Woolworths: Why the share market did not react (much) to the rights issue

What really matters for shareholders is the decision to invest in David Jones – much more than the funding choices made.

The Woolworths (WHL) rights issue designed to finance its takeover of Australian Department Store David Jones has been in the wings for some time. Despite the prospect of more shares in issue and dilution to come, the share market correctly has not yet reduced the price of a WHL share.

This is because the price at which a rights issue is pitched (the discount to current market values) hardly matters at all to established shareholders. The size of the discount is there to attract their attention – to make sure that they either follow their rights or sell their rights that will have a value related to the size of the discount. What they lose in the form of a lower share price when more are in issue may or may not be made up for by the extra shares they own. What will matter to established shareholders is what is to be done with the extra capital. In other words, is the extra capital they subscribe going to provide them with a positive rate of return? If they expect it to do so, then they should subscribe extra capital. If they do not, they should sell their rights to others who are willing to follow their newly acquired rights.

How well will the extra capital raised be employed by the managers of the company raising additional capital? Will the capital raised earn a return in excess of its opportunity costs? Will it earn a return in excess of the returns shareholders might expect from the same amount of capital they could invest in businesses with a similar risk character?

If the rights to subscribe new equity capital are taken up by established shareholders in the same proportion they currently hold shares, their share of the company is unaltered. They will be entitled to exactly the same share of dividends or the company as before. In the case of a rights issue, established shareholders may however elect to sell all or part of their rights to subscribe to additional shares should these rights prove valuable, in which case they are giving up a share of the company but are fully compensated for doing so.

Doing the numbers for WHL and confirming its own “theoretical value”

The terms of the Woolworths rights issue were announced on 1 September as an offer to shareholders of an additional 22 shares for every 100 held, representing 167.8m shares at a price of 59.5 cents. To quote the company announcement: “The subscription price is at a discount of 20% to the theoretical ex-rights price of a WHL ordinary share of R74.38 on Monday 1st Sept 2014.” See our note further below for the mathematics behind the offer.

The market value of WHL at yesterday’s (2 September) closing share price of R80.78 was R61.24bn. 758.2m shares are currently in issue. A further 167.8m shares are to be issued to current shareholders to raise an additional R9.984b. Adding this new capital to the current market value of R61.24bn gives a break even post rights issue valuation for WHL of R71.234bn or R76.9 per share of which 926m shares will be in issue post the rights issue. (71.234/.926=76.9)

Woolworths itself, basing the calculation on the closing price on 1 September of R79.69, indicated a “…theoretical ex rights price of R74.38 on 1st September excluding the dividend of 150.5c declared by the company…..”

In the case of the WHL rights issue, the break even share price gives a value of approximately R76.92 per share. Any higher share price for WHL, after the newly issued share starts trading in October, will mean a gain for existing shareholders who follow their rights; anything less will mean a loss. Over time, to justify their additional investment in WHL, shareholders will look to this share price rising by more than the risk adjusted return they should expect from WHL, that is by around 12% p.a.

The question that the Woolworths board would have considered would have been about the mix of debt or equity they would use to fund their acquisition that they must believe will be value adding for shareholders.

More debt would have meant less equity, less dilution and, other things equal, a higher share price to come, provided that the investment in David Jones pays off in returning more than the cost of finance. As they say, time will tell whether WHL has made a good investment decision. Time will also tell whether their funding choices added to or detracted from the value realised for shareholders.

Note: The break even condition for the shareholders who elect to subscribe the additional capital is that the market value of the company after the conclusion of the capital raising exercise (defined as MC2) will be greater or at least equal to the market value of the company pre the rights issue, defined as MC1 plus the additional capital raised defined as k. That is, MC2>MC1+k , if the capital raising exercise is to be judged a success.

This equation may also be used to establish a share price that would represent a break even for shareholders after the conclusion of the rights issue. That is, the share price after the event that would satisfy the value add (or rather the no value loss) condition. MC2, the value of the company after the rights issue is concluded, may be derived conventionally by multiplying the share price (post rights issue) by the number of shares in issue (S2), that is the market value of the company after the capital raising exercise, MC2 = P2 * S2 and MC1, the value of the company before the announcement, calculated in the same way as P1*S1 where S1 was the number of shares in issue before the rights issue. P2 is the breakeven price after the announcement.

Substituting P1*S1 for MC1 and P2*S2 for MC2 and solving this equation for P2, the break even post rights issue price, gives the following formula for the break even share price after a rights issue as: P2 = (S1*P1+k)/S2.