Rights issues and how to use them: Flexigroup

This week, the Income First model portfolio exercised its entitlements under the Flexigroup Limited (FXL) retail entitlement offer. The offer looks set to provide the portfolio with a free kick in terms of paper profit and is attractive based on current prices.

But not all rights issues are this successful, and investors should be equipped with the tools to evaluate them, and (most importantly) make the right decisions for their portfolio. Using FXL as a case study, it is worth exploring a portfolio approach to rights issues and some general basics on addressing the pitfalls of this type of capital raising.

FXL offer looks enticing

This offer was announced on October 27 in order to fund FXL's acquisition of Fisher and Paykel finance. Under the terms of the offer the Income First model portfolio (and any other holder at the ex-date of October 28) is entitled to 1 new share for every 4.46 shares held at a price of $2.20. Given that the current price of FXL is around $2.85 at the time of writing, the decision to exercise is an easy one – investors are being offered shares well below their market value. The value of FXL shares immediately prior to the announcement of this rights issue and acquisition was somewhere in the region of $2.46 (including the dilution for new shares). Even at that price the offer was attractive. Pleasingly, FXL's strategy to acquire Fisher and Paykel has been warmly received by investors, catalysing a lift in the share price and making the decision simple. (Also in recent news, Flexigroup has announced its new chief executive, Symon Brewis-Weston, who joins from the CBA-owned Sovereign Assurance Company of New Zealand.)

For FXL the decision is clear cut. But what if the share price was nearer the exercise price? The most practical strategy is to wait until nearer to the offer closure date and then assess. If the share price dips below the offer price, buy on market instead (providing you are comfortable holding the stock). Of course, there are many different possible scenarios so investors should always read the offer documents and ensure that they assess whether the company is raising funds for a good reason. If the use of funds is not likely to create value, then it might be a good time to sell out entirely.

Theoretical ex-rights prices and entitlement offers in general

Much of the documentation accompanying the FXL announcement and entitlement offer (and any rights issue marketing documents) talks about the theoretical ex-rights price (TERP) and the discount at which the new shares are offered.

The TERP is the expected value of ordinary shares in the company if all of the entitlements are taken up. A simple example is worth considering:

If a company has 1000 shares at $2 each, and issues say 900 new shares through a rights issue at $1.50, the TERP is calculated as follows:

1000 shares x $2 each = $2000 market cap

900 new shares x $1.50 each = $1350 of new shares

$2000 market cap $1350 of new shares = $3350 total market cap post rights issue

$3350 total market cap / total shares on issue (1000 900) = TERP of $1.7632 per share.

So the rights offer in this example is made at a discount to the TERP. This discount is calculated as the difference between the TERP and the exercise price, and in our example is about 15 per cent. In other words the TERP is the diluted share price assuming the issue of new shares at the stated exercise price.

The TERP is important because it is adjusted for the dilution caused by the new shares on issue. On the one hand it damages the value of the already issued shares, but on the other hand those that take up the offer are given a discount in their new purchase. The net result for those who held shares before the ex-date and exercise their full entitlements is nil. So this is all academic providing the issue price is well below the share price. What really matters, and what drives the share price when new capital is raised via an entitlement offer, is how the new funds will be used.

In the case of FXL, the new funds are being put to good use. The purchase of Fisher and Paykel has been much anticipated, and now warmly received by market participants. I echo this view in that the company will realise cost synergies and growth opportunities, leading to an eventual lift in dividends. Where a rights issue has resulted in the share price increasing to this extent, and is non-renounceable, investors generally will be well served by exercising the rights.

In my view the use of a rights offer (also known as an entitlement offer) is attractive to shareholders. Essentially it affords all investors an equal right to protect themselves from dilution of their ownership, as all holders are provided with the same pro-rata number of rights. Too often in equity markets, institutional investors are afforded the opportunity to participate in capital raisings with discounted share prices, and retail investors are either not offered anything or offered a smaller allocation that still results in ownership dilution.

Renounceable versus non-renounceable

A renounceable rights issue is one where the eligible shareholder can sell its entitlements, often on market under a temporary ASX code. For example, Westpac's recent entitlement offer traded on the ASX from October 27 until November 4. Under this renounceable scenario investors have the option to sell their rights and limit any additional investment. The sale of the rights is effectively a compensation for the dilution that will occur when the new shares are issued.

In the case of non-renounceable entitlement, this is not an option. Investors can either participate in the offer, or lose their rights, which are often sold at a discount in a bookbuild process to institutional investors. So, in the case of FXL's non-renounceable offer, there is no real point in letting the rights lapse. If an investor wishes to limit any additional investment a better approach would be to sell down the entitled number of shares and exercise the entitlements, provided capital gains tax is not a barrier.

FXL strategy and rights exercise

Under the offer in question, investors can buy more FXL at $2.20. Given the share price of $2.80 and the 1 for 4.46 entitlement structure, the offer is quite attractive and will add value to a portfolio (assuming no adverse tax situation).

For the Income First model portfolio, 2326 FXL shares were held at ex-date. This means that the portfolio will purchase an additional 521 shares for a consideration of $1146.20. Assuming a current FXL share price of $2.85, the shares are worth $1484.85, and a touch over $300 in paper profit will be made. The total exposure to FXL will be 2847 shares for a value of $8090.69 (again assuming a share price of $2.85). This takes FXL towards an 8 per cent weight in the portfolio.

I am comfortable with this additional exposure to FXL, as the portfolio is well diversified, and FXL's dividends are forecast to exceed 9 per cent (on a gross basis). Further to this, there is potential upside to FXL's guidance to the market as synergies from the acquisition are realised in FY17. These updates to the model portfolio will take the portfolio to a position above 65 per cent invested.