Late yesterday, at about 3:30, Associated Estates Realty Corporation (AEC) came out and announced that they were going to raise some money through a public offering of 5.5 million shares (comes out to about $76 million, or $14.40 per share).
Based on the market’s reaction, you would have thought they had announced that AEC was actually secretly a Chinese lumber company.
The stock immediately shed 2%, plummeting from $15.20 into the close. Last night was a bloodbath. It ended up opening today at $14.41. In a single night, AEC lost 5% of its market cap.
HOLY SHIT! They’re raising cash, so the market sets the company share price at what they’re getting from the underwriters?? Are you people high?
It seems we need to have a little discussion about raising money, and what it really implies.
But first, grab all those little books you have on capital raises, where savvy sounding professionals wearing douchebag-y clothing while waxing philosophical on the front cover, recite three hundred years worth of “rules of thumb”. Throw them into a pile, douse them in gasoline, and set them on fire. Then gather up the ashes, and ever so fastidiously, cram them up your ass.
That’s how many out-of-context Warren Buffet quotes I want to see in my comments section. You have been warned.
Rather than assuming that all capital raises are inherently bad, evil, dilutive things, let’s instead ask a simple question: when, exactly, do capital raises hurt outstanding investors?
Well, when they cut into a companies value. So anytime the shares sell for less than they’re worth. That’s bad.
Or when they cause the company to give away earnings to too many different places and suddenly any premium is overpriced and cash flow expectations are overpriced. That’s bad.
Or when the new capital has rights or priviledges that undermines the rights of existing shareholders, and sidelines them into an unfair position. That’s bad too.
Or perhaps when the capital raise is smoke tipping off something that’s very wrong with the company. All bad.
Or maybe when there’s some kind of fraud going on, because the company isn’t being honest about how many investors are really oustanding, and the sale is actually a red flag that your company is managed by criminals. That’s really bad.
So let me ask you; what’s the big fucking deal?
It’s not like AEC is desperate for cash, on Death’s door with the harpies flying overhead. They’re a $700 million dollar entity sitting on $6-13 million. They have annual expenses of $140 million, revenues of $172 million, and are modestly leveraged with debt equal to 70% of their total assets (all at insanely cheap rates, courtesy of the Fed). And they’ve secured enough credit lines to weather their debt load for several years.
Oh yeah, and AEC is a cash cow. While reporting that they’re losing money, their operations are generating a cool $50 million a year in untaxable cash flow. So they’re doing what any sensible company with deep pockets and record low prices would do – they’re buying everything they can. In fact, because they’re running with the black hole-budget accounting methods that are depreciation adjustments in a real estate centered environment, their net cash flow is up 70% inside of four years.
All of that money is going straight back into the company. In fact, they generated surplus revenue from also refinancing/closing/restructuring their debt. All of that $50 million a year right now is going out, buying up properties, and building AEC into a steadily larger, more competitive organization.
Which brings us back to the idea of capital raises. Why are you such a squirly little bitch?
Let’s say I have a company – we’ll call them Opportunistic Co. – that has a book value worth $900 million with 900 million shares outstanding, or $1 a share of value, including too little cash to really do anything with. Now let’s say an awesome investing opportunity comes along; the price tag is another $100 million. Opportunistic Co. has a choice to make – they can pay up for that opportunity (which based on Associated Esta – oops, I mean Opportunistic Co.’s – track record would generate a cool 16% ROI annually before taking into account any debt extinguishment or unrealized property appreciation), or they can puss out and go home.
So let’s say Opportunistic Co. decides, “hey, I want to take advantage of this” and they raise that $100 million by selling shares for $2.00 a pop.
Oh God! No! dilution…!
They take that $100 million that they raised by selling 50 million shares on the open market and put it on their books. And low and behold, they now have a $1 billion value, with 950 million oustanding shareholders.
And shares worth $1.05 apiece.
That’s right, miscreants. If you did the math, Opportunistic Co. just raised their book value, because the people who bought into the idea, and thereby their company, did so at a premium.
Now, I know this isn’t fail safe. Lots of companies trade at big premiums to their value, because people are banking on high growth rates. Capital raises can be a real threat to them, because if that money isn’t applied correctly and doesn’t generate enough funds to pull its own weight, suddenly those growth rates aren’t enough to justify the high price.
DOES AN REIT COMING OUT OF A HOUSING RECESSION SOUND LIKE A FUCKING GROWTH STOCK TO YOU?
AEC’s shares are trading very reasonably, just a little greater than their net worth. Their price to earnings is low. They’re operating income and revenues, from sky high occupancy rates and increasing rents, are running higher. They are a stealth-growth company trading like a utility.
And besides, both Opportunistic Co., and in real life AEC, already know what they’re going to do with the God-damned money. They already have the investment lined up, people. AEC said right when they were raising the cash, “hey, same shit…”. They have been killing it. Why should I be worried, without evidence, that they’ve suddenly forgotten how to manage a real estate company?
And if at any point, some or all of these properties start to actually go up in price…well then taking the time to raise the money, and make the call, will be a boon to ALL the company’s shareholders, probably better than if they hadn’t made the purchase at all.
So excuse me for thinking that MAYBE sometime between now and the end of time, we might just have a real-estate recovery.
But here’s what really bothers me.
Let’s have another little example. Let’s say there’s this other company – Superstar-Bullshit-Celebrity Managers Enterprise – who are also worth $900 million, with 900 million shares outstanding. And let’s say, for the humor of it, that a third group of investors beats both companies to the draw and acquires the opportunity first.
This third group raises the $100 million (raising capital, incidentally) by soliciting what happens to be $2 a share from an underwriter and forms the new corporatation – Sucker’s Buy Co. – which has 50 million shareholders
Now a not-meaningful amount of time passes, and the super smart SBC Enterprise managers decide, “hey, you know what, we’d like to have that property owned by Sucker’s Buy. I think we should buy it.” Never mind that Sucker’s Buy has been in business for like, a month, and has already given away all their revenue in the form of special dividends. So they get the paper work in order, and start the M&A process.
But of course, we can’t just buy Sucker’s Buy at market price – how would Sucker’s Buy’s investors be rewarded for their precious month of time? No, we need to run a leveraged buyout on these fuckers, giving them $2.50 a share. It’ll all be worth it later on, after all. SBC Co. can leverage SB Co’s operation to optimize synergies, and shit…
So SBC purchases the same thing – exactly, identically, the same thing – for an extra $25 million than it’s listed. And all financed, naturally.
And after goodwill gets rectified, SBC’s shares will be worth only $0.97.
But you and I both know, in this situation, SBC’s bullshit stock would rally.