China’s hidden debt problem

BEIJING (Reuters) — On the surface, China presents a fiscal study in contrast with the United States, keeping a remarkably low ceiling on debt even as it spends its way out of the financial crisis.

But when Chinese leaders meet their U.S. counterparts this week, they should pause for reflection before venting any criticism, because hidden liabilities mean China’s books are uglier — potentially much uglier — than at first sight.

Thanks to successive years of fast economic growth and even faster government revenue growth, the official debt-to-GDP ratio was 17.7% at the end of last year, far lower than almost any other major economy.

The trouble is that excludes local government borrowing, the current surge in loans backstopped by Beijing and bad assets cleared from the banking system but still floating about.

When all are thrown into the pot, analysts estimate that China’s debt may be closer to 60% of GDP, putting it in virtually the same league as the United States, which was at 70% at the end of 2008 before it launched its massive economic stimulus program.

To be sure, Washington is now set on a path of exploding debt that Beijing will largely avoid. The United States budgeted for a federal deficit of 12.9% of GDP this year, whereas China is aiming for just 2.9%.

But China’s finances are deteriorating more quickly than the government expected, fueling a rise in the stock of both explicit and disguised debt that will constrict its wriggle room.

“It is serious because, one, much of it is hidden and, two, local governments are currently doubling down on their bets,” said Stephen Green, economist at Standard Chartered Bank in Shanghai. “As with all fiscal deficits, it limits space for further stimulus.”

This is probably a moot point, for now. With China’s economy back on track and private-sector investment kicking in, few think Beijing will need to ramp up spending beyond its existing 4 trillion yuan ($585 billion), two-year stimulus plan. But the narrowing of options still discomfits Chinese leaders.

“Our fiscal work is very grim,” Chinese Premier Wen Jiabao told officials last week.
Eroding finances

Government revenues declined 2.4% in the first half compared to a year earlier, well shy of the official goal of an 8% rise. Expenditures were ahead of target and set to surge in the second half on the back of infrastructure projects.

Tax intakes are, of course, closely tied to economic activity, so China’s upturn should deliver cash to government coffers. But improvement in June came mainly from land sales, a one-off revenue source that masks the difficult road ahead.

“Even when we are already factoring in relatively optimistic revenue growth due to the economic recovery, the deficit is quite sticky at around 5 % per year for the next three years,” said Isaac Meng, economist at BNP Paribas in Beijing.

But the real worry is the thickening morass of indirect debt.

Officials at the Ministry of Finance estimated earlier this year that local government debt already topped 4 trillion yuan, or 16.5% of GDP, much more than previously assumed.

Above and beyond that are 400 billion yuan in bad loans in banks’ hands and at least 1 trillion yuan in non-performing debt hived off their books and assigned to asset management companies. The buck stops with Beijing on all of these.

The record surge in bank lending this year means that its sum of liabilities is about to swell in size.

Banks have showered money on infrastructure projects that are seen as having iron-clad government guarantees. Green said he “conservatively” estimates that Beijing’s bill for covering loans issued this year alone will be 1.75 trillion yuan, enough to push its 2009 deficit to 10% of GDP.
“Debt bomb”

Most troublesome of all is the potential for a “debt bomb”, in the words of China’s Economic Observer newspaper, at lower levels of government as officials engage in financial engineering that is both opaque and highly leveraged.

Rules prevent Chinese banks from lending to governments the equity capital which they need to obtain further loans for investment. But local officials and banks are now exploiting a vast loophole thanks to intermediaries known as trust companies.

The process is simple enough. Trusts create specially designed “wealth products”, which banks sell to their clients. Banks then give the funds to the trusts and they, in turn, funnel them to governments as equity capital.

Local authorities, in short, are piling debt on top of debt. The Chinese banking regulator has started to warn trusts and banks of the growing risks, state media recently reported.

It was not long ago that bad loans in China’s banking system seemed to pose a massive debt threat to the wider economy. The core solution over the past decade was sustained double-digit growth, vastly expanding the denominator in debt-to-GDP ratios and generating the taxes to pay down the numerator.

Beijing is already looking to raise taxes where it can — increasing the levy on cigarettes, for example — but a return to super-charged growth is again its principal debt reduction plan.

In the meantime, China needs to fund its rising deficit.

On that front, at least, the government can be supremely confident, even if it has to issue more than the planned 950 billion yuan in bonds this year and yet more to cover shortfalls in coming years.

“There is so much saving and so much liquidity, so there is definitely not a problem that China will not be able to finance its deficit,” said Tao Wang, UBS economist in Beijing

BIBLIOGRAPHY

1. Deutsche Bank Research (2010). Key economic indicators: China. http://www.dbresearch.de/servlet/reweb2.ReWEB?rwdspl=0&rwnode=CIB_INTERNET_EN-PROD$RSNN0000000000019927&rwsite=CIB_INTERNET_EN-PROD, 27 Jan 2010

2. The long shadow of liquidity risk (2010) by Xiao Gang, Chairman of the Bank of China. http://english.caing.com/upload/THE%20LONG%20SHADOW.pdf

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Kraft’s formal offer for Cadbury on Monday once again highlights the differences between the U.S. and British takeover systems I have previously highlighted.

The differences are likely to bring a much quicker resolution to this takeover battle and force Cadbury to fight this hostile offer on issues of price instead of resorting to the takeover defenses commonly employed in the United States.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate lawyer at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. He is the author of a new book, “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion,” that explores modern-day deals and deal-making.

Kraft waited until only a few hours before the absolute bid deadline set by the British Takeover Panel (5 p.m. London time) to announce its formal intention to make a cash-and-stock offer. It’s likely Kraft waited to make Cadbury sweat a little, but also because paying the commitment fees for the £5.5 billion ($9.2 billion) credit facility is expensive.

Here, we have the first big difference between Britain and the United States. Britain requires that any bidder have committed financing at the time of the making of its offer. Because of this, Kraft has been forced to drop its financing condition and replace it with a committed debt facility. In addition, because Britain does not allow due diligence conditions, Kraft has now dropped this condition as well.

The Kraft offer is now on a fast-moving train as Britain sets a timetable under the Takeover Code for the next actions. The timetable is set forth below:
Day Event
-28 Announcement of offer
0 Last day for mailing of offer
+21 First day offer may be complete (N.B. U.S. rules will over-ride this deadline and require offer to open a minimum of 20 business days)
+42 Target’s shareholders may withdraw shares if offer has not previously been declared unconditional as to acceptances
+46 Last day offer can be amended
+60 Last day offer can be declared unconditional as to acceptances
+81 Last day offer can be declared wholly unconditional

Kraft is now at Day -28 and has 28 days to mail its offer. Typically, bidders will mail the offer sooner than this day.

However, this is a cross-border deal and Cadbury has substantial American shareholders. Since the number of U.S. shareholders is more than 10 percent of Cadbury’s ownership, Kraft does not qualify under the SEC cross-border exemptions. The exemptions permit an acquirer to avoid the American registration process and tender offer requirements if U.S. holders own 10 percent or less of a foreign target.

Instead, Kraft must file a registration statement and tender offer document with the Securities and Exchange Commission. Kraft has not yet filed these documents, though it has filed the preliminary version of the proxy statement for Kraft shareholders to vote on this transaction. This vote is necessary under New York Stock Exchange rules, since Kraft is issuing more than 20 percent of its outstanding common stock in this acquisition.

Kraft presumably is looking to clear this document with the S.E.C. This document contains the same pro forma financial information for the two companies that the S.E.C. is most likely to focus on in a registration statement. However, since Cadbury uses International Financial Reporting Standards and Kraft uses Generally Accepted Accounting Principles, the pro forma financial information in the proxy and registration statement is a bit of a mishmash and the accountant’s best estimate as to these numbers. By pre-filing the proxy statement, Kraft can make sure that the S.E.C. will not tie up these numbers in review and force an update of them while the offer is pending.

The proxy was filed on Monday and there is a 10-day waiting period for it to be mailed if there is no S.E.C. review. Kraft will likely wait until at least then to commence the offer as it will want to commence the American and British offers at the same time.

Krafts’s offer can then close under the British rules 21 days after commencement. However, the American deadline is 20 business days and this will supersede the British 21-day requirement. Like in the United States, there is no requirement on Kraft to extend the offer if the conditions are not met by then.

In Britain, once shareholders tender their shares they cannot freely withdraw them. This is different from the United States, which allows shareholders to withdraw their tenders any time until the offer closes. However, if 42 days after the British offer is announced the offer has not been declared unconditional as to acceptances, shareholders can withdraw their shares.

Day 36 is the last day Kraft can amend its offer, as British offers are supposed to be open 14 days after for amendments, as opposed to 5 to 10 business days in the United States.

Finally, the big day is day 60. This is the last day that the offer can be declared unconditional as to acceptances. In other words, the minimum acceptance condition of the Kraft offer must be met by this date. Right now Kraft has set the condition at 90 percent, which is the squeeze-out threshold in Britain. However, Kraft can lower the amount to 50 percent of Cadbury’s shares, though it may not do so because of the financing needed here and the harder process for a scheme of arrangement to complete the acquisition, which requires shares with 75 percent in value and a majority vote of shares to approve the transaction.

If the offer is subject to extended antitrust scrutiny and therefore is unable to close before the date the offer must be declared unconditional as to acceptances (day 60), then the offer expires. The offer can be renewed 21 days after it clears antitrust review. Typically, if there is a problem with antitrust the bidder will announce a pre-conditional offer — one that does not start until antitrust is cleared. Here, Kraft must not think this will be a problem or is setting the offer up for expiration.

Cadbury will file a response document, which will also be mailed to its shareholders, and under U.S. rules it will be required to file a Schedule 14D-9 response statement with the S.E.C. However, unlike the United States, Cadbury will be prohibited from taking any “frustrating actions” including adopting a poison pill or other takeover defenses. This will mean the large number of arbitrageurs in Cadbury’s stock will have an outsize influence in this battle, and may just carry the day.

For those who follow takeovers, it will be worthwhile reading through Kraft’s U.S. and British documents when they are all released to see the markedly different information required of each. The British model is much more streamlined in its disclosure requirements. This may or may not be a good thing, but it is clear that the British process, through its timetable requirements and bar on frustrating actions, makes takeovers occur much, much faster than in the United States. The propriety of these differences is a topic I explore in my just-released book, “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.”

There may be good reasons for this difference, such as a need in the United States to have a mechanism for a board to protect the corporate enterprise by adopting takeover defenses and prevent corporate dismemberment. This need may not be necessary in Britain since works council laws provide workers a secondary voice in the operation of the company and often provide a similar protecting function.

In other words, in Britain there are substitutes for takeover mechanisms. Of course, this assumes that considerations in a corporate sale should run beyond the value provided to shareholders.

Nonetheless, one thing is clear: the year-long “forever war” between Agrium, CF Industries and Terra Industries would not happen in Britain.

By DANA CIMILLUCA, JEFFREY MCCRACKEN and ILAN BRAT

Kraft Foods Inc. on Tuesday clinched a deal to acquire Cadbury PLC for £11.9 billion ($19.44 billion), in a trans-Atlantic tie-up that ends the nearly 200-year independence of Britain’s most famous candy company.

Even after raising its offer by 10%, the multiple of cash flow Kraft is paying for Cadbury is still at the low end of the range of prices paid in recent food deals.

After more than four months of public sparring that followed Kraft’s hostile-takeover approach for the U.K. confectioner, Cadbury’s board accepted the U.S. food giant’s offer as Kraft relented to the demands of Cadbury management and shareholders, raising its bid and significantly boosting the cash component.

Kraft agreed to pay 840 pence a share for Cadbury, as well as a 10 pence dividend. The revised offer is for 500 pence in cash for each Cadbury share and 0.1874 new Kraft shares for each Cadbury share, an increase from its original offer of 300 pence in cash and 0.2589 new Kraft shares. Cash now makes up 60% of the offer; originally, it was just 40%.

Tuesday’s deal unites Cadbury, which focuses solely on candy and traces its roots to 1824, with its larger and more diversified U.S. counterpart. Kraft covets Cadbury in part because of the U.K. company’s access to fast-growing developing markets such as India and Brazil.

The deal came as Kraft faced a deadline imposed by U.K. takeover authorities to make a final offer for Cadbury by the end of Tuesday. Cadbury has repeatedly rebuffed Kraft since the Northfield, Ill., company first publicly announced its offer in early September, which was then valued at about $16.5 billion.

Many Cadbury shareholders in recent days have been vocal in their opposition to Kraft’s cash-and-stock offer, which until the weekend was valued at about 770 pence a share. They might now be won over by the new offer, since many of the holders are hedge funds that bought Cadbury stock after Kraft put the company in play, and are only looking for a relatively small return. The recommendation from Cadbury’s board is also likely to make a big difference in convincing long-term Cadbury shareholders, many of them big U.K. institutional investors, that selling to Kraft now is the right thing to do. Cadbury shareholders have until Feb. 2 to accept the offer.

It now appears likely that Hershey Co., which has been considering a bid of its own, will drop out. People familiar with the matter save said 850 pence is out of the Pennsylvania company’s price range. In addition, the Kraft-Cadbury accord includes a £117.7 million break-up fee, which would add to the price of a bid for Hershey.

The U.K. takeover panel on Tuesday gave Hershey until Monday to announce a competing offer for Cadbury or take itself out of the running.

Cadbury shares rose 3.5% to 835.50 pence in London. After trading for months at a premium to the offer, the shares now trade at a discount, indicating investors aren’t expecting a higher offer. As part of the new offer, Kraft said it would reduce the level of acceptances from Cadbury shareholders required to 50% plus one share from 90%.

The latest round of talks was initiated by Kraft on Monday, according to a person familiar with the matter. Kraft Chief Executive Irene Rosenfeld had returned to London over the weekend after spending last week in the U.K. trying to sell Cadbury shareholders on the deal.

The move to engage with Kraft was an abrupt U-turn for Cadbury and its chairman, Roger Carr. He called Kraft a “low-growth conglomerate,” accused it of showing “contempt” for Cadbury shareholders with its initial offer price and asked those shareholders not to let their company be “stolen.” He and Cadbury Chief Executive Todd Stitzer have also criticized the track record of Kraft management, led by Ms. Rosenfeld. The two men repeatedly signaled that they would rather do a deal with Hershey, which they indicated would be a better cultural and operational fit for Cadbury.

The deal comes with significant risks for Kraft. Cross-border transactions have tended to fare poorly over the years. And Kraft’s own shareholders—including its largest holder, Warren Buffett’s Berkshire Hathaway—have publicly worried about overpaying for Cadbury.

Ms. Rosenfeld met with Mr. Buffett recently and he was “totally supportive” of the new terms, a person familiar with Kraft’s offer said. Mr. Buffett didn’t return calls requesting comment. The billionaire investor had said he would vote against the issuance of shares Kraft had planned to use to help pay for the deal before it was reconfigured. The new offer involves the issuance of fewer shares and no longer requires a Kraft shareholder vote.

Ms. Rosenfeld said Tuesday that over the course of the transaction she had conversations with many investors, including Mr. Buffett, and they told her there was “tremendous intrinsic value” in Kraft shares. That eventually pushed Kraft to significantly reduce the number of shares in the transaction.

Combining with Cadbury would catapult Kraft into the highest tier of the global confectionery industry, potentially expanding Kraft’s sales outside of North America and Europe. Already, Cadbury is the biggest confectioner in growth markets such as India, Mexico, Egypt and Thailand, according to consulting firm Euromonitor International, and emerging markets provide 38% of the company’s global sales, compared with about 20% at Kraft. Cadbury’s sales in the Asia-Pacific region alone amount to about 20% of the company’s revenue. Cadbury has about $500 million in sales in Mexico, while Kraft has about $350 million there, according to Barclays Capital analyst Andrew Lazar.

Buying Cadbury would also add strong sales of chewing gum, especially in Latin America, to Kraft’s portfolio. Confectionary products typically have higher margins than Kraft’s company-wide margin.

In addition, Kraft would be able to secure more sales at convenience stores in the U.S. and Europe, a growing outlet for selling food in small servings. The gum, chocolate and other food sold in those outlets tend to carry higher profit margins than food sold at a grocery store, and convenience stores typically carry few Kraft products. Grabbing hold of Cadbury would immediately give Kraft a potentially new, and more profitable, channel of distribution.

“It’s a great deal for Kraft as it minimizes dilution of shareholders,” said William Ackman, head of Pershing Square Capital Management, which owns about 2.2% of Kraft shares. “Cadbury could not have achieved the same values on its own.”

A deal would largely consign Hershey to selling chocolate in the U.S., a country with a slow-growing population in the midst of deep economic turmoil. Without greater access to growth markets Hershey faces a future of sales and earnings growth largely dependent on price increases or cost cuts. A spokesman for Hershey declined to comment.

For Mr. Carr, the Cadbury chairman, the current saga began at the Lisbon airport one Friday afternoon last August. On his personal mobile phone, he found a voice mail from Kraft CEO Ms. Rosenfeld asking him for a meeting in London the following week.

When the two later met at Mr. Carr’s office, Ms. Rosenfeld surprised Mr. Carr by almost immediately announcing she had a proposal to make. What surprised him even more was that she expected a swift answer, he recalled. Mr. Carr said the price she had proposed was inadequate and that he needed to confer with Cadbury’s board. The meeting with Ms. Rosenfeld lasted a mere 20 minutes.

“She got on her Gulfstream, she flew back to America and I never heard from her again —until the letter,” Mr. Carr recalled, referring to the Aug. 28 letter that put the iconic company on the block.

—Michael Carolan, Cecilie Rohwedder and Anjali Cordeiro contributed to this article.

Sources:
* Cadbury Now Faces Rhetoric Shift
* U.K.’s Mandelson Seeks Meeting With Kraft
* Hershey’s Horizons Are in the U.S.
* Deal Journal: Cadbury buries the Hatchet
* The Source: New Frenemies | Kraft Call Recap
* The Source: The Price Action Said It All
* Heard on the Street: Cadbury Takes Cookie Dough
* Vote: Who was the better negotiator?
* Cadbury Statement

From the Archive

* Hershey Drafting Cadbury Bid (01/16/10)
* Cadbury Steps Up Kraft Defense (01/13/10)
* Kraft CEO on Defensive (01/07/10)
* Buffett Hits Kraft on Cadbury (01/06/10)

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via InvestorPlace.com: Kraft-Cadbury Merger Looks More Complicated (KFT, CBY, BRK.A, MO, HSY).

Cadbury’s formal defense against Kraft’s hostile £10.4 billion ($16.9 billion) bid was heavy on numbers, from its projections for organic revenue growth to the appropriate multiple for valuing the British confectioner.

But Cadbury wants shareholders to know there are intangibles, too. A whole section of its defense document makes note of its “values,” including commitments to the ethical sourcing of its ingredients and its attempts to minimize its impact on the environment.

Todd Stitzer, the company’s American chief executive, told DealBook in an interview on Monday that shareholders should factor in those values in deciding whether Kraft’s bid is fair.

“It’s a culture that very much cares abut how it conducts business,” he said. “Sharehowners will have to judge whether that little bit of magic that makes us special … they’ll have to decide what that’s worth.”

That line ties into Cadbury’s argument that it is special, and not just fodder for a so-called “low-growth” conglomerate like Kraft. Cadbury touts its founding by the eponymous Quaker family that sold sweets as an alternative to alcohol, and it prides itself on preserving something of a familial internal culture.

Many have speculated that the company feels a closer kinship to a fellow confectioner like Hershey, the iconic American chocolatier whose roots are steeped in philanthropy. Cadbury acknowledged on Monday that it has “received indications of interest from third parties.” And DealBook and others have reported before that Hershey is working on lining up the financing necessary for a potential run at its British counterpart.

Mr. Stitzer reiterated that Cadbury’s primary focus is on getting the best possible value for its shareholders. But he conceded: “If there were two equal offers, and one was more culturally compatible, the answer would be pretty easy.” (Of course, there’s only one offer on the table right now, and it’s by Kraft.)

So far, shareholders seem to be supporting Cadbury. Its shares closed on the London Stock Exchange on Monday at £7.95 each. One question that analysts and others have asked is the number of short-term investors — mainly arbitrageur hedge funds that bet on merger situations — that have taken up residence in Cadbury’s stock betting that a deal will get done. It’s a concern because Cadbury’s stock is riding high now in part on hopes that a bidding war will erupt; the stock could easily plunge if none does.

Still, Mr. Stitzer said that he has been talking to Cadbury shareholders and believes a good number of them are long-term investors. He estimated that hedge funds and other short-term investors comprise only about 15 percent to 20 percent of his company’s shareholder base, which he described as “a relatively modest level” for high-stakes merger situations and that he believed a number of them were “responsible.”

Nevertheless, he added: “I don’t think we can worry too much about that. We’re focused on what we do best.”

BY ERIC SWANSON

On Monday, Kraft KFT announced that it made an unsolicited bid to acquire Cadbury CBY for 745 pence per share, a 27% premium to our 585 pence per share fair value estimate. Despite this offer, we’re leaving our fair value estimate for both firms in place, as we doubt a deal will be completed at this price. However, we are raising our uncertainty rating for Kraft, as the bidding may become competitive given the number of large potential suitors, possibly causing significant dilution for the unfortunate winner.
Strategically, we believe this acquisition makes sense from Kraft’s perspective. In our opinion, the confectionery industry is attractive, as it offers some of the highest margins in the packaged-foods industry while also being relatively fragmented, providing larger firms plenty of room to grow. We believe this fits in line with the strategy that CEO Irene Rosenfeld has implemented over the past several years, as the firm has been focused on selling off less profitable brands and making acquisitions to drive growth. In addition, while Kraft is highly exposed to private-label competition (particularly due to its cheese and packaged meat offerings), private-label competition is minimal in the confectionery space, as private-label firms control only about 5% of the market–which is also appealing for Kraft. Further, this purchase would increase Kraft’s international presence, while also providing a platform over which it could expand the distribution of some of its existing brands, in our view.

From a financing perspective, we believe that Kraft maintains the financial flexibility to acquire Cadbury. Kraft’s debt amounts to about 45% of capital (average for a packaged-food firm). In addition, the firm operates with more than $1.7 billion of cash and $4.5 billion of funding available under its existing credit facility. Further, Kraft’s ability to service its debt has not been an issue, as its earnings before interest and taxes covers interest expense comfortably at nearly 5 times.

However, given the attractive nature of Cadbury’s portfolio, we believe that other bidders could emerge. Kraft is the largest packaged-foods company in North America and the second largest in the world, behind Nestle NSRGY. Although Nestle has not been focused on growing its confectionary portfolio, the firm could decide that it would rather make a bid for Cadbury than let one of its largest competitors gain this valuable asset.

Although Cadbury does not appear to be interested in any acquisition at this point, we don’t believe Kraft is willing to close the book on this deal. Kraft’s initial offer values Cadbury at just under 15 times the firm’s 2008 EBITDA. While this is less than the 19.5 times earnings that Mars paid for Wrigley just last year, we believe Wrigley was a better business and that the price paid was too high. Given that Kraft’s initial offer is already at a premium to our fair value estimate, we believe that if Kraft sweetens its offer, it runs the risk of overpaying for Cadbury–a move that would lead us to lower our fair value estimate for Kraft. Because the dust has yet to settle, we believe it is appropriate to raise our uncertainty rating for Kraft to high, meaning we recommend waiting for a large discount before purchasing the shares. We will update our analysis as we gain more details on any potential transaction.