Secondary Offerings: Friend or Foe?

In theory, a secondary offering shouldn’t impact the price of company’s stock — any dilution is offset by an increase in a company’s cash balance, and eventually offset by the addition of a revenue-bearing asset.

In reality, however … well, secondary offerings rank right up there with FDA decisions and crucial court cases when it comes to creating trade-worthy volatility.

The question is: Should you play with this fire?

A Secondary What?

A secondary offering is, in simplest terms, a way for a company that’s already publicly traded to raise additional capital by issuing more shares (as opposed to an initial public offering, or IPO, which is the issuance of a company’s first publicly traded shares).

The purposes of a secondary offering are nearly unlimited. A small biotech might make an offering to continue development of a key drug. A mining company might raise funds to acquire additional earth-moving equipment to increase production. JCPenney (JCP) is about to raise capital in the secondary market for “general corporate purposes,” while a little generic drug company called Lannett (LCI) recently did it because its stock had advanced some 340% this year so far, and at its lofty price the company would simply be able to garner a lot of cash for the future without giving too much of itself away.

Make no mistake, though — sooner or later, any company is going to do something with its idle money. The value of a secondary offering ultimately depends on what it’s going to do with that loot, and how much fruit that venture might bear.

Stocks Worth Investing In

There’s a common element among all the investment-worthy names raising post-IPO money by issuing more stock … the upside of that investment is clear, and plausible.

Take First Solar (FSLR) as an example. The long-beleaguered solar panel-maker gathered more than $400 million in June via the sale of newly issued shares. Although the funds were simply earmarked for general purposes, the odds are good — and not exactly veiled — that First Solar is looking to make acquisitions with the cash, and specifically looking to garner in-development power system projects.

But isn’t solar power a losing battle, riddled with too much competition and not enough demand?

Nope. That previously was the case, but it’s not anymore. Bloomberg New Energy Finance believes the capacity of new photovoltaic installations could exceed that of newly installed wind-power capacity this year, for the first time ever. And with PV prices still falling and PV efficiency still improving, solar power is closer than ever to cost-competitiveness with more traditional forms of power production like coal and nuclear. Industry forecaster IHS Inc. expects a solar installation growth rate of 18% for 2014, following a 20% expansion this year.

Point being, First Solar can actually do something constructive with that money.

The Chefs’ Warehouse (CHEF) is another company that recently announced a secondary offering, and like First Solar, has proven it can actually do something productive with the money.

The $500 million chef’s supply outfit might not be big enough to turn many heads, but the revenue growth rate for this young company has been an impressive — and impressively consistent — 20% for the past three years; earnings growth has been similarly strong.

Already proving it knows how to do well, empowering CHEF with another $75 million to expand the business (most likely through acquisitions) wasn’t a particularly big risk. The path to a solid rate of return on that cash is not only clear, but plausible.

Stocks Not Worth Investing In

Above all else, know that some (many) secondary offerings don’t benefit the company at all, but are instead brokered exits of a major shareholder’s position in that company.

Also be wary of an outfit that’s already in the habit of losing money. It’s often a sign that the company doesn’t have any idea where the leaks in the boat are — or how to fix them — and is building cash just to buy time.

Case in point: While it might be unfair to kick it while it’s down, JCPenney is a prime example of throwing away good money after bad. The retailer posted its weakest revenue in years in 2012, along with a loss of nearly a billion dollars, and 2013 is on pace to be even more pathetic.

JCP, under new/old chief Mike Ullman, says the worst is over, but cash is needed to restock stores and finish some needed remodels. That’s not the issue, however. What’s holding the company down is a couple of years’ worth of contempt for the customer, a rusty marketing shtick and a subsequent crimp in cash flow.

All the money in the world can’t undo that damage, and even if it could, JCPenney will need as much time as money to fix it. Even if its cash-bleed is cut in half, the company is still likely to be insolvent in a couple of years at its current rate, and that’s counting the $800 million it just raised by issuing new stock.

Bottom Line

The irony is, the investment-worthiness of a company raising money via a secondary offering has little to do with the offering itself. Good companies generally find productive things to do with extra cash in the coffers, while poor companies tend to waste it. That’s true whether or not the organization is in fundraising mode.

Ergo, the question you should be asking yourself is: Would you be willing to take on a stake in a particular corporation even if it wasn’t raising cash?

Either way, in almost all cases, either the announcement of a secondary offering or the issuance of those shares ends up being at least a temporary drag on the stock’s value. If you believe a company can use that capital to grow the top and bottom line, it still wouldn’t hurt to wait for the inevitable plunge in the stock’s price.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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