Mothers, daughters, and the Noble Group rights issue

WITH an additional half a billion US dollars just raised from a rights issue, Noble Group shareholders might yet see some light in the middle of a very long and dark tunnel.

Rights issues like Noble's are becoming more common as global growth slows and indebted companies need shareholders to rescue them. Otherwise known as cash calls, rights issues refer to the process of companies giving their investors the opportunity to purchase new shares.

The listing of 6.5 billion new Noble shares on Aug 4 will mark the end of two long months when the beleaguered commodities trading firm went through a process to raise money from its shareholders.

When Noble announced its rights issue on June 3, its shares were at S$0.30 apiece, already down dramatically from over S$1 at the beginning of 2015 and S$0.40 at the beginning of 2016.

The news of the rights issue triggered another plunge.

But the official day the shares were supposed to start trading excluding their rights entitlements - where a fall is then theoretically justified - was not until June 28.

On that day, retail investors got confused further. Indeed, Noble shares, trading "ex-rights", fell accordingly.

Some investors read this as a bad sign. But after you considered the theoretical price Noble should trade at when the day began, the counter actually rose rather strongly.

Then the rights themselves got listed, meaning investors can buy or sell these entitlements to subscribe for new shares.

Both these "nil-paid rights" and the "ex-rights share" counters topped Singapore Exchange (SGX) volumes for more than a week, with immense volatility on the nil-paid rights.

Again, some people got confused. They thought buying the rights would entitle them automatically to the new shares. In fact they had to "pay twice": Pay for the rights, and pay again to subscribe for the shares.

How do you understand the mathematics and mechanics of rights issues?

How do you work out whether the stock is actually trading up or down?

And how do you formulate a trading plan around the rights issue process?

In a two-part series, we highlight three trading points: After the rights announcement, when the stock goes ex-rights, and when the nil-paid rights start trading.

What is a rights issue

Rights issues are contrasted with private placements.

There, a company does not go to the market to raise money. It sells new shares to private investors. Existing investors are deprived of a chance to subscribe and will be diluted.

A rights issue, by contrast, entails giving all existing shareholders the proportionate rights to subscribe for new shares, so they can choose to maintain their holding in the company.

If the issue is renounceable, as was the case with Noble, existing shareholders can even increase their proportionate stakes by purchasing the rights to buy new shares from other shareholders.

Why call it a rights issue? In a rights issue, companies thus give out ("issue") entitlements or options ("rights") to existing shareholders to subscribe for new shares.

These new shares are often called "rights shares", which refer to the new shares that will be issued pursuant to a rights issue.

Do not confuse rights shares with the rights to the "rights shares" themselves, which will trade separately for a limited period.

To avoid running into problems with meanings, we will eschew the term rights shares.

Rather, we will stick to the phrase "new shares" when referring to the shares that will be issued to investors after they accept their rights and make payment.

Mothers and daughters

To kick off a rights issue, a company first has to make an announcement that it plans to do so.

Noble originally had 6.5 billion shares issued.

On June 3, it announced a plan to issue rights for investors to subscribe to one new share for every existing share owned, at S$0.11 per new share. This price was significantly lower than its last traded price of S$0.30.

Since this is a "one-for-one" rights issue, each original Noble share (which we call the "mother share") will effectively be "pregnant" with the rights to subscribe for a new S$0.11 share.

You did not pay anything for that right, which automatically gets attached to the mother share. Hence we call this right a "nil-paid right".

Shareholders will officially own these "pregnant" shares if their names are in the roster when books close for the rights. These shares confer the right, but not the obligation, for the owner to fork out another S$0.11 to get a second Noble share.

On June 22, two dates were announced, an ex-rights date of June 28 and a books closure date of June 30.

To get recorded as an owner of a "pregnant" Noble share by June 30, you need to buy it by June 27, because it takes three days for settlement to take place. If you bought it on June 28, the shares will no longer be "pregnant", hence June 28 is the day when the shares start trading ex-rights, or excluding their rights.

So upon the rights announcement on June 3, we effectively have pregnant mother shares on the market, which come attached with the choice for shareholders to pay a discounted price for another share should they so desire.

June 3: The post-rights announcement fall

Now, mother shares typically fall in value after the rights issue is announced, especially if the announcement was unexpected.

The post-announcement fall has nothing to do with the ex-rights fall explained later in this piece. The latter is technical, completely natural and justified, and shareholders don't have to worry about them.

Rather, the post-announcement fall happens because investors tend to read rights issues as an ill omen. They think the company is in serious trouble and cannot borrow from banks to stay afloat, hence it has to resort to selling a piece of itself to investors.

In the case of Noble, fundamental valuations did not matter as the stock was pushed down to new lows.

Using end-March numbers and assuming S$1.35 per US dollar, Noble had a net tangible asset (NTA) value of roughly S$0.62 a share. At S$0.30 before the rights announcement, it was trading at just 0.48 times its NTA.

After the announcement, Noble plummeted in two trading days, ending at S$0.235 on June 6, or 0.38 times NTA, 22 per cent down from S$0.30. It would eventually hit a closing low of S$0.215, or 0.35 times NTA.

In an alternate universe, if Noble needed to raise money to enter an exciting new business, its valuation could very well increase.

But the former scenario dominated. The market's confidence in Noble has been destroyed ever since a little-known research firm attacked its accounting last year.

The rights issue also came on the heel of the resignation of its CEO and the announcement that it is selling its profitable Noble Americas Energy Solutions unit.

Hence the most popular trade was to short the stock after it made its rights announcement on June 3.

Noble shares, even with their nil-paid rights attached, fell in value despite already being in technically oversold territory.

It was difficult to use metrics like price to NTA to determine how low Noble's shares would go, given that the NTA itself was in question.

The NTA was made up of mostly net fair value gains which cannot be easily calculated. The NTA also depends on long-term contracts being executed successfully, and commodity prices like coal not falling further.

To buy Noble, you would need to believe that the rights issue will shore up sentiment in the short term in a way that will narrow the discount to its NTA.

That didn't happen.

The justified ex-rights drop

After June 3, the next trading point comes at or right before Noble shares start trading without their rights, or ex-rights.

The ex-rights date was June 28, so the day to spot mispricing opportunities was June 27.

Ex-rights refer to the day when the "pregnant" mother share "gives birth" to the daughter share, otherwise known as the nil-paid right.

This daughter is not tradeable yet, though she eventually will be. But the significance of June 28 is that the mother is now trading without the weight of her daughter.

Shares going ex-rights thus naturally drop in value on ex-rights day.

Another explanation is that there are now many "daughters" out there who will eventually "grow up" to become new mother shares, once investors exercise this option to subscribe for new shares and pay up.

This flooding of shares acquired at a discounted price into the market will naturally decrease the value of the mother share.

Sometimes, in non-underwritten rights issues, you have to estimate how many new shares will end up being on the market.

But in Noble's case, the rights issue will definitely be a success. The issue was fully underwritten by a consortium of banks. This typically means the banks, or their related sub-underwriting parties, will end up owning some Noble shares and giving the company the required funds, should existing shareholders decide they don't want to fully subscribe for their rights.

Once Noble's shares starts trading ex-rights, a new reality will take hold: The reality where the number of issued shares will double.

You will thus pay less for the stake compared to the day before, when you are holding on to an additional right to subscribe for a cheaper share.

Determining a theoretical ex-rights price

How much less you are now willing to pay for the ex-rights mother share depends on the theoretical ex-rights price (TERP).

To calculate TERP, you need to know how many shares are in existence pre-rights, and thus calculate the existing value of the firm based on the latest share price. You need to know how many new shares will be issued, for how much per share, so you can calculate a value for the amount raised.

You then add the two values together to get a total value for the company. Then you divide the value with the total number of shares the company will have after the whole process is over. This is the price a new shareholder looking at Noble shares "the day after" would be theoretically willing to pay, assuming other factors driving valuation for the firm stay unchanged.

On June 27, the day before Noble traded ex-rights, shares closed at S$0.215. Its TERP the next day was thus [(S$0.215*6.5) + (S$0.11*6.5)] / 2 = S$0.1625 a share.

Another way to calculate this, given the one-for-one issuance, is to add S$0.215 (the price of a share with the rights attached) to S$0.11 (the price of a new share the rights holder can pay for).

If you plan to subscribe and buy a Noble share on June 27 for S$0.215, you are essentially committing to pay S$0.325 for a total of two shares. Thus each share is worth S$0.1625 to you.

So, it is to be expected that if nothing changes, Noble shares that traded at S$0.215 on June 27 will trade at S$0.1625 on June 28 when they start trading without their nil-paid rights.

An investor who bought at S$0.215 will theoretically see no change in the value of what he owns, because he will now own an ex-rights share worth S$0.1625, and the nil-paid rights itself, which is also worth something.

How much the nil-paid rights is worth is estimated simply by subtracting the cost to subscribe for a new share, or S$0.11, from the TERP. In this case, the nil-paid rights is worth S$0.1625 - S$0.11 = S$0.0525.

Intuitively, you would be willing to pay S$0.0525 for the option to buy a new share for S$0.11, for a total cost of S$0.1625. You wouldn't pay more, because you can otherwise just buy a new share on the market for S$0.1625.

Nor is the nil-paid right worth less, because traders can otherwise buy the right, eventually pay to convert it to a new share, and then sell it on the open market for an arbitrage profit - all assuming the price of the mother share does not change. This assumption is flawed, but we will touch on that next week.

So on June 27, at the closing price of S$0.215, you are actually paying S$0.1625 per ex-rights share that comes with a S$0.0525 nil-paid right. In price to NTA terms, meanwhile, you would be paying just 0.35 times the NTA of Noble before the new money was raised.

June 28: The ex-rights fall that wasn't

The trading opportunity of June 27-28 revolves around what investors think is a fair TERP.

Flash back to June 3, and you might remember that the banks were willing to commit to underwriting new shares worth S$0.11 each at a mother share price of S$0.30. The TERP then, assuming ex-rights was the very next day, was (S$0.30 + S$0.11) / 2 = S$0.205.

If you anchored yourself to that S$0.205 TERP, you would have noted with great interest that on June 27, a "pregnant" Noble share was trading at one point below S$0.205, at S$0.20.

This implied a price to NTA ratio of just 0.32 times, less than a third.

Meanwhile, you could have bought a pregnant mother share for S$0.20 and still have a right that you could trade away.

Or if you were intending to pay S$0.11 to subscribe for the rights, you have eventually ended up with two shares for just S$0.31, with an average cost per share of S$0.155. This is a 24 per cent discount to your imagined TERP.

Interestingly, S$0.155 has been a line in the sand, or a technical support, where Noble trading was concerned.

The historic low for Noble's ex-rights share was S$0.159 on June 28, the day it went ex-rights.

In fact, Noble closed way higher that day. It basically began the day with a TERP of S$0.1625, fell to S$0.159, but ended the day at S$0.180, 11 per cent higher than its TERP.

Retail investors who don't know any better might think Noble shares ending at S$0.180 was bad news, as they appeared to be down 16 per cent from S$0.215 the day before.

Had they logged into their trading screen when prices hit a low of S$0.159, they would have thought Noble was collapsing 26 per cent.

Yet as long as prices stayed above S$0.1625, Noble was theoretically in the green compared to the day before.

In fact, those who bought on June 27 at the closing price of S$0.215 and sold at the closing price of S$0.18 on June 28 actually made quite a decent profit.

This was because their nil-paid rights would turn out to be worth way more than the 3.5 cents that separated the two prices.

And as Noble's new shares get listed this Thursday, we will see if they end up getting shorted below what seems like a strong support level of S$0.155.

Also, its second quarter results should be out soon, providing another opportunity to trade.

Next week, we will continue our examination of the Noble rights issue process, focusing our attention on the dramatic period of nil-paid rights trading

This article was first published on August 1, 2016.
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