RR - Rolls-Royce

[Broeb22]

So the rights issue gives you rights to buy 10 new shares for every 3 you own at a steep discount to the market price - ~0.32 GBP instead of the current price of 1.45 GBP.

 

Isn't this a huge incentive to buy the shares currently? For every 3 shares you purchase @ 1.45 GBP, you get the right to buy 10 more at 0.32 GBP giving you a blended average cost of 0.58 GBP while the market value is 2.5x that price. As long as the market price remains above 0.32, shouldn't there be a bid for the shares to get these valuable rights?

 

Seems like a temporary technical lift to the stock and maybe why it's up 18% today. But the further it climbs, the more powerful that force becomes because the more valuable those rights are.

 

Makes one wonder what happens when the rights are issued/exercised though. Would that be the reversal of the trend?

 

It seemed like there were restrictions on US-based investors from investing through the rights offering. Is this correct/incorrect? I would like to invest via the rights offering, but don't think I can.

 

If US-based investors cannot invest, perhaps there is a weird arbitrage thing happening where some investors can't buy the rights but can buy shares and think the extra capital makes the investment case stronger, even at 1.45?

[TwoCitiesCapital]

So the rights issue gives you rights to buy 10 new shares for every 3 you own at a steep discount to the market price - ~0.32 GBP instead of the current price of 1.45 GBP.

 

Isn't this a huge incentive to buy the shares currently? For every 3 shares you purchase @ 1.45 GBP, you get the right to buy 10 more at 0.32 GBP giving you a blended average cost of 0.58 GBP while the market value is 2.5x that price. As long as the market price remains above 0.32, shouldn't there be a bid for the shares to get these valuable rights?

 

Seems like a temporary technical lift to the stock and maybe why it's up 18% today. But the further it climbs, the more powerful that force becomes because the more valuable those rights are.

 

Makes one wonder what happens when the rights are issued/exercised though. Would that be the reversal of the trend?

 

It seemed like there were restrictions on US-based investors from investing through the rights offering. Is this correct/incorrect? I would like to invest via the rights offering, but don't think I can.

 

If US-based investors cannot invest, perhaps there is a weird arbitrage thing happening where some investors can't buy the rights but can buy shares and think the extra capital makes the investment case stronger, even at 1.45?

 

I hadn't heard that, ,but then again it took a little bit for me to hear/see the full details of the rights offering.

 

Maybe it's only problematic if you own the ADRs? You'll probably receive a cash distribution from the sale of the rights, but I own the actual RR shares on the London exchange via my account @ Interactive Brokers so am expecting to still receive the rights unless if there is something I haven't yet heard.

[KJP]

 

Isn't this a huge incentive to buy the shares currently? For every 3 shares you purchase @ 1.45 GBP, you get the right to buy 10 more at 0.32 GBP giving you a blended average cost of 0.58 GBP while the market value is 2.5x that price. As long as the market price remains above 0.32, shouldn't there be a bid for the shares to get these valuable rights?

 

 

You are not accounting for the fact that post-rights offering the shares will not revert to their pre-offering price because of the dilution from the offering.  Here's the math behind a simple example:

 

1,000,000 shares outstanding at $1.45/share = Equity value of $1.45 million

3,333,333 shares issued at $0.32/share = Cash raised of $1,066,666

 

New shares 4,333,333; Assumed new equity value (old value + cash raised) = $2,516,667

 

New per share value = 2,516,667/4,333,333 = $.58 = blended cost basis of someone who fully subscribes under the terms you describe. 

 

Of course, the rights offering can create value by lowering the chances of default, and thus increasing new equity value by more than the cash raised.  But the price of the rights offering relative to the market price is irrelevant for shareholders who fully subscribe to their pro rate portion of the rights offering.  Of course, if you can't or don't fully subscribe, the price of the rights offering (and resulting dilution) are extremely important to you.  That's why transferability of the rights is important. 

 

It's also why Greenblatt advised looking for instances in which rights offerings are likely to be underscribed and insiders have agreed to not only fully subscribe but oversubscribe by taking up any unsubscribed portion.  That's insiders trying to transfer value to themselves (Malone/Jonas stuff).

[TwoCitiesCapital]

 

Isn't this a huge incentive to buy the shares currently? For every 3 shares you purchase @ 1.45 GBP, you get the right to buy 10 more at 0.32 GBP giving you a blended average cost of 0.58 GBP while the market value is 2.5x that price. As long as the market price remains above 0.32, shouldn't there be a bid for the shares to get these valuable rights?

 

 

You are not accounting for the fact that post-rights offering the shares will not revert to their pre-offering price because of the dilution from the offering.  Here's the math behind a simple example:

 

1,000,000 shares outstanding at $1.45/share = Equity value of $1.45 million

3,333,333 shares issued at $0.32/share = Cash raised of $1,066,666

 

New shares 4,333,333; Assumed new equity value (old value + cash raised) = $2,516,667

 

New per share value = 2,516,667/4,333,333 = $.58 = blended cost basis of someone who fully subscribes under the terms you describe. 

 

Of course, the rights offering can create value by lowering the chances of default, and thus increasing new equity value by more than the cash raised.  But the price of the rights offering relative to the market price is irrelevant for shareholders who fully subscribe to their pro rate portion of the rights offering.  Of course, if you can't or don't fully subscribe, the price of the rights offering (and resulting dilution) are extremely important to you.  That's why transferability of the rights is important. 

 

It's also why Greenblatt advised looking for instances in which rights offerings are likely to be underscribed and insiders have agreed to not only fully subscribe but oversubscribe by taking up any unsubscribed portion.  That's insiders trying to transfer value to themselves (Malone/Jonas stuff).

 

I understand those mechanics which is why I suggested it might revert post offering, but there's nothing that forces it to, right?

 

It's not like an ex-dividend where the company pays out $1.00 and the share price is reduced by a dollar. In this instance you're receiving rights steeply discounted from the market price and the share price isn't automatically reduced by that value, right? 

 

You can make the argument, as you've done, that the rights offering derisks the company and the share price could actually rise despite the dilution. Of course, I'm not saying it will happen, just that it's a possibility the rights offering in general can increase value despite dilution.

 

So, in this case, without an automatic mechanism to bring the share price down, is there not an incentive to buy the shares to get the deeply ITM rights on the cheap for incredibly cheap? And the further the shares rise, the more attractive those rights become fueling more buying?

 

Maybe the whole thing unwinds when the rights are distributed as everyone heads for the exits at once, but until then it seems it keeps a bid on the shares.

 

Why not buy a ton of shares, ride some of the technically driven buying upwards, buy protective puts before the official rights distribution date, and then sell the ITM rights when received to get most, if not all, of your capital back? Am I missing something mechanical here that brings all this down?

[TwoCitiesCapital]

As I've been mulling over this, I guess my main question was if everyone knows the dilution is coming, and by a calculable finite amount, why wouldn't the shares trade down instead of up by 50% and was trying to figure out why it's been rallying.

 

But I think I was just failing to put together all of the pieces properly like the de-risking and that it can't immediately trade down due to the rights still not being issued yet.

[MrB]

 

Isn't this a huge incentive to buy the shares currently? For every 3 shares you purchase @ 1.45 GBP, you get the right to buy 10 more at 0.32 GBP giving you a blended average cost of 0.58 GBP while the market value is 2.5x that price. As long as the market price remains above 0.32, shouldn't there be a bid for the shares to get these valuable rights?

 

 

You are not accounting for the fact that post-rights offering the shares will not revert to their pre-offering price because of the dilution from the offering.  Here's the math behind a simple example:

 

1,000,000 shares outstanding at $1.45/share = Equity value of $1.45 million

3,333,333 shares issued at $0.32/share = Cash raised of $1,066,666

 

New shares 4,333,333; Assumed new equity value (old value + cash raised) = $2,516,667

 

New per share value = 2,516,667/4,333,333 = $.58 = blended cost basis of someone who fully subscribes under the terms you describe. 

 

Of course, the rights offering can create value by lowering the chances of default, and thus increasing new equity value by more than the cash raised.  But the price of the rights offering relative to the market price is irrelevant for shareholders who fully subscribe to their pro rate portion of the rights offering.  Of course, if you can't or don't fully subscribe, the price of the rights offering (and resulting dilution) are extremely important to you.  That's why transferability of the rights is important. 

 

It's also why Greenblatt advised looking for instances in which rights offerings are likely to be underscribed and insiders have agreed to not only fully subscribe but oversubscribe by taking up any unsubscribed portion.  That's insiders trying to transfer value to themselves (Malone/Jonas stuff).

 

From spending 10 minutes scanning the reading the prospectus https://www.rolls-royce.com/investors/rights-issue/full-rights-issue.aspx

Clearly headlined with "Proposed 10 for 3 Rights Issue of up to 6,436,651,043 New Ordinary Shares at 32 pence

per New Ordinary Share" and page 11 "© Number of issued and fully paid securities As at the Latest Practicable Date, there were 1,930,995,313 Ordinary Shares in issue. Following the passing of the Ordinary Resolution at the General Meeting and pursuant to the Rights Issue, the Company will issue up to 6,436,651,043 New Ordinary Shares. The Rights Issue will be made on the basis of 10 New Ordinary Shares for every 3 Existing Ordinary Shares in the Company" or page 62 which lays it out nicely.

 

According to my (do your own work) reading..

 

1.9Bn shares @ today's price of GBP 1.50 = GBP 2.8Bn + rights of 32p * 6.43Bn shares (1.9Bn/3*10) or GBP 2Bn for a total of GBP4.9Bn.

GBP 4.9Bn/8.3Bn new total shares = 59p

 

P.S. Also 30Bn C shares and 1 special share (government) outstanding, but seems that you can ignore those...again that's my reading

 

 

Conclusion, TODAY the market is indicating a value of 59p for post rights issue shares, which is where you can expect them to trade.

[MrB]

Furthermore on p.19 of 2020H1 report they lay out the expected borrowings by Feb 2022 totalling GBP 6.5Bn. Looking at their balance sheet the cash is more than cancelled out by the contract liabilities (deferred revenue in my books), so very roughly EV is £11-£12Bn and Warren East is promising you £750m in FCF in 2022. So if all goes according to East's plan then you're buying at roughly 15x 2022 EV/FCF

 

Of course that is assuming you can get comfortable with their accounting; needs someone smarter than me...

 

Moving on....

[KJP]

As I've been mulling over this, I guess my main question was if everyone knows the dilution is coming, and by a calculable finite amount, why wouldn't the shares trade down instead of up by 50% and was trying to figure out why it's been rallying.

 

But I think I was just failing to put together all of the pieces properly like the de-risking and that it can't immediately trade down due to the rights still not being issued yet.

 

The quoted price of a publicly traded equity is just the last reported trade.  So, to the extent that nothing forces people to transact, then you're correct that there's nothing that forces the share price to account for the dilution, just as there is nothing that forces the share price to account for the dilution of a stock split.  But as a practical matter, prices generally do reflect these events once they occur. 

 

In general, in a value-neutral rights offering priced below the market price, the share price decline should not occur until the rights are issued, because the rights are valuable, thus pre-offering share price = post-offering share + value of right, which by hypothesis we've said is the same as the pre-announcement price because the offering is value neutral.

 

[SharperDingaan]

One might also want to consider that AFTER the 75%+ dilution, RR is NOT institutionally investable with 8.3B shares outstanding. There will have to be a material RS, and another material share issuance before this is eventually done. The only question is who is going to buy the shares that institutions are now forced to sell?  because RR no longer meets investment policy minimums. And how low does the price eventually go?

 

There is a reason for swing trading RR, and parking the proceeds in gilts.

No way you can be adequately compensated enough for the risk involved with continuing to hold.

 

SD

 

[ukvalueinvestment]

Can you expand on that?  Why would Rolls Royce not be investible by an institution?

[TwoCitiesCapital]

Can you expand on that?  Why would Rolls Royce not be investible by an institution?

 

My guess would due to the share price being so low.

 

Don't know what the rules are in the UK, but a lot of US pensions aren't allowed to own shares in penny stocks where that is defined as being anything less than $5/share. I think maybe RS in his message means "Reverse Split".

 

Back in 2009,  when Bank of America first breached $5/share it traded another 25% over the next 3 days  as many  institutional holders were forced to dump.

 

Shortly thereafter it breached $5 to the upside for 2 days before dumping another 41% over the next week - most of it occurring on the day that fell below $5 again. 

 

Those were volatile periods anyways, but it seemed to me, as someone who owned multiple financials at the time, that the volatility in BofA was being exacerbated by forced institutional selling.

 

My guess is that all the institutional holders are already gone though. I doubt the actual limit in the UK for "penny shares" is £1/share which is the only benchmark we currently exceed that wouldn't be maintained after the offering.

[SharperDingaan]

Correct. In Canada the minimum share price in most Investment Policies for a institutional financial is CAD 5/share. USD 5/share for the US. Probably around 1 pound/share for the UK, but need someone to confirm that.

 

There is some 'wiggle' room, but not a lot. In Canada, an average CAD 5/share over a 30 day period, No new purchases, up to 90 days to liquidate an existing position. For most, RR will very likely fall into the latter position. Sh1te does occasionally happen, and Investment Policies exist for a reason.

 

SD

[Spekulatius]

For reference, the largest bank in the UK -  Lloyds currently trades around 28 pence.

[TwoCitiesCapital]

Anybody have any good resources for seeing the characteristics on the warrants (like expiry and etc.)? IB isn't showing me anything other than details for the underlying stock from what I can see.

 

Just not familiar with sources for looking this sort of thing up in the U.K. and cant' seem to find any information on the security characteristics with google searches. 

 

Thanks for any resources you guys might have

[Broeb22]

https://seekingalpha.com/article/4384328-greenwood-investors-q3-2020-letter

 

Apparently Greenwood needed to add a Reflexivity Vulnerability filter to their process to avoid the Rolls-Royce's of the world.

[TwoCitiesCapital]

https://seekingalpha.com/article/4384328-greenwood-investors-q3-2020-letter

 

Apparently Greenwood needed to add a Reflexivity Vulnerability filter to their process to avoid the Rolls-Royce's of the world.

 

It's weird. I don't know what their cost basis was, but I remember reading their analysis when the shares were like 2.80 GBP/share where they said they had added to the position and actually were expecting near term weakness to take it back to below those 2.00 GBP levels where they would continue to add.

 

Maybe they didn't think a capital raise was in the cards, but even with the capital raise the shares are significantly higher than 2.00 GBP/share on an adjusted basis (~3.69 GBP/share). If they participate in the rights offering or sell the rights, they have made MORE money on this position than they had when it was 2.80 GBP/share pre-offering when this wasn't yet considered a failure requiring a new screen to their investment process.

 

Ultimately, it seems to me the only mistake was failing to immediately see the potential impact that COVID would have on international travel before the shares tanked. Otherwise, any subsequent purchases made after the initial crash, but before the announcement of the share offering, are probably in the money (or flat at worse!) and that's hard for me to call that an investment mistake.

 

 

 

[Broeb22]

https://seekingalpha.com/article/4384328-greenwood-investors-q3-2020-letter

 

Apparently Greenwood needed to add a Reflexivity Vulnerability filter to their process to avoid the Rolls-Royce's of the world.

 

It's weird. I don't know what their cost basis was, but I remember reading their analysis when the shares were like 2.80 GBP/share where they said they had added to the position and actually were expecting near term weakness to take it back to below those 2.00 GBP levels where they would continue to add.

 

Maybe they didn't think a capital raise was in the cards, but even with the capital raise the shares are significantly higher than 2.00 GBP/share on an adjusted basis (~3.69 GBP/share). If they participate in the rights offering or sell the rights, they have made MORE money on this position than they had when it was 2.80 GBP/share pre-offering when this wasn't yet considered a failure requiring a new screen to their investment process.

 

Ultimately, it seems to me the only mistake was failing to immediately see the potential impact that COVID would have on international travel before the shares tanked. Otherwise, any subsequent purchases made after the initial crash, but before the announcement of the share offering, are probably in the money (or flat at worse!) and that's hard for me to call that an investment mistake.

 

They've been in Rolls for years. Steven pitched my boss at the time on it in summer 2016. So unless he significantly traded around it or averaged way down, he's probably sitting on a loss.

[TwoCitiesCapital]

https://seekingalpha.com/article/4384328-greenwood-investors-q3-2020-letter

 

Apparently Greenwood needed to add a Reflexivity Vulnerability filter to their process to avoid the Rolls-Royce's of the world.

 

It's weird. I don't know what their cost basis was, but I remember reading their analysis when the shares were like 2.80 GBP/share where they said they had added to the position and actually were expecting near term weakness to take it back to below those 2.00 GBP levels where they would continue to add.

 

Maybe they didn't think a capital raise was in the cards, but even with the capital raise the shares are significantly higher than 2.00 GBP/share on an adjusted basis (~3.69 GBP/share). If they participate in the rights offering or sell the rights, they have made MORE money on this position than they had when it was 2.80 GBP/share pre-offering when this wasn't yet considered a failure requiring a new screen to their investment process.

 

Ultimately, it seems to me the only mistake was failing to immediately see the potential impact that COVID would have on international travel before the shares tanked. Otherwise, any subsequent purchases made after the initial crash, but before the announcement of the share offering, are probably in the money (or flat at worse!) and that's hard for me to call that an investment mistake.

 

They've been in Rolls for years. Steven pitched my boss at the time on it in summer 2016. So unless he significantly traded around it or averaged way down, he's probably sitting on a loss.

 

Sure - my point wasn't to say they made money or not cuz I don't know they're average cost.

 

What I do know is that they're over 30% ahead of where they were earlier in the year when they said that they expected it to trade lower and would add to the name and still saw substantial upside.

 

So it's just weird to me that we're sitting 30+% higher than when they said all of that and now is when they're saying it was a mistake? It traded down like they thought it would. It traded back up like they thought it would. It's been derisked at some expense to future gains, but the outcome is also far more certain at this point now that insolvency is off the table so it's arguably less risky (and less reward), but seems to me like their moves have been right in the nose post-COVID and the only problem was COVID - not some reflexivity that could have been foreseen by a checkbox on a list.

[Broeb22]

A cyclical business model with operating leverage and financial leverage crashing and burning? Could have been explosive to the upside but that’s the risk you run with that combination of factors, especially in a pandemic.

[rb]

A cyclical business model with operating leverage and financial leverage crashing and burning? Could have been explosive to the upside but that’s the risk you run with that combination of factors, especially in a pandemic.

How was this a levered up cyclical business model? This was sail on sail. Pretty much the only thing that would have fucked it up was a global pandemic.

[Broeb22]

A cyclical business model with operating leverage and financial leverage crashing and burning? Could have been explosive to the upside but that’s the risk you run with that combination of factors, especially in a pandemic.

How was this a levered up cyclical business model? This was sail on sail. Pretty much the only thing that would have fucked it up was a global pandemic.

 

I'll bet this isn't your first time believing things would go "sail on sail" and they went the exact opposite.

 

They had a net debt position and there are massive development costs not to mention massive liabilities when you screw up your design as Rolls has done repeatedly. Oh, and the "impossible to predict" pandemic is just one of several events that could have caused this result. Everyone is always going to say "if this didn't happen then it would have worked". That reasoning sucks if those kinds of things happen infrequently but pretty regularly (namely terrorism/war, disease/pandemic, economic recession, poor plane/engine design, etc.). Spare me your sob story "this pandemic was the only thing" bullshit. Be more creative when thinking about the risks to your thesis.

[kab60]

A cyclical business model with operating leverage and financial leverage crashing and burning? Could have been explosive to the upside but that’s the risk you run with that combination of factors, especially in a pandemic.

How was this a levered up cyclical business model? This was sail on sail. Pretty much the only thing that would have fucked it up was a global pandemic.

 

I'll bet this isn't your first time believing things would go "sail on sail" and they went the exact opposite.

 

They had a net debt position and there are massive development costs not to mention massive liabilities when you screw up your design as Rolls has done repeatedly. Oh, and the "impossible to predict" pandemic is just one of several events that could have caused this result. Everyone is always going to say "if this didn't happen then it would have worked". That reasoning sucks if those kinds of things happen infrequently but pretty regularly (namely terrorism/war, disease/pandemic, economic recession, poor plane/engine design, etc.). Spare me your sob story "this pandemic was the only thing" bullshit. Be more creative when thinking about the risks to your thesis.

While I basically agree on your points, and appreciate them, what's up with the hostility? I think that was uncalled for.

[colinwalt]

While I basically agree on your points, and appreciate them, what's up with the hostility? I think that was uncalled for.

 

+1

[Broeb22]

A cyclical business model with operating leverage and financial leverage crashing and burning? Could have been explosive to the upside but that’s the risk you run with that combination of factors, especially in a pandemic.

How was this a levered up cyclical business model? This was sail on sail. Pretty much the only thing that would have fucked it up was a global pandemic.

 

I'll bet this isn't your first time believing things would go "sail on sail" and they went the exact opposite.

 

They had a net debt position and there are massive development costs not to mention massive liabilities when you screw up your design as Rolls has done repeatedly. Oh, and the "impossible to predict" pandemic is just one of several events that could have caused this result. Everyone is always going to say "if this didn't happen then it would have worked". That reasoning sucks if those kinds of things happen infrequently but pretty regularly (namely terrorism/war, disease/pandemic, economic recession, poor plane/engine design, etc.). Spare me your sob story "this pandemic was the only thing" bullshit. Be more creative when thinking about the risks to your thesis.

While I basically agree on your points, and appreciate them, what's up with the hostility? I think that was uncalled for.

 

Maybe I'm getting a little jumpy behind the keyboard. I'm sorry rb for how I worded that. I probably could have gotten the same message across in a better way.

 

[rb]

No worries. I get a little spicy at times myself.