Meanwhile In China, Cow-Collateralized Stock Buybacks

Over the past few years, we have written many strange stories about China's often-ridiculous, perpetually-bubbly, always on the precipice financial system. The story about China's literal "cash cows", however, is by far the strangest.

As everyone knows by now, the primary reason the global equity market, taking its cues from the US, is where it is now is due to a relentless stream of debt-funded stock buybacks. Earlier this year Bloomberg stumbled on the same thing we have written since 2013, namely that "there is only one buyer keeping the bull market alive."

And, as it turns out, even China figured it out. There is only one problem... well two:

  • The first is that to buyback your own stock, a company needs to generate a substantial amount of cash flow which can then be used to directly buyback your own shares (making management/shareholders who use corporate cash flows to make themselves wealthier in the process). Unfortunately most Chinese companies, many of which are stunning case studies in fraud, have a glaring problem when it comes to actual profitability and generating cash flows.
  • The second problem is that unlike in the US, following the recent (and now largely burst) corporate bond bubble, issuing bonds to fund buybacks - and in general lending to risky companies - appears to now be rather frowned upon in China.

So in the absence of these two necessary conditions, how is a Chinese company to boost its stock price by buying back its stock? The answer, as it turns out is cows, and specifically a cow sale-leaseback transaction.

That's precisely what China Huishan Dairy Holdings, which operates the largest number of dairy farms in the country, has done.

According to Bloomberg, the company is selling about a quarter of its herd, about 50,000 animals, to Guangdong Yuexin Finance Lease Co. for 1 billion yuan ($152 million) and then renting them back. The reason: to obtain urgently needed cash (let some other sucker CEO worry about paying the coupon on the lease), so it can repurchase glorious amounts of its stock.

And yes, cows were used as collateral. "It’s not very common to use cows as collateral," said Robin Yuen, an analyst at RHB OSK Securities Hong Kong Ltd. "The value of a cow would fluctuate depending on milk prices and other factors, so it’s a risky asset for lenders. It would be hard to do forced selling - there’s no liquid market for a large number of cows."

Puns intended.

To be sure, there is a politically correct spin on the situation, and that's what the Bloomberg story focuses on. It writes that "with an estimated $1.3 trillion of risky loans in the country, Chinese banks are becoming more cautious about lending, forcing some companies to look for new ways to borrow." As a result finance leasing has been growing in popularity, especially for purchases of equipment. "In Huishan Dairy’s case, the story is an increasingly common one in China of rising debts, slumping commodity prices and the propensity of Chinese executives to use their shares as collateral for private loans."

And then there is the truth: "Huishan Dairy seems to be selling cows and leasing them back in order to raise money now, because they’ve been using cash to buy back shares," said RHB’s Yuen, who has a “sell” rating on the stock. "The chairman wants to prop up the share price for reasons that are unclear. It could be a way to get better terms for share pledged-based loans, which he’s done before."

Usually the reasons why any chairman would want to prop up their share price by engaging in activities that are ruinous in the long-run are simple, and they are really one: to cash out in the fastest possible way.

Only in this case, something is off - of only for the time being - because as Bloomberg adds, the company Chairman Yang Kai has been building up his stake in the company to almost 74 percent, according to the latest disclosure of interests to the stock exchange. Even uodder,Yang pledged shares he owned to Ping An Bank Co. to finance the buybacks, RHB said in a research note on Jan. 28.

Meanwhile, going back to "problem 1" above, the company spent HK$1.93 billion ($249 million) buying back 820.2 million shares in the six months ended September, equivalent to almost twice its cash from operations for the same period. This explains the drastic need to find outside funding.

In retrospect, there is nothing surprising about the structure: just like Hanergy manipulated its shares by hammering the close and inciting massive short squeezes in the process briefly making its CEO the richest man in China, the chairman of Huishan has decided to leverage - literally - his equity exposure to the company, and boost the stock prices in the process, before eventally unloading everything on unsuspecting buyers.

It appears that moments hasn't arrived yet, however judging by the stock price it will, and very soon. The share buybacks helped Huishan Dairy’s share price jump 72% since the beginning of July, even as Hong Kong’s benchmark Hang Seng Index fell 22%.


The fraud becomes even more obvious when observing how the rest of the balance sheet has been transforming over the past year: keeping the stock price buoyant drained cash as milk prices were slumping and the company’s debts were rising. Huishan had 10.4 billion yuan of bank loans at the end of September, with more than half needing to be repaid within a year. The value of short-term bank loans had more than doubled compared to six months earlier.

Here's a guess: the debt won't be repaid and Huishan will join the rapidly rising list of bankrupt Chinese companies, but not before the Chairman manages to either sell his company to the public or to the company's own buyback program.

To be sure, for a while the company's stock price was rising on its own. However, recently whole milk powder prices plunged, with the latest GlobalDairyTrade auction price of $2,252 a metric ton on May 17 down 57 percent from a peak in April 2013.

So the company turned some of its cows into cash, leasing them back through a unit at an annualized interest rate of as much as 6.2 percent, with an option to repurchase the cattle at the end of the five years.

Of course, Huishan was delighted to provide whatever terms the naive lenders wanted, if it meant the buyback circle jerk could continue. One was a "culling covenant" - as dairy cows are typically slaughtered after about five years, when their production declines, the agreement included provisions to cull and replace animals regularly.

"Huishan Dairy’s gearing was more than 60 percent last year, so it’s not a bad idea for the company to get a loan for working capital," said Anson Chan, an analyst at Daiwa Capital Markets, who also recommends investors “sell” the shares. "The interest rate for the finance lease is lower than the company’s current bank loans."

Which makes us wonder who the (shadow) bank is that issue the sale-leaseback loans. They may be a prime shorting candidate.

Sale-leasebacks, once unheard of locally, have become a generic way for "asset-rich" Chinese companies to fund themselves.

The growth of finance leasing in China is partly a reflection of the broadening of the nation’s banking system. Most contracts involve the leaseback of equipment, said Shujin Chen, a banking analyst at DBS Vickers Hong Kong Ltd. They totaled about 4 trillion yuan at the end of last year, with the percentage of equipment purchased by finance leasing at about 7 percent to 8 percent, compared to only 1 percent in 2008, she said. “Finance leases offer tax advantages, asset flexibility and cash flow certainty,” Chen said in an e-mail. In China they account for around 4 percent to 5 percent of bank loans, compared with about 22 percent in 2013 in the U.S., where as Bloomberg sarcastically adds, "cow leasing has fallen out of favor."

Even more odd, this is not the first bovine-collaterlized obligation done in China: the first registered cow lease plan was last July, when CreditEase Leasing took ownership of 200 cattle from Hebei Luan County Junying Pastures, a supplier to Inner Mongolia Yili Industrial Group. Huishan Dairy’s lease-back is 250 times the size. The company’s 190,911 dairy cows, valued at 5.73 billion yuan in September, are spread across 78 farms in Liaoning, a province in northeastern China between Inner Mongolia and North Korea.

Still, others are scratching their heads when confronted with the striking details of the cow sale-leaseback transaction.

"The environment just isn’t right for the practice with low interest rates, balance sheets generally in good shape, plenty of heifers and milk prices are low," said Mark Stephenson, director of Dairy Policy Analysis at the University of Wisconsin, who said it was more common in the 1990s. "Why would anyone want to lease what they could own?"

Especially cows.

"It might take a while for this to turn into a trend," Daiwa’s Chan said. "It won’t be easy at first for banks and other financial institutions to accept this kind of arrangement, because of the risk of holding animals as collateral."

But this is China, where increasingly more insane financial transactions have now become a routine event. And who knows, maybe if Huishan Chairman Yang Kai refuses to sell his overinflated stock, this scheme will catch on. But that begs the question: what's the point to propping up the stock price in an unviable company, and not to sell to the greatest fool? Especially since if there is one thing Chinese capital markets have a lot of, it's the latter.