Elders Ltd (ELD) v Elders Hybrids (ELDPA): Reservoir Dogs edition

This story reminds me of the famous scene from Reservoir Dogs: 

Directed by Quentin Tarantino, the story involves a diamond robbery gone wrong. The gang starts blaming each other, and in Tarantino style people start dying. I won't say anymore in case you haven't seen the movie. 

Just like Steve Buscemi and Harvey Keitel in the above scene, ELD and ELDPA shareholders seem to be in a similar Mexican stand-off. 

   

And just like the misfortune of our characters in the movie, my previous analysis (some years ago thank goodness!) on ELD/ELDPA was pretty much dead wrong. When it comes to fundamental analysis, getting involved in situations where there is not a decent underlying cash flow or asset backing is so very often asking for a lot of trouble if things go wrong. On reflection, my biggest mistakes have all involved taking a punt on otherwise truly shocking businesses, betting an announced takeover will complete or a turnaround will be successful. 

Over many years, management at Elders have destroyed shareholder wealth with impeccable efficiency. Capital raising's, write-downs, too much debt, asset sales, non-coherent business model. Cyclical business. 

But what really has me intrigued is the relationship between ELD and ELDPA shareholders. 

ELD are the 'ordinary' shares while 'ELDPA' are hybrids: the genetically modified stock which is half-equity, half-debt. ELDPA have a face value of $100, however the current share price is $15. ELDPA distributions have been suspended for a long-time. So for an investment aimed at providing stable income, receiving no income AND copping an 85% write-down in value is truly eye-popping. 

One of the common selling features of hybrids is they sit higher in the capital structure than equity. This should be important if things go wrong and the business needs to be wound-up. In a wind-up, creditors come first and the owners second. Hybrid's sit in between the two. Most importantly, hybrids sit above common shareholders. So let's assume things like secured bank loans and employee benefits are paid. Then comes hybrid holders. If they aren't paid 100% of their 'face value', in theory equity holders are completely wiped-out. 

Okay, it has been obvious for some time Elders has been in trouble. A year ago, ELDPA was trading $30-$40. There appeared to plenty of equity on the balance sheet to cover the full face value of the hybrids. Obviously there was a major inconsistency between the balance sheet and what the market believed. If ELDPA was truly worth say $35, you could be forgiven for thinking ELD should be worth zero. But the one year share price graphs of ELD and ELDPA don't agree with this theory: 

ELD

ELDPA

As expected, the share price of ELD has been awful. But why has ELD outperformed ELDPA in the last three months? And the logic continues: if the market is right and ELDPA is truly worth only $15, then surely ELD should have no value?  

If you arbitraged the capital structure (long ELDPA, short ELD - if possible), life would be pretty miserable for you right now. Even on a 12 month basis, you probably have made no money. 

The half year results (balance date 31 March) announced 31 May indicate there is still plenty of equity to cover the hybrid holders in full.  These figures aren't updated for recent asset sales. 

So what's going on? 

Back to Reservoir Dogs. Friction between hybrid and common shareholders can arise when things go pear shaped. This has happened with Paperlinx (PPX and PXUPA). Previously an offer was lobbed at PPX and PXUPA shareholders. PXUPA shareholders were offered $21.86. Therefore they would have taken a very large haircut on the face value of $100. Not surprisingly, they weren't happy and the deal fell over. But surprise(!) - even more value has since been destroyed and PXUPA are now $8.05. 

Hybrid holders can be better off with a company completely selling the assets off and returning cash in order of the capital structure. But there is one small problem: hybrid holders usually don't have a vote. So even though they are superior in the capital structure, management and ordinary shareholders get to decide how the company is run, and it is safe to assume it will be in their best interest. And if you were an ordinary shareholder, would you really care about the hybrid holders? 

Shareholders get to hold a gun to the head of hybrid holders: "accept a lower payment than face value and give ordinary shareholders cash or risk losing the lot". In reverse: "no way, we'd rather see the company wound-up. You get nothing. We get something". 

No one agrees. Stalemate. Steve Buscemi and Harvey Keitel style. 

This is my best guess as to why the share prices aren't moving as the balance sheet and capital structure would suggest. 

Even if I am wrong, what can be accurately concluded is that hybrid investments are not necessarily safer than ordinary shareholders. When things go wrong, things get ugly. Therefore, even though plenty of hybrids have demonstrated equity like returns for debt like risk (good!), sometimes they give debt like returns for equity like risk (bad!).  

This isn't a gun fight I want to get into and will not be trading either ELD or ELDPA. I just find the whole situation curious.  

And finally - Please let me know if I have missed something. Always happy to be proved wrong! 

Kristian 

Disclosure: no position in ELD, ELDPA, PPX or PXUPA