XJ International gets lesson on perils of zero-coupon bonds

The vocational educator said holders of its zero-coupon convertible bonds due in 2026 are asking for a permitted early redemption

Key Takeaways:

• Holders of all of XJ International’s $315 million worth of outstanding convertible bonds are asking to redeem the notes
• The company said it is seeking external financing to honor the demand, which is allowed under an option in terms of the notes that were set to mature in two years

By Warren Yang

To ordinary folks, lending money to a company nearly interest-free in exchange for possible future gains in its stock price must sound like a risky gamble. And yet before the Fed started raising interest to tame inflation, such financing schemes proliferated. Now, vocational education giant XJ International Holdings Co Ltd. (1765.HK) is offering investors a fresh lesson on the perils of this idea.

Last Thursday, the company, known as Hope Education before a sudden name change this month, said that holders of all of its outstanding convertible bonds worth about $315 million and due in 2026 were asking to redeem the notes on March 2 under an option in terms of the securities. The company said it was seeking external financial resources while exploring options to honor the bondholders’ requests, suggesting it lacks sufficient funds to pay them back. It said it was also preparing to hold discussions with them to find “feasible solutions.”

XJ International issued the bonds in 2021 through a wholly-owned subsidiary to raise $350 million. It later repurchased $34.9 million of the notes, reducing the total outstanding amount to the $315 million that bondholders are now seeking repayment for.

What makes the notes special is that they are zero-coupon convertible bonds that pay no interest until they are redeemed or mature. Even though they don’t generate any income for their holders during their lifetime, investors may find them attractive if they believe a company’s stock price will rise above the conversion price set the time they purchased the bonds.

Zero-coupon convertible bonds boomed in the U.S. before the Fed started raising interest rates in early 2022, as low interest rates suppressed bond yields. Back then, big-name companies including Ford, Twitter and Spotify jumped on this bandwagon to raise funds, dangling possible appreciation of their stock prices as rewards for investors looking for higher returns than what they could earn from simple interest-bearing bonds.

The landscape has shifted outside China since the Fed started raising rates. But within China rates are still falling as the country grapples with an economic slowdown and deflation. In China’s current low-rate environment, zero-coupon convertible bonds issued by Chinese companies can still look attractive to investors if they believe those companies’ stock prices will rise.

But that’s a big “if” as Chinese stocks have been some of the world’s worst performers over the last two years. XJ International is no exception. As of Tuesday’s close, its stock traded at just HK$0.34, down nearly 90% from an all-time high reached in February 2021 and far below a conversion price of HK$3.85 per share for the convertible bonds.

With little likelihood that the shares will rebound to anywhere near the conversion price over the next two years, the holders of its convertible bonds apparently decided to exercise their right to redeem the notes next month at about 103% of their principal.

Honoring its commitment

Now, XJ International must find a way to honor its commitment. The company held 2.8 billion yuan ($389 million) in cash and cash equivalents at the end of last August, just enough to cover what it owes the bondholders. But the convertible bonds aren’t XJ International’s only debt obligation. The company’s other liabilities, including bank loans and payables, amounted to more than 11.6 billion yuan, which already vastly exceeds the company’s shareholder equity.

XJ International booked a significant valuation loss for the convertible bonds in its last fiscal year ended in August, which contributed to a decline in its net profit despite revenue growth for the period. This indicates that perceived credit risks of the company have increased as its liabilities have grown faster than its stakeholder equity.

After all, the root cause of the deterioration of the company’s finances since it issued the convertible bonds is the cooling of its business during the pandemic and its lingering aftermath. At the end of last month, XJ International signed a deal to dispose of two subsidiaries and a school to raise 500 million yuan, which looks like a cash-raising exercise to strengthen its finances.

Last July, XJ International also terminated a deal for one of its entities to lend money to another for the purchase of land for a school. The company didn’t provide a reason for the cancelation, but it could also signal financial troubles.

XJ International’s shaky financial health may be a major reason for the selloff of its shares. The company is hardly alone in falling out of flavor with stock investors nowadays as the Chinese economy struggles. Some investors may also be avoiding education stocks in the wake of a crackdown on after-school tutoring service providers in 2021, though XJ International wasn’t affected by that campaign due to its status as a vocational educator.

In fact, the company’s position providing vocational education makes it well positioned to benefit from government incentives encouraging private companies to offer such services. That focus helped to lift the company’s revenue 18% to 3.58 billion yuan in its most recent fiscal year through last August, as its gross profit rose by a similar 20% to 1.68 billion yuan.

XJ International shares still trade at a seemingly decent price-to-earnings (P/E) ratio of 12, although the figure is inflated by its falling net profit. By comparison, China Education Group Holdings (0839.HK) fetches a lower P/E ratio of about 7, while Minsheng Education Group (1569.HK) trades at just 2.8. All those stocks have plummeted since 2021, reflecting generally soured investor sentiment toward this group.

XJ International founder Wang Huiwu has been buying the company’s shares lately, and this month’s name change may also indicate that he has some big plans to reinvigorate the business. But first the company must resolve the more immediate problem of how to repay its convertible bondholders. 

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