Understanding a Rights Offering

I received an email from one of my good friends moments after Ivanhoe Mines [IVN:TSE] released news that a rights offering was made to all shareholders. The company announced a US$1.8 billion rights offer allowing shareholders to subscribe to new shares at C$8.34, a discount of 26 per cent from the previous day's price. As would be the case, my friend had many questions and wanted to know if he should exercise his rights. I told him that a financial theory suggests an investor exercising their rights will not profit or lose. Here's why.

Ivanhoe Mines issued a rights offer at $8.34 to raise funds for a mining project. Prior to the news, the stock closed at around C$11.50 on the Toronto Stock Exchange. It seems like a great arbitrage deal for an investor, therefore, a profit must occur, but that is not true. Let us examine the reason with a very basic example.

If Mr. Jones bought 100 shares of Company ABC at $20 and exercises his rights, thus purchasing another 100 at $16, he would have spent $2000 + $1600 on 200 shares, bringing his average cost base down to $18/share. The market would also push the shares down to $18 as well because of market efficiency. Nobody would be willing to overpay for the stock if it is fairly valued at $18.

Now, Company ABC is trading at $20 with 1,000,000 shares outstanding; that means ABC is worth $20 million. The company issues a rights offer at 1:1 with a subscription price of $16 per share. If all share holders exercised their rights, the company would now have 2,000,000 shares and its new market capitalization would be the sum of the old market capitalization ($20 m) and the new cash received ($16m), which equates to $36 million. But that $36 million is divided evenly amongst 2 million shares, creating a share price of $18.

Assuming no change in company valuation, Mr. Jones would see his shares slowly fall to $18 creating no loss or gain following the completion of the issue.

So, with that basic lesson done, how do we understand Ivanhoe's second rights offer in under two years? The first important thing is determining the amount of rights an investor will receive. Although we are uncertain, it appears that an investor will receive about 20 to 22 rights for every board lot owned, determined by dividing $1.8 billion into the value of the company of $8.52 billion at the time of the news. The rights will not be trading on a secondary market, so holders will only have a few days to exercise their rights. Now, finding the fair market value of Ivanhoe will take a little more work. The company is looking to raise about $1.8 billion by offering shares at $8.34. That creates up to 215 million shares. The company's new market value would be $10.32 billion with 956,348,000 outstanding shares equaling a fair market value of $10.79. And where is that stock today? $10.88.

On the day of April 18, I told my friend if he did NOT plan to exercise his rights but wants to continue owning Ivanhoe, he should sell them immediately and repurchase them after share dilution. Normally, the rights would be available to sell in an open market, allowing him to capture the "loss" on his share's reduction in value. There was no financial gain in holding them for the next few weeks since the stock did not pay dividends and he did not sell covered calls. He would also partake in the dilution of his shares. I didn't ask what his decision was; that's just rude, but the shares actually rose to $13.50 on other news on the same day, which would have given an investor a good price to sell out.