Special Price for a Special Situation


Question: how to realize superior risk-adjusted high-yield return in LCD panel industry?

That seems to be an oxymoron for a shrewd value investor who cares anything about Asian panel makers. For the record, the total outstanding exposure of Taiwanese banks to AUO and Chi-Mei Innolux ("CMI"), the troubled panel makers with 38% market share in global large-size LCD panel, amounts to US$15 billion dollars, with an average yield of less than 2%. Compared to the US$20 billion cumulative and growing losses of this industry since 2007, and all the money made by South Korean archrivals, the risk-adjusted return is undoubtedly low, and the return-adjusted risk is deservingly high.

And stakes are even higher, according to one local banker involved in the government-sponsored restructuring meetings who prefers anonymity. "Take CMI for example. Big local banks (some of them are government owned) have an exposure of over US$7 billion to this chronic loss maker, of which over US$5 billion is due in one year. This amount almost equals the total net income of the Taiwanese commercial banking industry. If local bankers push out the maturity, it creates a huge drag on balance sheet. If bankers call CMI default, it will not only blow a big hole in their books, it effectively obliterates them."

Restructuring it is, as any sane elected official would nod. Calling LCD panel maker default and puking out 120,000 unemployed engineers are too much pain. The negative ramifications are best absorbed by those obedient bankers who toed the party line and made massive investment at the government's calling in early 2002.

The ultimate solution, says the anonymous banker, lies in the hand of Terry Kuo, the tight-fist boss of the Hon Hai Group, whose Innolux merged Chi-Mei in a 1:2.05 share swap at lofty 2009 valuation. "Clearly Terry has the ability to pay," says the banker, "but whether he has the will to top-up is another issue." Set aside paper loss on stock price, the future strategy of the enlarged LCD business unit at Hon Hai remains murky at best. Will Terry consolidate the large-size capacity and sell them as cheaper alternative to high-cost Japanese TV makers? Or is he carving out small- and medium-size capacity and work out a technological alliance with Japanese panel makers and come up with a better HD solution to Apple? The global LCD panel industry is a bloody business, with Corning and three other players selling high-margin glass substrate on the upstream, and panel makers selling at wafer-thin margin at the downstream, except Samsung, squeezing other Asian players left and right with its global reach and advanced intellectual properties.

Despite tough outlook, this publication argues that, with appropriate selection of financial instrument, the restructuring proceedings introduce a compelling opportunity to invest in Taiwanese LCD industry. The recommended selection is CMI none-recourse Accounts Receivables held by its major suppliers.

A staple product offering at any commercial banks, factoring -- buying accounts receivables is an esoteric exercise for the Masters of the Universe, for most of them would never dream of working in the Trade Finance department of a commercial bank. In a classic non-recourse factoring transaction, a Seller sells the invoice issued to Buyer (of its goods and services), usually 60- to 90-day outstanding, to a Factor (usually a commercial bank) at 10-15% discount. The Factor will extend a credit line to Seller, who will instruct Buyer to pay its payables into an escrow account at the Factor. Upon legitimate transferral, Seller will get cash in advance from the Factor for a small fee and pays a nominal interest margin on the notional amount so factored. Essentially, factoring is no different from trading short-duration discounted bills. The key risk factors to this transaction are the performance risk of the Seller and the commercial risk of the Buyer. In a non-recourse transaction, Factor would suffer a loss should either Seller or Buyer fail to perform under their supply contracts.

And this is where the investment thesis in CMI receivables begins to make sense. While a factoring bank is technically lending to CMI supplier, it is effectively taking CMI receivables as collateral and thus becomes exposed to CMI credit. For those syndicated lenders with CMI exposure, the standard operating protocols from the Credit Risk department would be to cease and decease any business activity associated with CMI, whose debt rating have been downgraded to Default across the street.  Pause for a moment and assess the situation: fateful bankers would rather restructure for a lower coupon which CMI can afford; government, heavily criticized for its failure in rescuing the deathly-leveraged DRAM industry, would certainly prefer bail-out to unemployment fall-out; and Terry would like to improve his entry point and bargaining power with the government in a potential distressed buyout. Logic dictates that it is in no one's interest to allow CMI to default, yet the major shareholder has every reason to hold out. Wary lenders in prolonged bank meetings thus set the panic selling of CMI receivables into motion.

"Anecdotally, we've heard quote from distressed lenders as high as 8% for CMI 90-day receivables," our banker betrays. "To be more specific, 8% actually means 3.5% margin per annum on the factored amount and 4.5% upfront transfer fee," continues our banker. "The margin is just peanuts, for the actually interest period is only 90 days. The real meat is the upfront fee. At 4.5%, the lender is making 18% annualized return for betting on CMI to honor its payment to upstream key suppliers, whose receivables should rank supersenior in any restructuring proceeding, for merely one quarter. Surely Terry will game brinksmanship on the negotiation table, but for CMI not to sustain production and pay its upstream suppliers is almost surely impossible. From risk-reward perspective, this deal is a no-brainer."

As of March 16th, CMI Board of Directors finally approved Mr. Tuan, the incumbent CEO, as the new Chairman, and the operation seems to be bottoming out, the whether Terry can finesse the structural conundrum remains to be seen. Judging from the smile on the anonymous banker's face, whoever dares to bet on CMI receivables must have made a small killing at the expense of short-term market irrationality.

In the long term, the outlook for the global LCD panel industry, and particularly for Taiwan, remains extremely opaque. Samsung is going full force on AMOLED, a niche display technology cultivated by typical South Korean persistance. With Samsung Mobile Display as the core value chain aggregator, Samsung fetches a 90% market in this technology and charging a premium for its limited supply. In addition, Mainland China is slashing higher import tariff on LCD panel import in order to promote its own panel makers, who are also ramping up losses of grand magnitude. Higher tariff may force Taiwanese panel makers to make further capacity investment on Mainland which has been delayed by previous embargo. Political calculations aside, it is crystal clear that capital intensive investment in a severely over-supplied market means more value destruction ahead. A portfolio of high-yield receivables from these Asian tech companies may be a suitable financial placebo for disgruntled taxpayers. As for CMI equity, we leave that to daring vultures.