Better to be a saviour than saved

The latest Teachers loan may save RailPower. If so, Teachers will also be the big winner

FABRICE TAYLOR

Fabrice Taylor is a chartered financial analyst. [email protected]
The Globe and Mail May 28, 2008

RailPower Technologies investors are suffering from another near-life experience. Late last year, they cheered when the Ontario Teachers' Pension Plan injected $35-million into the struggling company, saving it from insolvency. The stock tripled before promptly plummeting. This week, when Teachers once again saved the company's life, the cheering was just as short lived, even though the company's future looks a lot brighter than it did. RailPower shares almost doubled on the news, then crashed yesterday, probably as investors realized what being saved would cost them.

The lesson: It's better to be the saviour than the saved in a rough market.

RailPower makes ecofriendly locomotives that are used at ports and train yards. The engines also supposedly save fuel, so with oil at $130 (U.S.) a barrel and environmental calamity in the headlines, it's an alluring business. That allure once registered in the share price, which was above $6, compared to a few dimes now.

The trouble was largely caused by recalls, which cost a lot of money but also dried up the order book as wary buyers took the old wait-and-see approach. That took the stock down to about a quarter last December, when the first Teachers deal was announced.

The pension plan would finance the company by way of a loan convertible into shares. The loan would bear interest at 5 per cent and be convertible into stock at 30 cents a share. The stock rocketed to 75 cents in January when the deal closed after shareholders voted overwhelmingly in favour of it.

That money helped, but it didn't entirely solve the company's problem, which was that it outsourced manufacturing to third-party factories, leaving quality control and timeliness to someone else. In order to get the confidence of customers, RailPower's management and board figured they should manufacture the engines themselves.

But that would cost money. Where to get it? Enter Teachers again. This time the deal was a $20-million convertible loan bearing the same rate of interest but convertible into common stock at 40 cents.

That deal may or may not save the company, but if it does, Teachers will be the biggest winner. Look at the math: As of March 28, when it filed its annual information form, RailPower had 89.5 million shares outstanding. Assuming the company puts the Teachers cash to constructive use and turns things around, Teachers will convert its loan into shares. The retired educators of Ontario will own 65 per cent of the company. In other words, two-thirds of the company's future earnings, such as they may be, have been taken away from existing investors as a result of these two loans. (If you include outstanding warrants, assuming they, too, will be exercised, Teachers will own 61 per cent, by my abacus. They mostly strike at $1.25, though.)

Of course, the alternative - possible bankruptcy - makes that an easy choice. But there are questions. Why did RailPower choose convertible debt? While the financing rate - 5 per cent - is attractive, the dilution cost is astronomical.

Plus, convertible debt invites a short sale. I'm not sure if Teachers has done this, or if it's possible in this case, but investors buying convertible debt - who lend companies money this way, in other words - often raise some of the cash by selling the stock short, which increases their return. Hypothetically, let's say Teachers could borrow 10 million shares and sell them at 70 cents. It now has $7-million of the $20-million to lend RailPower essentially free (ignoring borrowing costs, etc.) and the effective interest rate it earns on the loan moves closer to 8 per cent. Plus, because it can convert debt into shares, it runs very little risk of being caught in a squeeze. (Again, I don't know if that's happening, or if it can, in this case.)

Another question: Given the tsunami of dilution, why did the company not do a rights issue, giving existing investors the opportunity to maintain their ownership? It could have been backstopped by a player, such as Teachers.

I asked but the company referred me to the proxy circular, which hasn't been filed yet, so investors will have to read it before they vote on the Teachers deal. RailPower may have very good reasons for not choosing a rights issue. One hopes expediency won't be among them.

In any case, Teachers seems to have struck a good deal by garnering a majority of the upside for $55-million compared to other investors' contributions in excess of $180-million.

Like I said, having both cash and courage when others don't can pay off.

The Globe and Mail