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What are Warrants and what is a Bond/Warrant?

PURE Asset Management

September 2023

What is a warrant?

A warrant is much like an option. Both are financial instrument that grant the holder the right, but not the obligation, to buy a specific underlying asset (such as a share) at a specific price (strike price) on or before a specified date (expiration date).

Options are more common instruments and are used for a variety of purposes such as employee incentive programmes, or in lieu of fees to a third party.

In smaller companies they can be offered as part of an equity raise, as an incentive for investors to participate. The terms and conditions of company-issued options are typically determined by the issuer Company.

The key difference is that warrants are usually negotiated between the Company and the incoming investor, be they debt or equity providers. As a bilateral negotiation the terms can vary widely, whereas options tend to be more standardised.

What are the main differences between warrants and options?

Warrants and options issued by a Company as an investor incentive are similar to warrants, with the key differences being:

1. Warrants are negotiated with the investor, but option terms are determined by the Company, typically without consultation.
2. Warrants tend to have a longer life until expiry than options, which can be up to several years. Options typically have expiration dates of 6-18 months.
3. Warrants often have strike prices that are at a higher premium to the current market price of the underlying shares.
4. Warrants are typically priced based on several factors, such as the underlying asset's price, the strike price, the expiration date, and the issuer's creditworthiness. Options, on the other hand, are typically priced based on the volatility of the underlying asset and the time until expiration.
5. Options are sometimes listed on the exchange, offering the holder the opportunity to sell the option, whereas warrants are normally unlisted, and although tradable, this happens rarely.
6. During negotiation with the Company a warrant holder can include more sophisticated clauses to protect the owner from dilution, or the loss of value in the event of a takeover.

What are the attractions of warrants/options?

Primarily the attraction of a warrant or option is leverage to the underlying share price.  The value of a warrant/option, in its simplest terms, if made up of two components:

• Intrinsic value - if the share price is above the strike price, intrinsic value is the difference between the strike price (the cost of exercising) and the share price (the value the investor receives when exercised. If the share price is below the share price there is no intrinsic value.
• Time value - this is a mathematical formula (typically a Black & Scholes model) that tries to value the potential for future profit. This component tries to value the probability by reference to how long the warrant/option has to run before expiry (the longer the better); how much the share price needs to increase before it rises above the strike price; and the likelihood of that happening, which is a function of the volatility of the share price.

What this all means is that although a warrant/option may not have intrinsic value, it can still be valuable if the potential of future profit remains high. The longer the time frame until expiry; the smaller the gap between the strike price and the share price; and the higher the volatility of that share price, are all positive attributes. And vice versa.

The appeal of warrants or options is that the holder may not have paid to acquire them or may have paid very little for this future potential profit. Over time, if the share price rises above the strike price, the investor will enjoy the opportunity of exercising and converting into shares for a profit, which may be far greater than the price paid to acquire the instrument.

For example:

A share price is trading a $2.00 and the warrant/option was acquired for $0.10, with a strike price of $2.50, with a two-year life. At the time of issue, the only value is time value. This value will rise as the share price moves closer to the strike price, but this increased value will be offset be the decline in the time that is left to exercise.

If after two years, the share price is $3.00, and the investor exercises the warrant/option and immediately sells the shares, they will be able to realise a $0.40 profit. This is calculated as follows:

The appeal is that, compared to simply investing the shares, there is much more leverage to the rising share price. Using the same example above, but instead buying the shares, the investor would have made a 50% return.

Therefore, although the investor is taking more risk by buying a warrant or option, because of the limited time frame until expiry, they can achieve the same profit while deploying far less capital. See below, where both scenarios yield a $5,000 profit, but the investor in the warrant/option has had to invest just 12.5% of the capital to achieve the same outcome:

What is a Bond/Warrant?

A bond/warrant is Convertible Loan broken into its two constituent parts, being a bond (or loan to a Company), with a detached Warrant (an option to buy the shares).

Just like a convertible loan, when the warrants are exercised, the investor is effectively converting from debt into equity. This is achieved by making the cost of exercising the warrant the same as the value of the loan, so that when the Company receives the proceeds from exercise, they can be used to extinguish the loan. In turn, the investor has effectively cancelled the loan, in exchange for shares from the Company.

Just like a convertible loan, the attraction to the investor is that they prior to conversion they receive the benefits of a loan structure: interest and more protection in the capital structure, but they also have the opportunity to make an additional profit if the share price rises above the strike or conversion price.

Often a traditional convertible note does not allow the flexibility of early repayment because when the loan is repaid the investor loses the optionality of converting into shares. Convertible notes often prohibit early repayment because issuer Companies may be incentivised to repay or refinance the convertible note, just before the investor can profit from the rising share price.

Therefore, a bond/warrant structure can be attractive to the Company versus a traditional convertible loan as the Company retains the right to repay the bond whenever it chooses. Likewise, the investor is happy because if the loan is repaid early, they retain the warrant and keep the optionality to make a profit from the rising share price, but without any capital at risk i.e., they have created a free warrant.

Bond/warrants are a win-win for both the investor and the Company, but they are also a win for other shareholders. This is because the inherent attraction of the structure means the warrant strike price can justify at a material premium to the prevailing share price, therefore shareholders are less diluted, compared to raising capital via the issuance of shares. It's a win-win-win!

Funds operated by this manager:

PURE Income & Growth Fund, PURE Resources Fund

Hedge Clippings | 06 October 2023

As expected, the RBA kept rates on hold last Tuesday, and in the Governor's statement following the board meeting, incoming chair Michele Bullock stuck to her predecessor's script: While cautious, she expects inflation won't be back to the 2-3% target range until late 2025 - at least 2 years away.

As always, the last sentence of RBA-speak remained consistent: "The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome." That warning provides those economists predicting one more rate rise this cycle the chance that they'll be proven correct, but based on the numbers available at present, the 12 upward steps totaling 4.0% taken to date seem to be having the intended result - although the progress is painfully slow, while the effect on mortgage holders is just painful.

Things may seem steady in Australia (at least on the monetary policy front) but in spite of our comment in last week's Hedge Clippings that the outlook for US rates was broadly the same as here (i.e. steady as she goes, although "higher for longer") but with the chance of one more rate rise, that possibility seems to have been confirmed.

The market was certainly not waiting for confirmation: The yield on 30-year US government bonds hit 5% on Tuesday for the first time since 2007. In the United Kingdom, the yield on 30-year bonds also reached 5% this week, the highest level in more than two decades.

Yields on German long-dated bonds are back to levels last seen in 2011. Yields on Italy's 10-year bonds hit 5% on Wednesday, the highest level since 2012, when the Eurozone debt crisis was in full swing.

So even though the outlook for Australian rates may be cautiously optimistic, (i.e.staying steady) the global outlook for bonds, and, as a result, equities, is causing considerable pain both globally and in Australia.

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Is Tesla just another car company?

Montgomery Investment Management

September 2023

In the ever-evolving landscape of the automotive industry, few companies have captured the world's attention quite like Tesla. Thirteen years ago, electric cars were synonymous with virtue signalling rather than high-performance excitement. However, Tesla disrupted this perception, transforming electric vehicles into something thrilling and aspirational. Its journey, from a modest initial public offering (IPO) in 2010 to a valuation exceeding $1 trillion in 2019, has been nothing short of remarkable. Yet, recent stagnation in Tesla's stock price has prompted a critical question: Is Tesla still the visionary pioneer it once was, or is it merely becoming "just another car company"?

A background to Tesla

Thirteen years ago, in 2012, hybrid electric cars were unsexy and uninspiring. Think of the Toyota Prius here in Australia, or the Chevrolet Volt and Nissan Leaf in the U.S. These were virtue-signaling vehicles designed without mass appeal in mind. Manufacturers also had a vested interest in their legacy internal combustion engine (ICE) models and weren't tooled up for mass adoption of electric vehicles (EV).

Tesla changed all that, first delivering exciting luxury cars that also happened to be fast and battery-powered, before widening the appeal by launching more affordable models that were also powerful and equally good-looking.

Around thirteen years ago, a small company called Tesla Motors (NASDAQ:TSLA) launched its initial public offering (IPO) on the NASDAQ stock exchange, raising a total of U.S.$226.1 million at a (split adjusted) share price of U.S.$3.40. Three years later, in 2013/14, Tesla transitioned from being essentially a start-up with highly uncertain survival prospects to being a credible auto business, redefining public expectations around electric vehicles with its introduction of the Model S, and in 2013, generating its first quarterly profit.

Excitement in the stock market for Tesla, however, was arguably greater. Between 1 January 2013 and 1 January 2014, consensus full-year earnings forecasts for Tesla were revised up sharply, with 2015 net income forecasts moving from U.S.$247 million to U.S.$432 million and 2016 net income forecasts moving from U.S.$415 million to U.S.$784 million.

The less-than-doubling of earnings expectations however, resulted in a 10-fold increase in the share price as the discount associated with doubts about the company's survival unwound.

Tesla's profits fell well short of those forecasts, with the company reporting a net loss in 2015 of U.S.$889 million and another net loss in 2016 of U.S.$773 million. Yet the market's excitement didn't wane. The share price gains didn't continue, but the price gains didn't reverse either. Profitable hopes were simply deferred.

At the start of 2015, Tesla commanded a market valuation of close to U.S.$30 billion, well short of the value ascribed to the world's largest automakers, but still around half that of Ford and General Motors.

It wasn't until 2019 that the fortunes of Tesla started to take off, with its shares jumping from U.S.$12.65 in May 2019 to a split-adjusted U.S.$409.97 on November 04, 2021, and a market capitalisation of over U.S.$1 trillion.

In mid-2020, Tesla achieved four consecutive quarters of positive net income for the first time in its history, and over the prior 12 months consensus net income forecasts for Tesla increased substantially. The 2021 forecast increased to U.S.$3.15 billion from U.S.$1.72 billion, and the 2022 number rose to $5.03 billion from $3.44 billion. This less-than-doubling of earnings forecasts had driven another 10x share price move.

Tesla today

Today, however, the share price is roughly where it was almost three years ago. If the gas has been let out (pun intended) of the share price's ascent, it begs a question: what if Tesla is just another car company?

Tesla is still the market leader in battery-powered electric car sales in the U.S., with a market share of above 60 per cent, and the company's flagship Model 3 is the best-selling EV model in the U.S..

Meanwhile, Tesla's market capitalisation today of U.S.$777 billion is more than the combined market capitalisation of the next eight biggest manufacturers, including (in descending order) Toyota, Porsche, BYD, Mercedes Benz, VinFast Auto, BMW, Volkswagen, and Ferrari.

Not unlike Apple, Tesla has adopted a closed-ecosystem approach to its products, owning the cars, the servicing, and the charging directly, setting it apart from other manufacturers.  But does this deserve the hefty multiple placed on the company's earnings that renders it as valuable as the world's next eight biggest manufacturers?

Investors can buy Toyota for $22,000 per vehicle sold in 2022, BMW for $27,825, BYD for $53,800 per vehicle sold, or they can buy Tesla for nearly U.S.$591,000 per vehicle sold.

The economics between Tesla and every other car manufacturer in the world, in the long run, might be slightly different. Still, they cannot be sufficiently dissimilar to justify such a disparity in either absolute market capitalisation terms or in relative terms. 

Despite a share price today that is 40 per cent below its all-time high, enthusiasm for the world-changing potential of EV technology has clearly translated to an equally transformative approach to stock market valuation for Tesla.

What investors are forgetting, however is that Tesla will ultimately be a car company.

As competitors catch up, the competitive advantage of Tesla will erode. Meanwhile, any differences in the economics of car manufacturing between Tesla and its rivals will also diminish as more of each brand's fleet moves to electric. In time it will be harder to justify such a disparity between Telsa's market valuation and that of its competitors. 

Ten reasons why the differences will narrow

Increased competition: As we have written about many times, an increasing number of automobile manufacturers, including traditional giants and EV startups, are producing electric vehicles that compete directly with Tesla's lineup. Brands like Ford, Rivian, Lucid, and Chevrolet have rolled out new electric models that, in some cases, outperform Tesla in terms of range, performance, and looks (the latter being subjective of course). And while the market for EVs overall is growing, Tesla's dominance in EV market share in the U.S. has already slipped from 72 per cent to 62 per cent in just the first year of rising competition and brand choice.

Meanwhile analysts believe Telsa's market share could fall to as little as 18 per cent by 2026 from 78 per cent in 2018.

Ageing product line: Tesla first new passenger vehicle model in three years is the just released updated Model 3. This 'stagnation' in model releases provides competitors with an opportunity to entice potential Tesla customers with newer and potentially more advanced options resulting in Tesla losing further share.

Struggles in key markets: China, the world's largest auto market, has been a significant growth engine for Tesla. However, the company has experienced a softening in demand in China. Local competitors, of which BYD Co. is the largest by no means alone, are making significant strides, offering a more diversified range of models that cater to various price points. Critics in China suggest Tesla does not fully understand the preferences of Chinese consumers.

Marketing and branding issues: Tesla's decision to offer discounts to boost sales is a departure from its earlier stance, indicating potential demand challenges and lower margins. Furthermore, Elon Musk's controversial takeover of Twitter Inc. has affected Tesla's brand perception, pushing some potential buyers away.

Distracted Elon Musk: Many shareholders are concerned that Elon Musk, the driving force behind Tesla, has been distracted with his acquisition and management of Twitter, now called X. Such diversions annoy analysts who believe they could impact Tesla's strategic directions and operational efficiency.

Share price malaise: Tesla's share price is unchanged from almost three years ago, suggesting investors are acknowledging the challenges Tesla faces and waking up to the reality of the long-term economics of manufacturing cars.

Inability to meet growth targets: Despite aggressive scaling efforts, Tesla is falling short of its annual growth targets. With a 40 per cent annual growth rate in 2022 compared to 87 per cent in 2021, the company's exponential growth might be plateauing if Elon Musk's target of two million vehicles in 2023 is not met.

Shifting strategies: Elon Musk's statement back in July 2021 that the "goal is not to be a car company" suggests a broader and potentially more diffuse focus and remains a reminder for analysts who focus too closely on the company's position and growth in the automobile industry.

Over-reliance on existing models: Rather than diversifying its lineup, Tesla is focused on scaling up and churning out as many of its existing models as possible. This strategy is at odds with conventional (and capex intensive) wisdom that releases new models almost annually. The traditional auto industry belief is car makers need to offer a wide range of updated and more advanced models to keep buyers interested and part of their brand 'family'.

Valuation metrics: At September 2023 Tesla is trading at 63.1 times trailing twelve-month (TTM) earnings. This compares to 120 times at the end of 2021. At either measure the price-earnings (PE) is a market valuation more typical of high-growth tech companies than a car manufacturer.

Conclusion

If Tesla does indeed become 'just a car company', the sharp drop in PE will continue and reflect a growing realisation in Tesla's growth prospects, its position in the auto industry, and its economics are less exciting than once believed.

Tesla remains a global leader in the EV market with strong fundamentals, however, there are clear signs that it faces increasing challenges from competitors, potential demand issues, and market sentiment shifts. The lofty valuations and hype surrounding the company needs to be re-evaluated considering these inescapable realities.

Author: Roger Montgomery

Funds operated by this manager:

Montgomery (Private) Fund, Montgomery Small Companies Fund, The Montgomery Fund

The hidden value in securitisation warehouses

Challenger Investment Management

September 2023

Funds operated by this manager:

Challenger IM Credit Income Fund, Challenger IM Multi-Sector Private Lending Fund

China - the re-opening trade that never quite was

4D Infrastructure

September 2023

Funds operated by this manager:

4D Global Infrastructure Fund (Unhedged), 4D Global Infrastructure Fund (AUD Hedged), 4D Emerging Markets Infrastructure Fund

For more information about 4D Infrastructure, visit https://www.4dinfra.com/

^{The content contained in this article represents the opinions of the authors. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.}

Hedge Clippings | 29 September 2023

Although some sections of the media attempted to make a big deal of it, Wednesday's headline annual inflation rate for August, which came in at 5.2%, up from 4.9% the previous month, was both widely expected, and no cause for the RBA to reverse their recent "pause" approach.  That will come as a relief for Michele Bullock, who would hardly have wanted to kick her tenure off with a rate rise after three straight months of them holding steady.  

The RBA board will be more interested in the core inflation level, which excludes volatile items such as fruit and vegetables, fuel, and holiday travel, and which fell to 5.5% from the previous month's level of 5.8%. The pain points in the numbers were bread and cereals, and dairy, both of which recorded a 12 month rise of just over 10%, offset by fruit and vegetables which fell by 8.3%. We assume anyone on a diet of bread and potatoes therefore (apart from a growing girth) would have come out about even!

On a more serious note, gas and electricity rose over 12%, and fuel costs were up almost 14%, as anyone who has filled up recently would know. While inflationary, both these are in part doing the RBA's job of dampening consumer demand, as evidenced by the insipid retail sales figures for August, which came in at 0.2% for the month, and 1.5% for the year.

While a few economists are still predicting the possibility of one more rate rise down the track from the RBA, on current data that's unlikely. However, the "stronger for longer" inflationary and interest rate outlook is far more likely, with our view that the 2-3% band is at best a long way off, and quite possibly a thing of the past.

Ditto in the US, although the potential for one more rate rise is possibly a little higher than here. However Jerome Powell is shooting for 2%, as opposed to the RBA's 2-3% band, and that's going to be even harder to achieve without more consumer and economic pain.

Ditto, or at least "deja vu" seems to be the best way to describe a number of goings on in the US at present: The recurring potential for a government funding shutdown is on again, although as yet markets don't seem too concerned. Maybe they're getting used to it, having seen previous negotiations always end up the same way - with an increased debt ceiling. Sooner or later one would think the ceiling's going to crack, or ...?

And finally, in the US everything to do with Donald Trump also seems to be a recurring theme, with yet another court appearance (and loss), and yet another non-appearance at a Republican presidential debate. Neither avoidance, nor appearance seem to dent Trump's self belief, or for that matter, his supporters' commitment to his cause. Only in America!

Moving on: We could try to intertwine commitment into any discussion regarding the Wallabies performance in the RWC last week, but that might be a cheap shot. If you take a youthful squad, many of whom should only have been playing at the 2027 event, and leave your most experienced players behind, what do you expect? As far as commitment goes, or the perception of it, Eddie's discussions with the Japanese RU will hopefully result in him accepting their job offer. If it comes, it can't come soon enough!

We hope the Wallabies can overcome Portugal on Monday morning, but even that might not be a foregone conclusion based on last week's performance. However, this week-end should see a tighter contest at both the AFL and ARL Grand Finals. Sit back and enjoy, and may the best teams win.

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