Controversial exchangeable from UOL as it banks UOB stake

Fierce competition and short-dated structure makes for another testing equity-linked deal out of Singapore.

United Overseas Land (UOL) moved to dispose of its stake in United Overseas Bank (UOB) after Singapore's close on Wednesday (December 1) with an S$506.22 million ($310.4 million) exchangeable via Credit Suisse First Boston. Like so many Singaporean equity-linked deals before it, the deal could hardly be described as a roaring success and the lead ended up having to re-price the deal at a level, which is believed to have come through its fees.

At the heart of the problem was a structure that investors were always certain to dislike coupled with aggressive terms that had been exacerbated by the bidding contest banks went through to win the mandate. The structure was based around a nine month maturity, the like of which investors tend to hate because it does not allow them enough time to ride the equity story or make money from the option.

No deal from Asia is ever believed to have structured a maturity this short before and only three have ever tried to squeeze the call or put option. In February 2001, for example, Quanta Computer completed a deal with a nine month put, followed by Cable & Wireless in April the same year with an immediately callable exchangeable into PCCW. Then as recently as February 2003, Macronix issued a convertible with a nine-month call.

However, whereas Macronix and Quanta are both highly volatile tech stocks that might reach the conversion premium relatively quickly, UOB is a low volatility property stock that has been range trading in the S$12 to $14 band for over a year.

The rationale for the short dated maturity lies with UOL's desire to sell its 4.2% stake in UOB, which in turn owns 48.9% of UOL. Both companies are owned by banking tycoon Wee Cho Yaw and analysts have long wondered how the cross shareholding would be unwound, while allowing the Wee family to retain control of the bank.

Under MAS regulations, local banks have until summer 2006 to divest non-core assets such as UOL. Earlier this year, Temasek made two approaches to acquire UOL, but both offers were allowed to lapse by UOB, which was being advised by CSFB.

Analysts speculated that the Wee family did nothing because it needed UOL's 4.2% stake in UOB to maintain majority control of the bank. The family is said to directly hold 10% to 14% of UOB stock and a further 7% through affiliated companies Haw Par Corp and Overseas Union Enterprises. The freefloat was 87% pre deal.

The exchangeable represents 2.1% of UOB stock. Concurrent to the deal, UOL released a statement saying it had sold the remaining 2.1% of its UOB stake raising S$284.15 million ($173.4 million) net of tax. It did not say over what time period it sold the stake or to whom. What it did say was that it would pay the proceeds back to shareholders in the form of a special dividend.

One month ago, UOB also announced a buy back programme of its own shares amounting to 2.4%. Analysts have said they were surprised this news did not have a beneficial impact on the stock price since UOB had previously announced its intention to boost ROE by various capital management exercises including share buybacks.

Having won the exchangeable over other UOB house banks including Deutsche Bank and Merrill Lynch, lead manager CSFB initially attempted to sell the exchangeable at 99%, but had to drop the price to 98.5% to clear it through the market. It is believed to have originally bought the deal at par and negotiated a 1% fee.

This means it will have made a loss on the trade unless it is sitting on a proprietary position, which it can sell at a premium if the deal trades up in the secondary market. All that CSFB is prepared to say is that it was fully distributed to institutional investors with participation by about 25 accounts.

Based on an issue price of 98.5% and redemption price of 98.3%, the zero coupon deal has a yield to maturity of minus 0.27%. Based on an issue price of par, the yield is minus 2.25%.

There is a also an exchange premium of 12% over UOB's spot close of S$13.70 on Wednesday.

Based on an issue price of 98.5%, underlying assumptions comprise a bond floor of 96.7%, implied volatility of 16.5% and theoretical value of 98.1%. This is based on a credit spread of 50bp, stock borrow cost of 50bp, dividend yield of 4.5% and 50-day volatility of 15%.

Specialists say there were two key selling points, which investors failed to heed. Firstly volatility levels have been falling all year and while many market participants believe they should start rising soon, they have so far failed to do so and investors have not as yet been prepared to give structures the benefit of the doubt.

As one puts it, "Volatility levels have now got so low that some investors are happy to own these kinds of options on the basis that levels have to start rising soon. Unfortunately we've been expecting the market to turn for the last four months and still nothing has happened."

This means that instead of using a 100 or 260-day volatility assumption in their pricing models, investors looked at short-term volatility levels, which made the difference between implied and assumed volatility far less attractive to play. For example, UOB's 260-day volatility is 19%, whereas its 25-day volatility is 14.2%.

As an issue price of 99%, the implied volatility was more like 18%, which was too far through accounts' conservative assumptions. At 98.5%, it dropped to 16.5%, which was felt to be more reasonable.

The second selling point was the conversion premium. While the stock has been range trading for over a year, the lead is likely to have argued that an overhang has now been removed from UOB, which should allow the stock price to bounce out of its current valuation range.

But again investors failed to bite. One banker comments, "The feedback we got was that two points isn't a great deal to pay, but a nine month option just wasn't worth the hassle and you'd have to have a pretty optimistic view of stock price performance."

And yet the stock did bounce on its first day of trading yesterday, rising 0.8% to $13.80 on Thursday and hitting an intra-day high of S$14. The exchangeable also rose to close Asian trading at 99% to 99.25%.

Some analysts believe the exchangeable will provide the catalyst for a re-rating of the stock. This is based on the prospect of increasing dividends as UOB sells off non-core assets such as UOL and boosts its capital management initiatives.

The bank has said it hopes to increase ROE to 15% by 2006. As of December 2003, the figure stood at 10.8%, with analysts forecasting a level of 12.5% level by year-end.

At 1.8 times price to book (adjusted), analysts also say the stock is trading at a low level relative to its peers and its own historic levels. DBS, for example is trading at 2.46 times adjusted book value.

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