361 Degrees (1361.HK) is an HK-listed Chinese shoe and sports clothing retailer. You can read about the company and see their products here. I stumbled across their 7.25% Jun’21 USD bonds, which currently trade around 93.5 – 13% yield, 1.25 years to maturity – and was expecting to see a highly leveraged, distressed business (like TUP :)); or an obvious fraud. Instead what I saw was this (from the last reported financials, Jun’19):
All these figures are in RMB. So the company says they have 6.1bn RMB – that’s ~$900mm USD – in cash on the balance sheet – against just 2.6bn RMB of long-term debt (entirely the USD bonds) and basically no short-term debt, with net assets close to $900mm USD to boot.
Moreover, the company appears to have been solidly profitable on a consistent basis over the last five years:
So if the company is making money consistently; can cover the bond repayment 2x over with cash on hand; there is almost no other debt outstanding; and the bonds are almost 3x covered by gross assets, then why would the bonds trade at 13% yield??
Is this a fraud?
In situations like this you don’t need to make many judgements about the future growth of the business or its underlying quality; you only need to figure out if the numbers are close enough to real to get paid. Indeed, the risk of fraud was the proximate cause of why the bonds crashed to the mid-70s last November (the auditor resigned in a pay dispute, and this was interpreted as being but the first of many accounting cockroaches, even if it was simply a pay dispute), so it is really the only thing worth spending time on here.
But how do you figure out if the numbers are real? One way would be to estimate what reasonable margins, earnings, working capital; and cashflow should be for a business like this, and see how the company compares. But given the latency of apparent cash on hand, in this situation, the most important thing to focus on is how much cash has been raised from investors – via stock and bond sales – versus how much has been returned in the form of dividends, stock buybacks, or bond buybacks (and bond maturities of course). If the company has been a net returner of capital rather than raiser of it, and if insiders are buying, then it stands to reason the cash is real enough and these bonds will be made whole.
On this front, the picture is somewhat encouraging, since:
- the company IPO’d in 2009 and since then has not raised any additional equity capital from investors (over 10 years);
- the company has consistently paid dividends at a reasonable level (average payout ratio 46%) since listing and has reported positive operating cash flow every year;
- the company has many times bought back bonds they had previously issued, including recently, and in large size (they have retired ~22% of the USD bonds outstanding in the last 3 months).
Most importantly, though, the cumulative capital returned to investors through dividends now exceeds that raised from the initial IPO:
So the company has already returned more in divs, cumulatively, than they raised in the IPO – a great sign. On a more holistic basis – considering stock and bond sales, not just stock sales – the ledger is not quite as flattering:
However, note that this just takes account of bond buybacks, not bond maturities – the piecing together of which I have found much more difficult (many of the bonds were historically convertible into stock, complicating matters). Whilst not flashing an ‘all clear’, this provides at least some comfort – as does the fact that cumulative returns even on this basis have far exceeded capital raised over the past five years. And the point remains that this business has not consumed outside capital in any form since 2016.
What are insiders doing with their money and the company’s cash now?
The other aspect is what insiders are doing with their money. This is a family controlled business (not uncommon in HK), with management owning >65% of the company. Importantly, all three key owners have been adding to their equity stakes in the last 9 months, at or above current levels, in reasonable size (each owner added ~1% to their existing position, not easy to do in an illiquid stock).
However by far the most positive signal is the that the company has been aggressively buying back bonds ever since the price cracked last November, with – so far – 3 discrete partial purchases that have retired ~$85mm out of the $400mm bond principal outstanding – see here. These are meaningful reductions in principal and seem highly opportunistic – not just token purchases to try to reassure the market. The company knows they have to pay 7.25pts of carry and these bonds at par in a year plus, if they have the cash and the market is there, why not retire them at 85-95c today and save 20-25pts? Clearly that’s what they are attempting to do.
The final consideration of course is that there is basically no other debt on the balance sheet (just a de minimis amount of short-term bank loans). In other words, if the company were to default, this $320mm bond claim (despite the structural subordination) would be almost the only debt claim outstanding and would, theoretically, sit ahead of the entire family interest that built and controls this company – a business with net assets at book value of >$900mm, almost 3x the bond claim. Clearly that is highly unlikely to happen and in practical terms the only way for the founders and controlling shareholders to avoid it is to pay off the bonds.
Putting it all together
So we have a family-controlled company, that owns 65%+ of the stock but is still acquiring shares; that is aggressively retiring bonds at a discount to par, in advance of a very-near term maturity that is more than 2x covered by cash on the balance sheet; and we have next to no other debt claims ahead of us. Despite all this we receive a 13% yield at current prices, in USD. Yes, the coronavirus will hurt business massively in the near-term and the business will likely burn cash in 1H this year (and perhaps all through 2020) – but given the track record of capital returns, and the latent cash available to the company as well as the very recent bond buybacks (despite the ongoing deterioration in the business), it seems highly improbably that the bond maturity at par would be threatened even after one bad year. In fact, I think it far more likely these bonds are bought-back by the company, in their entirety, before final maturity in June next year – leading perhaps to an excess return above the 13% current YTM.
Disclosure: long 1361.HK 7.25% Jun’21 bonds. No position in 1361.HK stock.