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Monday, April 03, 2006

CXTI convertibles

A big hat tip to George here

Ok, so now I see why both CXTI and ETLT have dragged in this bizarre set of rules for outstanding liabilities. Both of them have these floorless convertibles based on a fraction of the recent stock trading price. CXTI's is fairly easy to see. ETLT's is very small and associated with a legal settlement. I have to admit that I really didn't fully grasp the truly unlimited liability nature of these things.

I'm not worried about ETLT, where the face value of the convertibles is insanely small. But it's worth looking at CXTI more closely. If CXTI's stock price spent a week at some insanely low value before Halloween 2006 (how appropriate), then the dilution would be horrendous. Let's say CXTI drops to 20 cents for a week. Then the convertible holders get 40 million shares of stock in the conversion. Considering that my totally diluted estimated share count is 42 million, that's a nearly 50% dilution in ownership.

So it's conceivable that the convertible holders could manipulate the stock to increase their ownership of the company. Of course this could very easily backfire for them. It means having to sell possibly a gigantic number of shares for an entire week. There's no telling who might be sitting at the other end of the transactions, including people associated with the business, and how much money they'd be willing to sink into the company. Those people could end up buying a large part of the company at very cheap prices subsidized by the would-be stock manipulators. Here's another problem for them: there's a limit to how much of the stock can be sold. If someone gobbles up the shares and sits on them, then if the convertible holders short more than the float, they're screwed. Actually they're screwed well before shorting all of the float.

So shareholders look at this and see potentially unlimited dilution, but the convertible holders also have enormous risk in trying to manipulate the stock by any huge amount. A more realistic worst case would be CXTI selling for 90 cents for 5 days. In that case, the convertibles turn into less than 8.9 million shares.

We need to add that full amount to my share count, and probably bump it up to 10 million for a totally diluted share count of 52 million shares. Earnings for 2005 now look more like 17.9 cents per share and the stock would be currently trading at a trailing P/E of 10.

The convertible holders had a perfect opportunity back in early November 2005. And since the convertibles have such a short shelf life of one year, you'd think they would have done it back then if they were going to push the stock down and do the conversion. Here are the prices at that time:


Pushing the price down on Nov 4 and Nov 7 would have done the trick. Maybe they tried, I don't know. The volume was a bit heavy on Nov 7. At that time, they would have had no idea what developments might unfold over the coming year and news was at least as likely to be good (causing a higher stock price) as it was to be bad (giving them a lower stock price).

It's appropriate that I mentioned what Buffett wrote about Arcata in the 1988 letters to shareholders. With most of my investments, I view them as having two major parts, the first being very tangible and based on what seems clearly likely in the future. That's the part you'll see on this blog. The second part is the stuff that's difficult to pin down precisely, the possible payoffs that can't be relied upon. I can't say exactly how it might play out, but I want as much of it as I can get. Stathmore has a huge potential upside. So does ETLT, CXTI, and even EPLN.

With Buffett's Arcata, the market pushed the price of the stock even higher than the valuation of the tangible stuff that could be clearly nailed down and Buffett did something odd, but something he would do much more in the future: he continued buying at the higher prices because he started relying on the value of the icing on the cake. Ben Graham would never have bought Coca Cola at the prices Buffett paid, nor most of the private business purchases, I'd guess.

I look at CXTI and ETLT and see early businesses in what is clearly going to be a gigantic market in the future, not to mention the benefit of an overvalued US dollar in buying ownership of the businesses. CXTI could become an EDS and ETLT could become an ADM. Hey, Wal*Mart's own CEO said he thought the first Wal*Mart store was the worst store he had ever seen. But they don't have to be that successful for them to be extremely good investments today.

UPDATE: CXTI wins another big contract!

Amongst 83 cities and counties in Fujian province, only 7 of them have started their e-government construction and we have signed contracts with 6 of them.

UPDATE April 8, 2006: Why did CXTI get such a crappy deal when raising cash?
I don't know why CXTI paid a high price for cash. I look at other Chinese reverse mergers like Sunwin and they got reasonably good terms of around 6% interest. China Digital Media got diluted by a factor of 10, although I don't recall if it was raising cash or not. China Bak Battery raised $17 million on Jan 18, 2005 using shares at $1.98 and the shares soon after sold for around five dollars. That's in the same ballpark as what CXTI got. American Dairy raised $4.7 million (page 19 in the Notes) in 2004 selling 1.8 million shares of stock, 1.8 million warrants. Let's call it 3 million shares, which corresponds to getting about $1.56 per share. The shares were selling for over $2.50 during the entire year. So I don't see CXTI getting that much of a worse deal than other similar Chinese reverse merger companies.

Wow, Bruce, it's not like you to say things like "very small" or "insane small" without giving actual numbers or a reference :-).

Do you happen to know the quantity and terms of the ETLT toxic convertibles? Or what I might search for in the SEC filings?


It's a case of being tired and lazy. The ETLT convertibles in question are from the legal proceedings involving Bristol Investments seeking $53,000. A settlement was pending during last year's 10-K and was convertible into common at a 20% discount to the five trading day closing price prior to the settlement. The debentures have a two year maturity. Unconverted debentures are paid in cash. See ITEM 3 in the 2004 10-K.
Bruce, why wouldn't those same terms apply to the other CD holders who DID settle? I think there is more debt at similar terms; the details of the settlement:

:On May 24, 2005 the Company issued convertible notes,
allowing for conversion of the penalty to the Company's common stock, to
the holders of the subscription agreements who accepted settlement. One
subscription agreement holder elected to not accept a convertible note and
is pursuing legal action as discussed in Part II, Item 1.


The details of that lone holdout:

"The second cause of action was filed in State Court in New York City by Bristol
Investments Limited against the company and is seeking the payment of the
penalty due under their original investment for failure to have a registration
effective within a stated period of time. Bristol is currently seeking $53,000
in damages. Bristol has refused a settlement offer of a convertible promissory
note and continues to pursue the litigation.

The size of the settlement in convertible debt was also revealed in that same Q:

"and an increase in current liabilities of $757,137 attributable to
332,698 in convertible notes from the conversion of penalties, $319,560 in
accounts payable and accrued expenses, and $104,879 of accounts payable to a
related company. "

Which document is that from? I went through the 2004 10-K and didn't find anything else that had the funky conversion method. But perhaps it came about after Dec 31, 2005.
Hi Bruce-

I learned about toxic convertibles when I owned SYBR (fortunately a VERY small amount of it) around 1998. SYBR issued some toxic convertibles. Check out SYBR's long term price history on Yahoo especially from 1997 to about 1999. It destroyed SYBR's stock price, although the company has managed to survive by continually diluting their stock, although they no longer issue toxic convertibles.

But I think you may be right that CXTI has very good prospects and strong sponsorship (maybe even the Chinese government?) that would step in and support the stock price if it dropped too low.

One of the problems with toxic convertibles is that the stock sales can happen in stages and the drop is not just due to short selling. The bond holders can exercise some of the bonds first at 75% of the stock price, then sell off those shares to try to drive it even lower especially on low volume days. On each lower dip, they can exercise more shares to sell in a sort of vicious cycle.

Of course, the holders of the CXTI convertibles may not be sleazeballs who would use a strategy like this, so CXTI may be just fine.

Bruce, I found the details of the increase in the convertible debt increase in the Q2 2005 filing.

The company never filed an 8k or discussed within a Q the precise details of this convertible debt...as far as I can tell. I'm surmising that Bristol Investments was offered the same deal (convertible debt with "toxic" conversion rights) but rejected it...for unknown reasons.

BTW - I highly recommend a subscription to 10KWizard....its word search capabilities are worth every penny.
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