Outlook: Snags in a deeply discounted rights

At last, a company with the gumption to challenge the City's underwriting cartel and launch a deeply discounted rights issue. But hold on a moment. Is anything actually being achieved here?

Bodycote and its merchant bank adviser, Dresdner Kleinwort Benson, have decided to dispense with underwriting commissions altogether in raising pounds 99m from shareholders. Instead the rights are being pitched at a deep discount to the prevailing price of Bodycote shares, so that even if the stock market collapses before the issue can close, Bodycote is still virtually guaranteed of getting its money.

The company thus saves itself the traditional 2 per cent underwriting fee, while retaining the money in the bank certainty which provides the main justification for such fees. Just the ticket.

So if this is such a great idea, why isn't it more commonly used? One possible explanation is that in the wake of the recently ordered Monopolies and Mergers Commission probe into the underwriting cartel, the old system is already crumbling and the City is reforming itself under its own steam. In the old days companies would have been advised strongly against this approach, if only because it deprived the City of its commission.

Annoyingly for Dresdner, which now looks as if it is reacting to pressure, the deeply discounted route for Bodycote was under actually being planned before the MMC investigation was launched. But it is certainly the case that the threat of regulatory action has stirred the City into reform, of which this is an example.

Nor have the merchant bankers and lawyers been left entirely penniless by the exercise. There is still a pounds 2.4m charge to Bodycote in advisory fees (or 2.4 per cent of the sum raised), though to be fair most of this is accounted for by the related cost of the HIT acquisition in France.

Moreover, the Bodycote issue suffers from a familiar problem with deeply discounted rights; what the company gains in lack of underwriting commissions, it loses in terms of having to pay out enhanced dividends, which increase the long term costs of the capital raised. In order to make this issue attractive to shareholders, Bodycote is first increasing the dividend on the existing share capital by 34 per cent. The effect is that Bodycote will have an ongoing dividend cost on the new capital of about double what it pays on the old.

In Bodycote's case, this hardly matters. The amount raised in relation to its total market capitalisation is relatively small. Bodycote is also a high growth stock with a tiny yield. The real test of a deeply discounted rights is going to be when it also involves a pro-rata cut in the dividend, to reduce the costs of the extra capital. Some shareholders, particularly small ones, object to this because if you don't take up your rights it leads to the illusion of reduced dividend income. Will the City go for such an approach? Now why does that seem so unlikely?