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Rights or rites?

European companies have embraced rights issues as a great way to fix up troubled balance sheets and fund acquisitions. The deals, however, are sometimes not nearly as helpful to investors.

Bleeding kronor during the telecommunications meltdown, the Swedish phone maker L.M. Ericsson Telefonaktiebolaget called up what has become an increasingly commonplace strategy. In July 2002 it offered shareholders a chance to buy additional shares at a 70 percent discount. In a one-for-one share offering that diluted its shareholder equity by half, Ericsson raised $3.2 billion. The company was reeling, and it was far from clear that the shares were a bargain even at that price. But investors who answered the call and bought at the offering price of 3.60 Swedish kronor ($0.38) by the September 3 expiration date were handsomely rewarded. By early October 2004, Ericsson's shares were trading above SKr23, a more-than-sixfold gain.

"We knew the company had severe difficulties," recalls Robert Revel-Chion, European portfolio manager at T. Rowe Price Group, which has $1 billion under management in European stocks. "But we subscribed to Ericsson's rights issue because we felt the company, with its new capital infusion, could sustain its leading infrastructure status and remain a profitable operation."

But rights offerings, also known as cash calls, don't always work out that well. Consider Royal Ahold's deal. Disclosure of a billion-euro accounting scandal left the Dutch retailer on the brink of bankruptcy toward the end of 2003. In early December of that year, under the leadership of a new CEO and senior management, Ahold lined up a syndicate of banks to underwrite a rights offering in which the company would issue 66 percent more shares, at a 40 percent discount. The $3.4 billion rights issue closed in mid-December with nearly 95 percent of existing shareholders subscribing to it. But by September 2004 intensifying competition in the U.S., where Ahold pulls in more than half its revenues, had depressed profits. The company's stock was trading nearly a third below the share price before the offering was announced and just 14.6 percent above the discounted price.

Troubled companies typically use rights issues to pay down debt, especially when other borrowing options have been foreclosed. Healthy companies use them as a way to fund acquisitions. Because shareholders receive additional shares at a discount, a rights issue, unlike a secondary offering, prevents the dilution of existing positions for investors who choose to subscribe.

For the most part, U.S. companies have steered clear of rights issues. That's largely because even troubled U.S. corporations can issue high-yield debt in the liquid domestic bond market. But in foreign debt markets, which are less liquid, more and more European and Asian companies are deploying rights issues. They accounted for 50 percent of the $109 billion in European equity offerings in 2003, up from just 7 percent in 2000. For the 12 months ended June 30, 2004, Australian rights issues totaled a record A$10.1 billion ($6.97 billion), up from A$1.95 billion in 2001, and accounted for nearly a third of all equity offerings.

"Driving the surge in European and Asian rights issues has been an acute need to repair broken balance sheets," says Viswas Raghavan, head of European capital markets at J.P. Morgan Chase & Co. in London. Graham Secker, U.K. strategist at Morgan Stanley, points out that a jump in rights issues "usually coincides with the bottoming of the market." This year through August, European rights issues totaled $19.7 billion and represented 21 percent of all European equity offerings as stocks rallied from their first-quarter 2003 lows.

Among the firms that have financed expansion with rights issues is Australia & New Zealand Bank. Its $1.8 billion, two-for-11 offering, announced in October 2003, helped it buy out the National Bank of New Zealand. Propelled by the continued strength of the Australian and New Zealand economies, A&NZ's shares are up 42 percent from the offering price as of early October.

When a rights offering is announced, shareholders can subscribe to the issue, sell the rights or get out of the stock altogether before the dilution takes effect. Andrew Sawers, a London-based financial analyst, offers the hypothetical case of a company with 100 million shares selling at a share price of 100 pence before the announcement of a rights issue. If the firm is seeking to raise £20 million through a one-to-four offering at a 20 percent discount, and assuming no extraordinary news alters the underlying value of the stock, this dilution would produce an ex-rights price of 96 pence. This is derived simply by dividing the company's new market capitalization by the total number of outstanding shares. In this example it's easy to see how investors could find themselves in the red soon after subscribing to the rights issue -- a decline of 4 percent is all it would take.

Analysts recommend recalibrating P&Ls to discern the fundamental impact of dilution on a per-share basis. When a rights issue is used to pare down debt, a key benefit is reduced interest expense and improved earnings ratios. But these improvements will prove ephemeral if the cash call isn't part of an overall strategy that strengthens profitability.

As shareholders consider whether or not to subscribe, they must also bear in mind that shorting is commonplace after a rights issue is launched. "Trading on the back of rights issues is one of the most profitable plays a hedge fund can make," says Alexander Davidson, a London-based consultant at Complinet, a financial services research firm. "The fund is betting that a cash call will not be adequate to address a company's underlying problems, and that the stock will suffer further price erosion."

Not surprisingly, rights issues tend to do well when shareholders widely support the strategy. David Riedel, who runs Riedel Research Group, a New York­based equity research firm that focuses on Asian securities, cites the example of True Corp., a leading Thai telecom service provider with a market cap of $314 million. It made a $67 million rights offering in early August as part of an overall restructuring of its balance sheet. CP International, a Thai investing group that owns 44 percent of the company, and KfW Bankengruppe, a private German investing group that has a 19 percent stake, backed the deal from the start. True shares quickly tumbled, as shares often do after a rights issue, dropping 30 percent from the preannounced, discounted price of 5 Thai baht ($0.12) on August 4, 2004. But the market soon acknowledged the overall soundness of the company's financial strategy. In just over a month, by September 9, True was trading at B5.4.

Matthew Dennis, European portfolio manager at AIM Funds in London, avoids bailout issues, careful not to plow good money after bad. For example, in October 2003, German reinsurer Munich Re Group announced a two-for-seven, $4.6 billion cash call. At the time of the announcement, shares were trading at E95.27 ($111.70). A year later the price slid to E77.04. The slide reflected continued weakness in the company's reserves and higher-than-expected costs.

In one of the few long-term studies of rights issues that have been conducted, Simon Harris, head of investments in the London office of Grantham, Mayo & Otterloo, a Boston-based money manager, tracked 1,850 U.K. rights issues over 27 years through 2001. Harris found that these companies outperformed the market by 8 percent per annum during the two years before the announcement but trailed the market by an average of 4 percent annually over five years following the issue. He found comparable results among European offerings.

"When the rights issues were used for expansion," Harris explains, "management was often exploiting what it perceived to be an overvaluation of its share price to invest in projects that subsequently produced disappointing returns." He adds that in instances where companies used a rights issue to deleverage a troubled balance sheet, the stock's subsequent underperformance often reflected management's failure to address the underlying problems that had weakened the balance sheet in the first place.

Studying 437 European offerings made during the eight years ended August 2004, Daniel Bostrom, the London-based European strategist at Morgan Stanley, reported more sanguine results. An equally weighted portfolio underperformed the market before the rights issue and outperformed the market after the offering, Bostrom found. However, the strategist notes that "outperformance was generated by a small number of companies whose shares soared, subsequently outweighing the bulk of shares, which performed more in line with Harris's results."

Most critically, shareholders need to discern the purpose of additional capital before they accept or reject a rights issue. "It's easy for investors to be tempted by the prospect of buying shares at a substantial discount," says Morgan Stanley's Secker. "But if the issuer doesn't lay out a compelling explanation for why the offering and dilution are necessary as part of a strategically sound recovery plan, then shareholders should be cautious -- very cautious."