Don't gamble on Crown Subordinated Notes II

As with Crown's casino games, the terms of Notes II are heavily weighted in the company's favour.  

James Packer's Crown Resorts (ASX: CWN) has announced a $600m Subordinated Notes II ('Notes II') hybrid issue, joining the big banks in taking advantage of historically low interest rates to raise cheap capital.

But as with Crown's pokie machines, the terms of Notes II are weighted in the company's favour. Paying a 4% margin above the bank bill rate, Notes II compare favourably to term deposit rates and recent bank hybrid offers. ANZ's (ASX: ANZ) Capital Notes 3 pays 3.6% while NAB's (ASX: NAB) Capital Notes offers 3.5%. The comparative attractiveness explains why Crown's offer was quickly increased from its original target of raising $400m to $600m.

So in that sense this rather negative review has already been outdone by market demand for the offer. But we'll plough on regardless, making the point that only in the exceptional environment of a post-GFC world could offers like this be possible. Investors are giving away a great deal in return for modest, fixed returns.

The seemingly generous margin is 20% lower than the 5% margin paid by Crown's Subordinated Notes ('Notes I') hybrid issue of 2012. Despite Notes I maturing before Notes II, the other terms are all but identical. Although both hybrids rank equally in Crown's capital structure, Notes II pay less because the rush to yield permits it.

Notes II aren't convertible into shares and investors don't face the risk of having them automatically converted as they do bank hybrids. Crown, however, has the option to suspend interest payments, although it will be required to also stop paying dividends if it does so. Should Crown encounter financial difficulties and breach Notes II covenants, it will be required to suspend interest payments.

In that event, the price of Notes II will probably plummet. Ordinary shareholders would face the same prospect, but can also benefit from share price rises. Notes II holders cannot. All the risk is on the downside while the upside is capped.

Crown has various developments in the pipeline, including the $750m upgrade of its Crown Perth complex, a new hotel development adjacent to its Melbourne resort and the $2bn Crown Sydney. Crown also owns 34.3% of Melco Crown Entertainment (NASDAQGS: MPEL), which has seen its share price more than halve since January 2014. The Chinese government cracking down on corruption, visa restrictions and a China slowdown are affecting its Macau casinos.

These investments could pay off nicely over the long term. James Packer certainly believes they will, and will take existing shareholders with him. The return to noteholders, though, will be a 4% margin and, potentially, a small capital gain on the $100 issue price. That's the capped upside we were talking about earlier.  

Why isn't Crown tapping traditional debt markets? Because while the ratings agencies treat 50% of Notes II as equity, the ATO regards the entire issue as debt. Crown gets to claim the interest payments as tax deductible on the full amount raised. Together with the low interest it pays, it's a cheap form of debt.

And the really big drawback? Except in limited circumstances, investors can't get their money back by requesting Crown redeem the Notes. The company has that option from July 2021 but if it chooses not to exercise it, investors will have to either sell them on market or wait until they mature in 2075, when your analyst will be either 95 or six-feet under.

While James Packer will purchase $50m of Notes II, he has billions at risk through his 50% equity ownership in Crown. He's unlikely to care about foregoing interest or the resulting decline in his Notes II investment should his equity investment ever be at risk. We suggest you follow his lead.

Notes II is another example of a company seeking to take advantage of investors' desire for safety and a regular yield while tilting the risk-reward equation in its favour. Successful investing involves being properly compensated for the risks taken. With this offer, investors are being asked to take too many risks for too little compensation. AVOID

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