Tuesday, 27 October 2015

Capital Structure and Equity Dilution

Capital structure is the current and historical values of a company's Authorised Capital, Issued Capital, number of shares floating in the secondary market, the face value and Paid Up Capital of the shares.

And,

Paid Up Capital ≤ Issued Capital ≤ Authorised Capital



There's more to it, but we'll stick to the above definition for now.

For example....Capital Structure of Kirloskar Brothers.




§ EQUITY DILUTION §

Equity dilution is the dilution of value stored in one share. It occurs whenever the total number of ordinary shares available in the secondary equity market increases - face value per share remaining the same.

Causes:
1. Issuance of FPO.
2. Convertible bonds, warrants or debentures (previously issued) are converted to ordinary shares.
3. Stock options (previously created) are exercised.
4. Convertible preference shares are converted to ordinary shares.

Equity dilution is marked by the expansion of Issued Capital, number of shares, and Paid Up Capital in the Capital Structure.

Companies need to do the above from time to time, but if such manoeuvers are carried out recklessly, it not only dilutes, but destroys the existing ownership of existing shareholders.

The consequence of reckless dilution of equity is a highly depressed share price as well as a depressed EPS. 

For example, Suzlon Energy is a reckless diluter of its equity.

The following passage explains the sudden crash of Suzon Energy share price in September 2014, because unpaid FCCB (foreign currency convertible bond) holders agreed to convert their bonds to ordinary shares, and flooded the secondary market in an attempt to sell. Supply outstripped demand.

©Copyright NDTV Convergence Limited 2015.

The sharp selloff was triggered on Friday, when the shares allotted by the company to foreign currency convertible bond holders got listed on the exchange on September 19, 2014.

Suzlon Energy had issued 270 million equity shares at Rs 15.46 per share to FCCB holders under a restructuring arrangement.

According to the arrangement, FCCBs issued earlier - including unpaid interest and default interest - were converted into equity shares. The conversion of FCCBs to equity shares resulted in dilution of promoter holding from 37.81 per cent to 34.46 per cent.

Analysts say new shareholders have been selling their shares in the open market because the issue price was substantially less than current market price.


The following is via Investopedia: Dangers of Equity Dilution:

© Investopedia
There are several situations where shares become diluted. These include:

Conversion by holders of optionable securities.
Stock options granted to individuals, such as employees or board members, may be converted into common shares, boosting the total share count.

Secondary offerings where the firm is looking to raise additional capital.
A firm may looking to raise new capital to fund growth opportunities or to service existing debt may issue additional shares to raise the funds.

Offering new shares in exchange for acquisitions or services.
Instead of paying for an acquisition with shares, new shares might be offered to shareholders of the firm being purchased. For smaller businesses, new shares could be offered to individuals for services provided. For example, special counsel could be offered shares for representing the firm or in exchange for other legal services.

Warnings Signs Of Dilution:
Because dilution can reduce the value of an individual investment, retail investors should be aware of warnings signs that may precede a potential share dilution. Basically, any emerging capital needs or growth opportunities may precipitate share dilution.

There are many scenarios in which a firm could require an equity capital infusion; funds may simply be needed to cover expenses. In a scenario where a firm does not have the capital to service current liabilities and the firm is hindered from issuing new debt due to covenants of existing debt, an equity offering of new shares may be necessary.

Growth opportunities are another indicator of a potential share dilution. Secondary offerings are commonly used to obtain investment capital that may be needed to fund large projects and new ventures.

Investors can be diluted by employees who have been granted options as well. Investors should be particularly mindful of companies that grant employees a large number of optionable securities. Executives and board members can influence the price of a stock dramatically if the number of shares upon conversion is significant compared with the total shares outstanding.

However, the fact that convertible instruments exist, in itself, is no reason to turn away from buying a company's shares.

As explained on OneMint:

© Onemint.com 2015

Stock options are one example of these kind of instruments, preferred stock is another, and in the case of many Indian companies – FCCBs (Foreign Currency Convertible Bonds) feature prominently among instruments that can dilute the earnings. Subject to certain terms, all these instruments can be converted to ordinary shares by the instrument holders and if they did that then the profit available to each shareholder will be reduced and earnings will be diluted.

Now just because an instrument can be converted into a share doesn’t mean that it will be converted and that will be true in a lot of cases where the dilution occurs due to preferred stock or FCCBs.

The other aspect of this is that when you convert such instruments to ordinary shares the company is relieved of the obligations that arise due to them. So, if FCCBs were converted to shares then the company no longer needs to pay any interest on them and if the preference shares were to be converted to ordinary shares then they won’t have to pay dividends on that any longer.

SOME EXAMPLES OF EQUITY DILUTION

§ THE GOOD §

Companies that rarely dilute their equity would be better investments. For example:



There's lots more. Like Mukand Engineers, Shalimar Paints, MRF, Thermax. But still, such companies are rare, because the equity market is quite huge.



§ THE PRUDENT §

Tata Chemicals has been diluting its equity. But it has been done in a careful manner, so as to not destroy the value contained in one share.


Ballarpur Industries, has shrunken its Authorised Capital, as well as its Issued Capital, to match the Paid up Capital. They diluted equity recklessly in the early 2000s, but have recently taken steps to reduce the Authorised and Issued Capital, perhaps its an attempt to reverse the effects of reckless dilution. They may no longer be in a hurry to dilute.


§ THE BAD §

First source solutions for example. The speed at which they have been diluting their equity may not be a good idea, but being a successful company, they might get away with it. If dilution is done with careful consideration, it is an excellent tool.


Update Dec 05, 2015: They diluted their equity yet again! ESOPs were given on 5th October, 2015 and 370,075 equity shares were alloted on 20th November 2015, taking the total number of shares to 670,657,612. The stock crashed on Dec 1st, 2015.





§ AND THE UGLY... §

Suzlon Energy of course...by 2017, their equity will be diluted by another 70%.


And then you have Gammon India. Expanded their Authorised Capital from from 71 crores to 14942 crores, suddenly.




CONCLUDING REMARK


1. As long as the Earnings Per Share remains OK, the company is diluting its equity in a responsible manner. If the EPS of the share feels OK, there is no cause for concern.

2. If new shares are issued at a price lower than the current market price, the existing shareholders will be at a disadvantage; if the new shares are issued at a premium (Issue Price > Current Market Price) the existing shareholders will have an advantage.



Further reading:

1. Traderji

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