Saturday, March 28, 2020

What To Do With SQ’s Rights Issue

Last week, our beloved national carrier, Singapore Airlines (SIA), or SQ as it is known by its flight code, announced a bazooka rights issue and mandatory convertible bond issuance to shore up capital in the fight against the coronavirus. The two instruments amount to SGD 8.8 billion dollars but this is just the first wave. The firm alluded to further capital raise of SGD 6.2 billion if needed and subjected to shareholders’ approval within the next 15 months. 

In total, SIA is raising SGD 15 billion dollars which is roughly one year’s worth of revenue (last year’s revenue was SGD 16 billion) but probably 16 to 18 months of its annual cost base. It is also more than 15 years worth of last year’s net profit at c.SGD 900 million. From the balance sheet angle, 15 billion is also bigger than its equity base of SGD 12 billion. The firm cited many use of this massive amount of money but it’s not too important. We all know that without the capital raise, SQ will cease to exist. In accounting language, the firm will no longer be a going concern i.e. SQ will go bankrupt. This is serious! It's Singapore's national carrier, our pride and glory!

How is SQ falling?

Well, we are at war with COVID-19. These are unprecedented times. It was reported that all airlines will fail in three months. With global travel down 25-40%, no airlines can survive without new capital. Three days before the rights issue, SQ announced that it is cutting capacity by 96%. Ninety six percent! Then, we saw this SGD 15 billion dollar bazooka. To put this number in another perspective, this is 125% of its equity base and twice its current market cap. This magnitude is unprecedented and alarmingly dilutive. Essentially, existing shareholders will never see their invested capital if they don’t subscribe. 

SQ was trading at $6.5, the day before the announcement. The market cap was then SGD 7.7 billion dollars. This capital raise (the rights issue and the mandatory convertible bond or MCB) will be SGD 8.8 billion dollars. This means that the dilution will be more than 50% (53.3% to be exact). So whatever intrinsic value SQ should be trading at before, be it $10 or $12, it will only be half of that. We will show the number later in this post but it's hard to imagine SQ going back to $12, ever.

To be helpful with the math, SQ gives us a theoretical ex-rights price (TERP) of $4.4. This means that after the rights issue (just the SGD 5.3bn portion), all things equal, Singapore Airlines' share price should be traded at $4.4 vs the $6.5 the day before, because of the dilution. This does not take into account of the MCB dilution (SGD 3.5bn) and the additional capital raise (SGD 6.2bn) which is subjected to shareholders’ approval. 

That’s a lot of numbers to take in for most people. Some of the details are also not made public and only Singapore Airlines’ shareholders get to see all the numbers. Since I am not a shareholder, I can only analyse with what is available publicly. Here’s two simple conclusions to start with: 

Grounded or Bankrupted? Just kidding...

1. If you are a shareholder, you should subscribe to everything to maximize benefits. But that means coughing out a lot of money to stay in the game. So it's about how much dry powder you have. Do not use too much and don't ever use your savings. Royston Yang from thesmartinvestor reckoned that if someone bought 1,000 shares of SQ at $6.50 (initial capital of $6,500), he has to cough out another $7,450 to subscribe to the rights and the MCB. Do read his well-written post for the details. 

2. If you are not a shareholder, it might worthwhile to monitor SQ closely. It could fall below the theoretical ex-rights price or TERP of $4.4 and that makes it interesting. In an improbable but possible scenario, SQ might fall near or below its rights conversion price of $3. This is an arbitrage opportunity and one can earn a lot of money buying SQ at that ridiculous price (more on this later). Obviously nothing is ever 100%. If SQ falls to $3, it means the market thinks this capital raise is not enough or COVID-19 has won the war or something really apocalyptic. We have to then make a bet that the market is wrong. Remember it is never easy.

But first things first.

Let's try to come up with an intrinsic value for SQ. With that in hand, we can then verify that $3 is ridiculously cheap and justify buying SQ with a good margin of safety. I must say this is just a back-of-the-envelope kind of analysis. I have never been interested in airlines because its business model simply makes it difficult to generate cashflows and compound earnings. But if the share price do fall a lot from here (i.e. fall to $3), it makes an interesting arbitrage opportunity.

Singapore Airlines has never lost money since its listing and its net income hit SGD 1.3 billion in 2018. Its historical high was actually in 2007 and 2008 when net income powered north of SGD 2 billion for two consecutive years. Just looking at its own history, I would say that SQ can do a billion SGD in net income going forward. It has done this before and in the post COVID-19 world, it would be in a better position than most to continue pushing ahead. Singapore Girl Power!

Looking at its EBITDA, which is what most people like to analyze airlines with, we can also see that SQ has achieved SGD 2.5-3 billion dollar of EBITDA annually. Again, this is based on its past track record. I have subscribed to Warren Buffett's view that EBITDA is not worth looking at because it's not cashflow. We are using it here to help us triangulate SQ's intrinsic value. It is also worth reminding everyone here that SQ is not your typical high quality compounding value investor stock. This is just an arbitrage opportunity. If and when this analysis actually plays out, buy SQ close to $3 and sell it at close to $5. That's the thesis.

Okay, so we have the net income at SGD 1bn and EBITDA at SGD 2.5-3bn. Using PE of 12-15x, we have the first estimates of SQ's intrinsic value (IV) at SGD 12bn to 15bn. This is also where its market cap was over the last 5 years. With EBITDA, we would use a ballpark of 5-6x. At 5x, that gives us SGD 12.5-15bn as well! How coincidental!  (Actually, that is usually how valuation triangulation work, the no.s should come close to one another). Since SQ will have enough cash to cover all debt going forward, we can say that its market cap will be equal to its EV. So we have three sets of numbers that point to the same ballmark. I will add a fourth using 6x EV/EBITDA for a blue-sky scenario - SQ beats the coronavirus and rise to glory, take market share, blah blah. You know the story.

1. SQ's market cap at SGD 12-14bn
2. PE based IV at SGD 12-15bn
3. 5x EV/EBITDA based IV at SGD 12.5-15bn
4. 6x EV/EBITDA based IV at SGD 15-18bn (blue sky scenario, SQ did achieve SGD 20bn market cap before) 

Now, with this massive capital raise, SQ's share count will triple from current 1.2bn to c.3.6bn. By dividing the above IVs, we have a range of target prices from $3.3 to $5. I would say that we can take the median of $4.2 as our IV to work with. Coincidentally, this is within 10% of its TERP at $4.4. Recall that the rights issue and MCB allows the shareholder to get more shares at $3 and $1 (technically speaking, shareholders don't actually get it at $1, but simply even more shares), so if the current share price drops close to $3, we will be getting everything with a margin of safety of 40% (4.2/3).

Having said that, SQ is now at $6. It may not fall to $3. In fact, it's probably hard to imagine that happening. But it should fall. So if it falls through its TERP of $4.4, to say $3.9, then we have to start thinking hard. Maybe that's cheap enough. Remember its IV is anywhere from $3.3 to $5. As it gets close to $3, we have to act. In fact, the window will be super short at the bottom. Like just a single day or two. And all bets are off after the rights issue date, since we won't get the rights and the MCB. Hence it's important to have done the work before that.

Hope this helps! Huat Ah!

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