Can More Stock Save the Economy?
The dilution solution is a quick fix.
Editor's Note: This was originally posted in real-time on the Buzz & Banter (click for a free trial). It's being republished here for the benefit of the Minyanville community.
After the close yesterday, Smithfield Foods (SFD) and Genworth (GNW) announced that they would both issue common stock. With Smithfield up threefold since March and Genworth up tenfold, I can't say that I'm at all surprised -- and while I'll step away from all the "pigs get slaughtered" related comments I could write, I'll offer once again that corporations only issue stock in two situations: when they have to and when they're stupid not to.
At the risk of pouring a little rain on these two equity offerings, I want to make sure readers fully understand the enormous positive feedback loop that's developed around all of the stock issuance since March.
Ask anyone one on Wall Street and they'll tell you that there's nothing more profitable than equity underwriting in good times: Fat underwriting fees coupled with lots of associated trading and hedging create huge earnings.
I share this because what surprised analysts most regarding bank second-quarter earnings were their investment banking fees and how strong they were -- remember, at the end of the first quarter, no one saw a positive second quarter coming for the banks, so the surprise was huge.
Why this is important is because, like it or not, we have a market that remains firmly grounded in how well financial services firms are doing, but as a result, there's a very interesting feedback loop that has developed over the past six months.
And it is this:
The more underwriting fees, the better the banks. The better the banks, the better the market. The better the market, the better it is to issue stock if you're a corporation. And the more stock corporations issue, the better this is the for the banks...
And the fact that corporations are using the proceeds almost exclusively to pay down debt, adds even more fuel to this feedback loop: As corporate leverage ratios improve, credit spreads tighten, which raises the price of debt securities, which improves the profits of Wall Street, and so on and so forth.
Dilution is good for America. But can it fuel a sustainable recovery?
In reading Smithfield's press release, I was struck by the use of proceeds disclosure:
"The Company intends to use the net proceeds from the offering for working capital and general corporate purposes, with a goal of continuing to strengthen its balance sheet, which may include the retirement of debt."
Stock for working capital. Wow.
That a corporation is now willing to dilute shareholders to hold more work in process and/or receivables is enormously telling, particularly because, as at every turn, I keep hearing about how corporations are rebuilding inventories. But if they're raising equity to do so, is that really net positive?
Don't get me wrong, deleveraging is a net positive -- when your criterion is survival. But deleveraging in the context of sustainable earnings growth is enormously negative. Dilution for inventory? Dilution for receivables? This is hardly the making for a real future.
Right now, no one is thinking about this. We're still in the "we survived the plane crash" bounce.
But I think it's vital to understand the source of the enormous positive feedback loop fueling this bounce.
One of these days (and I suspect very soon) investors are going to begin to move away from "survival" as a criterion to "growth." And at that point, I think reality will set in: We now have smaller companies with far more outstanding shares with limited real earnings prospects.
Issuing more stock will become more difficult. Wall Street underwriting fees will decline. Bank earnings will decline. Well, you know the story.
Anyway, it was great while it lasted.
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