Investment Advisory Service

Saturday, 8 May 2010

Comparison of 2 quasi equity securities


Preference shares are quasi equity instruments which behave partly like equity shares and partly like debt instruments. They behave like debt instruments as they carry fixed dividend rates and the dividend is paid before any dividend can be paid to the equity shareholders.

They behave like equity instruments as the dividend is to be paid only out of distributable profits of the company and the dividend is not an obligation on the company unlike a debt instrument. Also, the preference shares carry the voting rights only in certain circumstances viz. non-payment of dividend.







Network 18 Media Investments Limited is a media conglomerate which has interests in CNBC TV 18, CNN IBN, Infomedia etc. The company issued NCCPS (Non Convertible Cumulative Preference Shares) in 2008 with the following terms.

Face Value : 150
Annual Dividend : 5%
Redemption Date : May 2013

This instrument offers 7.50 bucks of dividend every year and a redemption value of Rs 150. Currently it is trading at Rs 100. The annualized yield (including dividends) at this price works out to be 27% per annum for the next 4 years. Looks very attractive given the risk-reward ratio at the current market levels.

Where is the catch ? The company has been in red for the last several years. From 2005 till 2009, the company made profit  only in one year. For the current year too, the PAT has been negative for the last 3 quarters and the way it has been going , the business doesn't seem to be breaking even any time soon. This has made the company skip the dividend for the preference shares last year and most likely the dividend will be skipped this year too. The dividends are cumulative  in nature which means that any unpaid dividends need to be paid in the subsequent years.

But the absence of profits in the company puts the dividends and the redemption, both in jeopardy. Also, given that the Network 18 group knows the nuts and bolts of financial engineering very well, the risk of change in the terms of the preference shares can't be ruled out.

With these kinds of odds against the investment , sound sleep would be the first casualty.


Let's compare that with a relatively unknown company:







Sakuma Exports is a Mumbai based export house involved in the export of various products, especially agricultural commodities. 

The company issued CRPS ( Cumulative Redeemable Preference Shares) in 2006 with the following terms :

Face Value : 100

Annual Dividend : 5%

Redemption Date: Feb 2011

This instrument offers 5 bucks  of dividend every year and a redemption value of Rs 100. Currently it is trading at Rs 90. The annualized yield (including 2 dividends which are to be paid) at this price works out to be absolute 22% return in the next 10 months. That is an annualized yield of 26%.

The company is selling at an enterprise value of 34 crs and has cash and mutual funds of 60 crs. It's a cash bargain and the debt security of the same is available at 26% annualized yield. The total amount required for the redemption of the outstanding preference shares is 10 crs. Thus, 60 crs of cash equivalents amply cover the redemption of preference shares. In the past 3 years, the company has kept its promise of paying the dividends on time.

Moreover, look at this , this and this. The promoters' are buying the preference shares from the open market . This provides a lot of comfort for the impending redemption.

Variation in terms of the preference shares is a risk but given that the promoters' are buying it themselves, I would consider it very unlikely. Another risk could be the company going into losses in the coming quarters but that also seems hedged with the amount of cash the company has.

I would be very happy putting money in this security which not only provides good chances of the return on my capital but also return of my capital.







7 comments:

tanuj said...

Sec 87(2) companies act. Shareholders of Pref shares get the same voting rights as equity is the dividend remains unpaid on pref shares over 2 years. Would Network 18 risk that?

Ankur Jain said...

Hi Tanuj,

Thanks for informing about the Sec 87(2) of the companies act.

Network 18 promoters' have 52% stake in the equity shares of the company which will comfortably allow them to get the resolutions passed.

Also, the since the preference shares were issued on a rights basis, the promoters' will be holding around 50% of the preference shares as well.

I don't think voting rights being triggered on the preference shares will in any way jeopardise the position of the promoters.



Ankur

Raja Panda said...

Hi Ankur,

After you wrote this piece, a 5% dividend was paid by Sakura around July 10.
The redemption date is Feb 2011.
Whats the rationale behind adding '2 dividends which are to be paid' to the calculations ?
Are you expecting one more dividend from them ? If yes, when ?
Lovely blog. I hope you write more often :)
Regards
Raja

Ankur Jain said...

Thanks Raja.

2 dividends pertain to the years 2009-10 and 2010-11.

The dividend of Rs 5 which has been declared is for 2009-10. The second dividend will be paid on a pro-rata basis till the time of redemption. If the redemption happens by the end of Feb 2011, then an additional dividend of Rs 4.60 will be paid.

Mayur said...

what are the chances a company can default on preference shares???

Ankur Jain said...

Mayur,

The preference shares are junior to the debt and senior to the equity shares. They are quasi-equity securities which have a debt element in the form of a coupon and redemtpion period , if they are non-convetible.

The chances that a company could default on the preferred stock will depend on the ability of the company and the willingness of the promoters to pay.

The terms of the preferrred stock can be changed and possibly even a non-convertible preferred stock can be converted through a scheme of arrangement. In effect, everything is proabable and possible.

One needs to watch out and continuously evalaute the risk.

Mayur Jain said...

Thanks Ankur...