Following the glory of obscene growth potential yesterday – in the form of long term supply agreement amendments being announced – HCLP followed up by declaring a secondary offering. After hours and to the open, the price was off 5%.
I cannot in good conscience sit by and allow this to pass unaddressed. For you see, many of you have a very cliche, knee jerk opinion of companies raising money, which I have commented on before now.
Why is this? What is it about secondary offerings that you hate so much?
Myth One: They’re Dilutive
There is a major opinion in markets, unquestionably, that secondary share offerings inherently ruin the performance for existing shareholders.
The logic goes something like this – ahem – “ABC makes $100,000 per quarter, with 1 million shares outstanding, and I earn $0.10 a share. If they issue another 100,000 shares then I only make $0.091!”
Let’s just quickly break down this scenario and why it’s wrong.
First off, if a company sells shares, they take money onto their balance sheet. Especially right now, where new shares are routinely sold at prices FAR beyond their worth, the new cash on the balance sheet more than overcompensates for the loss of earnings, at least in the short term. If my company is selling stock at 20-30X earnings, it’s sort of a buffer to that dilution fear, isn’t it? Actually, lots of secondary offerings immediately make money for existing shareholders.
I only clearly lose if management is somehow selling stock for less than it’s worth; in which case they will most likely be sued up a tree. If they’re selling it at par, for fair value, then by definition it’s a wash (fair value including some form of discount for future earnings potential).
And then there’s the biggest question: what is management planning on doing with the money? Are they squirreling it away in non-marketable warehouses they plan on building, perhaps somewhere in Antartica? Or are they, like most businesses, trying to grow? And what is the potential of that growth? If opportunities that attract that new money have higher earnings per share than existing net operations, then all prior shares in existence will have benefited from the new equity.
Claim: whether or not a secondary offering is dilutive depends very much on what management is going to do with the money.
Myth Two: Debt Is Always A More Effective Way To Finance A Company
There’s another specious tidbit circling business community colleges. “So you have an opportunity to pursue; equity or bonds? Well offering bonds to finance the job will always have a bigger payoff for shareholders.”
Again, I find this claim to be wanting. The argument is weak from the onset. But please first note what I am not about to argue. I am not arguing that this claim is always false. But it is clearly also not always true.
If I raise money on a project, at best existing shareholders will be able to make a return above both the principle of the notes and the interest you owe on the bonds.
How is this that different from raising new money?
To start, the principle of the bond corresponds to the price per share of the equity raise. Turning these two objects over, we can see that, at least in our present environment, new shares being sold for more than they’re worth, from one perspective secondary offerings have a superior element to them for existing shareholders – existing shareholders can actually make money off the transaction (see above).
If my company issues debt, how have I benefited besides through “future possible earnings”? I cannot make money on the transaction. By nature of issuing a bond, every cent will need to be repaid (or else carry severe implications for myself as a shareholder). I personally have not directly benefited.
If my company issues stock at a big mark up – like they can right now – as a shareholder I have probably made money. New shares in a healthy market add more to the balance sheet than the new money receives in return.
After turning over the principle/equity issue, now let’s look at the dilution. Well, surely dilution corresponds to the interest on the bonds, does it not?
Where do you suppose interest gets paid? From the Ether? It comes directly from existing operations. If you’re lucky, the new/expanded business venture management is pursuing earns enough to offset both the principle of the bond and the interest and you, as a shareholder, make money on top. Otherwise, it’s a drag on earnings and…you guessed it – dilutive.
Now it could be parsed over here that debt’s return is finitely, contractually limited, so if a company raises debt to finance a project and that project has a fat payoff, then equity will always get more than in the alternative world where the project was financed through a secondary.
While this is technically true when peered at through the very narrow lens of a profitable, big payoff growth story, it overlooks two important points of view. The first is that 1) the game changes completely if a project does not make money, in which case the equity raise if vastly superior to the debt issuance (since the new equity will have diluted the loss for existing shareholders) whereas the debt, being a higher claim than stock, will compound the losses. The second being 2) a company can always just raise debt after a secondary (or vise versa) – and frequently many of the impacts of either a secondary or a debt issuance can be reversed or even transformed in the other direction (market prices permitting).
Claim: whether or not debt is superior to secondary offerings depends very much on a case by case basis for a company. Current debt levels, the possible payoff of the business growth, downside risks, interest rates, and market premiums for secondary must all be carefully considered. This business rule of thumb is overly simplistic.
Beware Billionaires Pushing Leverage
I couldn’t just let this stand unchallenged. Sometimes debt is the answer, but other times it’s best to just issue some more equity. It isn’t fair to turn the choice into a bumper sticker that management has to adamantly follow.
And so often, raising debt is exactly the wrong answer.
Some of the biggest pushers of corporate debt are so often big activist shareholders with goals ill-aligned with the regular mom and pop retirement accounts; people looking for a quick buck and possessing dubious intentions. Guys like Dan Gilbert in Detroit who are just too happy to fuck over an entire company of hardworking employee shareholders in a start up tech advertising company, then leave them holding nothing (and subsequently being supported by Michigan’s Supreme Court…cough cough). (For the record, that had nothing to do with debt, I just felt like spelling out what a piece of shit Dan Gilbert is).
It’s a long standing favorite of activist shareholders to take a big position in a lackluster company with low leverage, then pressure them to take on as much debt as possible, fling it around on the balance sheet to beat some poorly defined analyst metrics and make an illusion of growth, spice it up into a popular position, then unload the company for a fast gain on multiples expansion.
The only way it gets better for the hedge fund guys is if they can pay out as much of that leverage to themselves, either in special dividends, or – better – by bullying management into buying their private assets at a premium (you don’t have to share with anyone else that way).
At the end of the road, you have a lackluster and profitable company transformed into a glitzy and unprofitable one. That isn’t growing a business; it’s liquidating one.
It’s all fun and glam right now, with interest rates so low. However, as debt needs to get turned over next decade, we’ll get to see who was actually working for their company versus who was trying to rob it.
It All Comes Down To Trust And Timing
Do you trust your management, or don’t you? Secondary offerings and debt issuance can both go bad if the mood is right. What is the money being used for and what are the risks?
Is the company pulling a lot of strange moves on their filings? Are the cash flows pages telling the story of a company that isn’t actually taking in more cash, despite a great “growth” story? Are classes of shares being thrown around like a bowl of alphabet soup?
And what are prospects of the business looking like? Is demand for products growing? Does the company have more business than they can possibly service? At the end of the day, this is likely to be the biggest factor in the success or failure of any business. Debt versus secondary offering will probably play a backseat, if management is working as a proper fiduciary in a hot business cycle.
Update: I purchased more shares of HCLP for $62.47
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