Goldman Gears Up in China, with a margin of safety

From the WSJ:

Chinese car maker Geely Automobile wants to be taken seriously. It now has one seal of approval: Goldman Sachs Group's private-equity arm is investing $245 million through a convertible bond.

Geely will use the money to expand in China as it continues to reinvent its image. Its current reputation is of a company producing cheap, unreliable -- and sometimes eccentric -- vehicles. At the Shanghai auto show it unveiled a Rolls-Royce look-alike with only one passenger seat.

This has left it trailing a frothy Chinese market. Its sales this year were up 22% by the end of August, far behind the sector's 32%, JDPower figures show. The company is 10th in China, with a 2.9% share -- hence its multiple of 11.5 times expected earnings, even after Wednesday's 19% stock jump. Rival BYD, with Warren Buffett's backing and a hopeful future in electric cars, trades at 65.2 times.

Geely's investment in research and development and recruitment of overseas executives seem to be paying off, with better feedback on its pipeline of models. The next planned step could be bidding for Sweden's Volvo through Geely Holdings, Geely Auto's unlisted parent.

But Volvo would be a big bite, given Geely's small acquisitions to date and the challenges of cross-border auto deals. While Goldman is betting on a red-hot market, Geely still has to prove it can put the money to good use.

The Goldman Sachs investment seems like a smart bet. Convertible bonds will ensure that the investment doesn't suffer the same volatility of stocks yet will have the potential upside of a cyclical stock entering a strong earning phase. Convertible bonds seem a popular way to go about investing in this turbulent time. Buffett used it on Goldman and now Goldman is using it on others.

Of course the downside risk is that Geely hits some snags in its acquisitions or China changes the rules, but probably those things will not happen.

Anyhow, companies with a lot of convertible bonds would be wise to remember there are two sides to every coin. The cost of capital goes up as the shares get converted. Excessive use of convertible bonds may weigh on share prices and cause under performance.