CEB’s convertible preferred shares: Subscribe for capital gains, not income

A lot of investors buy preferred shares to earn bigger income compared to bonds as yields on preferred shares are higher. Moreover, dividends on preferred shares are taxed at only 10 percent, which is less than the 20-percent tax on interest income from bonds, providing investors of preferred shares with an even higher net return.

Remember though that preferred shares are riskier compared to bonds which is why yields are higher. If a company loses money, it must still pay interest on bonds. However, under the same circumstance, a company may decide to postpone or not pay dividends on preferred shares. Moreover, if a company goes bankrupt, bond holders take precedence over preferred shareholders, implying a greater risk of capital loss.

This week, investors who own common shares of Cebu Pacific as of record date Feb. 26, 2021 (ex-date Feb. 22), must decide whether to subscribe to convertible preferred shares being offered by the company. Owners of Cebu Pacific common shares as of the said date can purchase one convertible preferred share for every 1.825 common shares owned at the offer price of P38.00 a share. The convertible preferred shares carry a dividend rate of 6 percent and each share can be converted to one common stock. Furthermore, the shares have a mandatory conversion feature on the 6th anniversary of the issue date.

Although Cebu Pacific’s convertible preferred shares provide an attractive dividend yield of 6 percent based on its offer price of P38, it is not recommended for investors who buy preferred shares for passive income. There is a strong likelihood that Cebu Pacific will not be able to pay dividends on its convertible preferred shares in the near term. The airline industry is one of the hardest hit by the coronavirus pandemic. During the first nine months of 2020, Cebu Pacific lost P14.7 billion and although the Philippine economy is slowly reopening, Cebu Pacific needs to operate at around 45 to 50 percent of prepandemic level to reach cash flow breakeven, which is still a long way to go given that it is currently operating at only 20 to 25 percent of capacity based on COL Financial’s estimates.

Moreover, net proceeds of Cebu Pacific’s convertible preferred share issuance amounting to around P12.4 billion is only enough to cover the repayment of advances made by JG Summit, passenger refunds, aircraft operating lease and principal debt repayments due in 2021. The company is planning to raise up to P32 billion more through debt facilities and other equity-linked instruments to finance its operating and capex requirements, giving it enough runway to survive the next 18 to 24 months.

Due to its convertible feature, Cebu Pacific’s preferred shares are expected to closely track the performance of the airlines’ common stock, making it more volatile compared to typical preferred shares, which go up and down largely due to interest rate movements. Finally, Cebu Pacific will not be repaying the principal of convertible preferred shareholders because all outstanding convertible preferred shares will be mandatorily converted into common shares in six years. Investors could suffer from capital loss assuming that the price of Cebu Pacific’s common shares will be below P38 by then.

Although Cebu Pacific’s convertible preferred shares are not suitable for investors looking for passive income, it is an attractive instrument for investors who are looking for capital appreciation and can stay invested for a long time. In fact, Cebu Pacific’s convertible preferred shares are more attractive than its common stock because owners of convertible preferred shares also have the potential to earn cash dividends aside from the potential for capital appreciation.

Like common shareholders, the major risk facing convertible preferred shareholders is the risk of bankruptcy. At this point, there is no visibility on when Cebu Pacific can turn around its operations since the company is far from breaking even. As mentioned earlier, the company still needs to raise more funds just to survive the next two years.

Nevertheless, there is reason to believe that demand for air travel will eventually return if not exceed prepandemic levels, preventing Cebu Pacific from becoming bankrupt. For example, in China and Vietnam, demand for domestic air travel has already returned to 2019 level. The two countries’ success in controlling the number of coronavirus infections was largely responsible for the V-shaped recovery. With vaccines soon to be available, there is hope that it won’t take long for air travel to return to normal in the Philippines.

Cebu Pacific is also more efficient and less indebted compared to its peers. For example, in 2019, the company had an Ebitda margin of 33.3 percent, which is much higher than the 11-percent average of other airlines in Emerging Asia, based on Bloomberg estimates. It also had a net debt to equity ratio of 1.66X. These factors will allow the Cebu Pacific to recover faster compared to other airlines when demand for air travel returns.

Finally, at P38, the price of Cebu Pacific’s convertible preferred shares is reasonable. In 2019, Cebu Pacific’s stocks traded at an average price of P88.81. Admittedly, it will be difficult for Cebu Pacific to trade at the same price even if profits return to prepandemic level in the next few years because there will be more common shares outstanding. However, if the company won’t need to issue more than 470 million new shares on top of the 329 million shares that it will issue for the convertible preferred shares to survive the crisis, then there’s a good chance that its common stock will be worth more than P38 in the next six years.

In short, if you are looking for passive income, Cebu Pacific’s convertible preferred shares is not for you. But if you want to be a shareholder of Cebu Pacific because you believe that air travel will eventually return to normal and that the company will survive the crisis, then you should subscribe to the rights offering and buy its convertible preferred shares. INQ