Know Your Rights, Part II

By Rob Marstrand on November 18, 2011

In my portfolio review of October 28 I explained the terms of the recent Lippo Malls Indonesia Retail Trust (SIN:D5IU) / (PINK:LPMDF) rights issue. A number of you wrote in with questions about this. So I’d like to clarify some of the details today.

(If you do not own LMIRT shares directly, you may want to skip today’s report. It won’t be directly relevant to you.)

As I explained recently, rights issues mean that the stock price will fall. This is because companies issue new shares at a much lower price than outstanding shares trade for.

Because the pre-rights and post-rights shares have the same economic value – they rank pari passu in financial parlance – the new price has to average out somewhere in between.

The “Theoretical Ex-Rights Price” (Terp) is an estimation of where this new price should be. But market forces can send it higher or lower. It just gives you an idea of what to expect.

Key Takeaway: The original buy price should no longer be the benchmark that you use for working out if the stock price has gone up or down since purchase or for calculating your profit or loss so far.

Don’t Be Confused By a Falling Share Price

When I wrote last about the rights issue, LMIRT shares were trading for S$0.52. And I calculated the Terp as S$0.41. This compares with the rights issue price of S$0.31. But as I explained, there is no economic gain or loss to existing shareholders, except for the fees embedded in the transaction.

So you could sell your nil-paid rights for S$0.10 to make up most of the price fall of S$0.11, leaving a net loss of S$0.01 a share. Or you could buy the new stock at S$0.31…gain S$0.10, as it trades up to S$0.41…but then lose S$0.11, as your existing stock falls to the same level. The net loss is still S$0.01 a share.

Remember: This price fall of existing shares happens before the new stock has been issued. In the case of LMIRT, the “book closure date” was November 4. This means that all shareholders on that date got rights. This date is the trigger point for the share price to fall.

If you are a LMIRT shareholder and you don’t fully understand how rights issues work, it’s easy to make the mistake of thinking that your shares have collapsed in value. But you should expect your shares to trade close to the Terp from this point on…subject to other market moves. Later on, you will either get cash from selling your rights. Or you will get an immediate gain on the new shares you buy cheaply through the rights issue.

The first trading day after the book closure date was November 8. On this day the price of LMIRT closed at S$0.44 – slightly above my Terp calculation of S$0.41.

But the expected price fall happened a few days earlier. On November 1 shares closed at S$0.52 – the same level as in my previous update on the rights issue. The share price then fell to S$0.43 on November 2.

This is earlier than the book closure date of November 4. But this is because the final trades have to settle. And this takes a couple of days. (“Settlement” is just financial speak for brokers exchanging cash for shares and making sure everything has been properly recorded in their client accounts. How long this process takes varies by stock exchange.)

Still a Big Discount to Fair Value

The nil-paid rights trading period – when shareholders can buy and sell the rights – started on November 10. Shares closed at $0.43 that day, which means that the rights should have been priced at $0.12 (the difference to the S$0.31 subscription price). So shares stayed stable despite a Singapore stock market fall of 2.5% that day and a 2% fall in Indonesia.

But on November 11 LMIRT’s share price fell to S$0.39 – down 11.4% in one day. The latest price is S$0.38 – or 9.3% below the Terp that I calculated. This is disappointing, as the broad market in Singapore has been largely stable.

Usually, the investment banks underwriting a rights issue will provide market support during the subscription period to make sure the issue is successful. They are simply thinking about their own interests. They don’t want to have to buy any unsubscribed stock. They want other people to buy it up.

But in this case of LMIRT the fund sponsor is the underwriter. And it has promised to buy all the unsubscribed stock. This makes me wonder whether the usual level of buying support (to provide price stability) from the investment banks working on the deal has been absent. If it’s the case, then it’s disappointing for us in the short run.

Another potential reason is that the stock has simply traded down to its pre-rights valuation multiple. LMIRT released third-quarter results on November 3 (no surprises and a solid dividend). Using this latest information, I estimate that book value per share (BVPS) will be S$0.575, after the latest quarterly cash dividend is paid out on November 30 and after the rights issue is completed. This is close to my earlier estimate for BVPS of S$0.57 after the rights issue.

BVPS is the calculated by taking the net assets of the company (assets less liabilities) and dividing this figure by the number of outstanding shares. You can think of it as the liquidation value of the shares. If all assets were sold and all liabilities were paid, BVPS would be the cash left over.

In my last report on LMIRT I estimated BVPS at S$0.83 and the share price was S$0.54 before the rights issue. So the price-to-book ratio (P/B) was 0.65, a big discount to liquidation value. With the stock now at S$0.38…and the estimate of post-rights BVPS at S$0.575…this places the P/B at 0.66. About the same as before, in other words.

Key Takeaway: The implication of this is that by raising cash to buy new buildings, the company has resulted in a short-term loss for shareholders. The price the market is prepared to pay for a part share in those new assets is less that the amount the company will pay to buy them.

But it also means the stock is as cheap as before, trading at a big discount to book value. So today’s loss could be tomorrow’s profit, when shares eventually trade back up to fair value.

My latest estimate of fair value for LMIRT is S$0.55 – based on 95% of book value per share. This is 44% upside from the current level. And the estimated dividend yield is now 9.3%, and could increase further if LMIRT is successful at increasing occupancy rates in line with the average across the rest of its portfolio in its two new malls. (None of this includes the potential for the value of LMIRTs building assets to rise over time.)

What It Means for You…

Rights issues are complicated. And I apologize for the technical nature of today’s report. But I want to explain exactly what this one means for anyone who bought the stock when we recommended it on October 18 of last year.

Back then the share price was S$0.535. Today it is S$0.38. So a casual look at a broker statement could lead to the false conclusion of a loss of 29% (measured in Singapore dollars).

In between then and now each stock has paid out S$0.0445 as dividends (4.45 cents). And shareholders will get another 1.06 cents today from the latest quarterly dividend. So total dividends are S$0.0551. That’s 10.3% yield on the original buy price.

I’ve explained how subscribing to the rights or selling them “nil-paid” has the same dollar result. So here I’ll use the example of someone who sells the rights to see the whole picture.

I estimate the average price the rights could have been sold for during the nil-paid rights trading period at S$0.066. The closing price on the last trading day (today) was S$0.38. So if rights were automatically sold at the end of the period then the result should be a similar S$0.07.

Measured in Singapore dollars, this is how all the figures look:

Because of the rights issue I’ll change the way that I show LMIRT in the weekly investment summary from now on. I’ll keep the original buy price. But in the dividends column I’ll add an estimate for the proceeds from selling the rights. That means you’ll see a price fall offset by the cash received. I’ll also add a new line for new shares from the rights issue (bought at S$0.31) so those of you that subscribe can see how that performs over time.

Huge Profit Potential

The recent price weakness…and earlier general market weakness in recent months…have stripped away our profits on LMIRT.

Our paper loss at this point is just over 6%, measured in Singapore dollars. It’s about the same result when measured in US dollars, because the Singapore dollar is at about the same level as when we bought in.

But since the P/B is now at just 0.66, this remains a deep value investment…and one that has 44% upside to fair value. Huge profit potential, in other words.

Meanwhile, LMIRT continues to pay out a highly attractive dividend yield of nearly 10%. And I remain bullish on its long-term prospects.

The Indirect Option…

One more important point: SEC regulations typically mean that any rights issue that doesn’t comply with SEC disclosure requirements isn’t allowed for US citizens or US based investors.

This means that if you are based in the US you can’t use your rights to buy new stock. But you still get to sell your “nil-paid rights” for cash. So you don’t gain or lose either way.

If you are based in the US, one option you may want to explore is to indirectly take up your rights to buy new shares. There are small transaction costs involved. But the end result is close to the same as a non-US investor that takes up their rights.

Indirectly taking up your rights to buy new shares involves selling your nil-paid rights and then buying new stock on the open market after the rights issue has finished. (You don’t want to buy more during the rights issue; you would just end up with yet more rights that you can’t subscribe to.)

The current market price is S$0.38. And the new stock is being sold at S$0.31. So the rights would be worth the difference: S$0.07 for each right to buy a new share.

So you can sell each nil-paid right and receive S$0.07. You can then buy a new share on the open market any time after November 24, when the rights issue closes. Assuming the market price stays the same, the net cost is S$0.31 – the same as the right issue price.

In other words, you get the same net effect as someone who takes up his rights. Under both scenarios, you get to buy new stock trading at S$0.37 for a net outlay of S$0.31.

But the result will depend how the stock price moves between when your rights are sold and when you buy new stock. As with any purchase, you should try to take advantage of a down day in markets if possible. But in the long run it won’t make much difference.

Of course, there are transaction costs on the trades, involving broker commissions and the bid-ask spread. (Brokers buy stock at the lower “bid” price and sell it at the higher “ask” price and keep the difference.) But the outcome is close because the spreads are usually small, except for highly illiquid stocks. Spreads in Singapore are usually low.

Key Takeaway: If you want to own more LMIRT stock but are prevented from exercising your rights by US regulations, you can still do so indirectly. You’ll have a similar outcome to overseas investors that aren’t locked out of the transaction.

US investors or investors that hold the stock by way of the Pink Sheets will most likely have had the nil-paid rights sold automatically on their behalf by the investment banks managing the deal. The sale proceeds of all these sales will be pooled and divided equally, according to how many shares each ineligible investor owns.

The advantage of this is that if the price of the nil-paid rights has bounced up and down during the trading period, everyone will get an average sale price. The disadvantage is that individual investors don’t get to pick the moment when they want to sell. But in practice the trading period is so short that you’re probably better off taking the pooled price. Especially in the highly volatile conditions we have around the world today.

Conclusion: The recent stock price fall is mostly not a genuine loss for investors. You’ll either make most of it back from selling the nil-paid rights or from buying the new stock at the discounted issue price. I continue to believe LMIRT will rise to fair value over the long run. In the meantime the high quarterly cash dividends will keep rolling in.

Until next week,

[ilsig rmarstrand]Rob[/ilsig]

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