A look at Reset Preference Shares

In issue 95/Jan 02 we discussed the recent wave of preference share offers from a novice perspective, describing important terms you're likely to see crop up in such issues.

These include 'convertible', 'cumulative' or 'non-cumulative' and 'swap rate' – if this looks like a foreign language please refer to issue 95's Investor's College article.

This issue we'll discuss the topic in more detail and, as some subscribers have contacted us to ask about David Jones' recent offer, we'll take a look at that as well. Although the offer has now closed it will give you some insight into our thought process on such issues.

Conversion privilege

One point you need to be mindful of is the nature of the conversion privilege. In the past, convertible issues have usually had a fixed ratio or price at which they could be exchanged for ordinary shares.

This was effectively a call option, allowing investors to participate in any capital gains over and above the conversion price.

Ben Graham summed it up nicely in Security Analysis: 'The attractiveness of a profit-sharing feature depends upon two major but entirely unrelated factors: (1) the terms of the arrangement and (2) the prospects of profits to share.'

Graham's words apply today as well as they did when he first wrote them nearly seventy years ago.

When you consider such an investment you need to carefully examine the terms under which it's being offered and the prospect for capital gains. Most of the recent offerings convert into ordinary shares at a future price, thus eliminating the potential for any serious capital gains.

In our opinion, such preference 'shares' aren't shares at all but a form of debt, repayable in shares although, as we'll explain, for tax purposes companies won't emphasise that point.

The reason companies call them 'shares' is to allow the payment of franking credits with the 'dividends'. In these cases, preference shares are a nice way of saying 'subordinated debt'.

Subordinated is banking jargon for 'last in line'. That means that if the company gets into financial trouble, all other creditors will rank ahead of preference shareholders, with the exception of ordinary shareholders who always sit at the end of the queue.

To David Jones' Reset Preference Share (RPS) offer. The company explicitly states that an RPS 'is not a debt instrument'. Apparently, the taxman is convinced but we're not. Well, not fully anyway.

This offer is more favourable than some recent issues, so let's step through our approach to evaluating this type of offer.

The first thing to ask yourself is 'why is this company asking for more money?' In the case of DJs we are struggling to see why another $65m needs to be poured into the business. The company has a seemingly strong balance sheet and has pared its capital expenditure budgets. Also, the paper shuffling of the past has so far provided little value for shareholders. We'd be thinking twice before stumping up any more cash.

The dividend yield is the obvious attraction. A minimum 8% fully-franked dividend is better than bank interest. But, according to the offer document, payment of dividends is 'at the discretion of Directors'.

Dividend uncertain

Couple this with the fact that dividends are non-cumulative and there is some risk that a dividend could be skipped and then not made up in the future.

With the ordinary shares on a current dividend yield of 7.6%, you're capturing another 0.4% in yield, but consider what you may be giving up.

RPS holders will participate in any share price upside above $1.50 and any downside below 10 cents.

Let's believe management for a second and assume everything goes gangbusters over the next few years. Well, if that's the case, you'd be mad to take up the RPS offer.

If business is running hot, you'd assume the dividend on the ordinary shares would at least be maintained and the share price would rise.

Given a $1.50 share price, RPS owners are forgoing a capital gain of over 40% for only 0.4% in additional dividend yield (and possibly less if the ordinary dividend is lifted).

The only reason you'd participate in the RPS offer is if you believed the company was going to chug along and not do very well or exceptionally badly (and therefore threaten your dividend).

Effectively, you'd be betting on a mediocre performance – a situation that entices us not a bit.