Thoughts on CMED’s Debt and Equity

On China Medical Technologies’ recent $150M convertible bond offering, I wrote that it was a way to improve the company’s ROE. But I also think as important to strike a correct balance. As of Q2 (ending September 2006) the shareholders’ equity is $171.7M. Even factoring in possible increase of this number going forward, the debt/equity ratio is likely to remain close to 0.8 for quite a few quarters. I consider this a roughly healthy ratio for a fast growing young Chinese medical tech company.

However, the company should strive to maintain a high cash position to ensure good liquidity, particularly for it to be able to weather any possible hard landing or bubble bursting of the Chinese economy. I prefer them to maintain a current ratio of above 4 all the time. And I would not mind if the company still keeps it at 7+ as of now.

With regards to the use of the bond proceeds, an ideal acquisition target would be one that is immediately accretive to CMED’s earnings, and one that is easily integrated. If the acquisition is highly accretive to the earnings, the company might even be able to go after other targets and kick on a rapid and healthy (meaning not having to increase the debt/equity ratio significantly above the 0.8 level) self-sustaining expansion process. But, obviously, that sounds too good to be true at least for now. We just have to wait and see.

The $150M convertible bond offering allows the company to sell up to 5,345,230 ADSs; see the company’s recent F-3 filing. As of Q2 end, total ADSs outstanding was 27,381,116. The following formula can be used to calculate dilution effect:

1 – Original Shares / (Original Shares + Additional Shares)

OR

Additional Shares/(Original Shares + Additional Shares)

However note that the maximum number of ADSs issuable will be offset by the $30M repurchased by the company in association with the debt offering. Assuming the $30M ADSs repurchase occurred at an average ADS price of $26, the net maximum number of additional shares would be 4,191,384. And the maximum potential dilutive effect would be 13.3%. This potential dilution has pressured the stock for the past month and half or so. But since investing in this stock is about investing in China’s growing healthcare need, a long-term horizon is required.