"Level 13" is a 30-year-old retail investor who is a business analyst and has 4 years of investing experience.This article has been adapted from his blog, (‘Level 13 financial ramblings’) with his kind permission.

ON 21 July, China Holdings Acquisition Corp (CHAC) announced that it would make an offer to acquire all the shares of Bright World Precision Machinery Limited (BW). CHAC has entered into a definitive agreement with World Sharehold Limited (World Share), the majority shareholder of BW.

Under the agreement, CHAC will issue to World Share, which is controlled by Mr. Wang Wei Yao, the non-executive Chairman of BW, a promissory note automatically convertible into a minimum of 19.9 million initial shares of CHAC in exchange for World Share's 77.42% equity ownership in BW.

For the remaining 22.58% of BW's shares held by other shareholders, CHAC will offer SG$0.70. If 90% or more of BW's shares are purchased, CHAC will increase its offer price to SG$0.75 per share in cash.

The transaction, is expected to be completed in the fourth quarter 2008, values BW at a minimum of approximately US$263 million. Upon completion of the transaction, CHAC will seek to list its shares on the New York Stock Exchange.

The agreement between CHAC, on the one hand, and World Share, Mr. Wang Wei Yao and Mr. Shao Jian Jun, on the other hand, also provides the newly combined company with a right of first refusal to acquire four other companies controlled by Mr. Wang Wei Yao that manufacture agricultural machinery, auto parts and components, lawn equipment and construction equipment. The new company plans to grow through the use of cash flow from operations and cash available from CHAC's trust fund.

Stamping machinery. Photo: annual report
In order for the BW takeover to become a reality, there are 8 conditions to be fulfilled.

Currently BW is trading at about $0.34, a whopping 50% discount to the takeover offer by CAHC.

I believe the main reason why BW is trading at such a low price is because investors are skeptical that all the 8 conditions can be fulfilled under a gloomy economic outlook.

Out of the 8 conditions, investors are mainly concerned about the following 3 requirements:

1) Shareholders of CAHC holding 33.33% or more of the shares obtained during CAHC’s IPO (CAHC was
listed on the American Stock Exchange in Nov 2007) do not vote against the offer transactions and exercise their redemption rights.

(Note: CAHC is
a blank check company focused on acquiring companies with primary operations in Asia through a merger, capital stock exchange, stock purchase, asset acquisition or other similar business combination or contractual arrangements. CHAC currently has no operating businesses.)

At this moment, I would rate the possibility of the rejection of the offer transaction and cash redemption by the current CAHC shareholders as low.

Many other blank check companies have a redemption threshold of 20%, which makes it more difficult for such companies to consummate their initial business combination. Thus, because CAHC permits a larger number of stockholders to exercise their Redemption Rights, it will be easier for them to consummate an initial business combination with a target business which stockholders may believe is not suitable.

CAHC has increased the redemption percentage to 33.33% from the more typical 20% in order to reduce the likelihood that a small group of investors holding a block of our stock will be able to stop them from completing a business combination that is otherwise approved by a majority of our public stockholders and to be similar to other offerings by blank check companies currently in the market.

2) The Group Companies’ profit after tax (PAT) for the six-month period ended on 30 June 2008, nine-month period ending 30 September 2008 and full year period ending 31 December 2008 should not decrease by 10 per cent or more as compared to the same period in fiscal year 2007.

Unless you are an insider working in BW, it is impossible to forecast accurately the revenue for the next 2 quarters. However, I am aware that rising raw material cost and a slowdown in their customers' manufacturing activity can severely impact the bottom line. Barring a sharp drop in revenue, I don’t see any problem with BW fulfilling the 10% condition. Using HY08 results, we have a clear idea on how much more profit is need for the rest of the year.

                                   Profit After Tax in RMB 000 (thousands)

  6 months 9 months 12 months
2007 52586 95350 144865
2008 79003 At least 85815 (HY08 achieved 82.8%) At least 130378 (HY08 achieved 60.59%)

3) The Chinese authorities may not approve this takeover.

Investors who are aware of the recent failed bid by the Carlyle Group to acquire a 45% stake in Xugong Construction Machinery Co Ltd may be skeptical that this acquisition by CAHC, which is a foreign entity, will materialize. The failure of the deal has once again drawn attention to the political challenges facing foreign investors in China, especially in so-called "strategic" sectors. China is concentrating on its key strategic sectors and machinery is now a part of that. Probably a few years ago if a foreign company wanted to buy into such assets it wouldn't have created much trouble, but lately China has been trying to control them more.

The key point is that they want these key industrial sectors to remain in Chinese hands, whether through funds or other channels. In my opinion, I believe the Chinese authorities will give the green light for this BW takeover because, ultimately, when the whole acquisition is completed, Mr. Wang, who is a Chinese national, will gain control of CAHC which BW is a wholly owned subsidiary.

Some investors may think, if it is such a good opportunity to double your money over the course of a few months, why are the insiders not buying? I have extracted the answer from the pre-offer announcement by CAHC:

”CHAC and the Sellers have agreed to refrain from taking any action that would be prejudicial to the successful outcome of the Offer. In addition, until the termination of the Offer or the consummation of the Transactions, CHAC and the Sellers have agreed not to solicit or enter in negotiations regarding an alternative transaction.

”Furthermore, World Share has agreed to procure that Bright World and each of its subsidiaries (collectively, the “Group”) (A) refrain from taking certain actions without the obtaining the prior written consent of CHAC and (B) operate their business in the ordinary and usual course.”

Stock price surged towards the takeover price but has since slumped.

Does CHAC have the financial muscle to carry out this takeover?
As at 30 June 2008, there are USD125 million in CHAC trust account. After this whole acquisition is completed, they would have used up USD50 million as World Share's 77.42% equity ownership position in Bright World is paid for using CAHC’s shares. This leaves them with the cash holding of USD75 million to acquire any of the four companies controlled by Mr. Wang Wei Yao.

Since the announcement of this takeover news, there have been some positive developments in China’s machinery industry. China's machinery industry reports a 17.4 percent increase in the added value in July, and a 20.9 percent rise in export delivery value, according to China's National Development and Reform Commission. Experts held that the reform of the value added tax (VAT) has helped boost the development of the industry.

It will drive enterprises to invest on fixed assets, such as machinery equipment, said Zhu Qing, director of the financial department with the Renmin University of China. He predicted that this policy would be carried out nationwide in 2009 on the ground of industrial restructuring and the declined economy increase rate.

The country's eight million companies will be allowed from next year to use fixed-asset investments to offset valued-added tax payable to the government, according to sources. Analysts said reforming the tax system was a prelude to a new round of economic sweeteners from Beijing as policymakers struggled to cushion the impact of weakening global and domestic economies.

The adjustment in value-added tax will mainly ease the burden on manufacturers that have large investments in fixed assets such as factories and machinery. Analysts estimate that the change will reduce funds flowing into government coffers by between 100 billion yuan and 150 billion yuan a year. Analysts said the top beneficiaries of the policy change would be machinery and equipment makers, which have large fixed-asset costs that can now be offset.

Readers can draw their own conclusions if this represents an excellent opportunity. Personally, I consider the potential gains outweigh the risks.
For further views, please read Bright World thread at NextInsight forum.

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