Secondary Equity Offerings

[no_free_lunch]

I have noticed that it is quite common for small companies (especially microcaps) to have secondary offerings of their shares.  Sometimes stock and options are issued as a unit.  Generally the offering is below the current stock price and so you effectively get diluted.  I am just wondering if this isn't a huge red-flag or if it is just a standard part of investing in micro-caps?  If the stock is quite cheap but occasionally does this type of thing, would you still buy it?

[Ham Hockers]

I have noticed that it is quite common for small companies (especially microcaps) to have secondary offerings of their shares.  Sometimes stock and options are issued as a unit.  Generally the offering is below the current stock price and so you effectively get diluted.  I am just wondering if this isn't a huge red-flag or if it is just a standard part of investing in micro-caps?  If the stock is quite cheap but occasionally does this type of thing, would you still buy it?

 

It's a red flag. I think it's equally common among larger companies, too.

It's hard to invest with management who you feel isn't always looking out for minority shareholders, no matter how cheap the stock is. I would probably do it if the stock was very cheap and there was an activist holding a large position who could police the company.

[gg]

As with everything else on Wall Street, secondary offerings were created for good reason but they also have the ability to be abused by management. If you have an investment in a small cap company A trading at P/E of 6, and 1x BV, and they have an opportunity to acquire a competitor B at a P/E of 4, and .7x BV, to the extent that A doesn't have other good financing sources, you should not be upset if A's management issues a secondary offering at a reasonable discount in order to raise cash in order to buy B.

 

Bottom line - you just need to figure out what the reason for the dilution is, and decide if it is ultimately a good/bad decision on a case-by-case basis.

[ItsAValueTrap]

They're definitely a red flag.

 

A secondary offering is a very expensive way of raising money.

- The shares will be sold at below market price.  Shareholders suffer significant dilution.

- The underwriters will take their pound of flesh.  The commissions are usually 5-8%.

- On top of that, the underwriters also (effectively) get a bunch of call options on the stock for "over-allotments".

- There are legal, professional, and other fees that usually run six figures.

- It takes up management's time

- Management will likely spent time and money promotion the stock ahead of a secondary offering

 

This usually leads to adverse selection.  Most management teams won't do a secondary offering unless the stock is expensive.  Whenever insiders are compensated with options, they have an incentive to avoid secondary offerings unless the shares are overvalued.

 

[Uccmal]

As per gg, it is situational.  Seaspan just had a secondary offering to raise money to buy more ships.  We know they are getting a deal on the ships, and will have them working the day they get commissioned, and for 10 years after that. 

 

On balance probably most are crappy deals for existing and new investors.  Same as most IPOs. 

 

 

[BG2008]

I would it's usually a red flag. 

 

Situation A) The company is severely undervalued and they raise capital, management just diluted the existing shareholders

 

Situation B) You believe the company is severely undervalued, management knows better and it's actually the right decision to take advantage of the robust equity market.  Well, you're holding an over valued security. 

 

There are situations where secondaries are the right course of action, i.e. XPO Logistics, issue equity at 10-13X EBITDA and roll up smaller freight forwarders at 6-8x EBITDA.   

[ItsAValueTrap]

Seaspan just had a secondary offering to raise money to buy more ships.  We know they are getting a deal on the ships, and will have them working the day they get commissioned, and for 10 years after that. 

Their shares are probably overvalued.

 

Nobody has a huge edge in operating ships.  The shipping industry is largely about timing the cycles in pricing.  The market for newbuilds and old ships is somewhat liquid; I don't think that anybody really gets a really good deal on ships.  The assets aren't that difficult to value for those working in the industry.

[Guest wellmont]

like everything it depends. but it does imply that markets are ebullient and that the companies believe that the shares are either overvalued or investors are feeling giddy and confident and will tend to see the glass half full. cannibals are better than reverse cannibals. managements can issue stock and create value ala singleton buffett malone, usually accomplished in a merger transaction, or convert, and not a secondary offering. they know when to sell stock and when to buy it. it goes without saying that it's going to be bad for shareholders when a capital constrained company is forced to offer shares in a secondary.

[Uccmal]

Seaspan just had a secondary offering to raise money to buy more ships.  We know they are getting a deal on the ships, and will have them working the day they get commissioned, and for 10 years after that. 

Their shares are probably overvalued.

 

Nobody has a huge edge in operating ships.  The shipping industry is largely about timing the cycles in pricing.  The market for newbuilds and old ships is somewhat liquid; I don't think that anybody really gets a really good deal on ships.  The assets aren't that difficult to value for those working in the industry.

 

You should probably familiarize yourself with the business model.  The shares were issued right at book value. 

[Phaceliacapital]

 

 

Nobody has a huge edge in operating ships.  The shipping industry is largely about timing the cycles in pricing.  The market for newbuilds and old ships is somewhat liquid; I don't think that anybody really gets a really good deal on ships.  The assets aren't that difficult to value for those working in the industry.

 

I wouldn't necessarily agree with that statement, I think that those shipping titans that were born and raised in the shipping industry (for a quick summary, those mentioned in Dynasties of the Sea) are significantly more capable to assess the value of a ship than those private equity players/hedge funds that are entering the industry as they are starving for yield.

 

 

[no_free_lunch]

Thanks for all the replies.

 

I am going to give an example, just to quantify things.

 

The company was trading for say $1 and had a secondary offering of a stock/warrant unit.  The units were sold for $0.90 and provide one stock and half of a warrant with the warrant expiring in 18 months with a strike at $1.2.  So with the stock alone they are getting a 10% discount to the current price with the half warrant being thrown in for free.  Given it's volatility, I think the warrant is worth at least $.20.   

 

On the other hand, I think the stock could double in 2 years.  The management has an acquisition strategy and has been sticking with it to date.  It is just this share issuance that has made me question their thought process. 

 

Are these good enough odds to ignore the serious dilution that just occurred?