What price the Rock?

Assessing Northern Rock's value is a battle between long investors and short sellers
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The Independent Online

Another day, another harrowing ride for those with the nerve to still be holding on to shares in Northern Rock.

In the first full day of trading after Sir Richard Branson became the latest in an ever-expanding cast of characters to unveil a hazy – and for investors fairly unappetising – plan to save the stricken Newcastle lender, its shares went into freefall, losing a fifth of their value. A pair of analysts reiterated their "sell" recommend-ations on the company. Credit Suisse slashed its target price by more than half from 390p to 180p.

Oriel Securities, meanwhile, put out a note urging investors to jump into the company's shares, estimating that its "going-concern" valuation was 357p. UBS revealed that it bought a 5.4 per cent stake in the group, making it a top-five investor.

It was a typically torrid day for the bank, a microcosm of the blizzard of conflicting information and massive stock swings that have become standard fare over the past two months for the group as it subsists on Bank of England loans and looks for a buyer. Yet no one in the City seems to have inched any closer to solving the most vexing question hanging over the Rock: How much is it worth? An analyst at Citi suggested last month that it could be as little as 6p per share, about one-hundredth the Oriel valuation.

So who is right? The major investors that have been furiously buying and selling the group's shares in recent weeks have all been doing so based on convictions that roughly reflect Citi's worst-case scenario on the one hand or Oriel's most optimistic outcome on the other. They can be divided into the "shorts", who believe the shares have nowhere to go but down, and the "longs", who have bet that the Rock's fortunes will improve, and the share price with them.

Short-sellers such as the hedge fund Lansdowne Partners have already made a killing. These investors make bets that a certain stock will fall. They do so by paying a fee to borrow shares held by large institutions under an agreement that they will have to return them by a certain date. They immediately sell the shares, wait for the stock to fall, and then buy them back at the cheaper price, returning the shares to the original owner and pocketing the difference.

Lansdowne is understood to have made a mint doing this on Northern Rock. GLG Partners, one of Europe's largest hedge funds, has placed the same bet. Yet most short-sellers have already pocketed their winnings from the Rock's downward spiral that has seen more than 80 per cent of its value evaporate in less than two months.

According to Data Explorers, a firm that tracks short positions, short sellers reached their peak on 18 September, when the Chancellor of the Exchequer, Alistair Darling, issued his extraordinary public guarantee of all of the bank's deposits. Since then, the shorts that had held up to a third of the bank's shares have unwound their positions and trousered the profits. Now, according to Data Explorers, they hold just 10 per cent.

What's more, investors hoping to place a wager on further falls will find it next to impossible. That's because the large long-only institutions from which short-sellers borrow shares have also beaten a path toward the exit. Once comprising a third of the shareholder register, they now account for only 9 per cent. The upshot is that the "rental fees" that short sellers must pay to borrow shares from these investors have skyrocketed to 30 to 40 times what they were just two months ago. "It's a function of supply and demand, and there are very few shares left to borrow," said Will Duff-Gordon of Data Explorers. "There are no new massive shorts coming into the stock."

Yet the sentiment in the City that the Rock will sink like a stone is growing. Indeed, Northern Rock faces an array of challenges. For one, it must secure a financing package of up to £30bn to refinance the £13bn it has taken out at penalty rates from the Bank of England, about £14bn in wholesale debt, and for cash to invest in the business going forward. Its brand name, of crucial importance for a consumer business, is in tatters. While it struggles to get its house in order, new business has slowed to a trickle because it has purposely priced itself out of the market by increasing rates and eliminating sweeteners that it used to offer with mortgages.

Even if Virgin pulls off its takeover, which would ensure Northern Rock continues as a public entity, it would probably mean a major dilution of current holders. (Those fears were the primary cause of yesterday's share fall.) Credit Suisse's Jonathan Pierce said: "We see no upside, only downside, and would sell the shares."

Of the 21 analysts who follow the company, five have a "sell" or "underperform" rating on the stock, nine have a "hold" or "flat" recommendation, and five have suspended their coverage or have no rating.

That leaves a minority of one, Mike Trippitt at Oriel, with an "add" recommendation on the stock. He estimates that on a run-off basis the company is worth 207p. A refinancing of its balance sheet would release another 90p in value and would allow it to reopen to new business, which would add up to another 61p.

"I'm still of the view that people have written it off a bit too quickly. One thing is the short-term earnings, which don't look very pretty," he said. "But the only way you can roll that out is if you assume that the lousy funding markets continue, and I'm not sure that will be the case."

Others share his optimism. RAB Capital, the hedge fund run by Philip Richards, is the lender's second biggest holder at 6 per cent. Mr Richards believes that the bank is fundamentally sound, a victim of an unforeseeable disruption in the short-term money markets, and that it will be able to recover.

"All the published metrics suggest that it has a high-quality mortgage book, including a low delinquency ratio and moderate loan to house value ratio," Mr Richards said in a recent public letter.

The chances of that becoming the consensus view any time soon, however, are slim. Mr Trippitt said: "There are a lot of 'beats the hell out of me' recommendations out there at the moment."