Voting For The Camelot Management Buyout: An Extremely Bad Idea

Until March 25 shareholders of Camelot Information Systems (CIS) can vote for or against the merger with Camelot Employee Scheme. This is a management buyout of a Chinese small-cap. Important stake holders in Camelot Employee Scheme are the CEO and his wife. At the moment the share price is slightly above $2 and below the buyout price of $2.05.

Apart from the shares held by the buyer group only 15.96% of the shares is enough to approve the deal. To these shareholders I am addressing this article. While it seems that Mr. Market thinks the deal will complete please read this article and think about it once more.

I strongly recommend shareholders to vote against this deal.

Camelot is a provider of software and support for the financial industry. Its share price suffered first in the aftermath of the discovery of several Chinese small-cap frauds. Then the company turned in the red. As a result the company is a net-net now, with an extremely high margin of safety. At the end of September 2013 the company had about $254 million of current assets and about $79 million of liabilities. So, the net current asset value (NCAV) is $175 million. Compare this with the market cap at take-over price of about $95 million. This means that the NCAV is $80 million above the take-over price. With a share count equivalent to 46.32 million ADSs one can compute the difference per ADS. Camelot ADS holders: you are giving $1.72 per ADS away!

How is this possible? Are US investors dumber than other investors? Well, you shouldn't be, because you are extremely privileged. Famous American investors, such as Benjamin Graham, taught you, your parents and your grand-parents, to think like an owner when it comes to investing. Think like an owner: is it possible to buy a shop for much less than the NCAV? No, because the seller can get a higher price by liquidating the shop. Graham made this point already in 1934! On the stock market it's different because shareholders can't get to the companies cash. That doesn't mean that net-nets are bad investments. In contrary, Graham already wrote in 1934 that net-nets are usually extremely good investments. And they still are. Many researchers have confirmed the rationality of Graham's preference for net-nets. Their statistical research typically finds that a net-net strategy has on average a return of between 20 and 30%. See for example here for a scientific paper on net-nets with a high margin of safety and here for a more general paper on the returns of net-nets.

I suppose investors are still afraid of more fraud cases with Chinese small-caps such as Camelot. In this case there are at least 3 reasons for not being afraid:

1. Management is trying to steal the company, so the company is real and the value is there.


2. The company is doing business outside of China. In 2012 over 10% of the revenues came from outside the PRC. This amount had grown compared to 2011 and 2010. Camelot had 178 employees in Taiwan and Japan. Therefore management won't like to be accused of fraud and end up on an international wanted-list.


3. Other companies have tried to buy Camelot for a higher price than the buyout price, see here. This is another sign that this is a real company. I suppose they were turned down because the CEO and his wife wanted a better deal for themselves.

So far, I have not seen any Chinese company in a buyout situation that turned out to be a fraud. Let me know if you have. In general and in particular with software companies, the CEO is the chief salesman. And in order to sell anything salesmen have to travel. This becomes difficult if the CEO is accused of fraud. Therefore I haven't seen any exporting Chinese small-cap being involved with fraud yet. Let me know if you do know an exporting Chinese small-cap that turned out to be a fraud. Furthermore, in this highly competitive business losing sales in Taiwan and Japan might be negative for the PRC revenues as well.

Other investors might be afraid that Camelot's losses will quickly take away its liquidity. I think this concern is without merit for 3 reasons. First, the buyout offer signals a high chance on a successful turnaround. Second, management might be manipulating the results to get a better buyout price. I have seen this before. Third, non-profitable net-nets have (much) better statistical returns than profitable net-nets. See also page 10 of the first paper linked above.

Conclusion

So don't sell your shares for less than net liquid assets! Instead be patient and keep them. If the merger is voted down management will look for other ways to make Camelot more valuable for them. That could involve buying back shares or paying a dividend, just as a number of other Chinese small-caps are already doing. In addition the company might become profitable again in a few years. Or, another company might offer a better take-over deal. Either way, it is likely that a patient majority against the deal will be rewarded with a return of 100% or more within 2 years.

Why as much as 100%? On average net-nets have a return of between 40 to 70% or so in 2 years. I suppose most of this return results from the adjustment of the market value to the liquidation value. But if Camelot will be valued at book value then that would mean a return of 100%. For this to happen the company will need to become profitable again. I think the chance that the company will return to profitability soon is high because of the take-over offer. Also I suppose that in 2 years time the market will recognize that not all Chinese small-caps are frauds, and that, for example, the exporting ones are more likely to be clean. That will result in a higher valuation for Camelot as well. When the company combines profitability with consistent payouts it might even result in a valuation of twice the book value.

Net-nets are assets most people don't want. That's why they are so cheap in the first place. So if the merger is voted down the share price will probably go down temporarily. Most shareholders don't want to suffer this short term loss. These shareholders can follow a simple strategy:

1. Sell your stock. Judging from the current price your price will be almost as good as the take-over price of $2.05.


2. Vote against the merger. ADS holders that sold on or after February 21 are still shareholders in the companies records on February 24. This means they can still vote.


3. If the merger is voted down simply buy the shares back at an handsome discount.

Source: Voting For The Camelot Management Buyout: An Extremely Bad Idea

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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