You would have heard about Reliance Industries’s mega Rights Issue in the recent days. If you are wondering what a Rights Issue means or if you are contemplating on exercising your rights, this article would help you gain useful information on it.
What Is A Rights Issue?
A Rights Issue is an offer of additional shares at a discounted price, provided by publicly listed companies on stock exchanges. Only the existing shareholders of the company are eligible to exercise the right to accept the offer. The existing shareholder holds a right and not an obligation to accept the additional shares. When the offer is made, a criteria can be set on how many shares are offered for every X number of shares that the shareholders holds. For example, a criteria can have a ratio 1:5 i.e., 1 share is offered for every 5 shares you hold. So if you have 18 shares, you are eligible for 3 shares, but if you have 4 or less, you are not eligible for the rights issue. In some cases, the shareholders can sell their right to another eligible shareholder for a premium if they are not interested in exercising their right. These are called renounce-able rights. If the rights cannot be transferred, they are called non-renounce-able rights.
Why Does A Company Offer Rights?
A company offers a Rights Issue to generate cash. The need could be to reduce debt, to support operating costs, to fund capex or to fund acquisitions. Rights Issue is generally not viewed as a positive action from the market’s perspective due to the fact that the company does not have adequate money to fund whatever their intentions are and has to raise capital from its shareholders. But it should not always be considered negative, if the additional capital ultimately helps to improve the profitability of the company. This would depend on the current balance sheet strength of the company.
Reliance Industries Rights Issue - A Review
The record date of Rights Issue ended on May 14th, 2020, meaning only those who have the shares in their DEMAT account as of May 14th are eligible for the issue. The rights subscription is open from May 20th, 2020 to May 29th, 2020. Reliance offers the shares at Rupees 1,257/share. The rights ratio is 1:15, i.e., you are eligible for 1 share for every 15 shares you hold. This is at a discounted price as compared with the market price, which is pricier as on the date this article was published.
Though, you would be lapping up the shares at a discounted price, you need to understand if this is beneficial to you as an investor depending on why Reliance could be offering the rights. Let us see the recent developments and news surrounding Reliance prior to the rights issue.
Reliance has been in a capital raising spree over the past few weeks. It has roped in Facebook, Silver Lake etc to buy a sizeable stake in Jio. It has also announced allotment of Rupees 3600 Crore worth unsecured, redeemable NCDs (Non-Convertible Debentures). The proposed Rights Issue would raise Rupees 53,125 Crore. It is expected that Reliance would use the capital to pay off debts in its target of becoming a zero net debt company. So this is the broadly circulated news. Paying off debts is a very good thing, especially under the current COVID situation, because this would lighten the load weighing on Reliance and put them in a better position to use their free cash flow in expanding their business once the economy recovers.
But there are other things to consider. First and foremost, the EPS dilution. EPS is Earnings Per Share. It is a fundamental metric used to determine the health of a company. Higher the EPS, the better it is. When Rights are issued, the number of shares increases, leading to an erosion of EPS. Hence technically, your share is worth less.
Also, generally during rights issues, since portion of the shares are bought at a discount and since EPS is reduced, the market participants tend to sell the additional shares to profit out of the difference in the rights price and the market price which is higher. Eventually, this causes the share price to drop to levels near to the issue price itself once the subscription is over.
Secondly, it is also known that Reliance is largely expected by the market to float an IPO for Jio. In such a case, Reliance could act as a holding company which presents a consolidated balance sheet of various businesses, somewhat similar to Tata Sons. If this does happen, we can expect an equity split on Reliance, which could potentially reduce investor participation, in other words, equity dilution. Generally equity dilution is perceived to cause pressure on the stock’s valuation.
On the other hand, in a seemingly unrelated news/perception, Government of India had announced that IBC(Insolvency and Bankruptcy Code) is suspended for an year as part of the COVID stimulus package. This is in addition to the moratorium of interest payments on loans, that is already announced. So obviously there is no incentive for Reliance to pay off debts in the short term. Instead the additional liquidity can be used for other purposes such as capital expenditures(CapEx) or for acquisitions. In line with this possibility, the Government of India has also announced privatisation of key sectors. So could it be a possibility that Reliance could use the capital raised via stake sale and rights issue to fund capital expenditures or acquisitions in these newly privatised sectors? Maybe or maybe not, but assuming if this is indeed the case, how does this affect investors in their decision to subscribe for the rights issue?
Well, if you take it on face value, diversification is an excellent way to grow your business and is definitely a plus for the long term. BUT, in the short term, it might not be so. During every capex cycle or acquisition, the company needs time to improve the efficiency of the new venture. It takes time to extract optimal revenue from these new projects and due to this fact, there will be pressure on revenue and profitability initially. The market tends to discount this loss in profitability and react negatively. This could cause the stock price to be under pressure on the short term.
Final Take
In summary, considering the EPS erosion and the tendency of investors to sell and book profits after the issue subscription and also by considering the intuitive yet highly speculative CapEx possibility explained above, an investor can decide to skip the subscription. In addition there is also some economic uncertainty adding to difficulty of doing business in the current environment. You could always buy the shares in the regular market once you get more clarity on how these funds get used in reality. If the stock does come under selling pressure, you could even buy it cheaper than the issue price, but that isn't a guarantee. But do note that, the promoter group has anyway announced that they will buy unsold shares of the issue themselves which is inherently positive and all mainstream media has given a thumbs up on the issue. But this article has a contrarian opinion on the short term, while bullish on the long term, but does not recommend for or against any decision, as it is the sole discretion of the investor.
Hope this article helps in adding another dimension to the thought process!
Wonderful article covering the basics of Rights issue and expressing your view about this. Very useful and informative.