Sunday 24 September 2017

If You Invest In Fixed Income, Read the Fine Print

After the exertion to read the Offer Information Statement (OIS) of Hyflux's preference shares and perpetual capital securities (perps) in the past few weekends, this week's post will be a lighter one. 

In my post last week, I extracted the relevant portions of the OIS of Hyflux's preference shares and perps to discuss the conditions upon which Hyflux could omit the preference dividend and perps distribution respectively. For me, the most surprising discovery is that the preference shares are ranked pari passu (or have the same seniority) with the perps! See the figure below, which is extracted from the perps' OIS.

Fig. 1: Relative Ranking of Hyflux's Preference Shares and Perps

All along, I had thought that the preference shares would rank lower than the perps, mainly because the preference shares are a type of shares and perps have characteristics of a bond. Conventional wisdom suggests that a bond must rank higher in seniority than a share. It was only until I read the above from the perps' OIS that I realised that I was wrong!

The relative ranking of the preference shares and perps have important implications for their respective holders. If the preference shares were ranked below the perps, the preference shares would serve as a cushion for the perps. Any losses would be absorbed first by the ordinary shareholders, followed by the preference shareholders before the perp holders suffer a loss. As at Jun 2017, the total debt of Hyflux is $1,308.7M. The equity attributable to ordinary shareholders is about $226.9M (corresponding to net asset value per share of $0.289 for 785.3M shares, which is down from $0.451 in Dec 2016). The debt-to-ordinary-equity ratio works out to be 5.77, which is very high. If the preference shares were ranked below the perps, there is another $392.6M of preference equity between the ordinary equity and the perps. The debt-to-(ordinary + preference)-equity would be 2.11, which is a lot less than the original ratio of 5.77.

Unfortunately, that is not the case. Both preference shares and perps are ranked pari passu with each other. This means that both preference shareholders and perp holders share in the loss together if losses exceed the $226.9M equity attributable to ordinary shareholders. 

The key takeaway for me from reading the Hyflux's OIS is never to assume the relative ranking of different instruments based on their names. And if you invest in fixed income instruments, better read the fine print too.

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Sunday 17 September 2017

Watch Out for Hyflux's Omission of Ordinary Dividends

Hyflux announced its half year financial results last month. For holders of Hyflux preference shares and perpetual capital securities (perps), perhaps the most noteworthy point is that it did not declare an interim dividend on its ordinary shares. Why is this important? It is because the payment of a preference dividend or perps distribution is discretionary. If certain conditions are met, the company can choose not to pay or only pay partially any preference dividend or perps distribution. One of these conditions is that a dividend on the ordinary shares is not paid out. The conditions for preference shares and perps are different, so let's discuss these separately.

Preference Shares

There are 2 conditions upon which Hyflux can choose not to pay or only pay partially its preference dividends. The 2 conditions are:
  1. If it does not have sufficient Distributable Reserves; or
  2. If it does not pay its next dividend on its ordinary shares.
See Figs. 1 and 2 below for extracts of the Offer Information Statement (OIS) for the preference shares.

Fig. 1: Conditions for No/Partial Preference Dividend (Extract)

Fig. 2: Definition of Distributable Reserves

For Condition 1, if Hyflux does not have sufficient Distributable Reserves, it will not be able to pay its preference dividends in full. The definition of Distributable Reserves is shown in Fig. 2 above. I interpret it to mean that Hyflux must have sufficient retained earnings to pay dividends, regardless of whether they are ordinary dividends or preference dividends. As at Jun 2017, the retained earnings are $146.9M. The retained earnings have been dropping recently. In Dec 2015 and Dec 2016, the corresponding figures are $284.2M and $210.3M. See Did Hyflux Make Money for its Ordinary Shareholders? for more information.

For Condition 2, if Hyflux does not pay its next dividend on ordinary shares, then it can choose not to pay or only pay partially the preference dividend. Nevertheless, this does not mean that Hyflux will definitely not pay its next preference dividend in full. It only means that Hyflux can choose not to if it wishes.

In addition, the preference dividends are cumulative. If a preference dividend is skipped, it will continue to accumulate until it is fully paid out or the preference shares are redeemed.

Perpetual Capital Securities

For perps, the condition upon which Hyflux can choose not to pay or only pay partially its perps distribution is if it does not pay a dividend on, redeem or buy back any of its Junior Obligations in the preceding 6 months. The ordinary shares are considered as Junior Obligations. In addition, Hyflux can defer part of the perps distribution if it pays a dividend on, redeem or buy back its Parity Obligations on a pro-rata basis with the perps in the preceding 6 months. The preference shares are considered as Parity Obligations. See Figs. 3 and 4 below for extracts of the OIS for the perps.

Fig. 3: Conditions for No/Partial Payment of Perps Distribution (Extracts)

Fig. 4: Ranking of Hyflux Preference Shares and Perps

The last ordinary dividend was paid on 25 May 2017 and the last preference dividend was paid on 25 Apr 2017. As Hyflux did not declare an interim dividend on its ordinary shares in its latest financial results, if Hyflux chooses not to pay the next preference dividend scheduled on 25 Oct 2017 in full, Hyflux can defer part of the next perps distribution scheduled on 27 Nov 2017.

And like the preference dividends, the perps distributions are cumulative. If a distribution is skipped, it will continue to accumulate until it is fully paid out or the perps are redeemed.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell Hyflux's preference shares or perps. It is also based on my interpretation of the terms in the OIS. You can find a copy of the OIS/ prospectus in Bondsupermart. Please read the OIS and do your own due diligence.

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Sunday 10 September 2017

The Small Cushion That Warrants Provide

I have a small, speculative strategy affectionately called the "minion strategy", which involves throwing a small amount of money into certain depressed stocks that have the potential for a turnaround. The money is mentally written off the moment it is invested. The strategy is described in more details in Meet The Minions. Since the money will be written off anyway, if the stock has a warrant, I would choose the warrant over the mother share, as warrants are cheaper and rise (or fall) proportionally more than the mother shares. 

One of the recently added minions is Ezion warrant. As luck would have it, on the day I bought the warrant, Ezion called for a trading halt (later changed to a suspension). I literally had to write off the amount the moment it was invested. Later announcements by the company mentioned that it was in discussion with lenders to secure additional funds for working capital. On some investor forums, there were comments that Ezion might need to call a rights issue again to raise funds.  

When a company calls a rights issue, shareholders either have to cough up more money to subscribe to additional shares, or sell the rights (if the rights are renounceable) to collect some money back. Because a rights issue dilutes the amount of shares a warrant can be converted into, there are adjustments made to the conversion terms of the warrants. For example, each Ezion warrant is currently convertible into 1 Ezion share at an exercise price of $0.45. If Ezion were to call a rights issue and increase the no. of shares outstanding, the shares that warrant holders get would be worth less if the conversion ratio and the exercise price stay the same. Hence, there is an adjustment to the conversion ratio and/or exercise price. 

The Ezion warrants were issued in Apr 2016 as bonus warrants to all shareholders. Each warrant was then convertible to 1 share at an exercise price of $0.50. In Jun 2016, Ezion called a 3-for-10 rights issue at an issue price of $0.29. Adjustments were made to the warrants such that holders got 0.113 free warrants for every existing warrant (in lieu of changing the conversion ratio of 1 share for every 1 warrant). In addition, the exercise price was adjusted from $0.50 to $0.45.

Ezion is not the only company that adjusted the conversion terms of its warrants after a rights issue. Viking did the same after its rights-cum-warrant issue in May this year. Innopac also issued free warrants (but did not adjust the exercise price) after its rights issue in Jun this year.

Perhaps the most generous adjustments are made by Olam, which adjusts the conversion terms of its warrants even for ordinary dividends. For example, in Aug this year, Olam declared an interim dividend of SGD0.035. The exercise price was adjusted from USD1.12 to USD1.09 and the no. of warrants was increased by 1.8%.

Thus, there is a small cushion that warrants provide in the event of a rights issue.

Monday 4 September 2017

It Is Possible to Survive a Currency Depreciation

Since that fateful day when Britons voted for Brexit a year ago, the British Pound (GBP) has fallen by 11.8% against US Dollars. Worries about Singaporean companies' investments in UK were raised in the aftermath of the vote. However, the fall in GBP was small fry to one Singaporean company which faced much larger currency depreciation in the countries it invested in. The company is Food Empire, which derived 58% of its revenue from Russia and 13% from Ukraine in 2013. 

In Mar 2014, Russia annexed Crimea from Ukraine. International sanctions on Russia followed suit. Both the Russian Ruble (RUB) and Ukraine Hryvnia (UAH) fell against major currencies. Fig. 1 below shows the fall in RUB (blue line), UAH (red line) and GBP (orange line) against USD since Mar 2014. At the lowest point in Feb 2016, RUB fell by 60% while UAH fell by 70% against USD. In comparison, GBP's fall of 24% against USD over the same period appears mild. 

Fig. 1: Fall of RUB and UAH against USD

Food Empire, which derives the majority of its revenue from Russia and Ukraine, saw its earnings fell from a gain of USD11.3M in FY2013 to a loss of USD13.6M in FY2014. However, despite the continued depreciation of RUB and UAH, earnings began to recover for Food Empire. In FY2015, it narrowed the loss from USD13.6M to USD0.1M. By FY2016, it had recovered to a gain of USD13.8M, which was even more than in FY2013, even though neither RUB nor UAH had recovered to their previous values against USD.

Likewise, Food Empire's share price also followed its earnings. The share price fell from $0.535 in Dec 2013 to a low of $0.205 in Jan 2016 before staging a spectacular recovery to a high of $0.765 in May 2017. 

Fig. 2: Food Empire's Share Price Performance

When a currency depreciates in value relative to other currencies, there are usually 2 impacts -- accounting and economic. The accounting impact means that all assets, liabilities and cashflows denominated in that currency are worth less. However, such impact on assets and liabilities are usually one-off, unless the currency continues to depreciate.

The economic impact means that the real purchasing power of consumers in that country reduces and consumers are not able to afford as many as before the products that companies sell. However, such effects will also readjust themselves over time. When a currency depreciates, imports become more expensive and the real purchasing power of its consumers reduces. However, at the same time, exports also become cheaper and exporters can sell more products overseas and increase their earnings. The net effect of a currency depreciation is that imports will decrease while exports will increase, thus increasing the current account surplus of the country. Over time, a part of these surplus will be spent within the country, leading to a recovery of the real purchasing power of its consumers. Hence, eventually, the profits of companies selling products in the country will also recover.

Having said the above, not all companies will survive a currency depreciation. Those companies with large debts denominated in foreign currencies would have difficulties repaying the debts which have become much more expensive in local currencies. To avoid such situations, companies need to hedge their foreign currency exposure, either by entering into a currency swap, or by holding foreign assets denominated in the same currency. For example, if you take a GBP-denominated loan to buy a property in UK, the effect of the currency depreciation on the property and the loan will offset each other if the loan quantum matches the property price.

Thus, although a currency depreciation will lead to immediate losses for companies invested in a particular country, eventually, prices within the country will readjust and the companies could make normal profits again.

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