In the mid-pandemic economy, the scramble to strengthen balance sheets, cut costs, and raise finance is on. Moreover, that is placing rights issues on investors´ radar.
What is a rights issue?
A rights issue is an invitation to existing shareholders to purchase additional new shares in the company often at a discount. With the rights, the shareholder has the option to purchase new shares at a discount to the market price on a stated future date. Put simply, a rights issue is where a company is giving shareholders a chance to increase their exposure to the stock at a discount price.
“A rights issue is an invitation to existing shareholders to purchase additional new shares in the company often at a discount”
WEALTH TRAINING COMPANY
How does a rights issue work?
The company stipulates the number of stocks it will offer existing shareholders for every stock that the investors hold in the company.
So, let’s zero-in on a current example of Rolls Royce which last week announced plans to raise £2billion from 10-for-3 rights at 32p. In other words, existing shareholders will be able to buy 10 new shares for every 3 they own, at a 32p each.
Some of you may be thinking what a bargain, bearing in mind that the current share price at the time of writing this piece is 118p.
But it is not as simple as comparing the current market stock price with the ex-right price for the very simple reason that when a company issues more shares that will not increase the company’s net asset value, it’s worth it. So, if a company’s issues more shares in a rights issue and its value remains the same then that should, in theory, reduce the stock market value of each share.
“the company stipulates the number of stocks it will offer existing shareholders for every stock that the investors hold in the company”
WEALTH TRAINING COMPANY
If given a rights issue how then do investors calculate the theoretical ex-rights price (TERP), which is the market price that a stock will theoretically have following a new rights issue?
Using a real-world example, Rolls Royce is offering existing shareholders a 10-for-3 rights at 32p with the current market value of 118p (at the time of writing this piece).
Let me introduce you to a basic formula with just four variables, all you need to do is a few basic additions, multiplications, and divisions.
TERP = (mP + nQ) divided by (m + n)
Let P = 118p (current share price)
Let Q = 32p (rights issue price)
Let n= 10 (new shares)
Let m = 3 (shares held)
“a black swan event, the pandemic travel restrictions, which is currently soon to be lifted was a demand shock for RR that adversely impacted the company’s revenue” – Wealth Training Company
So, now let’s apply the TERP formula above to Rolls Royce’s latest rights issue.
TERP= (3 x 118p) +(10 x 32) divided (3+10)
Therefore, TERP= (354p + 320p) / 13
So, the theoretical ex price is 51.8p which means the Rolls Royce rights issue price of 32p represents a theoretical discount of 61.8% based on the current market price of 118p.
So, in the case of RR the rights issue has been sexed up. Very few people were expecting RR to offer a rights issue at such a discount.
But is a rights issue a good deal for shareholders?
In the case of RR, shareholders have been bleeding dry due to the pandemic restrictions on civilian flights. Approximately 50% of the company’s revenue comes from maintaining civil aero RR engines fitted on 33% of the world’s fleet of long-haul widebody airlines. RR defense division is likely to experience growth as governments of advanced economies expand their Fiscal spending out of the economic recession. RR engines power UK’s fleet of nuclear submarines and recently the company landed a deal with the US Navy to build engines worth $115.6 million. In other words, RR is a strategic company, a relic of Britain’s excellence in engineering.
Then it is no surprise that RR came first in line for corporate government bailouts.
So, a black swan event, the pandemic travel restrictions, which is currently soon to be lifted was a demand shock for RR that adversely impacted the company’s revenue. But management didn’t dither, they responded quickly by cutting costs, headcounts and embarked on a £2bn rights issue and £3bn government-backed debt package to sure up the balance sheet.
“our fifty cents worth is that the RR rights issue is an alpha play for investors with a medium long-term time frame” – Wealth Training Company
Before considering whether a rights issue is a good deal shareholder need to look ahead concerning disruptive technologies
Disruptive digital technologies shattered household names like Kodak and Rank Xerox.
The electrification of transport, carbon-free travel is the next big thing for automobiles, it sent Tesla stocks sky-high.
Can RR, now cashed-up, be the big disruptor and innovate the next generation of carbon-free aerospace jet engines. Maybe, RR is designing the hybrid-electric future of high power class aircraft.
RR shares could be on the launchpad and about to take a moonshot. With the price now affordable for millennials investors RR could have the Tesla appeal and put a positive spot light on UK plc if the company pioneers the hybrid-electric future of air travel
Our fifty cents worth is that the RR rights issue is an alpha play for investors with a medium long-term time frame.
We believe the recovery in air travel will be at the very least U shaped. But risk could come from corrupt management, all those billions raised, then looted and squirrelled away into offshore accounts and the company stops innovating. But maybe MI5 has got a spook in there keeping an eye on things. Think about it. A failed RR and a no-deal Brexit would be a commercial and PR disaster for the UK.