Does Capital Raising Sound the Bell to SELL?

As the financial crisis plays out, more Aussie companies are going to the market to raise capital. The question is: if a company goes to the market to raise capital, does that sound the bell to sell?

In theory, capital raisings to fund future growth and expansion should be a good thing. A capital raising to reduce debt in an otherwise fundamentally sound company should also be a good thing.  But in practice, capital raisings of almost any kind and for any debt-related reason more often than not drive down the share price.

A dramatic example can be found in the recent announcement of Seven West Media (SWM). The company announced that it was offering new shares at $1.32, representing an 18.5% discount to the prior closing price of $1.62. The rights issuance will raise about $440 million primarily for the purpose of cutting debt.  To demonstrate what investors thought about the capital raising, here is a price chart of Seven West over the five ensuring days:

Obviously, many investors took the capital raising announcement as a SELL signal, but were they justified?  Managing director of fund manager Ausbil Dexia, which owns 5.2% of Seven West Media, sees the raise as a positive sign.  Fund manager Paul Xiradis feels the shares have been beaten down over concerns about the company’s capital position and eliminating that risk through the capital raising should propel the stock to better performance.

Time will tell who is right.

Capital raisings do, however, dilute of the value of shares for existing shareholders. And while company management may celebrate the view that capital raisings will increase shareholder value over time, in the minds of many retail investors capital raisings mean nothing but short term trouble.

In reality, capital raisings take different forms, some of which benefit institutional far more than retail shareholders.  Seven West’s offering was a Renounceable Rights issue, meaning both retail and institutional investors had the option to participate; should they decide not to participate, those rights can be sold on the open market.

Non-Renounceable Rights Issues, on the other hand, are essentially a take it or leave it proposition.

Traditional rights issues involve halting trading in the stock to minimise the risk of a slumping share price.  Institutional holders go first and retail investors take the remainders.  In short, if the company throws a sweet offer on the table and institutionals investors won’t eat it, this is probably a good a sign as any to sell.  Within days, 91% of Seven West’s institutional holders bought in with the retail entitlement offer set to start on Monday 23 July 2012.  While some would say such high participation is nothing more than investors trying to prop up a failing company, others disagree and instead see high rates of participation as an indication investors feel the raise is needed and will help.

The other major type of capital raise is the Institutional Placement, where the offer is restricted to “significant” institutional investors and in some cases “sophisticated” individual shareholders with major existing holdings.  The ASX has recently expressed a growing concern over the perceived unfairness of Institutional Placements to retail shareholders as they have no rights in the offer and will see the value of their shares diluted.  From the company point of view Institutional Placements are preferable because they are quick and less costly.  In general an Institutional Placement can be completed in 1-2 days and often do not require as large a discount to current share price as does a Renounceable Rights offer.

While placements might seem inherently unfair, in the long run if the capital raise does what it is meant to do all investors will benefit.  So again the key issue with any type of capital raise – Renounceable Rights or Institutional Placement – is why the company needs the cash in the first place.

One reason for the prevalance of capital raisings is the current state of the debt market. The GFC hit credit markets hard and even though conditions have improved, many companies choosing to  raise capital rather than enter the debt market.  In better times, a company that needed more capital than it had available (say for an acquisition that would spur future growth), might consider taking on debt to finance it.

While debt in and of itself is not a bad thing, deteriorating market conditions, sometimes beyond the company’s direct control, can make supporting the debt repayment schedule a problem.  Corporate debt instruments are complicated and often include covenants that if breached allow the creditor to call the loan in full.

Earnings can decline as a result of global conditions such as commodity price drops.  Lenders don’t care and if earnings deteriorate to the point debt repayments are threatened, the company could find itself in trouble.  Thus current macroeconomic concerns are pushing more companies into capital raisings despite their cost in terms of discounted share price and dilution.  The idea in some cases is to reduce debt to allow a company to withstand global economic shocks but many investors see capital raisings to reduce debt as strictly a bad thing.  Debt reduction as a goal of a capital raise is not in and of itself a hard and fast sell signal.  Seven West is a case in point.

The Renounceable Rights offer was followed by a wave of updates from the major brokerage firms.  RBS Australia actually upgraded SWM to BUY stating that the improvement in the company’s debt position coupled with the inherent value of the stock justified the upgrade.  Others adjusted price targets downward, but this company now has 4 BUY/OVERWEIGHT recommendations and one HOLD.  Not a single one of our major firms is pressing the SELL button.

Not all Rights Issues are greeted with unbridled enthusiasm by analysts and certainly not by investors, as evidenced by the 25 June offering from Billabong (BBG).  The company’s share price dropped almost 50% in reaction to their announcement of a Non-Renounceable Rights issue to raise $225 Million with an offer price of $1.02 per share.  The prior close was $1.88 and the size of that discount plus the fact the company’s Chairman had claimed they didn’t need a capital raise six weeks prior was simply too much.  To add to the disaster the company had announced the elimination of any forthcoming dividends and cut earnings guidance.  Here is what the chart looked like for the last month:

In contrast to the SWM offer, Billabong institutional shareholders took up only 79% of their share allocation, raising $155 million.  The Retail offer closed on 17 July and the company has yet to release results.  Billabong tells us the remaining portion of the institutional allocation was sold through a bookbuild process, which was oversubscribed with the majority of new shares going to existing shareholders.  Bookbuilding is a process used during share issues to ask the investment market at what price the shares should be sold.

The company’s total debt for the most recent quarter prior to the offering was $716.97 million.  You do the math!

Not all capital raises send investors scurrying for the exit doors, especially those meant to fund growth rather than reduce debt.  A case in point is one of the ASX top performers year over year, Buru Energy (BRU) an oil and gas exploration and production company. On 14 June 2012 the company announced an Institutional Placement at $3.00 per share, discounted from the prior close of $3.21, to raise $50 million.  Here is the market reaction to the news:

Note the share price went up as the company’s stated intent for the funds was to continue and expand existing exploration, appraisal and stgelopment programs in the Canning Super Basin as well as to fund the intitial phases of gas commercialization in other assets.  Not a dime for debt.  However, Buru has no debt.

The question remains: is there an example of a capital raising for debt reduction that didn’t cause the share price to fall through the floor?

On 22 April 2012 Ainsworth Game Technology Limited (AGI) announced an Institutional Placement to issue 30 million new shares for institutional and sophisticated investors.  The offer was to raise $44 million with a share price of $1.42, discounted from the prior close of $1.57, about 10%.  And here is market reaction:

The offer was completed on 23 April and the following trading day the share price closed at $1.73.  The company’s stated intention for the funds was a mixed bag of debt interest repayments, redemption of convertible notes, and funding for future growth through market and new product expansion.

It is true that capital raisings focusing on debt reduction beg the question of how the company got into big debt in the first place.  The answer to that question often tells the tale of what to expect going forward.

At first glance, Billabong looks like a death spiral nearing its end, and indeed has been referred to as a “train wreck.”  The reasons for their fall from grace are well documented starting with the expensive decision to change from wholesaling exclusively to direct retailing to the general malaise in our retail sector.  One has to wonder what could possibly have been going through the minds of BBG Board members when they decided to reject a $3.50 per share offer from private equity firm TPG without putting the offer to a shareholder vote.

Yet that management is gone and BBG has something that takes years to build – strong brand identification across the world and a youthful market.  With some breathing room with the added capital from the raise, new management has at least a chance to turn things around.  And there is always the possibility of another takeover bid, considering the current bargain basement price.  For high risk investors the capital raising may in actuality have opened a buying opportunity.

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