Capital Raisings

Are they always a value investing opportunity?

Why do capital raisings by companies need to be carefully considered when value investing? ... mainly because they could have a devastating effect on value.

Here I consider various ways a company can raise capital and how that activity can affect value.

But first, what are some ways companies involve themselves in capital raisings, and why do they engage in this activity?


Types of Growth

Companies like to grow, and can grow in different ways. They are said to undergo organic growth when they use retained profits and debt to expand their operations.

The less debt that is involved, the better.

If the company has limited opportunity to grow organically, it might take over other companies using its own resources or new capital.

A decline in per share value may ensue if the return on funds employed (ROFE) from the acquired company is less than the ROFE of the existing business.

Whether a decline in profitability ensues will depend on the management's ability to lift the overall performance of the combined (merged) business.

Hence there is a greater risk in those types of merger acquisitions where a company acquires a less profitable business.

Companies talk about the potential synergies (or efficiencies) that will accrue to the combined business to justify this type of merger.

The risk is that synergies may never occur.

Companies make a great play in using increase in earnings per share as evidence for growth in the company as a result of merger acquisitions.

Companies often say when taking over another business that the take over will be earnings per share accretive in the first year.

In plain language they mean that the earnings per share will get bigger in the first year.

But what they should be indicating is whether they expect that the merger will increase or decrease the return on equity over time. That is, whether the combined company will be more or less profitable.


Mis-Representing the Facts

A very misleading impression can be created using bar charts of earnings per share growth, profits and dividends in company reports - particularly, but not solely in relation to mergers.

The increasing height of bars may have more to do with increased revenue from employing the new capital and retained earnings than with the performance of the company.

Why?

If for example you have a capital raising (which increases the number of shares) as well as injecting more cash into the company from the retained earnings (profits) of both businesses, you have more cash per share to earn income from.

A term deposit could do a similar job of increasing income!

The real question is whether the extra cash has been used to increase the profitability of the company as measured by the return on equity.

What the company needs to display is a graph of return on equity(ROE), or return on funds employed if they are using debt as well.

Why don't they?

Probably because the graph will not display an ever increasing bar height, but may look flat - quite likely a good thing if the average ROE is high.

If the additional cash is not being used profitably then the bar graph would be decreasing in height - not a good look!

So when a company undergoes a merger, it is the future profitability, as measured by ROE or ROFE, which I focus on - not increasing earnings per share or profit.

Unfortunately, I may have to wait one or two years to be able to see what effect the merger has had.

But for some companies that have a history of successful take overs, and particularly for takeovers that expand their core business, I can be more reassured in the short term.


Stock Buybacks

During market downturns such as during a recession, an opportunity may arise for companies to purchase some of their own shares and cancel them, hence reducing the number of shares.

This constitutes a buyback.

This is in effect the opposite of capital raisings, unless the company needs to raise capital in order to undertake the buyback.

Click the 'buyback' link above for a discussion as to whether a buyback is always an appropriate strategy.


Rights Issues

A rights issue or rights offering to a company's existing shareholders is an invitation to buy a proportional number of additional securities at a given price (usually at a discount) within a fixed period.

It is a capital raisings option.

Rights are often transferable, allowing the holder to sell them on the open market. For example, renounceable rights have a value and can be traded.

The price at which the rights trade on the share market will initially be close to the Theoretical Ex-Rights Price (or TERP for short).

The TERP is the 'diluted' share price - calculated by multiplying the pre-rights issue share price by the ratio of the number of shares previously issued to the new number of shares now on issue.

The shares are now theoretically worth less because of the increased number of shares on issue.

Stockholders that have received renounceable rights can either ...

• act on the rights and buy more shares as per the particulars of the rights issue
• sell them on the market
• or they can pass on taking up their rights, that is, do nothing.

Unlike a renounceable right, a non-renounceable right is not transferable, and hence cannot be bought or sold.

This is unfair as stockholders, who for whatever reason do not wish to respond to the issue, will be disadvantaged.

By issuing more shares the company is effectively diluting the value of outstanding stock.

As the rights issue allows the existing shareholders to buy the newly issued stock at a discount as part of the rights issue, they are compensated for the inevitable share dilution.

The discount the rights issue provides them is equivalent to the cost of share dilution.

But to be equitable a rights issue limited to existing shareholders should be priced at the existing equity per share.

However, shareholders who do not exercise the rights by buying the discounted stock will lose money as their existing holdings will suffer by being diluted.

So when a rights issue is on offer, I have to weight up whether the reason for the capital raising is sufficiently appealing for me to either ...

• take up the offer
• sell the rights if that is an option
• or retreat out of the stock!

Since if the capital raising through the rights issue is to pay for an overpriced acquisition, somewhere along the line the stock price is likely to suffer.


To Conclude

The ability of a company to manage its capital has a lot to do with the ongoing success of the company.

Capital raisings, mergers, rights issues and share buybacks all need careful management and appropriate timing from a value investing point of view to maximize shareholder value, rather than destroying it.

An important aspect of being a value investor is to recognize how competent company managers are in managing capital. Capital allocation is a key attribute that managers need to possess.

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