The Dilution Solution: Prepare for a Flood of Equity Issuance

Since mid-March, I have been pegging the peak of the rally at 860-920 on the S&P 500.  While the high close was about as close to 920 as one can get (919.53), the market briefly traded above my "line in the sand" yesterday and even again in the pre-market this morning.  It could go higher, but I continue to think that this is a proper rally from extremely oversold conditions but that the headwinds will keep blowing for many quarters to come despite the current optimism.

With the benefit of hindsight, it is now much easier to understand why stocks went so low and rallied back so sharply.  Scenarios of equity extinction gained a lot of traction early in the year.  In a very cold and calculating manner, one can envision scenarios where companies face short-term gaps in their funding that can't get met due to the capital markets being "frozen", and they get "Lehmanized".  Very simply, if a company has a short-term obligation and can't either borrow the money by extending the loan or refinancing it or raise cash through asset sales, it is technically bankrupt.  The only alternative is to sell stock.  Hence, we had lots of stocks heading well below book value or even tangible book value.  This is exactly what was going on with General Electric (GE), which I called a "value pit" in late December.

Things got so insane that I had to defend GE (see the comments in that same article) on March 4th:

I am following up 10 weeks after I published my views on GE. While I continue to believe that GE's equity may ultimately be wiped out, I believe that today's price of 6.40 or so is most likely a price that better reflects the risk/reward opportunity than previously. If I were short the stock, I would consider covering here for now. If I were long the stock, I would avoid selling it now.

 

The market failed to realize that if the credit markets stayed frozen forever the conclusion was correct, but they wouldn't stay frozen forever.  While spreads remain sky-high and availability relatively low, credit is flowing again. We see now that banks are beginning to issue equity, with WFC doing a modest $6 billion deal today.

 

I believe that the rest of the year will see equity issuance pick up.  Many companies outside of Financials need to address their capital structures.  The cost of issuing debt remains high, and the risks of waiting for improvement would seem to be too great.  It's time for companies to bite the bullet and repair their balance sheets, raising enough equity  to cover debt maturities for the next several years.  Many companies have been repurchasing their debt at steeply discounted prices, which further supports the potentially accretive nature of share issuance despite the low PEs (are they really so low?).

 

The need to raise equity capital is even greater for companies with high amounts of intangibles on the balance sheet.  These companies will be running impairment tests later in the year and could see their equity written down.  Impairments could potentially trigger debt covenant violations.  I believe a great example of this is Vulcan Materials (VMC).  I have recommended shorting the stock to my clients, as they have a short-term funding gap (0.7X current ratio), a ton of intangibles (thanks to buying Florida Rock at the top), debt covenants on their substantial debt and maturities in the intermediate term.  They should eliminate their dividend immediately and sell $1 billion of stock (20% of the market cap).  This is just one example, but go back and review my list of companies with high intangibles.  These stocks, like the market in general, have rallied from their lows.  It's time to recapitalize.  If they don't, they could be subject to the whims of the market later this year.

 

Disclosure:  No position in any stock mentioned.