Western Financial Group (common: WES.TO) is primarily an insurance brokerage in Western Canada. They have been able to grow their top line consistently over the past few years, while their bottom line, although profitable, has fluctuated with the market. It is likely they will continue to be making money in the future, so payment of debt and preferred securities should not be an issue, barring any huge global financial crisis.
They have an issue of preferred shares (series 5, WES.PR.C) that has the salient details:
$100 par value, 9% coupon, payable semi-annually;
Holders can convert into common at $2.81/share anytime;
Issuer can convert if common is $3.79/share or higher after September 30, 2012;
Issuer can convert if common is $2.81/share or higher after September 30, 2014.
As I write this, the common is trading at $2.87/share and gives a 4.28 cent annualized dividend (1.49% yield). The preferreds are illiquid and the bid-ask midpoint is $113/share.
To value this preferred share, you must break down the fixed income component and the embedded call option that you (a preferred shareholder) sell to the company.
The fixed income component is simply [coupon / (share price / par value)], which in this case is 7.96%.
The more difficult valuation is with the conversion component. This creates a few scenarios, and note that we assume we sell the common shares immediately after conversion:
1. If the common trades above $3.79/share on September 30, 2012;
2. If the common trades above $3.79/share between October 1, 2012 to September 30, 2014;
3. If the common trades less than $3.79/share after September 30, 2012, but trades above $2.81/share after September 30, 2014.
4. If #1, #2 and #3 do not apply and if the common trades less than $2.81/share after September 30, 2014 until X date.
Scenario 1 is fairly easy to calculate – if you anticipate this happening, you really should invest in the common shares rather than the preferred shares. If the common stock ends up at $3.79/share on September 30, 2012, you will essentially be receiving $135 of value for your preferreds, plus 5 semi-annual coupon payments. A $113 investment will result in $135 in capital gains, plus $22.50 in coupon payments over a 2.40 year period. Annualized, this works out to a 7.69% capital gain, plus a 7.96% income yield. This is contrasted with a common stock performance of 12.3% capital gains and 1.49% income yield (assuming no dividend increase) over the same time period.
In this event, the preferreds seem to be the better investment, especially when seniority is considered. If the common shares go higher than $3.79/share before 2.4 years, the returns between the preferred shares and the common will be proportionate.
Scenario 2 will result in the same absolute return, but depending on when the threshold common stock value is reached, it will result in the same absolute return in terms of capital, but the annualized yield will be less because of the extra time taken to reach the conversion threshold. As an example, if $3.79 is reached on September 30, 2013, the preferreds will have an annualized capital gain of 5.37%, and an income yield of 7.96%, while the common will have a capital gain performance of 8.52% and income yield of 1.49%.
Scenario 3 – assuming the common stock does not go anywhere (i.e. stays at $2.87/share) for the next 4.4 years, a common share investor will receive a 0 capital gain and 1.49% income yield; the preferred holder will receive a 6.4% capital loss on conversion (annualized will be 1.42% loss), but retain an income yield of 7.96%. There are multiple variables at play – when the conversion price is reached and what price occurs at September 30, 2014. For a 10% increase in common share value above $2.81, the preferred shares’ effective value on conversion also increases by 10%, but is capped to 35% when $3.79 is achieved.
Scenario 4 involves a loss – in this event, the fixed income nature of the shares will be more apparent and the conversion privilege becomes less valuable. A common shareholder will lose more capital than the preferred shareholder.
At a value of $113/share, the value of the common shares needs to be $3.18/share in order to avoid a loss of capital upon conversion. This is approximately 11% above the current common share price, but the preferred share holder is compensated for this by the higher coupon payment – they would receive payback for this difference in about one and a half years of coupon payments.
As such, somebody interested in Western Financial Group should be better off buying their preferred shares rather than the common shares as their preferred shares, for now, has a relatively high correlation to the appreciation of common shares, but will be giving out a significantly higher income stream. The only disadvantage is that the preferred shares are horribly illiquid and getting a fill at a decent price and/or size is not easy when nobody is trading.