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Is there a right reason or not for a rights issue?

Nicki Bourlioufas  |  05 Oct 2016Text size  Decrease  Increase  |  

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While it is easy to be enticed by shares when offered at a discount, shareholders should analyse each rights issue carefully before deciding to participate.


A rights or entitlement issue is a new issue of shares to a company's existing shareholders, entitling them to buy additional shares at a discount from the company in proportion to their existing holdings.

Existing shareholders enjoy these exclusive offers, but will they always be worthwhile?

While it is easy to be enticed by shares when offered at a discount, shareholders should analyse each offer carefully before deciding to participate, says Peter Warnes, Morningstar's head of equities research.

First and foremost, investors need to make an informed decision about the new issue and look at the rationale behind the raising of new equity.

"The first thing you need to do is look at why the company is raising the money and whether it's a good idea. Usually fresh capital is required to fund an acquisition or a capital spending program," Warnes says.

"In some cases, the company may need to pay down debt, as was the case in the recent issue of Virgin Australia (ASX: VAH). So, it's important to look at the reason behind the raising.

"The second question to ask is whether the use of the money is a good idea, so you need to ask yourself whether, for example, a proposed acquisition makes sense.

"The third thing to consider is whether they should fully participate because if they don't, their shareholding in the company will be diluted. The dilution would be greater should they not participate in a 1:1 rights issue than a 1:10 issue.

"But if they do fully participate, then there is a conscious decision to increase your exposure to the company. So if, for example, it is a 1:1 issue, and the shareholder fully participates, this will increase the weighting of that company in the investor's portfolio by a meaningful amount. An investor needs to ask themselves whether that is prudent."

Warnes says a final consideration for the investor is whether the price is attractive enough to want to buy more of the company's shares.

"If the offer is priced below fair value, then it makes sense to participate. But if it is priced at a meaningful premium to fair value, then it's probably not worth a look. So the issue price is an important factor," he says.

All rights issues are priced at a discount to the market price, but the size of the discount varies.

"Every issue will be different because the lead manager or underwriter will test the waters in the market and the price will reflect the price at which the lead manager or the company believes it will get the issue away," says Warnes.

The other thing to consider is that the rights themselves often have a value apart from the shares themselves. If the rights issue is renounceable, then the entitlement or right to participate in the issue, can be traded on the market.

On the other hand, if it's a non-renounceable issue, then the rights can't be traded in the open market.

Virgin Australia, for example, recently had a rights issue at a price of 21 cents. Ahead of the $852-million raising, Virgin's shares traded below its rights issue price, a warning to investors about the pitfalls about the offer.

Virgin sought the money to pay down debt and get its balance sheet in better shape. Virgin shares are now trading around 23 cents--a sign that not all rights issues will make shareholders big bucks. It depends on the earnings outlook of the company.

In contrast, a rights issue this month by data centre operator NEXTDC (ASX: NXT) was taken up heavily by retail shareholders, with the price set at $3.74. The share price on the day of their allotment, 4 October, was $4.20.

The rights issue and institutional placement raised $150 million and will help NEXTDC's growth through the funding of another data centre. 

A share purchase plan is similar to a rights issue in that existing shareholders are offered shares in the company, but their entitlement to participate isn't tied to their existing shareholding.

The potential for dilution is much greater for the larger retail shareholder, says Warnes, given small shareholders can participate for the same amount of shares per shareholder.

In most cases it appears $15,000 is the ceiling and the size of the individual shareholding is irrelevant.

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Nicki Bourlioufas is a Morningstar contributor.

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