Tuesday, February 4, 2014

Wheels India Rights Issue – A Free Lunch for minority investors??

Wheels India has announced a rights issue only for minority investors, which seems to present an interesting opportunity.

However, before we get into the discussion, let us quickly talk about the opportunity in rights issues in general. Those who know about rights issues can jump forward to the next section on the specific opportunity in Wheels India.

How rights issues work

Let us say Company X has 1 cr shares outstanding with a CMP of Rs. 200. Since the company wants to raise additional funds from the market it announces a rights issue whereby the shareholders have the right to subscribe to, say 2 additional shares for each share held at a price of Rs 100 per share.

How can you participate in this opportunity? While many others have also explained this in the past, the following is the way in which we evaluate this.

Step 1: Buy 1 share before the record date at a cum rights price of Rs 200

Step 2: On the day the stock goes ex rights, you have the choice of selling this share in the open market. You should do this only on the ex date or thereafter and thus retain the right to participate in the rights issue. At what price will you be able to sell this 1 share?? The theoretical price on ex date will be determined as per the formulae by the exchange

[(Pre dilution no of shares x cum rights price)+(New shares issued x Price at which issued)]
Fully diluted no of shares

In the above example this should be [(1 x 200) + (2 x 100)]/3 = 400/3 = Rs 133.33. While this is the theoretical ex rights price, the price at which you will actually be able to sell your share will of course be decided by the market. In cases that we have followed in the past, the market has generally allowed an exit at or about this theoretical ex rights price. Let us assume that we are able to sell at this price ie Rs 133.33. Therefore, we have booked a loss upfront on this 1 share of Rs 66.67 (Rs 200-Rs 133.33). What have we got in exchange?? We have bought the right to buy 2 shares at Rs 100 each. You can also think about this as similar to having bought a call option with a right to buy 2 shares at an exercise price of Rs 100 and a premium paid upfront of Rs 66.67.

Step 3: The company will announce a period during which you can make your application. Let us assume that there is no change in the market price which if you now remember is at Rs 133.33. You go ahead and make your application to buy 2 shares. You can also bid for additional shares which you should at this stage. Some investors may not choose to bid for their entitled shares. These shares get allotted to those who bid additionally on a pro rata basis.

Step 4: Receive your 2 entitled shares and let us say 1 additional share (assumed). Sell these shares at CMP which if there is no price movement in this case is Rs 133.33. So how does the final math work? On your original entitlement of 2 shares you make [(133.33 – 100)*2] = Rs 66.67. However, if you remember you had already booked a loss originally in Step 2 of the same amount. Thus on the original entitlement there is no arbitrage returns on a theoretical basis. The returns on this trade would come entirely from the profit generated on the sale of the additional 1 share on which you make [(133.33 – 100)*1] = Rs 33.33.

Thus if all goes as per above assumptions you make a return of 16.67% on your original investment (33.33/200). What can go wrong?? Firstly, there is no science to confirm what will be the additional shares allotted and thus there is no way to compute the expected return outcome. If too few people let go of their rights or too many people think like you and bid additionally, overallotment might be quite low. Secondly, the outcome would also depend on the prices at which you are able to exit your various positions at multiple stages. In the above example, the ex price has been assumed to remain constant. However, as we all know markets are anything but stationary.

The Wheels India Opportunity and why it is different..

First a quick background. In the various alternatives that SEBI had provided promoters to bring their shareholding within the regulatory limit of 75%, one was allotting rights only to minority shareholders. Thus, in these issues, the promoters forego their rights entitlement and only the residual shareholders participate in such a way that post issue promoter shareholding is brought down to less than 75%. In the case of Wheels India, promoter (TVS group + Titan International) is at 91.44%. The promoters have thus chosen to use the rights to minority holders as the route to bring down their shareholding also presumably raising much needed funds for the company (to pay down existing debt) in the bargain. They have now spelled out the terms of this issue in this announcement.

So what are the facts?

CMP 825 (A)
Current o/s Equity : 9869444 shares (B)
Fresh Issue : 2162835 shares (C)
Diluted Equity = B+C = 12032279 shares (D)
Issue Price 400 (E)
Record Date for entitlement : February 14th 2014

If you were to work the above explained math for Wheels, how will it look? So let us say you buy 20 shares at CMP which will give you a right to subscribe to 51 shares subsequently at issue price. Total cost of purchase will be (825 x 20) = Rs 16500/- Since we will look to sell these 20 shares on the ex date, what should be the theoretical ex price. As per the formulae it should be [(B x A) + (C x E)]/D = 749. While all other things are constant, the CMP would of course keep changing going into the last cum day and thus this ex price would change accordingly.

Now if you are able to sell your 20 shares at this ex price viz 749, you would book an upfront loss of Rs 1528 [(825-749)*20] on your investment of Rs 16500/-. This as discussed is akin to paying a premium for buying a call option for the right to buy 51 shares subsequently at an exercise price of Rs 400 per share.

Subsequent to the issue, if you are able to sell these 51 shares at the same ex right price viz 749, you would make a profit of Rs 17799/- explained as [(749-400)*51]. Net of your loss of Rs 1528 booked earlier, you would still be left with a profit of Rs 16271/- leading to a theoretical return of roughly 98% on your investment of Rs 16500/-!!!

WTF...Had we not mentioned earlier that there is no theoretical arbitrage on the original entitlement?? The reason why this is there in this case is because this issue is only for minority investors and the promoters are foregoing their entitlement, which is what is different in the Wheels India rights issue. Of course the returns will look even more ballistic if we were to start using some estimates of overallotment and further profit on those shares!!

The basic point is as under. If you were to divide potential profits from rights issues into entitlement shares and additional shares, in normal issues almost no returns can be made on your entitlement. The only returns are on additional shares if you get allotted any. Here, the entitlement shares itself seem to be suggesting supernormal returns. Any additional shares will only add to the math.

So what are the risks and where can things go wrong?? The key to these returns would of course be the price at which you are able to exit the trade at various stages. While the current math looks like as we have explained, what do the fundamentals say?? Can we get some sense as to what could be a fundamental fair value??

While we would urge you to read more about the company from public sources, Wheels India is an auto ancillary in the production of steel and aluminium wheel rims. It derives its revenues primarily from selling to OEMs in the various vehicle segments of CV, Buses, cars, 2 wheelers and tractors. Exports form roughly 20% of sales. Given the recent weakness in the auto sector, near term nos are nothing to write home about. However, the company is still trending towards making some 140 – 150 cr of EBIDTA on nearly 2000 cr of sales at some 70% capacity utilisations. Being largely a fixed cost business change in utilisation can obviously lead to both positive or negative operating leverage. While it is obvious that it is no generic me-too business neither is it a great business. Historical ROCE/ROEs are in the early teens suggesting high capital intensity. Debt is at roughly 475 cr on a market cap of roughly 800 cr providing an EV of ~ 1275 cr translating to an EBIDTA multiple of ~ 8.5x.

The way we would like to look at this is question what happens in a worst case scenario. The worst case would be if we subscribe to our rights shares and subsequently the price falls leaving insufficient profits or for that matter losses, leaving us holding those shares. Would the loss in that situation likely be ‘permanent’ or temporary?

We have earlier written that when you sell your original 20 shares at 749 (assumed ex price) you book a loss of Rs. 1528/- (para marked in red). Since this translates to a right to buy 51 shares, the per share cost is [1528/51] ~ Rs 30/-. The total cost per right share for you is Rs 430/- (explained as Rs 400+ Rs 30). You will start making a loss in this trade only if the price falls below Rs 430/- under the above assumptions. This translates to a fall of more than 40% from the theoretical ex rights price of Rs 749/- within a span of 1 month (rights allotment after issue generally takes 15 days while new shares might take 1-2 more weeks to get listed) for you to start making losses. Can it happen?? Of course it can..However, we are comforted by the fact that at a price of Rs 430/- Wheels India would be available at roughly 6 times EV/EBIDTA which may start interesting value investors.

Opinions from the investor community would as always help us analyse this situation better!!

Best of Manufactured Luck!!

Disclosure: Long


  1. Looks like a good risk arb opportunity. Just 1 question (that is the risk)-

    Imagine currently this is selling at 400 Rs per share. Will you buy it then??
    If no, then are we not hoping (praying) that the stock won't fall before we sell completely.

    1. Thanks JK,

      We cant be sure of the outcome and thus dont think that it is a riskless trade. We cant forecast wether Wheels India at a price of 400-450 will or will not interest somebody, just as we cannot explain why it had been trading at close to 700 even prior to the rights issue announcement. There are a lot of stocks which we find expensive but the market still buys them. Likewise we find some stocks quite cheap but market for some reason does not agree :) The only thing possible to judge is wether the risk reward is favorable and thus size your position accordingly.

      Also, stock price in these situations can fall rapidly if a lot of arbitrageurs are simultaneously seeking exit. The last couple of months of delivery volumes do not seem to suggest any meaningful interest from them so far.

  2. It is a very good thought provoking analysis...... but instead of decrease in price in last 3 trading sessions price has reached to 1050 and also volume from avg 8-9k to 49k, 129k & 28k.....can u plz share ur thoughts on this and how this will impact the arbitrage opportunity??

    1. Hi Jitendra,

      Thanks for your comments. Sharp movements accompanied with high volume but low delivery % age is making us increasingly risk averse. While in theory the arbitrage continues to remain interesting but since healthy returns seem to have been made upfront, we are asking ourselves whether 'a bird in hand is better than two in the bush'. As always make your own judgement backed by independent analysis..

  3. Hi Abhinav/Niren,

    Thanks for the great analysis of the Wheels rights issue. Would like to know your views on the Piramal Glass delisting as well.

    1. Hi Gaurav,

      Glad you liked the piece. Without specific view on Piramal Glass, we are not big fans of the delisting theme. You can read our earlier piece on the blog titled 'Extraordinary popular Delusions" to get a gist of our thoughts..

  4. With the closing cum rights price of 1054.55, the theoretical ex-rights price works out to be 936.89. However, the stock today is in a downward freeze at 749.55. With this momentum, I don't think the market will allow an exit at or about this theoretical ex-rights price as of now but seems it may drift toward ~500+ in another day, to match the diluted price with the market price before rights announcement. Let's see.

  5. Ex-Rights price seems to be settling at Rs.650. It will drop further when the rights shares are allotted and become tradeable. Assuming cum-rights price of Rs.1,050, the break even point of selling cum-rights vs ex-rights is as below.

    Loss on 20 shares for selling ex-rights = 20 x (650-1050) = Rs.8,000
    Profit Required to recover the above = 51 x (556.86-400) = Rs.8,000

    So the million dollar (or 8,000 rupees) question is will the price remain above Rs.557 when the rights shares come into the market.

  6. Hi, I have a general question regarding the subscription in the right issue. If in a company right issue is under-subscribed. Can willing public participants and promoters apply for remaining offer shares on pro rata basis at the same time?

    1. Yes. However, the basis of pro rata allotment is the no. of shares as on the record day and not the number of times overbid..

  7. Hi, You have mentioned that You are long on Wheels India. Presently it is at 550+. are you accumulating at this price?

  8. Hi, Interesting special situation. Looking back how did it work out ? I see that the price is 740 now so it has been a good trade, also what is the taxation impact?

  9. Hi, any view on the Can fin homes rights issue?

  10. Hi,
    in the example you have mentioned the return as 33/200 = 16.67% but shouldnt the return be 33/300 = 11% as any gain is coming only from the additional shares received.

    1. Hi carpedious,

      We have used 200 in the denominator as that is the total amount of risk capital. The capital outlay on account of the additional shares has no downside risk to it, but only has an opportunity cost element to it and thus has been ignored.

      Rather than the percentage return generated, it might be useful to think about the absolute return instead since denominator can change based on your judgement of the capital outlay in this trade.

      Thanks for your thoughts.

  11. very informative, thanks for such a good article