17 June 2008, Financial Times Fund Management

Last October, the Belgium-Dutch financial Fortis raised more than $19 billion in a rights issue to help finance the portion of ABN-Amro it was acquiring.  The offering enabled investors to buy two new shares for every three they owned at a discount of nearly 50 percent to the stock at the time of the announcement.

In early June, another two big European banks made cash calls to help repair strained balance sheets. Royal Bank of Scotland, which led the ABN-Amro takeover, made the largest rights offering in history.  The 11 for 18 offering sold at a discount of more than 46 percent, raising more than $24 billion.  And UBS’ $15.4 billion offering gave investors the chance to buy 7 new shares for every 20 they held at a 63 discount.

While banks have been the dominant issuers of new shares of late, rights issues are a conventional means used by all industries around the globe–save for those in the US–to raise new cash.  When overextended telecoms blew out their balance sheets in 2003 bidding ridiculous sums for 3G licenses while their stocks plummeted, many were forced to raise billions, led by France Telecom’s $16 billion cash call.

Over the past year, Austrian insurer Wierner Staedtische and Australian mining interest Newcrest mining each raised $1.8 billion. India-based Tara Steel raised more than $2.3 billion.  Danish brewer Carlsberg raised nearly $7 billion in a 1 for 1 rights offering that doubled the number of shares outstanding.

According to Thomson Reuters, from the beginning of July 2007 through mid-June 2008, there have been 617 rights issues, which raised nearly $140 billion. That’s more than a ten-fold increase from the amount raised in 1999.

Financials have been behind more than half the capital raised over the past year. But real estate and consumer staples accounted for nearly 9 percent each.  Materials and energy/power have collectively issued nearly 10 percent new rights issues.

All this makes rights issues important events for investors. The problem is that most reporting on cash calls has been supply-side focused: on the issuance of new stock.  Virtually nothing has been written about the demand side: whether investors should be subscribing to rights, in essence, doubling down their bets, or trading away their rights for quick cash, or getting out of such companies all together before dilution sets in.

The vetting process involves three basic considerations: how does a rights issue mathematically affect share price, what the issuer plans to do with the proceeds, and how is the market reacting to corporate strategy.

The first assessment is straightforward, known as the Theoretical Ex-Rights Price, or TERP.  It’s a calculation that dilutes the current stock price by the value of the new shares being issued at a specific discount to create a new, weighted average price.  The value of the rights is the difference between the TERP and the discounted stock price at which the issuer is letting existing investors buy additional shares.

During an offering, which typically lasts several weeks, these rights trade independently of the stock, allowing existing investors to sell them and pocket a quick gain.  But this may not be a particularly profitable move.  The offering is designed to enable shareholders to sustain their overall position. If recapitalization helps the company rally, shareholders who have sold their rights will have seen their original exposure diluted.

Where foreign rights cannot be exercised, such as in the US when new offerings aren’t registered, holding the stock may be expensive.  The rights have to be sold in such instances.  “The stock price, which will already be correcting downward because of pending dilution, will be reduced even further by the value of the rights once the trading period is over,” explains Ed Cofrancesco, head of the Florida-based International Assets Advisory with $350 million under management.  Proceeds from the rights sale will then be taxed.

There is clearly temptation to sell out of a troubled position rumored to be preparing a cash call to avoid the impact of dilution and institutional short-selling that often accompanies such a corporate action. However, in some cases, this could be an opportune time to buy, especially given the discount.

Then there are some rights issues that fund capital expenditures or expansion, where additional shares are not dilutive, but supported by increased revenue and profitability.  UK retailer Kingfisher, for example, rallied following its July 2002 one for one rights issue, which raised two billion pounds to fund a large French acquisition.

A recent study by Morgan Stanley’s UK market strategist Graham Secker attempts to get a handle on all this by contrasting the size of offerings, their purpose, and stock performance preceding the issue.  After looking at over 100 British rights issues that have taken place over the past 15 years, he has uncovered distinct trends, which he believes would likely apply to continental European issues as well.

Secker found that stocks that underperformed the market by 50 percent or more in the year prior to announcement of a rights issue outperformed the market by 25 percent over the next two years.

This dovetails with his second finding that large rights issues outperform smaller ones. Two reasons: the severity of the crisis that demanded such action may have already priced all the bad news into the stock; and the huge capital infusion supported forward performance.  Secker found that stocks that raised more than 75% of its market capitalization outperformed the market by 45 percent after two years.

Boding well for today’s distressed financials, Secker also discovered that stocks that raised cash to repair balance sheets outperformed those that used it to finance acquisitions or capital expenditures.  The former issues outpaced the broad market by 11 percent over the following 24 months.

Shares of Société Générale, which were pummeled after disclosure of a huge trading scandal and subprime writeoffs, may prove to be a case in point, according to Vincent McBride, comanager of the $1.6 billion Lord Abbett International Core Equity fund.

The French banking giant raised $8.5 billion in its 1 for 4 rights issue this past March. Even when accounting for the current difficulties, McBride thinks the stock is trading very cheap in contrast to historical valuations. “Current price-to-book value is 1.2 versus a secular average of 2,” McBride observes, “and 2007 return on equity was a paltry 3.4 percent, which we expect to rebound this year to 12, still well short of its historical rate of 20 percent.” He began investing in SocGen shares after they had been fully diluted by the offering.

When rights were used to refinance short-term debt incurred by Imperial Tobacco for its purchase of Spanish tobacco manufacturer Altadis, Matt Dennis, manager of the $1.4 billion AIM European Growth Fund, decided to subscribe to the 1 for 2 offering.  He’s been in the British firm, which he calls a consistent value creator, for more than six years.  “We believe the $9.9 billion recapitalization is sound financial engineering,” says Dennis, “that will improve Imperial’s balance sheet, enabling the company to redeploy cash for further expansion.”

He may be right. According to the Morgan Stanley study, rights issues used to finance acquisitions have on average outperformed the market by two percent two years following the offering.

But certain troubled banks may be the more shrewd plays these days.  While they are fraught with uncertainty, they seem to meet all the criteria that characterize the most successful rights issues for the patient investor.