## Thursday, August 18, 2005

In THEORY, a secondary offering has no impact on current shareholder...

Let us assume that Google is worth \$75b (its really 77, but 75 makes easier math).

So, it's pre-money value is \$76b. Pretend Google is selling \$5b work of shares. Now, Google has an additional \$5b in cash, making its value \$80b. However, everyone has been diluted. So, your previous 1% of Google is now 15/16 of a percent, but the company is worth 16/15 what is was before.

Now, assuming that Google has a profitable use for that cash, then Google takes that \$5 and turns it into \$25b of value (but loses the \$5b in cash). Now, the new Google is worth \$100b. So while you own a smaller share, at the moment of sale you were made whole (by the cash coming in), and you benefit from the increase in value.

However, reality is NOT so kind. In reality, Google selling \$4b worth of shares will probably be at a slight discount, to encourage the big funds to pony up the cash (you don't normally unload \$4b of shares on the open market and hope for the best), plus the bankers get paid. So the company ends up diluting by more than the net cash position improves.

Assuming Google has a profitable use of that cash, you should still come out ahead, because Google will in theory sell \$4b in stock, collect \$3.8b, and as long as they turn it into at LEAST \$4b of value, you're even, and at \$8b-\$10b, you come out ahead...

Now let's add a little more reality. Generally, companies deploy their capital in less and less valuable area, which makes sense. If you have 20 profitable investment opportunities, each of which take \$1m. If you have \$10m to invest, you do the top 10 of them. If you get an extra \$10m, you choose the less valuable ones, and if you are stuck with investing another \$10m, you either sit on cash or chase the 10 best unprofitable activities to look busy. That's part of why dividend companies with reasonable payout ratios look so good on a dividend-reinvestment basis, they only chase REALLY profitable activities.

In addition, Google is very profitable, so it should be able to chase most of its profitable investment opportunities. With a P/E of 80, the implied cost of capital is MUCH higher than a junk-bond offering, which would only expect an 8%-10% return (interest) compared to investors expecting an 80% return (no I'm not doing the math, but its a ridiculous annual return to justify paying 80 times trailing earnings, somewhere in the 40%-80% annualized range).

Therefore, the non-financial view of the situation is: profitable companies that think their stock is undervalued do stock buy-backs, which boosts EPS, and make sense if the company believes that their stock is a better investment than any other projects that they could invest in (meaning they can only get a 20% return on new projects, but a 40% return buying their shares), and tend to do secondary offerings when they think their stock price is high (meaning, they can get a better return on the money than the market, they expect the company's stock to be a -10% return and they can get a 3% (money market) or higher return on the cash).

I would consider this offering bearish, even though the fundamental financial analysis looks closer to neutral.

Alex