Taking Stock / Market Value Is King

Polar Investments (TASE: PLR), a member of the Shrem, Fudim, Kelner (TASE: SFK) group, delivered an important announcement to the Tel Aviv Stock Exchange last Thursday: U.S. real estate baron Ziel Feldman is lending it NIS 120 million for dollar-linked bonds convertible into 30 percent of its shares at NIS 75 per share.

Polar's leaders marketed the deal as a major coup: an American investor is evincing faith in the company and buying bonds convertible into shares at a premium of 65 percent above the company's market value.

But as the initial jubilation died down, two other details came to light. One, the bonds' conversion price is stipulated in dollars, so the moment you factor in the dollar price of the money into the equation and multiply by five years, you get a premium of only 20-30 percent over the market price.

Second, and more interestingly, the deal priced Polar at NIS 380 million - or NIS 300 million if the price of the money is factored in. That is half the price Polar deemed itself worth nine months ago, via the kind offices of Brightman-Almagor, public accountants.

To recap, when 2003 began, share prices in Tel Aviv were slumping. Israel government bonds were trading at double-digit yields, the credit crunch was at its nastiest and the stench of fear of mass bankruptcies permeated every corner.

The newly imposed Standard 15 was terrorizing Israel's leveraged companies, forcing them to adjust the book value of their assets to their real values. Desperate to avoid steep charges and writeoffs, managers crawled on their knees to appraisers, commissioning hopefully favorable evaluations of their assets. Their dread of writeoffs was mainly a problem vis a vis the banks. Charges lead to losses and equity erosion, which could lead leveraged companies to violate the covenants appended to their loan agreements with the banks. Then the banks would demand additional collateral, or have to set aside provisions for the loans rendered doubtful.

Polar also commissioned an appraisal. Brightman-Almagor delivered it in March, just before Polar was to publish its financial statement for 2002. The accounting firm appraised the company at NIS 750 million.

Like many of the evaluations being penned in those days, this one seemed a little over the top. It was 300 percent above Polar's market cap at the time, which was just NIS 120 million.

That yawning gap didn't seem to bother the accountants or Polar itself. TASE prices are divorced from reality, they shrugged.

Six months went by. The Israeli government received $9 billion in loan guarantees, Benjamin Netanyahu spearheaded an economic program that restored the markets' faith, stock markets the world wide rallied, Israel's risk premium plummeted and share prices on the Tel Aviv Stock Exchange shot up by as much as 60 percent. You see? screamed the tycoons, the appraisers, and the other aficionados of commissioned evaluations. This proves it! Share prices on the TASE are climbing toward the valuations we thought appropriate all along.

We want a divorce

That view is divorced from the reality of financing theory. It ignores the fact that corporate valuations change over the axis of time, based on economic parameters. In our case, two economic parameters with tremendous impact on company values changed dramatically - interest rates and risk.

Short- and long-term interest rates dropped dramatically in the last year, and so did Israel's risk premium, thanks to the guarantees and to the American presence in the Middle East. The steep climb in share prices does not attest that company values in the past were too low, or unrealistic. It attests to change in the parameters affecting company values.

In fact, when you factor in the steep drop in interest rates and risk over the last year, and examine the transactions closing over the last months, you are bound to reach the opposite conclusion. Market value turns out to be the most powerful indicator of corporate values, while the prices set in most of the appraisals carried out last year seem more inflated than ever.

In Polar's case, it turns out that Itschak Shrem, a wily market animal indeed, proved willing to bring a partner into the most important asset in the SFK group at a price 50 percent below the valuation he commissioned just nine months ago. He agreed, even though Polar's value dramatically climbed since then, partly due to the Nasdaq surge that lifted the values of most of Polar's investments, and partly because the capitalization coefficient - interest and risk - determining the values of Polar and other companies contracted during that time.

What does it mean? Simply, that Itschak Shrem did not believe in the appraisal Brightman-Almagor delivered. That for him, that evaluation, like all others, was merely a piece of paper to be highlighted when convenient, for instance when avoiding writeoffs.

And most importantly, even if Shrem firmly believes his company is worth far more than the stock market thinks, he knows it doesn't matter. What counts isn't that piece of paper from Brightman-Almagor, or any other document, it's the price he can get from investors, and that is influenced primarily by the company's price on the stock exchange.

The bankruptcy of appraisals and triumph of market valuations has been demonstrated again and again in the transactions closed in recent months. A lot of controlling shareholders, like Shrem, have been taking advantage of the rising share prices, fueled by dropping interest rates and risk, to sell the controlling interest or major chunks of their businesses, at far below the valuations set by evaluations commissioned a year or two ago.

Given the change in economic circumstances, when push comes to shove through that transaction - the businessmen find they are forced to put aside their precious appraisals and accept the decree of the ultimate parameter - market value.