• Due to high gearing levels and concerns about Companies ability to refinance or repay their debts, auditors have raised going concern worries over companies such as Frasers Commercial Trust and China Fashion, to name a few.
• With auditors turning more cautious, there is a risk that China Essence’s full year accounts may be qualified by its auditors.
• As at end December 08 (3Q), China Essence had short-term debts of RMB 460.9m and a long term debt (convertible bond) of RMB222.7m. Net gearing remained reasonable at 0.41x. Interest repayment ability was healthy with interest cover at 6.6x but operating cash flow for the 9 months was negative.
• Long-term debt – the long term debt which is a convertible bond is less of a concern at this point in time as bond holders are not able to demand redemption from the Company before maturity of the bond on 20th December 2011. While China Essence has the option of redeeming the bonds earlier, its current cashflow does not allow the Company to do so.
• Short-term debt – the greater concern is on the Company’s ability to repay/refinance its short-term debts of RMB460.9m. In July 2008, China Essence obtained a US$60m (RMB 409.6m or roughly 89% of its short-term borrowing) loan from DBS with a maturity date not exceeding 30th June 09.
• Given that China Essence market cap (approximately US$35.1m) is less than the amount loaned by DBS, we understand that there is a possibility that DBS will either demand full repayment of the loan or reduce the amount it is willing to lend to China Essence when the loan expires.
• Given that China Essence still has RMB262.6m in cash and receivables of RMB170.2m, the Company has leeway to manage the situation appropriately.
• Possible options include paying down some of the DBS loan with its cash balance and we understand that the Company has already started talks with domestic Chinese banks for banking lines.
• The Company is still profitable but the obvious risk is that a demand for full repayment of the short-term loan could cause auditors to highlight going concern risk since current cashflow are not sufficientfor full repayment of the loan. However, the Company could get financing from domestic banks and it would be foolhardy for its current major banker to jeopardize its borrower’s finances at this stage when cash flow generation capability still exists.
• At the same time, the share price was under pressure from sales by major shareholder, Dunross Investment Ltd which reduced its stake from 7.40% to 4.95% (9.6m shares) on 18th March 2009.
• Major shareholders have however been buying shares from the open market. CEO Zhao Libin bought shares on 26th March and 31st March at average prices of S$0.11373 and S$0.10958, bring his stake in the Company from 43.36% to 43.92%. Another major shareholder, Lee Kah Bao raised his stake from 4.984% to 5.099% on 3rd April with his purchase of 452,000 shares at an average price of S$0.135.
• On 27th march, the Company issued a statement to inform investors that they were considering various options in regard to the repayment of the DBS loan of US$60m.
• Maintain BUY with S$0.34 target price. This recommendation would be subject to the Company being able to resolve its debt issue. The dividend yield is only a ball park figure as we have assumed a 10% payout ratio which may not materialise since the Company is likely to seek cash preservation.
• China Essence has formed a bullish wedge pattern, and it is about to breakout of the said pattern. Trading volume has been increasing, suggesting that there is accumulation by strong hands.
• Technical indicators are also positive with the MACD and RSI hooking upwards. RSI has breached its resistance earlier. The bullish divergence on its MACD is supportive of our bullish call. Resistance is seen at S$0.15 and S$0.175.
• It appears that the bulls are about to shift into overdrive soon. Traders should buy half now and the rest near the S$0.11-0.12 levels before the impending breakout. Place a stop at S$0.105.
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