Early premarket gappers
- Gapping up:
- BREW +121.7%, LTS +21.7%, KDMN +20.4%, FOE +16.8%, RKDA +13.3%, APYX +13.3%, KEM +13.1%, ICUI +11.2%, GO +6.9%, FNV +3.5%, LIN +1.6%, LYV +1.2%, BUD +1.1%, BZUN +1%, FGEN +0.8%
- Gapping down:
- FLNT -22.4%, OGI -14.5%, HBM -11.2%, TDW -6.7%, UGI -5.9%, RETA -4%, EPC -3.7%, TME -3.3%, JCOM -3.1%, FTK -1.1%
China’s $1tn scramble for convertible bonds reflects hot market
Bidding for new deals including Shanghai Pudong Development Bank stuns investors
New debt and equity offerings often draw a crowd.
But when investors last month placed more than $1tn worth of orders for a convertible bond issued by Shanghai Pudong Development Bank, about 140 times the $7bn raised, it was enough to shock even the most seasoned China investor.
That $1tn is almost as large as the entire stock-market capitalisation of Apple or Microsoft — two of the biggest companies in the world. “It was a ridiculous amount,” said Gerry Alfonso, head of research at Shenwan Hongyuan Securities in Shanghai.
As so often with runaway deals, the over-bidding in part reflects quirks in the way new debt and equity ends up in investors’ hands. But it also reflects a surge in issuance of these equity-linked instruments in China — a rise helped by an unusual embrace of the product by policymakers better known for cracking down on financial innovations to ensure stability.
So far this year, Chinese companies have issued a record $40bn in convertible bonds, up more than 80 per cent from the full-year total in 2018, according to Dealogic.
Convertible bonds typically carry a lower coupon payment than normal bonds but they offer investors the right to switch them for equity if a company’s shares rise to a certain price. For companies, convertibles offer a way to raise money more cheaply than by issuing regular debt and do not immediately dilute shareholders’ equity.
Ronald Wan, chief executive at Partners Capital in Hong Kong, said Chinese convertibles had become more attractive to investors thanks to this year’s stock rally, while the government was promoting the instruments as a way to rein in financing done off-balance sheet, or through a fragile shadow banking sector.
But Mr Wan cautioned that convertibles’ performance “depends on the quality of the issuer”, with investors typically favouring large banks and big blue-chip companies over small and mid-sized issuers.
Mr Alfonso eachoed that, warning that while large issuers such as Shanghai Pudong have seen ample liquidity in their convertibles after listing, investors in smaller issuers faced the prospect of taking heavy losses in the event of a sell-off.
“The liquidity is bad but there is liquidity,” he said. “The thing is, the price you’re going to get there is pretty horrendous.”
China’s first domestic convertible bond was issued in November 1992, two years after the Shanghai Stock Exchange opened. The bond, which never converted to stock, was the only onshore convertible issued for more than half a decade.
Today’s market is different, as Chinese convertibles carry special features that set them apart from those in the US or Europe. For one, conversion levels can be reset after a bond is issued, significantly increasing the chances it will switch into stock.
Convertibles also tend to be looked on favourably by regulators because they are treated as debt until conversion, meaning investors have a better chance than equity shareholders of getting some form of repayment if the company goes bust. Chinese companies are normally required to wait at least 18 months between offerings of shares, which makes convertibles a useful way to gain access to new funds quickly.
“The process of [convertibles] approval still takes time — half a year or so — but it’s faster than an IPO or secondary offering,” said Yulia Wan, a senior analyst at Moody’s in Shanghai.
Ms Wan said that while the floor for conversion prices at issuance was determined by criteria including average trading price, it could be lowered if the shares traded well below the initial level for long enough. She added that because convertibles usually have a maturity of five to six years, a company’s shares have plenty of time to rise high enough for conversion.
The convertibles’ equity-like features mean they offer higher returns to investors than regular debt. But that alone does not explain the huge over-subscriptions common to the local market.
Mr Alfonso of Shenwan Hongyuan said some of the rush is down to scarcity. Because existing shareholders are entitled to a large chunk of any convertible bond that is issued, the number of lots a company can offer more broadly is limited.
In the open market, the highest bids naturally win out, but buyers know that they will get only a fraction of what they request. And because no money is required up front to make an offer, there is no reason not to bid as much as possible to maximise the odds of a successful purchase. “You put up as much as you can and hope for the best,” Mr Alfonso said.
Before regulators banned buyers from bidding through multiple accounts in March, it was not unusual for convertibles to be even more heavily over-subscribed. Prior to Shanghai Pudong’s latest convertible, the largest issuance on record of nearly $6bn, from China Citic Bank, was about 5,500 times oversubscribed, according to local media.
Deliveroo and the profitability problem
Deliveroo, the lossmaking food delivery company which once briefly employed Alphaville’s editor, announced a new product line on Sunday.
From the Telegraph’s James Cook:
DELIVEROO is introducing food collection services at 10,000 UK restaurants in a move that risks inflaming tensions with its delivery riders.
The online food delivery group plans to roll out a new "Pickup" service, where customers save money by collecting food themselves, at half of its UK restaurants within six months.
It hopes the scheme will help it win new customers and sign up extra restaurants as it wages a battle with rivals. Uber Eats launched a similar service in May.
Alphaville commented on the speculation around this service back in February, and it seems it is now becoming a reality.
As the Telegraph points out, the new click ‘n’ collect service risks exacerbating the already strained relationship with its self-employed drivers. The Deliveroo honeybees have made various complaints over the years about their working conditions for the queen bee -- with the most recently reported issue being over safety on the job. It now seems being annexed entirely from the delivery process will be their latest gripe.
However, Deliveroo’s (or should we say, DeliverYOU’s) new service also speaks to another criticism which has been made of the food delivery space as a whole: its lack of profitability.
The fundamental issue with any food delivery service, as many have pointed out, is that it’s a business with low barriers to entry and high fixed costs. Let’s examine each point separately.
To set up a food delivery business in the modern age requires a few things: an app that can link supply (restaurants) and demand (customers), gameable labour laws and urban density. The first two points here are crucial, because these are conditions which take relatively little capital to act upon. This has lead to a series of competitors entering Deliveroo’s market in the UK’s metropolitan areas, most noticeably the equally loss-making Uber and its UberEats division.
Arguably the only competitive edge in the space comes from locking-in popular restaurant chains exclusively, as Deliveroo have done with Pret A Manger and UberEats with MacDonalds. Yet these relationships are often on fixed-length terms, allowing suppliers to pick a new delivery service when the agreement expires, and likely one with a lower split of revenues going to the delivery company (also known as the “take rate”).
This dynamic of pricing pressure from suppliers is not just limited to the mega restaurant brands. Alphaville has heard several stories of regional chains with only a dozen locations successfully leveraging offers from competitors to bring down the fees paid to the delivery companies they use.
That pressure on take rates leaves the delivery fees as the main driver of profits, which, going by the public results of companies with the same dual business model of both being a platform and logistics company, is problematic.
Take Just Eat, which after a long history of being the UK’s dominant takeaway platform (ie restaurants fulfil the orders), decided to enter the delivery logistics business in 2018. Since then, its ebitda margins have shrunk considerably -- from 28.3 per cent in 2017 to just 15.4 per cent in the first-half of 2019 according to data from S&P Capital IQ.
In the US, the results for dual-platform businesses are even more disastrous. Grubhub’s third-quarter results, for instance, saw it miss Wall Street estimates for revenue and guide to far lower growth and profitability going forward. Its stock cratered over 43 per cent on the news.
While the US market does have different dynamics to the UK -- particularly in terms of urban density and competition -- the accompanying shareholder letter from Grubhub chief executive Matt Maloney and chief financial officer Adam DeWitt spoke to the cost problem at the heart of the delivery business.
With our emphasis:
In 2015, we added delivery capabilities to enable restaurants that didn’t have delivery to join our platform. We did this as a means to an end - we knew it would be valuable to have those restaurants on the platform. But, we didn’t then, and still don't believe now, that a company can generate significant profits on just the logistics component of the business. It is a commodity and there are significant variable costs that are hard to leverage even with technology and scale. Extremely large delivery/logistics companies can generate slim margins, but only because of the hub and spoke efficiencies they gain at substantial scale. The point-to-point nature of our business mostly eliminates that aspect of operating leverage.
A common fallacy in this business is that an avalanche of volume, food or otherwise, will drive logistics costs down materially. Bottom line is that you need to pay someone enough money to drive to the restaurant, pick up food and drive it to a diner. That takes time and drivers need to be appropriately paid for their time or they will find another opportunity. At some point, delivery drones and robots may reduce the cost of fulfilment, but it will be a long time before the capital costs and ongoing operating expenses are less than the cost of paying someone for 30-45 minutes of their time. Delivery/logistics is valuable to us because it increases potential restaurant inventory and order volume, not because it improves per order economics.
Deliveroo’s decision to allow the customer to collect food from a restaurant is arguably a tacit admission that these same profit-draining dynamics apply to all but the densest of the UK’s urban areas (where it’s theoretically possible to sustain a velocity of deliveries to cover the various variable costs).
Shifting costs to the consumer can be a winning strategy, but will its customers bite? The Telegraph reported that several hundred restaurants across 13 UK cities have signed up for the service already, so there’s traction on the supply side, but the real question is whether demand will follow.
After all Deliveroo is partly a play on slovenliness -- you pay a delivery high fee (and, usually, higher prices for the food) to not leave the sofa -- so we’re not so sure a schlep down to the local curry house will be that attractive an offer. Particularly if one can save on Deliveroo fees by calling the restaurant directly.
In an ironic way, this may lead to Deliveroo experiencing a sort of reverse Amazon effect -- where customers browse the platform for food, and then call the restaurant directly to secure a cheaper price. If that happened, then the digital delivery era would have truly come full circle.
After Hours Summary: BREW +122% on Anheuser-Busch buyout... ICUI +9.5%, GO +7.5%, APYX +6.6%, FNV +4%, DXC +2% are higher, while FLNT -22%, UGI -4.8%, TME -1.2% are lower following earnings/guidance
After Hours Gainers:
Companies trading higher in after hours in reaction to earnings/guidance: ICUI +9.5%, GO +7.5%, APYX +6.6%, FNV +4.4%, DXC +2.1%, FGEN +1.4%
Companies trading higher in after hours in reaction to news: BREW +121.7% (Craft Brew Alliance shares to be purchased by Anheuser-Busch for $16.50/share in cash), KDMN +21.7% (announces that KD025 met primary endpoint at interim analysis of pivotal trial in chronic graft-versus-host disease; call today at 5:00 p.m. Eastern Time), KEM +12.7% (Yageo will acquire all of the outstanding shares of KEMET's common stock for US$27.20 per share in an all-cash transaction valued at US $1.8 billion), RKDA +8.4% (attributed to HB4 soybean approval in Paraguay), LYV +1.2% (upgraded to Outperform from In-line at Evercore ISI)
After Hours Losers:
Companies trading lower in after hours in reaction to earnings/guidance: FLNT -22%, HBM -5.7%, UGI -4.8%, TME -1.2%
Companies trading lower in after hours in reaction to news: RETA -8% (announces top-line year one results from Phase 3 portion of CARDINAL study), JCOM -3.1% (announces proposed private offering of $500.0 mln aggregate principal amount of convertible senior notes)