The stock market sell off validated an internal decision to abstain from the bubble in the months leading up to January 2020, but it wasn’t the only forecast that came to pass. We also discussed at length the likely prevalence of deeply-discounted capital raisings by companies needing to shore up balance sheets, to weather the COVID-19 lockdowns or simply be rescued from insolvency.
And thanks to emergency capital raising relief rules introduced by the ASX and ASIC on 31 March 2020 (allows issuers to selectively issue 25 per cent of new shares provided placements are accompanied by a Share Purchase Plan (SPP) at the same or lower price), those capital raisings are now flowing thick and fast. Our contacts at the major investment banks tell us there is a tidal wave yet to come.
Form a corporate governance perspective when a large placement can be made to one or a small number of investors selected by an investment bank and a subsequent SPP is inconsequential, retail investors can be shafted. But it’s the circumventing of our takeover rules that should have investors even more concerned. Australia’s takeover rules prohibit a placement of more than 19.9 per cent to any single or associated investor. If however the investor acts as a sub-underwriter to a subsequent entitlement offer they can land on a stake of more than 20 per cent without being required to bid.
The simplest illustration of this is a company with 100 million shares on issue where a placement to a favoured shareholder or investment banking client is made for 20 per cent of the issued capital (20 million additional shares). The placement is then accompanied by a 1-for-1 entitlement offer to potentially issue another 100 million shares. Now, suppose the same investor ‘underwrites’ the entitlement offer (guarantees the raising) and other shareholders only take up half their entitlement (50 million shares). This would leave the underwriter to take up the remaining 50 million. In total this shareholder now owns 70 million of 220 million shares on issue of 31 per cent of the company.
Who is already raising money?
Companies that have already raised capital include Cochlear (ASX:COH, $880m), NextDC (ASX:NXT,$672m), Webjet (ASX:WEB, $360m), Kathmandu (ASX:KMD, $201m), Flight Centre (ASX:FLT, $700m), IDP Education (ASX:IEL, $125m), oOh!media (AX:OML, $156m), regional media proprietor Southern Cross Media (ASX:SXL, $170m). Of course this list excludes the government bailouts or bail-ins for example, of regional airlines.
Most of the discussion surrounding these capital raisings involves the terms of the offer, a reduction of debt or “derisking of balance sheets,” the dilution of earnings per share, or the removal of the risks surrounding the recoverability of receivables. Few explain the mechanics of the raisings, the often destructive impacts on valuation or the corporate governance issues.
You can watch this video from 2010 where the impact of dilutive capital raisings at Santos produced an intrinsic value of $4.70 when the shares were trading at $13.55. Today of course the shares are indeed at $4.45. (As an aside and for a bit of fun, we also looked at Lynas, which was trading at $8.50 in 2010 and I gave it a value of zero. Since then the shares have fallen 85 per cent. We also looked at Fortescue at $4.10 and gave it an intrinsic value of $2.00 – it subsequently fell to $1.88 before recovering strongly).
The benefits of capital raising
In an ideal world, a capital raising would deliver a ‘win-win,’ shoring-up capital reserves and/or paying down debt while offering all shareholders equal access to more shares at attractive discounts to traded prices. But more typically, the benefits of capital raisings fall to one side.
It’s not uncommon for a share price to rally following a capital raising – typically due to a quick mop-up of any perceived overhang in the market or the resolution of uncertainties surrounding survival – and when it does, shareholders are understandably satisfied with their windfall. But long-term wealth generation is a different matter, and it can sometimes take years to identify whether attempts to repair the balance sheet also added value.
A capital raising may indeed reduce company debt, but it’s important to note that capital raised to pay down debt generates a once off return on equity equal to the interest rate on the debt. Consequently, large capital raisings massively dilute the return on equity, and depending on the discount or premium to equity per share, can be hugely value destroying.
Importantly, if a capital raising has resulted in a material decline in intrinsic value, then sustainable price increases are less likely. That’s because in the long-run a company’s share price and its intrinsic value are destined to converge.
It’s not uncommon for the share price to gravitate towards (lower) valuations following a capital raising. When capital raised increases equity, but profits don’t rise proportionately return on equity plummets. This looks likely for a large portion of the companies raising money today amid store closures and COVID-19 lockdowns. And the same was true for a raft of raisings during and just after the GFC such as Wesfarmers (ASX:WES) in 2008, Newcrest Mining (ASX:NCM) after 2011 and BlueScope Steel (ASX:BSL) in 2009.
Let’s briefly look an example of a capital raising whose purpose is to reduce debt. Company XYZ Limited has $2 billion of debt and $2 billion of equity as well as 100 million shares on issue. Each share is therefore entitled to $20 of the equity. The company generates net profit of $500 million or $5.00 per share. The company’s Return on Equity is therefore 25 per cent and if we assume the shares are trading at $40, the PE ratio is just eight times earnings.
Now let’s assume the world goes into lockdown, the shares fall to $20 a piece and the company decides to raise a billion dollars at a deeply discount $10 per share to reduce its debt by 50 per cent.
In order to raise the required funds, at $10 per share, the company will have to issue 100 million new shares. Debt will decline by $1 billion and equity will rise by $1 billion to $3 billion. But there are now 200 million shares on issue so each share is only entitled to $15 of equity (down from $20 equity per share previously). And if we assume a four per cent interest rate on the debt, the interest bill will halve to $40 million. The saving of $40 million per year will add $28 million to NPAT – all else being equal and assuming a 30 per cent tax rate) – producing a ‘normalised/adjusted’ return on equity the following year of 18 per cent, down from 25 per cent.
With a lower equity per share and a lower ROE (and this assumes profits aren’t impacted by the lockdown!) the intrinsic value of the company has permanently rebased lower.
A company desperate for capital, especially if the decision is live or die, will be prepared to dilute existing shareholders and care little for the long-term impact on return on equity and intrinsic value. But investors have a choice. There are many dangers surrounding the market and economic recessions but even though post-capital-raising share prices might rise, don’t let value destroying examples be another trap you are potentially left to fall into.
very clear explaining. Thank you.
Thank you Erika and Tham, happy Easter to you and your family.
Roger - great article. I fully commend you, as a Fund Manager (dare I call you that?), to raise this issue in this forum noting it is not unreasonable to expect many contributors' firms are the beneficiaries of these sorts of issuances (apologies for any unfounded aspersions to any FMs). In the media, many finance journalists have been raising it but will obviously have limited traction on this issue.
Excellent explanation thank you. One can but only wonder how many retail investors are aware of this. I as one always had the suspicion now confirmed .
In Reply to Ken Adams, the debt is halved (2 billion to 1 billion), so the interest cost is halved.
Hi Roger, It's been a little while since I completed my valuation classes but I'm not sure that the example you give of exchanging debt for equity at a particular point in time is correct. I think it is the Miller-Modigliani Theorem states that the value of the assets in place for a firm is independent of the capital structure. So using your example, if at this point in time the firm has an enterprise value of $4B comprising equal amounts of debt & equity and the debt is replaced by equity. The market value of the assets in place have not changed. Therefore the value attributable to equity holders has not changed (new and old) at that point in time. Now rolling forward into the future, the returns to equity holders very much depends upon the future cash flows generated after any additional reinvestment. Provided that future free cash flows exceed the cost of equity then equity holders will be rewarded with a higher valuation. I think that the premise in your article would be correct if the new equity was not used to retire the same amount of debt but instead used to increase the amount of capital in the business. I'm happy for you to correct any errors that I have made because it has been a long time since I studied this material. Best regards, Rob
Hi Rob, thanks for the comment. This might be true if we didn’t care about the returns on the equity or the equity per share. And remember if the register changes so does the relative ownership stakes. Theories are great until they meet reality.
Roger is a very smart man. But...I suspect, and I'm a rank amateur, that he lacks the "hunch" factor, the one that separates the inspired from the technical.
Brilliant as always, thanks Marcus. I won't be so eager in the future to buy into a spp as your article clarified the other issues to consider besides the dilution.
Thanks for the topical analysis Roger. What are the options (and impacts) here for retail investors when companies they have holdings in raise capital through placements and SPPs?
Hey Sam, the answer is dilution - to the extent the retail investor doesn’t participate.
So what do you do if you own shares in the company? Participate to maintain your proportion of the company or not participate and suffer easily dilution. Or sell beforehand and cut your losses?
Hello Russell, The answer should always come back to the price versus intrinsic value. While there may be an adverse impact on intrinsic value, if the price is below that value, then holding may still be acceptable. If you take Bapcor’s recent raising as an example, the equity per share was boosted by the raise (which has a positive impact in IV) but the ROE will inevitably be diluted from the average of about 14% over the last three years (all things being equal), and this is because the funds are being directed to reducing debt. Hope that helps