Earning Dilution - ICULS

Reminder: All information provided in this post might not be accurate

Irredeemable Convertible Unsecured Loan Stock (ICULS) is another way for a listed company to raise money besides rights issue and warrants.

As the name implies, ICULS is a loan which can be converted into common stocks/shares.

Basically investors who take up the ICULS will "lend" their money to the company and in return, the company will pay interest to them, usually twice a year.

Holders can convert their ICULS into the company's shares at any time within the conversion period. 

From what I learned so far, it seems like all ICULS are compulsory to be converted to common shares. So, it will certainly cause earning dilution to the company in the future unlike warrant which may not be converted if they are not "in the money".

Unlike warrants also, ICULS holders do not need to pay extra cash when the ICULS are converted to common shares.

They only need to surrender their ICULS at a conversion price.

How much earning dilution can ICULS bring to a company?

Well, most of the time the maximum numbers of new shares from ICULS conversion will be given in the circular to shareholders while issuing the ICULS.

So, it's easy, just refer to the circulars to know the extent of potential earning dilution.

Lets take SAM Engineering as an example.

In order to acquire engine case manufacturing business in early 2012, SAM "borrowed" RM135mil cash through issuance of ICULS.

Below are part of the salient terms of the ICULS found in the circular.

SAM

Issue size : RM135mil

Issue price : 100% of the nominal amount

Form & Denomination : RM1.00 each

Conversion price : RM2.10 nominal amount of the ICULS per SAM share

Conversion mode : by surrendering ICULS with an aggregate nominal value of at least equivalent to the conversion price

Maximum new shares from ICULS conversion : 64,285,714

With conversion price of RM2.10, this means that potential ICULS buyers know that they can buy SAM's shares later at RM2.10 each. 

As the total loan is RM135mil, it can be converted to 64,285,714 new SAM shares. (135mil divided by 2.10)

I only knew about this recently. Previously, I looked at the information on my trading platform which looks like this:

The "Share Issued" shown above is RM117.524mil as at 5th Nov 2015. 

I thought the number of new SAM shares after all ICULS converted will be 117.5mil, and this is the main reason why I didn't invest in SAM in mid 2015.

Apparently I was wrong.

This RM117.524mil should be the total amount of loan remaining out of RM135mil issued, which means RM17.5mil has been converted into 8.32mil new SAM shares.

The maximum new shares is only 64.3mil, and from 5th Nov there are potentially 56mil more new shares when all ICULS are converted.

From its circular as well, it is mentioned that SAM's total shares will go up to 135.167mil once all ICULS are converted.

If I expect SAM's FY16 net profit to be RM60mil, my projected fully-diluted EPS for SAM will be 44.4sen.

Here is another example,

L&G

Issue size : RM77,779,589 (equivalent to 598,304,530 units)

Issue price : 100% of nominal value of RM0.13 each

Form & Denomination : RM0.13 each

Conversion price : RM0.26 for every one new L&G share

Conversion mode : by surrendering nominal value of ICULS equal to conversion price, OR by surrendering RM0.13 nominal value of ICULS together with cash such that in aggregate it equivalent to conversion price

Maximum new shares from ICULS conversion : 598,304,530

At conversion price of RM0.26, one would expect that the maximum numbers of new L&G shares from ICULS conversion is 77,779,589 divided by 0.26 = 299,152,265 shares.

However, it is stated that maximum new shares is 598,304,530.

This is because of its conversion mode, in which ICULS holders can either choose to surrender RM0.26 ICULS for a new share, OR surrender RM0.13 worth of ICULS and top up RM0.13 cash to get a new L&G share.

The latter works like a warrant with an "exercise price".

The maximum scenario assumes all holders will pay RM0.13 to get a new L&G share, which is unlikely I think.

So we will not know the exact numbers of new shares until the ICULS reach maturity. We only know that there will be minimum 299mil new shares and maximum 598.3mil new shares.

TGUAN

Issue size : RM52,602,650

Issue price : 100% of the nominal value

Form & Denomination : RM1.00 each

Conversion price : RM1.00 for every one new TGUAN share

Conversion mode : by surrendering the ICULS with the aggregate nominal value equivalent to the conversion price

Maximum new shares from ICULS conversion : Not mentioned

In Thong Guan's case, the maximum new shares from ICULS conversion is not mentioned in the circular.

We can know that from conversion price of RM1.00 and straight forward conversion mode, the maximum new TGUAN shares will be 52.6mil once all ICULS are converted.

Nevertheless, this is not the end of the calculation of EPS dilution from ICULS conversion.

Just look at the simple formula of EPS below,

Net profit attributable to shareholders

_____________________________

Weighted average numbers of ordinary shares

After the conversion of ICULS into ordinary shares, the denominator will increase thus EPS will drop.

Nevertheless, net profit attributable to shareholders will also increase at the same time as the company will save on the loan interest payable to ICULS holders if ICULS are converted.

If the company issue RM100mil worth of ICULS with interest rate of 4%, then it will "save" RM4mil a year if all the ICULS are converted into ordinary shares.

This RM4mil "saved" is subjected to normal tax like other profits in the company, so we need to deduct the tax rate to get the actual figure.

So, for EPS dilution from ICULS, the formula will be:

Net profit attributable to shareholders + convertible loan interest (1-tax rate)

____________________________________________________________

Weighted average numbers of ordinary shares + new shares from ICULS conversion

For convenience, personally I think I will not include the interest saved in my calculation of EPS dilution from ICULS conversion. It's always better to overestimate the dilution effect rather than underestimate.

As I only learn all these stuff by myself from online search, I can't be sure that all the information here are correct as I might interpret them wrongly.

So please correct me if I'm wrong.

For EPS dilution from warrants conversion, please refer here.

TGuan: Moving Up The Value Chain

In stock market investing, I like growth, especially when a small company grow into a big company.

Thong Guan seems to have the potential to be one of such companies.

TGuan, which is based in Sg Petani, is a small company with market cap of RM200mil (RM1.97 x 105mil shares).

It has 2 business divisions:

• Plastic products manufacturing & trading
• Food & Beverage manufacturing & trading

Its plastic products include stretch film (like Scientex), garbage bags, PVC food wrap etc.

Its F&B products are mainly tea & coffee marketed as "888" brand, and also some organic food.

TGuan was established way back in 1942 and was initially involved in distribution of coffee and tea. It ventured into manufacturing and trading of plastic products in the 1970s.

It was listed in 1997 on second board and was promoted to main board in 2002.

It was once the largest stretch film producer in Asia Pacific region. However, I think this title should belong to Scientex now.

Anyway, TGuan is still the largest manufacturer of PVC food wrap in Malaysia.

In year 2014, TGuan tabled a 3-year RM100mil expansion plan until 2016.

This aggressive capex aims to expand its plastic manufacturing division especially its stretch film and PVC food wrap .

CIMB Research expects TGuan's production capacity to increase by 40% from 120,000MT in early 2014 to 170,000MT per annum in 2016.

The initial plan laid out includes:

• Install thin stretch film machines with in-line pre-stretching capability & edge-folding
• Increase PVC food wrap production lines from 4 to 10 lines
• Install 33-layer nano-tech stretch film line
• Install its first blown film line
• Setting up an R&D center

Before this capex plan in early 2014, TGuan already has:

• 11 stretch film lines (9 in Malaysia, 2 in China) with annual capacity of 80,000 MT
• Garbage bags lines with annual capacity of 40,000 MT
• 4 PVC food wrap lines with annual capacity 6,000 MT

From TGuan's 2014 annual report, it is mentioned that TGuan has successfully installed the thin stretch film line in 2014.

At the same time, two additional PVC food wrap lines (5th & 6th) have also been added to increase its production capacity to 720 MT/month, or 8,640 MT/annum.

From its latest FY15Q2 quarterly report released in Aug15, it seems like the nano-tech stretch film line, blown film line and R&D center are still not in place.

Anyway, it has acquired organic noodles manufacturing facilities recently for its F&B division.

In 2016, it will continue to increase its PVC food wrap lines to 10 line with total production capacity of 15,000 MT annually.

Besides, I believe that it will also increase the production capacity of its thin stretch film gradually.

So, we know that PVC food wrap production will get an 150% rise in production capacity. How much net profit can it contribute to TGuan in the future?

This PVC food wrap business is a JV with a Korean company Power Wrap Inc since 2011. TGuan has 85% shares in it.

In FY14, TGuan's PVC food wrap division (TGPW) contributed RM32.8mil revenue and RM3.25mil profit to TGuan. 

Since the additional 5th & 6th lines were ready only at the end of year 2014, the figures above should be derived from 4 production lines.

This means that 150% increase in capacity can potentially raise the profit contribution from TGPW to RM8mil (should be operating profit).

As TGuan owns 85% of TGPW, it will work out to be around RM7mil.

Meanwhile, its stretch film capacity might also get some significant increase in capacity, especially the thin & nano-tech film which fetch higher margin.

In FY14, TGuan's PATAMI dropped 38% despite a slight increase in revenue.

The drop in profit is mainly due to forex loss and impairment of receivables etc which adds up to almost RM10mil.

Without these special items, TGuan's PATAMI should stay flat at around RM27mil since 2011.

With outstanding shares of 105.2mil, its "revised" EPS for FY14 should be 25.6sen.

At recent share price of RM1.97, it is trading at lowish PE of 7.7x.

I don't have any clue on how much profit its additional stretch film production can give.

If both PVC food wrap and thin stretch film can contribute an extra RM10mil net profit a year once fully operational, its projected FY16-17 net profit could be RM37mil.

Anyway, this is just a rough guess.

From info available online, TGuan's projected net profit for FY16 is RM35mil, RM27mil & RM40mil from RHB, Kenanga & CIMB respectively.

Base on the median projected net profit of RM35mil by RHB, its projected EPS in FY16 will be 33.3sen.

If given a PE ratio of 10x, its target price will be RM3.33!

Nevertheless, this is not the end of the story.

In order to raise fund for the massive expansion, TGuan undertook rights issue of 2 ICULS and 1 warrant for every 4 TGuan's shares in 2014.

This exercise was ex-ed in Sep14 with the listing of 52.6mil ICULS and 26.3mil warrants.

Both ICULS and warrants can be converted to TGuan shares at 1:1 with conversion price of RM1.00 & RM1.50 respectively before they expire in Oct 2019.

All ICULS are mandatory to be converted but holders can only do so after 2 years from listing, which is after Oct 2016.

This potential additional shares of 78.9mil shares is huge with a potential earning dilution of 75%, as TGuan's current outstanding shares are just 105.2mil.

If TGuan's PATAMI can reach RM35mil in FY16, its fully diluted EPS will be 19sen, though in accounting, diluted EPS is not calculated like that.

If its PATAMI stall at RM35mil until FY19, and all the ICULS and warrants are converted into mother shares, then it will not be good.

If I'm sure that its net profit can continue to grow beyond FY16 to FY19, then I will surely invest in it now.

However, no one can predict until year 2019.

Its profit may continue to grow due to penetration into new markets or Tokyo Olympic effect.

Its profit may also drop due to stiff competition, higher operating and raw material cost etc.

It might also implement another round of cash call for further expansion.

TGuan is a growing company with good balance sheet and cash flow.

Earlier this year it suffered significant forex losses due to high USD denominated loans used for expansion.

It has recently pared down its borrowings substantially and I can foresee healthy cash flow in the near future.

Sales to its major export market Japan suffers a bit recently after the increase of VAT (value-added tax) in Japan from 5% to 8%.

However, TGuan still enjoys the largest market share (12%) of garbage bag in Japan.

I think this is a remarkable achievement for a small cap company.

The only thing I don't like is its relatively huge ICULS and warrants.

I do not invest in SAM Engineering because of this similar reason. Just look at SAM now.