Capital Raise Season

April 4, 2020

Dear Fellow Investors,

 

As many of you will have seen I have been buying shares in GC1 recently, make your own mind up but the market is depressed, LICs are out of favour, people are selling shares because they are short on cash and we are trading at a reasonable discount, while coming into a period where the portfolio should benefit from the significant number of opportunities that are currently presenting themselves.
 
This is a unique period for companies as we see the effects of Coronavirus, causing massive disruption to people's lives and businesses.  It is forcing companies who were previously trading well to face the prospect of depleting their current cash reserves, forcing many to borrow more money or look to equity markets for additional capital. The issue with that in simple terms is that a business that was earning $50 million NPAT and had a $500 million market capitalisation, trading on a PER of 10x may be forced into raising so much capital that when earnings do come back to normal you may have 50% extra shares on issue. If you take the example of the company above if or when it gets back to the $50 million of NPAT, you may have had 100m shares trading at $5 a share before the recent correction and now the share price is $2.50 and you are forced to raise at a discount to that price. To raise another $50m at $2.00 a share means issuing another 25 million shares.

 

When the business returns to earning $50m NPAT again EPS has gone from $0.50 a share to $0.40 a share.  Putting the company on the pre coronavirus multiple, the shares will trade at $4.00 a share. Many companies have no choice but to raise capital or face imminent failure.

 

The key takeaway from this is that the investor who bought the capital raise has made a 100% return at the expense of existing shareholders. So amongst all of the turmoil, there are opportunities in the following areas:

 

  • Companies facing short term benefits

  • Companies that are oversold

  • Companies who have recurring revenue that isn’t impacted by the current situation

  • Companies needing to raise at heavy discounts

 

There are also some companies that are priced for failure, some will make it and some will not.  Virgin Australia fits in the latter category, with a high probability of failure as the Federal Government has already stated that they won’t bail out the airline which requires $1.8bn.
 
Cash not always king


Normally a company with no debt and strong cash levels is a safe investment. Pre GFC there was a trend for companies to optimise their balance sheets by selling surplus assets like buildings and do sale and leasebacks to be able to put the funds raised back into income-generating assets. This provided the company with no flexibility during times of economic hardship.  Currently, we are seeing good companies raise capital to give them balance sheet flexibility but we are also seeing companies draw down on debt facilities. It doesn't take long to burn through cash, so companies need to reduce expenditure.  The problem with reducing expenditure is that getting rid of people can permanently impact the ability of the business to return to normal revenue levels if it doesn't have the human resources to do it.
 
Balance sheet strength


We originally started filtering the market looking for companies that didn’t have large balance sheet debt, with the view that they would not be at risk. We changed our thinking slightly on that metric given that sometimes having debt provides some companies with the ability to borrow additional funds from existing facilities as the banks already have familiarity with the company and existing security arrangements.
 
IDP Education


We held a small position in the company prior to their trading halt.  We participated in the recent capital raise and then bought more shares at $13.07. We exited most of the position at $14.90 being satisfied that a 14% return in one day was sufficient for a business that will face reduced earnings from closed centers.  We also had made 40% on the shares we acquired before the capital raise.  There will be opportunities to buy at lower prices.

What this chart does show is the extreme volatility where you have a 50% trading range in a company that was suspended in a 10 day period, for a company that was trading at over $24 earlier in the year.

 

 

 

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