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Two share classes worth Investigating

Ever wonder why some companies seem to have two listings, and two different prices on those listings? In earlier articles I've investigated the dual-share class / dual-listing structure for these companies:

Royal Dutch Shell (NYSE:RDS.A) & (NYSE:RDS.B) - Article - Dutch law for withholding taxes on dividends makes different shares right for different situations.

BHP Billiton Ltd (NYSE:BHP) & BHP Billiton PLC (NYSE:BBL) - Article - Australian tax law makes one of these shares far less attractive for US investors.

Unilever NV (NYSE:UN) & Unilever PLC (NYSE:UL) - Article - Dutch law for withholding taxes on dividends makes different shares right for different situations.

Carnival Corp (NYSE:CCL) & Carnival PLC (NYSE:CUK) - A lot to consider for the two listings, but in the end not a lot of difference between them.

Greif, Inc. (NYSE:GEF) & (NYSE:GEF.B) - Two share classes that trade relatively close to each other in price have remarkably different claims on earnings, dividends, and assets.

Lennar Corp (NYSE:LEN) & (NYSE:LEN.B) - Two essentially identical share classes available for investors, but liquidity concerns result in very different market prices.

(For unlinked articles check under author's articles)

Here, I am looking at Reed Elsevier. For American investors buying shares on the NYSE there are two options for investing in Reed Elsevier: ADR shares for Reed Elsevier NV (NYSE:ENL) and ADR shares for Reed Elsevier PLC (NYSE:RUK). This article will investigate and try and draw some conclusions on which shares are right for you and your investing situation.

Company Structure / History

Reed Elsevier provides professional information solutions worldwide. The company offers information and workflow tools that enables researchers to generate insights in the advancement of scientific discovery; publishes science and technology research articles and book titles; and provides abstract and citation databases. Other business segments include: Risk Solutions, Business Information, Legal, and Exhibitions. Reed Elsevier PLC was founded in 1894 and is based in London, the United Kingdom. Reed Elsevier NV was founded in 1903 and is based in Amsterdam, the Netherlands. (Edited from Yahoo! Finance sources: here and here)

The dual-listing structure for Reed Elsevier was created in January 1993, when Reed Elsevier PLC and Reed Elsevier NV contributed their businesses to two jointly owned companies, Reed Elsevier Group plc, a UK registered company which owns the publishing and information businesses, and Elsevier Reed Finance BV, a Dutch registered company which owns the financing activities. (Source: Corporate Website)

The investor website provides a visual aid for this:

(click to enlarge)

In conjuncture with the 1993 restructuring, several equalisation (equalization-US/UK spelling) agreements were entered into. Here is an outline of those agreements, with my own analysis following each section:

Ownership Structure in Shared Entities

-Reed Elsevier PLC and Reed Elsevier NV each hold a 50% interest in Reed Elsevier Group plc.

-Reed Elsevier PLC holds a 39% interest in Elsevier Reed Finance BV, with Reed Elsevier NV holding a 61% interest.

-Reed Elsevier PLC additionally holds a 5.8% indirect equity interest in Reed Elsevier NV.

Analysis: With this structure, changes in the level of profitability at Elsevier Reed Finance BV as compared to Reed Elsevier Group plc would have a greater impact on Reed Elsevier NV (61% interest) than Reed Elsevier PLC (39% interest). This would be modestly offset by Reed Elsevier PLC's 5.8% indirect equity interest in Reed Elsevier NV.

Share Relationship Structure

-One Reed Elsevier NV ordinary share is, in broad terms, intended to confer equivalent economic interests to 1.538 Reed Elsevier PLC ordinary shares.

-The equalisation ratio is subject to change to reflect share splits and similar events that affect the number of outstanding ordinary shares of either Reed Elsevier PLC or Reed Elsevier NV.

Analysis: I found no further agreements to ensure the 1.538 ratio into the future, which leaves the ratio hostage to the underlying business performance of Elsevier Reed Finance BV as compared to Reed Elsevier Group plc. Inquiries sent to investor relations regarding "share splits and similar events" went unanswered. I found no such events since the 1993 restructuring.

Breakdown of % Ownership in Combined Company

-Under the equalisation arrangements, Reed Elsevier PLC shareholders have a 52.9% economic interest in Reed Elsevier, and Reed Elsevier NV shareholders (other than Reed Elsevier PLC) have a 47.1% economic interest in Reed Elsevier.

Analysis: This is a reflection of the business values at the time. Changes in value at Elsevier Reed Finance BV that aren't identical to changes in value at Reed Elsevier Group plc would change this ratio. Furthermore, this is a statement apart from the equalisation ratio. This covers aggregate ownership interest as opposed to ownership interest on a per-share basis.

Dividends

-Holders of ordinary shares in Reed Elsevier PLC and Reed Elsevier NV enjoy substantially equivalent dividend and capital rights with respect to their ordinary shares.

-The Boards of both Reed Elsevier PLC and Reed Elsevier NV have agreed, other than in special circumstances, to recommend equivalent gross dividends based on the equalisation ratio.

-Reed Elsevier PLC ordinary share pays dividends in sterling and is subject to UK tax law with respect to dividend and capital rights.

-Reed Elsevier NV ordinary share pays dividends in euros and is subject to Dutch tax law with respect to dividend and capital rights.

Analysis: This states that dividends and capital rights (breakup / dissolution value) are substantially equivalent with regards to the equalisation ratio. This also highlights currencies and tax law associated with each share class.

Principal Assets

-The principal assets of Reed Elsevier PLC comprise its 50% interest in Reed Elsevier Group plc, its 39% interest in Elsevier Reed Finance BV, its indirect equity interest in Reed Elsevier NV and certain amounts receivable from subsidiaries of Reed Elsevier Group plc.

-The principal assets of Reed Elsevier NV comprise its 50% interest in Reed Elsevier Group plc, its 61% interest in Elsevier Reed Finance BV and certain amounts receivable from subsidiaries of Reed Elsevier Group plc.

-Reed Elsevier NV also owns shares, carrying special dividend rights, in Reed Elsevier Overseas BV, a Dutch registered subsidiary of Reed Elsevier Group plc.

Analysis: This once again highlights the differing economic stakes the two share classes hold in Elsevier Reed Finance BV. It also highlights a separate share class in Reed Elsevier Overseas BV owned by Reed Elsevier NV that carries special dividend rights.

(Edited from source: 2012 Form 20-F)

In summary, the most important point is that 1 share in Reed Elsevier NV was designed to equal 1.538 shares in Reed Elsevier PLC. Given that their ownership shares in the jointly-operated companies are not equal, it would be expected that this could diverge in either direction over time, however.

Investing Options / Currency Exchange

Here is a table showing the tickers for the four most common ways to invest in Reed Elsevier:

Tickers

Reed Elsevier NV

Reed Elsevier PLC

Local Exchange

REN: Amsterdam

REL: London

US ADR

ENL: NYSE

RUK: NYSE

Here is another table showing the currency exchange each dividend declared must go through before being received by the holder of the various shares:

Currency Exchange

Reed Elsevier NV

Reed Elsevier PLC

Local Exchange

Declared Euro

Declared GBP

US ADR

Euro-USD

GBP-USD

For ADR investors on the NYSE, additionally, each Reed Elsevier PLC ADR share represents 4 Reed Elsevier PLC ordinary shares, while each Reed Elsevier NV ADR share represents 2 Reed Elsevier NV ordinary shares. That means that 1 ADR share of Reed Elsevier PLC was designed to be the equivalent of 1.3 ADR shares of Reed Elsevier NV (calculation below).

1 share Reed Elsevier NV = 1.538 shares Reed Elsevier PLC

1 ADR share Reed Elsevier NV = 2 shares Reed Elsevier NV

1 ADR share Reed Elsevier PLC = 4 shares Reed Elsevier PLC

ADR Reed Elsevier PLC: ADR Reed Elsevier NV Ratio = 1 ADR share R.E. PLC / 1 ADR share R.E. NV

ADR Reed Elsevier PLC: ADR Reed Elsevier NV Ratio = 4 shares R.E. PLC / 2 shares R.E. NV

ADR Reed Elsevier PLC: ADR Reed Elsevier NV Ratio = 4 R.E. PLC / 2 * (1.538 R.E. PLC)

ADR Reed Elsevier PLC: ADR Reed Elsevier NV Ratio = 1.300

1 ADR share Reed Elsevier PLC = 1.3 ADR shares Reed Elsevier NV

Now, let's just focus on this from the perspective of a US investor looking to invest in one NYSE-listed share or the other. From all of the evidence above, I will consider as a base case that 1 ADR share of Reed Elsevier PLC is economically equal to 1.3 ADR shares of Reed Elsevier ADR . There are a few steps to take before making a decision though, so let's take them one at a time.

Taxation

Taxable Account

Assuming your Reed Elsevier shares are being purchased to be held in a taxable account, here is a table that summarizes the base tax implications of an investment in each share class:

Share Class

ENL

RUK

Dividend Tax Rates

Foreign Tax Withheld

15%

0%

Normal Applicable US Rate

0-23.8%

0-23.8%

Capital Gains Tax Rates

Foreign Tax Withheld

N/A

N/A

Normal Applicable US Rate

0-23.8%

0-23.8%

At first glance, RUK appears to be the more desirable choice from a taxation perspective. Since both share classes pay out dividends of about 3% at their current prices, taking 15% off of your dividends for foreign withholding taxes means .45% of your investment would be lost annually owning ENL. This, however, does not take into account US tax law regarding foreign taxes paid. This allows for a dollar-for-dollar credit for foreign taxes paid, restoring what you lost on your dividend when you file your taxes. Keep in mind, though, there are tax situations when this does not hold true. I have outlined two below and you can consult the IRS website (IRS topic 856) for more information.

Alternative Minimum Tax

If you are subject to the Alternative Minimum Tax (AMT), the foreign tax credit you are able to take may be reduced. Here is a table summarizing the dividend tax consequences for ENL investors who are and are not subject to the AMT.

Reed Elsevier NV shares

Subject to AMT

Yes

No

Foreign Tax Withheld

15%

15%

Cancel Effect at Tax Time

(<=15%)

(15%)

Net Foreign Tax Effect

0-15%

0%

Normal Applicable US Rate

0-23.8%

0-23.8%

Form 1116

Another instance is if your foreign tax paid exceeds a $300 limit for individuals or $600 for married couples filing jointly. In this instance you will need to file Form 1116 and you are at risk of not receiving full credit for foreign taxes paid. Check with a tax expert or look at the form for yourself if you think this might apply to you.

Reed Elsevier NV shares

Required to file Form 1116?

Yes

No

Foreign Tax Withheld

15%

15%

Cancel Effect at Tax Time

(<=15%)

(15%)

Net Foreign Tax Effect

0-15%

0%

Normal Applicable US Rate

0-23.8%

0-23.8%

So for taxable accounts, RUK shares have an advantage over ENL shares for those investors who are subject to the tax circumstances described above. For everybody else, these two share classes have equal tax consequences, making them equally preferable from a tax perspective.

Opportunity Cost of Delayed Value Realization

For those not affected by the above stated tax situations, it is worthy to note that roughly 15% of your annual dividends from ENL will be received as a tax credit with varying dates of value realization. If you precisely keep track of your taxes due (tracking all inputs) throughout the year and make estimated payments as a result, this will be muted. For the majority who overpays, and therefore receives a tax refund when they file, there is an opportunity cost associated with not receiving immediate value from your dividends. Here is a quick summary:

The one-year dividend yield on ENL is 3.08% (look under "Valuation" below for calculation). If 15% of this amount is withheld from you, that is approximately a .46% yield on your investment that is being delayed for part of the year. With the dates for dividends received being May and September, with approximately ¾ of the dividend being paid in May the average time that each dollar of your dividend is withheld is 10 months (assuming tax benefit is realized when taxes are filed in April of the next year). Assuming you could earn 10% annually on your investment your opportunity cost would be $3.85 annually per $10,000 invested in shares of ENL (using the closing share price on 4/15/2013).

$10000 x 3.08% x 15% x (10 months / 12 months) x 10% / year = $3.85 / year

Here is a table showing the opportunity costs on $10,000 invested in ENL, using different assumptions for annual rate of return. The table also includes the dividend yield premium you would need to offset this opportunity cost. (once again using the closing share price on 4/15/2013)

Annual Return

Opportunity Cost per $10000 Invested

Dividend Yield Premium Required (ENL vs. RUK) to Offset Opportunity Cost

4%

$1.54

0.015%

6%

$2.31

0.023%

8%

$3.08

0.031%

10%

$3.85

0.039%

12%

$4.62

0.046%

IRA-type Account (tax deferred or otherwise tax advantage)

Now let's look at taxation for the two share classes for somebody who is investing through a Roth IRA or a tax-deferred account, like a Traditional IRA.

Share Class

ENL

RUK

Dividend Tax Rates

Foreign Tax Withheld

15%

0%

Normal Applicable US Rate

N/A

N/A

Capital Gains Tax Rates

Foreign Tax Withheld

N/A

N/A

Normal Applicable US Rate

N/A

N/A

In these types of accounts ENL still has the 15% foreign tax withholding, while RUK does not. There are no US taxes applicable, and no foreign tax credit to recover the foreign tax that was withheld. This reduction in your dividend from owning ENL shares becomes a permanent loss. Certainly from a tax perspective, RUK is the more favorable choice in an IRA or similar account.

Price Discrepancy

Using Yahoo! Finance I pulled historical prices for RUK and ENL shares. I used the closing price on the first trading day of the month going back to January 2008 and through April 2013. This graph compares the price of the two stocks over that time period.

(click to enlarge)

Here is another graph showing the % premium for RUK over ENL over that same time period.

(click to enlarge)

The two share classes have traded quite similarly over the last 5+ years with RUK trading mostly at between a 25% and a 45% premium to ENL in this time frame. This is as expected since both share classes only differ slightly in how they represent the same underlying assets, and that RUK should equal 1.3 shares of ENL.

For a better picture, here is a graph comparing share prices for 1 share of RUK to 1.3 shares of ENL over the same time period as above.

(click to enlarge)

Here is another graph showing the % premium for 1 share of RUK over 1.3 shares of ENL over that same time period.

(click to enlarge)

Once again you can see the shares trade in tandem over this period, and with regards to the equalisation ratio RUK has traded at between a 5% discount and a 12% premium over this time frame.

Analysis of the Equalisation Ratio

Given the conclusion drawn earlier that the equalisation ratio from 1993 could vary over time, it is worth doing further research on. While it isn't a perfect proxy for the underlying ratio, I believe the most telling figures to look at for American investors are the dividends paid out to each ADR share. The dividend amounts are affected by currency exchange rate fluctuations, but looking at 14 dividend payments over 7 years should smooth out these effects. Furthermore, looking at the equalisation agreements (outlined above) from 1993, we would expect gross dividend payments to be a good proxy for business performance.

Reed Elsevier PLC ADR (RUK

2006

2007

2008

2009

2010

2011

2012

Interim dividend ($)

0.31

0.36

0.39

0.35

0.33

0.37

0.38

Final dividend ($)

0.93

1.06

0.98

0.86

0.97

1.00

1.02

 

Reed Elsevier NV ADR

2006

2007

2008

2009

2010

2011

2012

Interim dividend ($)

0.22

0.26

0.28

0.26

0.24

0.27

0.28

Final dividend ($)

0.70

0.82

0.69

0.62

0.73

0.70

0.74

 

Ratio RUK/ENL

2006

2007

2008

2009

2010

2011

2012

Interim dividend

1.39

1.36

1.36

1.35

1.42

1.37

1.37

Final dividend

1.34

1.29

1.43

1.38

1.33

1.42

1.37

Averaging the ratio across the 14 payments gets about 1.37. This would suggest that for an American investor 1 ADR share of Reed Elsevier PLC has been roughly equivalent to 1.37 ADR shares of Reed Elsevier ADR over the last 7 years.

In the interest of being thorough, here is a graph comparing share prices for 1 share of RUK to 1.37 shares of ENL over the same time period as above.

(click to enlarge)

Here is another graph showing the % premium for 1 share of RUK over 1.37 shares of ENL over that same time period.

(click to enlarge)

Once again you can see the shares trade in tandem over this period. With regards to the equalisation ratio of 1.37 proposed above, RUK has traded at between a 10% discount and just over a 6% premium over this time frame. Most of the time was spent considerably closer to parity, however. Additionally, it would be expected that with a moving equalisation ratio the appropriate % premium/discount for RUK over ENL would change over the course of years.

Valuation

Here are some key metrics to compare the two (as of April 15, 2013 - Closing prices and P/E from Yahoo! Finance, Dividend yield was calculated for both ENL and RUK using the dividends declared in the last 12 months compared to current price):

Share Class

ENL

RUK

Share Price

33.12

46.23

P/E

14.37

15.83

Earnings Yield

6.96%

6.32%

Dividend Yield

3.08%

3.03%

Bringing it all Together

The dual-listing structure for Reed Elsevier PLC and Reed Elsevier NV differs greatly from those structures found at other like-companies that I have investigated before. The fact that each share listing represents a different mix of the same assets creates somewhat of a moving target for how to value each share against each other. It is important to remember, however, that the differences are small and looking at the big picture, one would expect the performances of each listing to remain very close over long periods of time. That being said, I feel confident in being able to reasonably calculate an appropriate equalisation ratio of 1.37 between the share listings.

Given all of this I would advise that the listing that provided a discount (with regards to the 1.37 equalisation ratio) at the time of purchase would be preferable. A US investor should consider all of the above factors that would limit the favorability of ENL, however, when making this decision.

Here is a flowchart that a US investor can use to make the correct decision on which share class of Reed Elsevier they should own. Keep in mind that this flowchart takes into account the status quo as the time this article was written, assuming a relatively benign premium/discount relationship with regards to the equalisation ratio of 1.37 calculated above. Changes to US Tax law, English Tax Law, Dutch Tax Law, international Tax Treaties, the underlying fundamentals of specifically Elsevier Reed Finance BV, or a sharp change in the premium/discount relationship between RUK and ENL could render this analysis and flowchart useless.

Source: Investigating Reed Elsevier's Dual-Listing Structure