Are Investors Too Concerned With Dilution?

By Eric Fox | September 17, 2009 AAA

Investors tend to have a knee-jerk sell reaction to a secondary offering that dilutes the shareholder base. Although this dilution is a mathematical fact, the additional capital may allow the company to get over whatever business cycle trough it finds itself stuck in.
Two recent offerings highlight the risk that investors incur when a company raises capital and dilutes existing shareholders.

The Dilution Solution
Eastman Kodak
(NYSE:EK) announced that it was raising as much as $700 million in capital through a complex deal involving Kohlberg Kravis Roberts & Co. L.P. Kohlberg agreed to buy up to $400 million in senior secured notes due in 2017 at an interest rate of 10-10.5%. Kohlberg will also get 53 million warrants to buy Kodak stock. (Read about KKR's historic leveraged buyout of RJR Nabisco in our article Corporate Kleptocracy At RJR Nabisco.)

Kodak placed another $400 million with institutional investors in a convertible note due in 2017. This note pays interest at 7%. Kodak will use the proceeds to buy back an existing convertible issue that was due in 2033. Under the terms of that convertible, holders could have put the issue back to Kodak in October 2010.

This financing eases concern the market had regarding whether Kodak would have the funds to meet this put.

The bottom line is dilution of as much as 35-40% to existing shareholders once the new capital structure is in place. Investors' reaction was predictable: shares sold down about 15%.

Kodak had little choice in agreeing to the deal, as the company's losses have been mounting the last few years. Kohlberg extracted as much as it could from the company to the benefit of its investors. The drop in the stock's price sounds scary, but this just might be what Kodak needs to get over the recession and survive until the economy starts to grow and consumers and businesses start buying its products again.

Watering Down Palm
Palm Computer
(Nasdaq:PALM) also raised capital and did a straight equity offering, just as its stock price was nearing its highest point in years. The company issued 16 million shares, an 11% dilution of the existing shareholder base. Palm Computer is not in distress and was simply taking advantage of an overbought stock and investor enthusiasm. The stock sold off on the day the deal was announced.

Earlier in the year, several small and micro cap exploration and production companies had to raise capital to meet debt maturities or to fund ambitious capital plans.

In May 2009, Kodiak Oil and Gas (Nasdaq:KOG) raised $7.15 million in an equity offering, priced at only 75 cents per share. Brigham Exploration Company (Nasdaq:BEXP) offered 32 million shares to the public that same month at $2.75 per share.

Although these deals were dilutive, since then the stocks have outperformed the market by a wide margin. Kodiak Oil and Gas and Brigham Exploration closed at $2.52 and $9.43 per share, respectively, on September 18, 2009.

Conclusion
Investors tend to exhibit the typical short-term reaction to a dilutive offering, ignoring the positive macro effect the additional capital can have for a company. However, secondary offerings are not always a bad thing, despite the dilution of shares. Maybe more forward-thinking investors can take advantage of the market's short-sightedness.

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