J.C. Penney (NYSE: JCP ) potentially destroyed huge amounts of shareholder wealth last week with a 44% dilution of shareholders in what could be management's last chance to return the company to relevance with close to $1 billion in new cash. Just a few weeks prior, Clean Energy Fuels (NASDAQ: CLNE ) issued $220 million in convertible notes, paying 5.25% interest to bondholders while also seeing CEO Andrew Littlefair buy almost $1.5 million in shares.
While dilution through new share offerings and the accumulation of debt can both be detrimental, but not always. What was the result of J.C. Penney and Clean Energy Fuels' recent actions, and what should shareholders look for?
Paying for growth
Clean Energy is in full growth mode with its "America's Natural Gas Highway," and its use of convertible notes to raise capital, while not directly dilutive, still carries the potential to dilute shareholders if the notes are converted to shares. Per the press release:
Interest on the notes will be payable semi-annually at a rate of 5.25% per year, and the notes will mature on October 1, 2018 unless earlier purchased, redeemed or converted. The initial conversion rate will be 64.1026 shares of Clean Energy's common stock per $1,000 principal amount of the notes (subject to adjustment in certain circumstances), which is equivalent to a purchase price of approximately $15.60 per share and represents an approximately 25% conversion premium relative to the closing sale price of Clean Energy's common stock on September 10, 2013.
So in a nutshell, holders of convertible notes are making a calculated bet that shares will be trading above the conversion price at maturity. The downside risk (outside of bankruptcy) is only getting the interest if shares don't trade above the conversion price at maturity.
The benefits for Clean Energy and shareholders are numerous:
- There is no immediate dilution for shareholders today.
- The company is able to generate more cash with less potential dilution in the future due to the conversion value's premium to the current share price.
- Senior convertible notes usually carry a lower interest rate than nonconvertible notes, so more of the money can be used to fund expansion versus debt service.
And with the trucking industry's transition away from diesel and toward natural gas just getting underway in the past year, investing heavily in growth today is worth it for shareholders, even at the risk of dilution in three years.
Think about it this way: Clean Energy Fuels is on track for $350 million in sales this year. The 25 billion-gallon diesel market in North America generates about $100 billion in revenue. That's the opportunity.
It's hard to fault Penney's management for issuing 96 million new shares in a serious effort to raise capital. The 112-year-old retailer has lost its luster among consumers, as is reflected in the 30% drop in its sales since 2011. And shares, already down more than 56% from 2011 through mid-September, have fallen another 36% in the past two weeks.
While management may be using the only tool at its disposal to raise enough cash to save the company, investors have been, if not wiped out, significantly damaged in the process. With trailing net income and free cash flow both in the range of -$1.6 billion to -$2 billion, it will take an enormous turnaround to regain anything close to the losses investors have taken.
When Tesla Motors (NASDAQ: TSLA ) founder and CEO Elon Musk announced that he would buy $100 million of the $830 million share offering in May, what in many cases causes a stock-price drop (dilution) fed a continued rally:
Using the capital raised to pay off its Department of Energy loan well in advance -- especially with the stock having already tripled in the three months prior -- was a shrewd move. However, even investors in that offering, buying at around $92 per share, have seen their investment double since.
But nearly any way you slice it, using the share price run-up to generate more than $800 million -- at the cost of only 5% dilution -- to pay off debt and invest in the company's enormous growth is the kind of move investors want to see management make.
Dilution and debt are never ideal. However, growing companies often need to use one or even both to fund growth. As with most investing metrics, what matters is whether the cost of the capital is lower than the return it brings to the business.
And looking at these three companies, it's pretty easy to see which companies are creating shareholder value in excess of the cost of the investments and which one is simply destroying shareholder value in a last-ditch effort to save a failing company. Invest accordingly and use this Foolish method with all your investments.
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