Monday, April 21, 2008

Dilution: An Investor's Nightmare and the new Risk to Wall St.

I hope everyone had a great weekend. I wanted to talk about dilution of shareholder stock today after National City Corp's capital raising announcement.

I see this as being a huge new risk to investors as the pressures of maintaining the debt bubble combined with tighter credit markets is making it increasingly more difficult to raise capital.

National City Corp. is a regional Cleveland based bank that got into trouble because of the housing slump in Ohio that was caused by massive losses in manufacturing which is a large part of the Ohio economy. We all know what this has done to Detroit. The bank also did a lot of bad subprime lending.

So how bad is the situation at National City? Well the stock is down 82% in the past year and they just announced their third quarterly loss in a row. This is a bank that was obviously on the verge of a collapse and needed a massive capital infusion in order to survive. We almost had our first major bank failure folks.

Well Bloomberg reported today that National City was able to secure $7 billion dollars in new capital today. Great news for the company and shareholders right? Wrong.

The terms for the deal are terrible and the stock is down 27% on the news because shareholders were crushed as the company was forced to massively dilute their shares in order to raise the capital. From Bloomberg:

"National City will raise $6.37 billion selling convertible securities, the Cleveland-based company said today in a statement. The bank is also offering shares of common stock for $5 apiece, about 40 percent less than National City's closing price on April 18. The dividend was slashed to 1 cent a share from 21 cents.
``Shareholders continue to get penalized,'' said Gerard Cassidy, a Portland, Maine-based analyst at RBC Capital Markets, in an interview yesterday. ``It's another major company going to the capital markets to enable them to survive in this incredibly deflationary environment.''

Corsair and another private equity investor are contributing $985 million. Some of National City's largest current institutional shareholders are also providing funds, the bank said.

The company ranked among the 10 biggest originators of loans to people with poor credit histories in 2006."

My take:

Well my first question is where are all of the Sovereign Wealth Funds that were going come in with billions of dollars and save Wall St.? I guess after taking massive losses like the 30% hit that they took on buying Citi shares has made them realize that maybe catching falling knives is not such a good idea.

Without the easy SWF's cash flowing like it used to, companies like NAtional City are now forced to go to the credit markets and hedge funds with hat in hand and take whatever terms they have to in order to raise capital so they can stay alive.

Listen to the terms of this deal. National City agreed to sell an additional 1.4 billion in shares of the company at $5 a share which is a 40% discount of where the stock closed on Friday. They only had 600 million shares of stock before the capital raising. Talk about dilution!! They more then tripled the amount of shares outstanding in one day!!!

So if you bought National City on Friday you have lost 27% on your investment due to dilution. You are down 82% if you bought this stock a year ago. They also lowered their dividend to a whopping one penny a share.

Bank of America Earnings:

A quick blurb on these. Earnings were down 77%. Ooops. From Bloomberg:

"First-quarter net income declined 77 percent to $1.21 billion from $5.26 billion a year earlier, the Charlotte, North Carolina-based bank said today in a statement. Results included $1.31 billion in trading losses and $2.72 billion in costs for uncollectible loans. Earnings per share shrank to 23 cents from $1.16, falling short of analysts' estimates and sending the bank's stock down as much as 2.6 percent in New York trading.
The slide casts doubt on Chief Executive Officer Kenneth Lewis's goal to increase profit by at least 20 percent this year."

Wow this is ugly. Well Kenny I am sorry but my guess is that 20% growth in earnings this years isn't going to happen.


Real quick. Meredith Whitney is announcing that Citit may eliminate their dividend and she slashed her earnings outlook. More on this later.

Bottom Line:

If you have a moment of insanity and decide to buy a financial stock or any company with a weak cash position you need to consider the risk of dilution when you are making your investment.

The reason the risk of dilution is so high right now is because the housing downturn has frozen the credit markets and as a result of this, they will only lend money at ridiculous terms like buying shares of your stock at a 40% discount. I wouldn't touch any stock that has a weak cash position right now which in my book includes just about every financial.

I wonder how those bottom callers are feeling right now? Something tells me they may be sweating a little bit. As long as housing continues to deteriorate expect these financials to be in a tailspin. They will continue to need capital infusions and dilution will be one of the easiest ways to find capital.

Expect the market to start reacting negatively to any dilution news as they did with National City today instead of buying on the dilution news like they did last week with Washington Mutual thinking financials are at a bottom.

Each dilution will damage confidence in the market and you will start seeing stocks selling on dilution news instead of being bought by bottom callers.

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