The American Depositary Receipts (ADRs) of Allied Irish Banks (OTCQB:AIBYY) may be the most misunderstood ADRs in the US. Until August 2011, AIBYY was a normal ADR. Each share of AIBYY traded on the New York Stock Exchange and represented 10 "underlying" shares of Allied Irish Banks, which traded under the symbol AIB on the Irish Stock Exchange.
AIBYY is still trading as though it were a normal ADR worth 10 shares of AIB. For example, on Tuesday (April 29, 2014) AIB closed in Ireland at €0.121 Euros, which at current exchange rates is $0.167 dollars. The same day in the US, AIBYY closed at $1.66, almost exactly 10 times AIB's price.
This would be fine if AIBYY were still a normal ADR. But it isn't. AIBYY no longer represents 10 underlying shares of AIB, and it hasn't for more than 2 years. For the past 2 years, the depositary that manages AIBYY has been gradually selling its shares of AIB, so that today AIBYY actually represents just 2.262 underlying shares of AIB plus about 86 cents in cash. The fair value of these underlying shares and cash is just $1.24.
How much longer can AIBYY trade so far above fair value? Not long: 7 months at most. Sometime around early December of this year, AIBYY's shareholders will be forced to redeem their ADRs for fair value - minus a "depositary fee" which is typically about 5 cents. So the payout at redemption will be something like $1.19.
Of course, once market participants realize that, AIBYY will quickly stop trading for $1.66 and drop much closer to $1.19. This is likely to happen well before December, and without much warning.
The inflated price of AIBYY offers existing shareholders an excellent and probably fleeting opportunity to cash out at a premium of more than 30%, a much better price than what they can expect if they wait till December.
AIBYY is shortable, with a recent rebate of 5%.
AIBYY: The ADR that isn't
The story of AIBYY's mispricing has its origins in the Irish financial crisis. Until October 11, 2011, the ADRs of Allied Irish Bank were authorized by a deposit agreement between the Irish issuer (Allied Irish Banks) and the American depositary (Bank of New York Mellon). The depositary held 270 million shares of AIB and had sold 27 million shares of AIBYY on the New York Stock Exchange. So each share of AIBYY was in principle exchangeable for 10 shares of AIB.
This could have gone on indefinitely had Allied Irish Banks not failed. In 2008-2010 mortgage losses and depositor flight brought Allied Irish Banks to the brink of insolvency, so that between December 2010 and July 2011, the Irish government had to bail out Allied Irish Banks three times for a total of €21 billion. In exchange for the bailout, the Irish government almost completely took over ownership of Allied Irish Banks. Since the third bailout in July 2011, 99.8% of AIB's shares have been held by the Irish government, and just 0.2%, or 1 billion shares [sic], remained on public markets.
About a quarter of the Irish shares that remained in public hands were owned by the American depositary. But that wasn't going to last, either. After a corporate takeover, ADRs are typically delisted and terminated, and the government takeover of Allied Irish Banks was no exception. On August 26, 2011, at the request of the issuer, the ADR AIBYY was delisted from the New York Stock Exchange and since then it has only traded over the counter. On October 10, 2011, the depositary announced that it was terminating the deposit agreement so that in six months it would begin selling the Irish shares of AIB that underlay the ADRs. Once all the underlying Irish shares were sold, the depositary announced, the cash proceeds would be used to "redeem" the ADRs. That is, each ADR holder would be forced to exchange their ADRs for the cash that proceeded from the sale of the underlying Irish shares. After that, the ADRs would cease to exist.
The depositary commenced selling the underlying Irish shares on April 10, 2012. This date is given in the termination notice and confirmed in AIB's 2013 annual report, page 419. The sale of underlying shares proceeded gradually; because the depositary held one-quarter of the Irish float, it could only sell a small fraction of its shares each day, or risk flooding the market. By December 31, 2013, according to AIB's 2013 annual report, the depositary had sold 65% of its underlying Irish shares, so that at the end of 2013 each ADR was "backed by approximately 3.5 ordinary shares and a cash amount which has been accumulated following sales to date completed by the Depositary." Evidently the depositary had been selling about 3.14% of the underlying Irish shares each month, or 0.15% per trading day, since April 10, 2012.
We can now extrapolate forward to the present day. If in 2014 the depositary has continued selling the underlying Irish shares at its previously established pace of 3.14% per month, then by Tuesday (April 29, 2014) the depositary had sold approximately 77.38% of the underlying Irish shares, so that each share of AIBYY now represents just 2.262 shares of AIB plus the cash that has accumulated from the sale of the other 7.738 shares.
How much cash were those 7.738 shares sold for? About $0.862. To calculate that figure, you have to realize that the 7.738 shares weren't all sold for Tuesday's AIB price of €0.121. Only 0.15% were sold at yesterday's price, 0.15% were sold the day before, and so on back to April 10, 2012. So the average sale price was €0.081 - the average share price from this Tuesday back to April 10, 2012. The 7.738 shares were sold for a total of 7.738x€0.081= €0.624, which at current exchange rates is equivalent to $0.862. That's how much cash is held by the depositary for each ADR.
In addition to the cash, for each ADR the depositary is still holding 2.262 shares of AIB, which at Tuesday's prices were worth €0.274, or $0.378.
So in total each ADR is backed by assets worth about $1.24=$0.862+$0.378, which is 42 cents below Tuesday's closing price of $1.66.
We can also forecast the last day of the ADR. If the depositary continues to sell at its established pace, then sometime toward the end of the year -- my best guess is December 8, 2014 -- 100% of the underlying Irish shares will be sold and the ADRs will be redeemed for cash. The cash at the depositary will probably be around $1.24, but ADR holders won't get all of that. In recent redemptions of Irish ADRs, the depositary has deducted a depositary fee of 5 cents per share. So the amount actually paid at redemption will be something like $1.19=$1.24-$0.05.
ADR holders who sell now will get a heck of a sweet deal, much better than if they hold until December's redemption. Shorting is also likely to be profitable. A short position in AIBYY can be hedged by a long position in Bank of Ireland (London: BIR, NYSE:IRE), whose shares are strongly correlated with AIB but more reasonably valued.
Appendix: Assumptions and alternative scenarios
My base case value for AIBYY is $1.19. I made some assumptions to arrive at that value, but the assumptions were reasonable, and reasonable changes to the assumptions don't change the conclusion that AIBYY is overvalued.
For example, in my base case I assumed that the depositary is holding cash in Euros, which I converted to dollars at Tuesday's exchange rate. It may be instead that the depositary exchanges Euros for dollars at the first opportunity; that is, every day the depositary sells 0.15% of its AIB shares for Euros, which it converts to dollars at that day's exchange rate. That doesn't change the conclusion, though. I ran the numbers assuming immediate exchange of Euros for dollars and got a fair price for AIBYY of $1.15, actually a little lower than my base case of $1.19.
In my base case I also assumed that the last 2.262 AIB shares in the depositary could be sold for Tuesday's closing price of €0.121. That's a plausible guess, but in truth the last 2.262 AIB shares will be sold at whatever prices prevail from now until December. Future AIB prices could be higher than Tuesday's price. But more likely they will fall lower, since, as others have pointed out, the underlying Irish shares of AIB are themselves overvalued.
Future AIB prices don't matter as much as you might think, because they only affect the last 2.262 AIB shares that the depositary hasn't sold yet. Consider two extreme scenarios. If AIB immediately falls back to its two year low of €0.047, and stays there, then the depositary's last 2.262 AIB shares will sell for a total of €0.11, or $0.15, and the ADRs will be redeemed for just $0.96. On the other hand, if AIB immediately returns to its two year high of €0.166, and stays there, then the depositary's last 2.262 AIB shares will sell for a total of €0.38, or $0.52, and the ADRs will be redeemed for $1.33. So even in the most optimistic scenario, AIBYY is still worth 33 cents less than Tuesday's close.
Another assumption I made was that the depositary has been selling its AIB shares at a steady rate of 3.14% per month. That's the most likely scenario, but you could imagine a market-timing scenario where the depositary has been holding back when AIB is high, and selling only when AIB is low. However, such market timing is not plausible. Look at the price history of AIB.
After the depositary commenced selling shares on April 10, 2012, AIB's price was roughly flat for the next 15 months. Do we really believe that the depositary was holding back all that time because it somehow knew a big runup would start in September 2013? It couldn't even if it wanted to. After terminating the deposit agreement, the depositary had a responsibility to sell its AIB shares in a timely and orderly fashion. It had to start promptly, and as the largest AIB shareholder (besides the Irish government), it couldn't dump shares opportunistically for fear of crashing the market. In addition, the depositary has no incentive to time the market, since it can't keep the sale proceeds but has to return them to ADR holders. A gradual sale of the underlying shares makes the most sense. As stated in AIB's 2013 annual report, "Because of the limited liquidity in the ordinary shares [of AIB] this disposal process [i.e., the depositary's sale of the underlying Irish shares] has extended over a significant period and is continuing."
Finally, there are some small transactions that I ignored because they would clutter the presentation and wouldn't meaningfully affect the valuation. For example, I ignored any interest that the depositary is earning on its cash; I ignored any commissions that the depositary pays to trade the underlying Irish shares and convert Euros to dollars; and I ignored any fees that the depositary is collecting in addition to the 5 cent "depositary fee" subtracted at redemption. I also didn't discount the December redemption back to April's present value. Except for the cash interest, most of these considerations point toward a lower rather than higher fair value. Had I included these items, the presentation would have been more complicated, and my estimate of fair value might have been a couple of cents lower.
In short, there's no scenario that comes anywhere close to justifying Tuesday's closing price of $1.66. That price is based on a pure misunderstanding of which each share of AIBYY now represents. The price of AIBYY is going to fall to something like $1.19, and it's going to do that by December, or possibly much sooner.
This is a great time to sell.
Disclosure: I am short AIBYY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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