Company warrant of MRCB

MRCB just released its 2014 second quarterly result ended 30 June 2014. It recorded cumulative revenue and net profit before tax of RM530.3m and 162.7m respectively as compared to the same period of RM447.8m and RM18.2m respectively in the preceding cumulative period. The earnings per share for the quarter is 7.11 sen. Thanks to the higher revenue contribution by the Q Sentral Office and the Sentral Residences projects, and the gain from the disposal of the Duke Highway.

Going forward, there appears to plenty of excitement with the achievement of several milestones; the resolution of the dispute with PKNS on P.J. Sentral, the entering of the Definitive Agreement with Kwasa Land for the development of MX-1 Land and the completion of the acquisition of the balance 51% equity interest in Penang Sentral Sdn Bhd, transportation hubs and others.

Hence it appears that there may be some excitements in investing in MRCB as there will be many ongoing as well as new projects in the near future. Rather than just looking at MRCB itself, why don’t we look at its warrants too?

Why invest in company warrant?

Company warrant is a derivative instrument, like a call option, which gives the holders the right, but not an obligation, to subscribe for new ordinary shares at a specified price during a specified period of time. Warrants have a maturity date (up to 10 years) after which they expire are worthless unless the holder had exercised to subscribe for the new shares before the maturity date.

Because the prices of warrants are low, and hence the relative much lower investment outlay, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains. Warrants generally exaggerate share price movements in terms of percentage change, and hence a perfect security in a bull market.

Warrants also experience outsized declines in a falling market, or even a total loss when the warrant expires out-of-the-money. However, as the investment outlay is low, there is a limit of that loss.

A case of MRCB Wa

MRCB and its warrant, Wa closed at RM1.68 and 27.5 sen respectively on 22^nd August 2014. The exercise price of Wa is RM2.30 and the expiry date is on 16 September 2018, or more than 4 years time. The warrant is hence way out-of-the-money with zero intrinsic value. The premium now is 53.3%.  Why do we invest in Wa when it is out-of-the-money and with a seemingly high premium of 53.3%? Why don’t we just invest in the underlying share?

The value of Wa is purely in its time value, a value which is considerable due to its long expiry date. If there is an increase in volatility and MRCB share price spikes up quickly, Wa will be in-the-money when MRCB share price goes up above RM2.30. MRCB share price has a time duration of 4 years to do that. Beyond that the sky is the limit for the return for Wa. The trick is in its relatively high gearing of 6.1 times which is very attractive. Hence Wa appears to be a good alternative investment if you are bullish about MRCB.

Black-Scholes Option Pricing

With the underlying share price at RM1.69, exercise price of RM2,30, 4 years to maturity, risk-free rate of 4% and a historical volatility of MRCB at 27%, the option value of Wa is 27 sen. This shows Wa at 27.5 sen, is apparently slightly overvalued. But why we want to buy it if it is overvalue?

The volatility as measured by the standard deviation of the return of MRCB for the last one year is a historical volatility. With the bright near term future outlook of MRCB as described above, the price of MRCB could spikes up quickly with much higher volatility. This can result in the increase in the warrant price quickly too, further amplified by its high gearing.

Payoff for MRCB warrant

Table 1 below shows the payoff for Wa for various price of MRCB before expiry of the warrant in four years time.

Table 1: Payoff

If the price of the underlying share does not move above RM2.30, the exercise price, when Wa expires in 4 years time, it will be worthless. Your initial outlay is the limit of your total loss. However, if MRCB share price moves up by 55% to RM2.60 any time within this 4 years, Wa can be exercised for a gain of 9%, way below the return of the underlying share. However, from then on the rise of warrant will be very steep as shown in Figure 1 below.

Figure 1: Payoff for underlying share and warrant of MRCB

If MRCB share price rises up by 138% to RM4.00, you can exercise the warrant and make a gain of 518%, , about 4 times more than the gain in the underlying share. Figure 1 above depicts the payoff at different price of MRCB. It can be seen from the figure that when the share price of MRCB goes above RM2.60, Wa will provide very handsome return.

Conclusion

MRCB Wa, with quite a long time to expiry of four years,  is trading at an undemanding valuation in terms of premium of 53.3%. Furthermore, it has a high gearing of 6.1 times which would greatly amplify the gain if the underlying share price spikes up before the expiry date.  Hence, if you believe in a company like MRCB as an investment with its various high profile projects, Wa is definitely a good alternative buy.

K C Chong (23/8/14)