Capital moves raise questions for shareholders

Listed companies’ quests for cash can be an opportunity for investors who do their research and understand what’s involved, writes Oliver Mander

Risk is being transferred from debt holders to shareholders – but that is as it should be.

The economic impact of Covid-19 has resulted in a plethora of listed companies raising cash on the market. Kathmandu (raising $207 million) and Auckland Airport ($1.2 billion) were first to jump on the post-Covid cash injection. But they’re in good company: Z Energy, Sky TV and others have all followed suit, with more likely.

For investors, there’s plenty to think about in relation to these types of offers. Good questions might include “why do they want my cash?”, closely followed by an understanding of the mechanism through which they are raising it.

Reasons

Raising new capital is usually a good thing for a company, even if it creates short-term pain for shareholders in terms of stumping up the cash. Often it signals growth. For example, Arvida Group has had multiple rights issues over the past few years, as it has acquired new businesses that have added value to its bottom-line profit and earnings a share.

Right now, though, there’s no doubt that Covid-19 is putting a whole different spin on things. As economic conditions tighten, the primary objective of new capital is shifting from growth to minimising exposure to high debt levels and even supporting operating cashflow.

After all, in a recession cash is a non-gender-specific superior being.

Too much debt at the wrong time creates pressure in servicing loans, using up cash that the organisation can ill-afford. Even if interest rates are low, upcoming pressure can be caused by maturing debt that needs repayment in the near future. Also, debt holders may have specific conditions on what they have loaned, such as a minimum share price or profitability-related ratios.

Over the past few weeks, as expectations of company income and share prices have fallen, a key factor in raising capital from shareholders is to reduce debt to provide a stronger balance sheet.

Effectively, risk is being transferred from debt holders to shareholders – but that is as it should be. Higher risk equals higher returns (in the long term), and equity markets are key facilitators of risk.

Timing is not always helpful. Kathmandu’s A$350m Rip Curl acquisition already left it with a heightened debt load – perhaps acceptable in the pre-Covid-19 world, but far less so afterwards.

Traps and pitfalls

So, for non-institutional investors, what is worth looking out for? In all cases, it pays to do some basic research or analysis to compare the “before” and “after” of the capital raise.

● The ‘earnings a share trap’: If a company is raising capital for an acquisition, does the increase in the number of shares still allow an increase in the earnings a share? It should be better than today (or at least, better than the alternative forecast without the capital raise). If not, it’s sensible to question why said company is acquiring its target in the first place.

This might also be a factor of the offer price for the new shares. The

NZX is chock-full of profitable companies which have a relatively high share price relative to what they earn (ie, Price/Earnings ratio). Even if your research tells you the company has a good future, it could just be that the offer price is too expensive and there may be better opportunities for your cash elsewhere.

● Your entitlement has value (sometimes): Where the mechanism used to raise capital is a renounceable rights offer, the rights themselves are worth something.

This is reflected by the company either allowing the rights themselves to be traded on the NZX between the record* and closing date*, or through returning money to shareholders who did not take up their rights once the rights issue has been completed.

This latter case assumes that other shareholders have asked to take up more shares (ie, beyond their entitlement), effectively picking up new shares that others did not want.

Sometimes, an entitlement offer is “non-renounceable”, meaning there is no value in the rights themselves. In this case, shareholders cannot “sell” their rights or expect to get any cash back if they choose not to take up their entitlement. It also means that a shareholder is facing a stark choice between stumping up cash or suffering dilution.

If you feel a company’s future is uncertain, it makes little sense to invest more. But if the justification is sound, it might make sense to find the cash and make the investment.

● Dilution: If you choose NOT to participate in a rights issue or share purchase plan, you will own a smaller slice of the company – and the value of your total parcel of shares is likely to fall. The amount of dilution depends on the number of shares being issued; for example, Kathmandu’s rights offer more than doubled the number of shares in the company.

This doesn’t always hold true – new capital may create more certainty for the company to such an extent that its “after capital raise” share price may actually increase.

● Timeframes: Receiving an offer with extremely short timeframes can be problematic, as it means a decision on whether you hand over your hard-earned needs to be made very quickly.

Shorter timeframes for entitlement offers were enabled by changes the NZX made in late March for all types of capital raising, one of the many responses to the impacts of Covid-19. At the time, the exchange said that it wants companies to “recognise the interests of existing investors”. Broadly, the difference between entitlement dates and closing dates suggests that companies are indeed doing this, with the notable exception of Kathmandu, which gave investors about five days to submit their applications.

Mechanisms

Rights issues are a common way for a company to raise capital in a manner that is equitable to all existing shareholders. They allow shareholders to purchase a given number of shares for each share they already own.

A share purchase plan is when a company allows existing shareholders to purchase shares up to a specific amount. There is no “entitlement” – you just need to be a shareholder. This is often a good way to increase the number of shares you own, well beyond the proportion implied by your existing holding.

Some companies undertake a capital placement – placing shares in the hands of selected institutions or large shareholders (for an appropriate value, of course).

Recent capital raises by Auckland Airport and Z Energy are good examples of this; institutional placements were then followed by a share purchase plan open to noninstitutional investors.

Will there be more this year? No doubt. It might be that the sheer number of capital raises will eventually force investors to prioritise opportunities available to them. The capital raises finalised so far this year have been successful in achieving their target, with some over-subscriptions being accepted by the companies.

For example, Cannasouth was targeting $3m in its share purchase plan, but accepted nearly $6m in new capital from investors.

While most capital raising this year has been focused on creating balance sheet strength, there may be a time when stronger organisations may look to examine acquisition opportunities or invest in new business models to support a different direction. It’s worth keeping half an eye open – but make sure you get the advice that you need to support any decisions.

* There’s a great guide to rights issues on the Financial Markets Authority website. This also explains some of the terms used in this column.