Brian Gaynor: Flocking to capital notes costs millions

New Zealand investors have missed out on over $450 million of capital gains by investing in capital notes instead of ordinary shares.

As the accompanying table shows, 10 listed companies issued capital notes in the three years ended December 31 last year, raising a total of $1084 million (the figures do not include rollovers of existing capital notes or issues by companies that do not have listed ordinary shares).

If investors had put their money into ordinary shares on the day the capital notes were listed, the shares would be worth $1553 million, a capital gain of $469 million or 43 per cent.

The ordinary share price of eight of the companies has risen since the capital notes were issued, with only Pacific Retail and Provenco experiencing share price falls.

Sky City's share price has risen a spectacular 158 per cent and if investors had bought the group's ordinary shares instead of capital notes the gross dividend yield on the shares, at the August 2000 purchase price, would now be 18.1 per cent.

Investors pour their life savings into capital notes, and other low-quality fixed-interest securities, instead of ordinary shares because they have a misguided concept of risk. They believe that the sharemarket is risky and fixed-interest investments are always secure.

This is far too simplistic.

Capital notes are the lowest-ranking form of debt. They are unsecured and subordinated and rank just ahead of ordinary shares on the liquidation of a company.

They are fixed-interest securities but the issuer has no obligation to pay back the principal. At maturity the issuer can either roll over the notes or issue ordinary shares at a small discount to the market price. If the notes are redeemed for ordinary shares these shares would be expected to come under heavy selling pressure because note holders are not natural holders of listed shares.

Capital notes are a relatively cheap form of funding as far as companies are concerned. As this benefits shareholders, investors would be better advised, based on the evidence of the past three years, to buy ordinary shares instead of notes.

Telecom

Telecom's result for the year ended June 30 was good news for the sharemarket. It wasn't a spectacular result but it gave the impression that Theresa Gattung and her management team are beginning to build a solid innings and the company is heading in the right direction.

Australia is still a problem, but New Zealand is doing much better because costs have been contained and margins improved.

But the big issue is the company's dividend policy.

In 2001 Telecom cut its dividend from 46c to 20c, a move that had a huge impact on the company's share price.

Directors have said they will increase the dividend once the company has achieved certain gross debt to Ebitda (earnings before interest, tax, depreciation and amortisation) ratios.

Analysts are confident that Telecom will reach these targets in the current year, particularly if the proceeds from the sale of Independent Newspapers' publishing assets are distributed to shareholders.

Three leading analyst are expecting Telecom to raise its dividend from 20 cents last year to a 23c to 33c range in the current year and 35c to 43c in the June 2005 year. All these should be fully imputed.

At yesterday's closing share price of $5.23 Telecom is on a prospective gross dividend yield of 6.6 per cent for the current year and 10.0 per cent for the June 2005 year based on the lowest forecasts.

Why would anyone want to buy capital notes when Telecom, based on analysts' forecasts, offers much better investment prospects over the next few years?

Rights Issues

One of the great mysteries of the sharemarket is the willingness of investors to throw away money by not taking up their entitlements to a pro rata cash issue or not selling their rights. In the past 12 months investors have given away:

* $13.7 million by not taking up their Tower entitlements.

* $0.8 million in relation to Capital Properties' recent issue.

* $1.3 million on Richina Pacific's issue.

* $0.6 million by Tranz Rail shareholders.

* $5.2 million in Affco's one-for-one issue at 10c a share.

* Nearly $1 million by Capital Properties shareholders in last year's rights issue.

Auckland residents complain about Auckland Regional Council (ARC) rate increases yet 70,000 of Tower's 117,000 shareholders, many of them ARC ratepayers, did not take up their entitlement or sell their rights. By doing nothing they threw away nearly $200 on average.

For every loser there is a winner and Tony Gibbs of Guinness Peat Group has plenty to smile about as he underwrote half the Tower issue, with sub-underwriters taking up the other half.

CDL Hotels/Tourism Holdings

The harsh reality of the sharemarket hit CDL Hotels last week when its excellent result went virtually unnoticed. Friday's Business Herald gave Tourism Holdings front-page status, five columns and a graph whereas CDL Hotels' good news was buried near the bottom of page 3.

The reason is that CDL Hotels has almost no institutional support, except for the Accident Compensation Corporation, and is not covered by analysts but Tourism Holdings is an institutional stock, covered by brokers.

CDL Hotels announced a net profit for the six months to June 30 of $8.2 million compared with $6.5 million for the same period last year.

Its net earnings for the second half of the December 2002 and the first half of the current year were $18.8 million.

At yesterday's closing price of 30c CDL Hotels has a sharemarket value of $105 million and price/earnings multiple for the 12 months to June of 5.6.

On the same day Tourism Holdings told the exchange that it expected to announce a net profit, before unusual items, of $7.5 million for the June 2003 year. At yesterday's closing price of $1.40 Tourism Holdings has a sharemarket value of $137 million and a historic price/earnings ratio for the twelve months to June of 18.3.

The problem with CDL Hotels is its complex structure and ownership.

CDL Hotels is 70.2 per cent owned by the listed UK company Millennium & Copthorne Hotels, which is controlled by Singapore interests. CDL Hotels operates the Millennium, Copthorne and Quality Hotel brands in New Zealand. It also owns 60.1 per cent of CDL Investments and 50.7 per cent of Kingsgate Corporation.

As the market value of these two holdings is $75 million, the residual operations, the New Zealand hotels, have a market value of just $30 million. These hotels achieved net earnings of nearly $14 million in the 12 months ended June.

The CDL group is reasonably optimistic about the second half of the year to December. CDL Investments says it has a good range of residential sections and demand for sections and properties should continue.

Kingsgate believes that the redevelopment of Sydney's Millennium Hotel into apartments "should have a positive impact on the group's result in the second half" and CDL Hotels expects to see its hotel operations "achieve further profit growth during the second half of the year".

But the good news will probably fall on deaf ears as CDL Hotels is one of those companies, as is Pacific Retail, which always looks cheap but attracts little attention. The company has appointed a public relations firm to beef up its profile but it won't appear on investors' radar screens until analysts start covering it.

To achieve this, CDL Hotels' major shareholder will either have to sell some of its holding, as Ryman Healthcare controlling shareholders did, or break up the group into three separate companies.

* Disclosure of interest: Brian Gaynor is a CDL Hotels, CDL Investments, Kingsgate, Tourism Holdings and Telecom shareholder.

* Email Brian Gaynor