to update their estimates in the wake of the sharp run-up over the past couple of months. One indication that this may be the case is the fact that the average target price is only HK$3.02, which is 7% below Friday's closing price.

Meanwhile, TPG will also receive 100 million five-year warrants at no additional cost. Each of these gives it the right to buy, at any time, one additional share at a price of HK$4, a 23.1% premium over the latest close and a 46.9% premium over the average close in the past 30 days. If fully converted, this will provide an additional HK$400 million ($52 million) worth of capital for Daphne, and bring TPG's total investment into the Chinese retailer to approximately $132 million.

Daphne is being advised by Merrill Lynch, now a unit of Bank of America-Merrill Lynch, while TPG is advised by Nomura.

The Chinese shoemaker has earlier said that it plans to open approximately 300 points of sale under its Daphne brand this year, as well as 250 outlets under its mass-market "Shoebox" brand. According to a research report by KGI, more than 100 of the new Daphne outlets will be franchised, which is a model the company is using to expand in tier four to six cities in particular without putting too much capital at risk. The company has said that it plans to spend less than HK$200 million on capex this year.

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