Creating Free Warrants: The Case of JSW Steel

On January 20, 2006, JSW Steel gave the following notice to the exchanges:

JSW Steel Limited has informed the Exchange that the Board at its meeting held on Jaunary 20,2006 has pursuant to section 81(1) of the Companies Act, 1956 has approved the issue of Equity Shares with Warrants on Rights basis to the existing shareholders of the Company. The total amount proposed to be raised by Rights issue of equity shares (excluding the amount of equity issue pursuant to conversion of warrants) shall not exceed a sum of Rs. 400 crores. The said Rights issue proceeds shall be utilized for part financing the Cold Rolling Mill Project of one million tpa capacity proposed to be set up at the Company’s manufacturing unit at Village Toranagallu, Bellary Dist, Karnataka at an estimated project cost of Rs. 1000 crores. The principal terms and conditions governing the issue of equity shares with warrants on rights basis are as under: The equity shares and warrants will be offered for subscription for cash on a record date (to be decided later) as under: (a) (1) Equity shares for every (8) Equity Shares held as on the Record Date and (1) Series A and (1) Series B Warrants for every fully paid up Equity Share being subscribed and allotted on Rights basis under this issue. (b) Each equity share shall be offered at a price to be determined (including the warrant conversion price) later by a Committee of Directors formed for this purpose. (c) Each warrant will entitle the holder thereof to apply for 1 (one) equity share of Rs. 10/- each at a price and on terms set forth below (i) Warrant Conversion Period for Series A Warrants shall be the period commencing after 18months from the Date of Allotment upto 36 months from the Date of Allotment. The Warrant Conversion Period for Series B Warrants shall be the period commencing after 24 months from the Date of Allotment upto 48 months from the Date of Allotment.

On January 30, 2006, the company filed the draft offer document with Securities and Exchange Board of India (SEBI) for the rights issue.

On February 27, 2006, the stock price of JSW Steel closed at Rs 203.55. That’s the date on which I wrote a note on a potential opportunity to acquire free warrants in the company.

Given that the current stock price of JSW Steel is Rs 303 per share, and the expected terms of the forthcoming rights issue, its now quite likely that the warrants would be free for investors who bought on or around the date of the note.

Here is the text of the note:

Note on JSW Steel Opportunity
By Sanjay Bakshi
February 27, 2006
JSW Steel Limited is planning a rights issue. Depending on the exact terms of the issue, we believe there may be a lucrative opportunity to acquire a zero-cost, or very low-cost, long-term warrants in this company.

When a company wishes to issue new shares to raise equity capital, it has to first offer them proportionately to its current shareholders. This “pre-emptive right” is granted to shareholders of all Indian companies by law. If the company wishes to issue shares to a different body of shareholders than its existing shareholders, this law requires the company to take prior approval from its current shareholders to waive off their pre-emptive right.

Obviously, like all options, this pre-emptive right to buy shares has value. So, when warrants are issued by a company, that action takes away the value of this pre-emptive right and transfers it to a separate certificate. Therefore, the value of the shares before issue of the warrants must equal the sum of (1) the value of the shares after such issue; and (2) the value of the warrants. At least that’s what the theory says.

Well, in practice, things don’t work out as the theory says. That’s because the theory assumes that markets are efficient and there is no difference between price and value. But the reality is quite different. Price and value often diverge by a large margin. And when value of a stock exceeds its price, the act of separating something valuable from that stock typically does not result in a compensating reduction in its price after the separation.

In the context of warrants this means that when the stock is cheap, the package of stock and warrants will tend to command a better price in the market than would the stock alone. This means that, under certain circumstances, it is possible to buy shares on cum basis, and sell them on ex basis at a price which implies acquisition of warrants at zero cost, or very low cost.

Before we return to warrants, however, we would offer two more applications of the above rule which we have profitably employed in the past. We want to do this to demonstrate the practical utility of the rule.

Dividend stripping

Cheap stocks often offer high dividend yields. If dividend cover is sufficient and its highly likely that the past dividend will be continued, then it’s possible to buy the stock on cum-dividend basis, and subsequently sell it on an ex-dividend basis at the same price, and strip the dividend for free. This approach has worked in spades in the past. The package of dividend plus ex-dividend stock price is worth more than the stock price before dividend.
Spin offs
When a cheap conglomerate company spins off a business division, then it is often possible to buy the stock of the conglomerate on a cum-deal basis, and subsequently sell it on an ex-deal basis, and get the shares of the newco for free, or almost free. There are plenty of examples of this working in the past. The package of newco and oldco shares commands a better price than the price of oldco alone.

JSW Steel Opportunity

This company is planning to raise a maximum of Rs 4 billion by offering shares to its existing shareholders. For every 8 shares held in the company, 1 share will be offered to the current shareholders at a price which is yet to be determined. And for every share subscribed, the company will allot 2 warrants. One of these warrants could be converted into one equity share 18 to 36 months from allotment. The other warrant could be converted into one equity share 24 to 48 months from allotment. The conversion price for both warrants will be at a discount to the stock price prevailing at the time of conversion. The extent of discount is yet to be determined. The warrants are adequately protected from corporate actions like stock splits, bonus issues, and further equity dilution. Moreover, the warrants shall be listed for trading soon after they have been allotted.

The exact terms of the right issue – in particular the price at which one share will be offered for every eight shares held, and the exact discount for pricing of warrants, will be announced shortly. Of the two, it’s the discount for pricing the warrants which is very important for the profitability of this operation. We expect the discount to be a minimum of 15%.

Assuming a discount of 15% and a stock price of Rs 300 at the time of conversion of the warrants (which is about 31 months from date of issue), the expected present value of two warrants allotted for every eight shares acquired comes to Rs 60 (assuming an opportunity cost of 15% p.a.).

The operation will involve the act of buying eight shares at Rs 205 on a cum-deal basis, selling nine shares on an ex-deal basis, at cost, and ending up owning the warrants for nothing. The basic assumption is that when the stock trades on ex-rights basis, the market would ignore the dilution factor caused by warrants. That is, nine shares in the company (eight bought from the market and one directly from the company) would sell for their cost, and two warrants would come for free. The reasoning behind this assumption has already been stated above. Specifically in this case, we expect the market to ignore the dilution factor due to warrants because of the following reasons:

  1. The underlying stock is ultra-cheap and the principle (when value of a stock exceeds its price, the act of separating something valuable from that stock typically does not result in a compensating reduction in its price after the separation) stated earlier is applicable.
  2. The warrants are of a long duration and uncertain subscription price.
  3. Only two warrants will be issued for every nine shares, so the extent of dilution is relatively small.
  4. If the stock price on ex-rights basis takes into account the value of the warrants also, then the stock will become ultra-cheap relative to current earning power, which will induce buying.

There are two ways this opportunity can be exploited. One would be from a pure arbitrage point of view. The other would be from an arbitrage plus straight equity viewpoint.

From the straight-equity-plus-arbitrage viewpoint, our recommendation is to buy the stock now. This will allow us to participate in the possible run-up of the stock price just before the stock turns ex-rights. Of course, this strategy also exposes us to market risk, which we believe, is worth taking in this case, given the inherent cheapness of the stock. If we are willing to take a market risk of about one month, then not only do we have a good change of getting the warrants for nothing, we are also likely to end up with a handsome profit on the straight equity component of the operation.

From a pure arbitrage viewpoint, we should buy just before the stock trades on ex-rights basis and sell it just after it turns ex-rights. Under this strategy, our intention will be to basically acquire the warrants at a zero-cost, or low cost basis. The chief advantage of the pure arbitrage approach over the other approach is that even in the worst case scenario i.e. even if the warrant dilution factor is factored in the pricing of stock on ex-rights basis, its hard to lose money.

This is just a preliminary note which will be updated as soon as the pricing information about the stock and warrants becomes available.

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