Nothing Ventured, Something Gained: The Titan Industries Special Situation

On August 31, 2005, Titan Industries made the following announcement to the exchanges:

Titan Industries Ltd. has informed the Exchange that at the meeting of BODs of the company held on August 31,2005, the directors have approved the issue of Partly Convertible Debentures(PCDs) of Rs.600 each on a rights basis in the ratio of one PCD for every twenty equity shares held in the company to the shareholders of the company as on a record date to be fixed by the board or by a duly constituted committee thereof. The duly constituted committee of the board for the Rights Issue will also decide on matters incidental to the Issue. The PCD will comprise of:a)Part ‘A’ will be converted into one equity share(Face value of Rs.10/-) in a price band of Rs.325/- to Rs.375/- which shall be fixed closer to the record date by the BODs of the company.b)Part ‘B’ will be one Non-Convertible Debenture(NCD),of the face value of the balance amount out of the Rs.600/- on due appropriation of the amount of equity shares priced as per ‘a’ above. The NCDs will be carrying a coupon rate of 6.75% per annum payable annually and redeemable at the end of 5 years. The total issue size is calculated to be around Rs.126.83 crores comprising of 21,13,813 PCDs of Rs.600 each.

On December 26, 2005, another announcement was made by the company:

Titan Industries Ltd. has informed the Exchange that at the ‘Rights Issue Committee Meeting’ of the Board held on December 26, 2005, the Members after deliberations on the subject have finalised the price of the equity shares comprised in the Partly Convertible Debentures (PCD) (forming Part A of the PCD) to be issued on allotment, at Rs.350 per equity share of a face of Rs.10 per share and inclusive of premium of Rs.340 per equity share and within the price band of Rs.325 – Rs 375 per equity share, as approved by the Board in their earlier Meeting. The price of the Non-Convertible Debenture (NCD) comprised in Part B has been fixed at Rs.250 per NCD carrying an annual interest of 6.75% p.a. and redeemable at par at the end of 5 years from the date of allotment.

On January 3, 2006, the company filed the draft offer document with the Securities and Exchange Board of India (SEBI).

On February 3, 2006, the company fixed March 06, 2006 as the record date for the purpose of the rights issue.

One of the key aspects of the offer was the buyback arrangement made by the company for the Part B of the PCD. Called the “Khokha buyback scheme” (see page 288 of the offer document), the applications had the option to sell the Part B of the PCD, having a face value of Rs 250, at a small discount.

Given that the stock price of the company was around Rs 800 per share, this looked like a very interesting idea. The investment operation would have involved buying 20 shares at Rs 800 on cum-rights basis, selling all of them ex-rights basis, and acquiring a the right to subscribe for the PCD at a low, or zero cost. The reasoning was that given the low dilution, the market would virtually ignore the dilution factor. Moreover, once the Rs 600 PCD was bought, a sum of slightly less than Rs 250 could be recovered by opting for the Khokha buyback scheme. In effect, the operation, if successful would have resulted in the acquisition of one share of this company at a price slightly more than Rs 350, even though its prevailing market price was Rs 800.

Not bad, eh?

Even more interesting was the fact that Titan stock was traded in futures and options segment. This meant that it was possible to buy 20 shares in the spot market on cum-rights basis and sell 21 shares in the futures market on ex-rights basis, locking in a handsome profit. However, the NSE decided make the necessary adjustments for the rights issue in the outstanding futures and options contracts. See this notice, and this one and this one.

So what happened exactly?

On 24 February – the last date on which the stock traded on a cum-rights basis, Titan stock closed at Rs 799 and had an average price of Rs 792 for that day. So one could easily have bought 20 shares @ Rs 792 costing a total of Rs 15,840.

On 27 February – the first date on which the stock traded on ex-rights basis, Titan stock closed at Rs 780 and had an average price of Rs 785. However, by March 1 the price had increased to Rs 792 which was the same as the cum-rights price. The market had, as expected, ignored the dilution.

I did not do this transaction though. Why? There were several reasons.

One was the capital intensity of the operation. The maximum spread, ignoring all costs, was Rs 442 (Rs 792 less Rs 350 effective cost of one new equity share). To get this gross maximum spread, one had to invest Rs 15,840 initially which was 35 times the gross maximum spread.

The second reason was to do with costs. In order to get one rights share, one had to buy and sell 20 equity shares in the spot market. In addition, the operation would have involved selling 21 shares in the futures market, and then squaring up that position later. The transaction costs of doing business in the spot market for 20 shares, and the futures market for 21 shares, must be loaded on to the cost of the one share to be acquired in the rights issue. Simple calculation showed that once when this was factored in the gross spread of Rs 442 was reduced very substantially. This made the operation less profitable and even more capital intensive than before.

In risk arbitrage, transaction costs matter – they matter a lot.

The third reason killed it. To generate the capital to do the deal would have involved substantial sales of the existing portfolio, resulting in significant taxes, which should correctly be counted as the cost of this operation.

All in all, nothing was ventured, but something was gained – knowledge – and that’s what I am sharing here with you tonight…