The Credit Bubble Stocks blog has written repeatedly about the overvaluation of Suntech Power, a Chinese manufacturer of solar panels. The Company has $541 million of bonds that are due in March and are trading for roughly 50 cents on the dollar for a yield to maturity of almost 500%. Despite the fact that the senior part of the capital structure expects to lose money the equity part of Suntech Power has a significant market capitalization. The stock has more than doubled last month and the company is now valued by the market at $340M.
Just based on the discrepancy between bond and equity prices you know that something doesn’t add up, and if you start looking at the financials I think it’s pretty obvious what part of the equation is right. The company has approximately 2 billion in debt and isn’t earning any money at the moment. EBITDA for the last twelve months is minus $117M, and that is a number that’s not including some very real costs. Last year the company paid for example roughly $100M in interest. It’s a bit unclear what the current financial condition of Suntech is. While the company announced financial results for the third quarter last month it’s a press release short on details: I don’t think I’ve ever seen a company announce financial results, but not tell anything about the achieved earnings or EBITDA. The latest complete financial numbers are from the first quarter of 2012.
What we do have is a nice presentation for bondholders that the company filed with the SEC last November. Included is for example a graph of the debt maturity profile:
Suntech has been able to work with bank lenders to refinance their existing domestic loans, but the offshore debt that will reach maturity this quarter is more problematic. Suntech included the follow slide in the presentation about possible solutions:
As is visible the company doesn’t expect to have a lot of options. Chinese banks are not willing to refinance the offshore debt, and issuing new bonds also doesn’t seem to be an option. So that means that there are basically two options left: bankruptcy or a conversion of the bonds to equity. It’s hard to see how that could work out favorable for equity holders…
It’s not a long, but is it a short?
Just because a company is a terrible investment it doesn’t have to be a good short. Especially when something is obviously overvalued there is often no cost effective way to go short. It might be impossible to borrow shares or the annualized cost of borrowing might be through the roof (100%+ was not uncommon for Chinese frauds). Not only can a short position be difficult and expensive to maintain, if it’s a popular trade you also risk a short squeeze. At the same time you also see that the implied volatility of put options increases dramatically. So what often happens is that you end up with a situation that can only be ‘arbitraged’ away by people that are currently long the stock.
Suntech Power certainly falls in the ‘obvious short’ category. My broker has currently just a handful of shares available for shorting and for the privilege of borrowing these you’ll have to pay a 25% annualized fee. With a possible catalyst in March when the bonds reach maturity this might be doable, but it’s certainly not perfect. Same can be said about buying put options. If you think that STP will go to zero in a few months time you can make a profitable bet, but profiting from a small(er) decline isn’t that easy.
Mini Short Certificates
Luckily for us there are also some exchange traded structured products that have STP as an underlying that make it possible to initiate a cost effective short position. RBS is offering several STP Mini Long and Mini Short Certificates. These are popular retail products (marketing names of similar products: Turbo’s, Speeders, Sprinters) in Europa that offer the possibility of creating a levered long or short position with some build-in risk-management since you can’t lose more than your initial investment.
Let’s take a look at the Suntech Power Mini Short Certificate with a $3.40 stop loss and a $4.08 financing level. The value of the product is the financing level minus the value of the underlying, so with STP trading at $1.75 this product is currently worth $2.33 (€1.78). When STP reaches the $3.40 stop loss the product will be liquidated. In theory you should receive roughly the difference between $4.08 and $3.40 when this happens, but it could also be zero if, for example, STP gapped up on open to more than $4.08. So the risk that RBS is taking is limited: only when the price moves up more than 20% above the stop loss they will need to take a loss. But it’s nice that they offer some insurance against a tail event: you basically get a call option with a $4.08 strike. Because the financing level of this product is high relative to the share price the leverage is less than one (0.84x).
RBS offers a few different variants: this certificate has a lower financing level ($2.52) and has as a result more leverage (2.2x). The downside is that you will be stopped out of your position as soon as the STP price reaches the $2.10 level. I suspect that the Mini Short Certificates are relatively cheap because they are targeted towards retail investors, and RBS does not have a need to hedge their short position and borrow shares if they sell more long certificates then short certificates. The bid/ask spread for the certificate with a $3.40 stop loss is at the moment of writing €1.79/€1.82, so you are paying a very small premium.
Investing in structured products does have a number of risks. It’s a retail product, but it’s nearly impossible to figure out how it exactly works. The base prospectus (that should be read in combination with the final terms) is ~1000 pages thick. Despite the number of pages the document is surprisingly short on details. A search for the words “reasonable discretion” (my translation: we do what the fuck we want, and if we can screw you, we will) generates 516 hits. The fact that RBS is issuer, counterparty, and the only market maker is probably also not working in your advantage.
It’s obvious that I’m not a lover of Turbo’s and similar structured products, but compared to simply shorting the stock or buying puts I think it’s in this case a superior solution. That STP itself is a good short actually doesn’t need a whole lot of in-depth analysis. Based on the bond prices, the maturity profile, EBITDA and the short interest in the stock it’s clear that the current stock price is too high. With the bonds maturing in March it shouldn’t take too long to see how this is going to work out.
Short STP through a long position in STP Mini Short Certificates ($3.40 stop loss)
Re: put options. I think they work because the possibilities are binary. If there’s no bailout, the equity is worth zero.
The equity might be worth zero, but will it trade at zero? Wouldn’t bet that the stock would suddenly start behaving rational if the bonds default. Think there are also plenty of examples of stocks that are worth zero, but that take some months to reach that level (check for example CCME to name something).