Rights offers – to follow or not to follow?

Investment 101: Beware of too little, too late.

This article was originally published in Moneyweb’s monthly investment magazine, The Investor – now available for download in PDF format.

When a company in which you’re invested has a rights issue, do you conduct your own analysis; take your lead from the large institutions; or simply ignore the event, unconcerned that your shareholding gets diluted to another infinitesimal decimal point?

A rights issue enables a company to raise capital from existing shareholders. They are awarded rights to acquire additional shares in a set ratio to their existing holding and at a set price. They can exercise those rights, let them lapse, onsell them, or go for a combination of these options.

Richard Court, analyst at RECM explains that rights issues can broadly be separated into two distinct camps. “The first type relates to capital raising that will grow or expand a healthy business, and these tend to be popular with the market. The second group is rights issues that recapitalise a distressed business that cannot further access funding from debt providers. It then has to look to shareholders as capital providers of last resort and the rights issue enables it to continue as a going concern.”

A frequently used and simple way for investors to assess a rights offer is to compare the price at which the new shares are issued to the ruling share price. One private investor explains his practice is to always follow the right – being already invested in the company, and obviously liking it – as long as there is a discount to the market price. But something which often irks him is that by the time the rights offer closes, the market price has sunk down towards the rights offer price. “I see this quite frequently – even in deeply discounted offers – and this downward drift obviously makes the rights issue less attractive.”

As a value investor, RECM’s evaluation of a rights offer goes far beyond a simple comparison of offer to market price. “Our methodology is to compare the price of the rights relative to the intrinsic value of the company after the new shares have been issued” says Court. “If the rights offer price is below this intrinsic value, post the issue, the next step would usually be to follow the rights. This approach builds in the likelihood of recapitalisation of the business into the intrinsic valuation, and also considers any negative impacts of the rights issue. The premise here is that a shareholder following his rights will be giving up less than what he receives back after the rights issue.”

Rights offers for growth are well received, in contrast to the rescue type. Keith Mclachlan, fund manager at Alpha Wealth, highlights that rights issues in the small cap segment can be particularly challenging in this regard, and he points out Gijima as a small cap rights issue that did not go well, coming to the market twice in as many years.

“As a general rule, if a small cap is doing a survival rights issue, I would not only consider not following it – but reconsider why I am still holding on to this stock at all?” says Mclachlan. “These poor quality companies are doing rights issues because no one else is willing to lend to them, so why should you give them your money? In these instances your funds that follow a rights issue are comparable to buying duct tape to try and patch a sinking ship.”

The private investor interviewed gave comment that companies engaging in recovery or survival rights issues often come to the market way too late. “Management delays the capital raise until the company is in real trouble. This in turn affects the pricing and ratio of the rights offer, and shareholders are unfairly asked for a bigger relative contribution because of the delay.”

Quite offensive to shareholders is a second rights issue, also known as the ‘double tap’. “For distressed companies, there is a tendency to underestimate problems, and therefore to under-raise on the first offer, so a second one becomes inevitable” says the private investor.

Compounding this is that when the first offer is in the works, executives can be too focused on discussions with lenders and risk neglecting the operational side of the business. The private investor laments that as a shareholder you can clearly see another rights offer coming further down the line, and this will have to be aggressively discounted. “That first offer should be large enough to recapitalise and stabilise the business, and management should be competent and focused enough to ensure this funding does the job. A business cannot gain traction for recovery when inadequate funding is dribbled in overtime and management is not operationally focused. ”

The private investor cites Ellies, in his view, as an example of a company which should have conducted its first rights issue at an earlier stage, perhaps when the share was trading at around R6. “Now we have a second rights offer at a mere R1.10.”

Richard Court reflects on the well-publicised ABIL decline and the consequential rights issues required by this business. “When the unsecured lending market started to turn down in 2013, we took an interest in ABIL which had been sold off dramatically. Our valuation metrics specifically factored in the November 2013 rights offer, which we followed. But we underestimated two matters – the size of the rights issue that was required, as well as the large loan impairments in the business.”

With ABIL in mind, he cautions it’s important to determine whether the challenges the business faces have led to a permanent impairment to the future cash flows that underlie intrinsic value. “If this is the case, a further capital injection won’t lead to a better outcome, and we’d be pouring good money after bad.”

When a company has specific funding problems or hits a particularly bad patch in its operating cycle, but remains an intrinsically good business that can recover, investors tend to have sympathy and follow their rights. Court highlights one such example. “In mid-2014, JD Group engaged in a rights issue in order to redeem outstanding convertible debentures and strengthen its balance sheet. The credit retail industry that JD is exposed to was (and still is) going through a tough time. The rights issue price of R25 was below our estimate of intrinsic value post the transaction, and accordingly we followed these rights. In May 2015 the JD Group is in the process of being fully acquired at R34/share by controlling shareholder Steinhoff.”

Rights issues for growth are an entirely different animal. As a small cap specialist, Mclachlan often sees these corporate events in young companies. “These are emerging operations that are growing so fast they are straining their balance sheets and need to turn to the market for funding – hence the likely reason for their original public listing. The rights issue will allow them to manage the solvency and liquidity risk of their fast growing balance sheets. As a shareholder, your rights funding will go into assets that generate revenue and profitability.”

In this category, Mclachlan cites small cap Curro as a favourable example. RECM points out Invicta and Discovery as companies which have had rights issues leading to demonstrable growth and value creation, and Court points to the Mediclinic announcement of a rights issue that will fund the acquisition of Spire Healthcare.

In considering a rights offer, it’s also important to observe what company directors, management and large private shareholders are doing. “I want these guys to be following all of their rights” says the private investor. “It is very telling if they are not willing to commit their own funds – and in full.”

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