Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
As a shareholder in China Health Labs & Diagnostics Ltd. (CHO-X), I was stunned by a recent press release which proposed, among other things, a 47-million-to-one share consolidation. To be fair, the TSX Venture Exchange is awash with companies trading for pennies a share and a share consolidation or reverse stock split is a perfectly legitimate way to move out of the penny stock category.
In a normal situation, shareholders turn in their certificates and receive one new certificate for every 10, 20 or maybe 50 of the old shares. This way, each shareholder's percentage ownership is preserved and the stock price moves out of the basement. To simplify shareholder record-keeping, if fractional shares are created as a result of a reverse split, they are typically redeemed for cash.
Now the 47 million share consolidation makes sense. One shareholder, Wilson Yao, president and CEO, owns 47,009,266 (approximately 72 per cent) of the 65,606,686 shares outstanding. As a result, all other shareholders will finish up with a fractional share and be cashed out at 62 cents per original share. What we are looking at is a backdoor takeover of China Health Labs by a knowledgeable insider who is also responsible for day to day operations of the company.
On receipt of this proposal from Mr. Yao, the company created a special committee of the board and retained an independent valuator to prepare a valuation report and fairness opinion. Within two weeks, a 50-page valuation report was completed indicating a fair value range of between 61 cents and 65 cents. The special committee promptly endorsed the original proposal and recommended that shareholders vote in favour of the share consolidation at a meeting to be held on Dec. 18.
We could argue that a rapidly growing diagnostic lab business in China is worth more than the six to eight times cash flow assumption used in the valuation report, but the reality is that there is only one buyer – Mr. Wilson Yao. That's why the special committee didn't waste a lot of time shopping the company in search of a higher bidder: There is only 28 per cent of the company available for sale.
If a majority of the minority shareholders don't approve the share consolidation on Dec. 18, then there is no deal. But they go forward as shareholders in a company where management has a declared interest in buying the company and may not be motivated to boost the share value in the future. Not an appealing proposition.
The share consolidation proposal makes this takeover situation unusual, but it is far from unique in the Canadian stock market. We rarely see the testosterone-fuelled takeover battles that erupt from time to time in the United States, to the benefit of the shareholders on the sidelines, because many Canadian listed companies are closely held. Some, like China Health Labs, have a shareholder with a control block. Others achieve the same result with much less financial commitment through the use of multiple or subordinate voting shares.
This isn't to suggest that the management of companies with a controlling shareholder aren't hard-working and motivated: It is just that any takeover discussion will only take place on their timetable, which may not be in your lifetime. If a takeover does take place, market regulations ensure that minority shareholders will receive "fair" value, but the odds are slim that they will receive what we all hope for – a wild and crazy value.
Many investors believe that it is a good sign if management owns a significant block of stock in the company where they work: After all, they have skin in the game, don't they? Yet my experience as a professional investor is that a small percentage ownership of the company coupled with a large percentage of the manager's net worth is the ideal combination. A controlling block ownership, illustrated once again by the China Health Labs example, typically results in an illiquid stock and a valuation discount, not a premium.
Robert Tattersall