Sunday, 20 November 2011

What is wrong with good old fashioned bonds?

I don't agree with the below article in The Edge Financial Daily. The ICSLS of E&O are irredeemable, in other words can not be converted back to cash, the holder has no choice. But if they always convert to shares then somebody who wants to value the company should calculate the number of shares on an "as converted" basis, in other words with the shares being diluted. There is a difference in some matters like voting at AGM's (an ICSLS does not count as a share), liquidation events (ICSLS often have preference at liquidation events), but that does not matter in the normal cause of action.

Instead of these difficult instruments that are often misunderstood, why are companies not just issuing plain bonds? Are they not sexy enough? There was a time when they were quite normal on the Bursa Malaysia. What has happened, why are they not used anymore?

I am of the opinion that the share market can perfectly well operate with:
  • Shares: investors invest money in the company for a piece of the company, and will receive back dividends when declared;
  • Bonds: investors loan money to the company, they don't get a piece of the company, but they will receive a fixed interest rate and at the maturity date they receive back their money.
Shares appeal more for the risk seekers who are looking for capital appreciation and/or dividends. Bonds appear to risk averse people, like pensioners, who want stable income.

There is no need for difficult instruments like Irredeemable or Redeemable Loan Stocks, Warrants, Options and what do you have.

E&O could have just issued plain old bonds, at such a interest rate that it was enough attractive for investors to buy them, without causing any dillution for the shareholders. Of was this a too simple solution for the corporate advisors, would they receive lower fees for such a solution?

Sime Darby Bhd’s already expensive acquisition of Eastern & Oriental Bhd’s (E&O) shares could look even more pricey after the surprise announcement last night that the latter will be converting an estimated 220.11 million loan stocks into ordinary shares before year-end.

E&O announced on Bursa Malaysia yesterday that it will be converting all its remaining 10-year 8% irredeemable convertible loan stocks (ICSLS) issued in 2009 to new ordinary stock units of RM1 each on Dec 27. The number of oustanding ICSLS was not indicated, but totalled 220.11 million as at June 30, 2011.

When the 220.11 million shares enter the market at the end of the year, the resulting dilution in book value per share coupled with a potentially large share overhang could well make Sime Darby’s RM766 million stake in E&O come at a greater premium as the price-to-book value of its acquisition rises and the share price falls.

To recap, Sime Darby had bought 273 million ordinary shares and 60 million ICSLS from three vendors — E&O managing director Datuk Terry Tham, Tan Sri Wan Azmi Hamzah and GK Goh Holdings of Singapore at a 60% premium to the market price, or RM2.30 per share.

Issued in 2009 as part of a fundraising exercise, the ICSLS are due only in 2019. However, E&O said that based on conditions stipulated in the Trust Deed dated Sept 11, 2009, the company is exercising its rights of mandatory conversion, and the early conversion shall be on Dec 27 at 5pm.

E&O may convert the ICSLS at any time after the second anniversary of the issuance with the sole condition being that its three-month volume weighted average price (VWAP) exceeds RM1 preceding the exercise.

The three-month VWAP as at Nov 17 was RM1.52, skewed upwards by the jump in price following Sime Darby’s acquisition.

The ICSLS have a conversion price of RM1 per E&O share. As they were issued at 65 sen, the remaining 35 sen will be debited from the company’s share premium account.

Based on E&O’s June 30 balance sheet, there were 908.90 million E&O ordinary shares issued. The conversion of the ICSLS will increase that figure by 24.2% to 1.129 billion shares, according to estimates by The Edge Financial Daily.

However, given that Sime Darby also holds 60 million ICSLS, the conversion will not materially dilute Sime Darby’s 30.04% stake in E&O, which will fall slightly to 29.49%.

Sime Darby should not be adversely affected as it had the foresight to acquire the 60 million ICSLS to ensure it would continue holding close to 30% of E&O. Otherwise, its stake would have been diluted to 24.18%, according to The Edge Financial Daily’s estimates.

An analyst estimated, based on “back of the envelope calculations” that resulting from the conversion, E&O’s book value per share will fall to RM1.06 from RM1.24 at the time of Sime Darby’s acquisition.

This is because, while the number of ordinary shares has increased by 24%, total equity will increase by only 4% to roughly RM1.2 billion due to RM71.61 million of the ICSLS located in non-current liabilities being transferred to shareholders funds, he said.

Another RM60.66 million in ICSLS is already parked under shareholders’ funds. The conversion of this tranche would not increase total shareholders’ funds.

On the other hand, earnings per share will remain mostly unaffected, only dipping to 4.77 sen  from 4.8 sen for the quarter ended June 30, due to the high 8% coupon rate attached to the ICSLS.

Tham held about 65 million ICSLS as at July 29, but that figure should be much lower as he and the other vendors sold their ICSLS to Sime Darby.

When the ICSLS are converted at year-end, there will be over 160 million shares flooding the market excluding Sime Darby’s 60 million ICSLS. The resulting overhang could further depress E&O’s share price and exacerbate Sime Darby’s paper losses.

Furthermore, the flood of liquidity coupled with depressed market price could provoke another entity to acquire a significant stake in E&O.

The second largest shareholder with a 6.3% stake, ECM Libra had attempted, but failed, to nominate two directors to the board of E&O on Sept 30.

E&O ended down one sen to RM1.41 yesterday with 1.06 million shares traded. Year to date, the stock has risen by 6.82% from RM1.21.

This article appeared in The Edge Financial Daily, November 18, 2011.

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