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Archer Daniels Midland: New Equity Offer Signals Peak is Near

by: Cross Profit May 29, 2008 | about stocks: ADM    

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Archer Daniels Midland Co. (ADM) announced Tuesday that it intends to offer 35 million equity units at $50 each with an additional maximum of 5 million units to cover over allotments. ADM intends on using the proceeds to pay down debt and for other general corporate purposes. 

 

For the past two years, companies have been buying back shares, reducing their float in order to give EPS (earnings per share) a boost. At times, several companies took on new debt in order to finance their share buybacks. The logic behind this is simple. Take on new debt at 7% interest, buy back shares thus reducing the shares outstanding count, resulting in higher earnings per share.

 

Based on an accelerated EPS growth on a YOY comparison the stock appreciates. Once the stock has appreciated let's say 30%, issue new shares and pay back the debt that was created for the share buybacks in the first place. This is a neat way to earn 23% cash for companies' coffers without any long term dilution. The company returns to the same float starting point before the buybacks. Debt is reduced to pre buyback levels as well. However, over the following quarters shares start to drift lower as EPS growth is harder to maintain on the larger share count.

 

International Business Machines Corp (IBM) for instance is still in the first phase; taking on debt while buying back shares. This signals that IBM's share price is still climbing as projected here. Once the buybacks stop, this would signal the beginning of phase two. New shares would come to market at a considerable premium to the ones that were taken off market and the proceeds used to pay off the debt accumulated for the original buybacks. Share price would continue to increase for another quarter as the company benefits from the 'windfall' profit.

Phase three is where you have to be careful. As the EPS is now calculated for a higher share count and no longer benefits from the one time profit spread between buying and selling, EPS growth on a YOY comparison becomes tougher. Growth can still be achieved based on the business fundamentals, yet is no longer inflated by a lower count or the buy/sell spread.

 

This works only for healthy companies that can project with a degree of certainty that during both phases one and two EPS will continue to grow. Should EPS decline on a lower share count, this strategy usually backfires - big time.

 

ADM's announcement signals the beginning of phase two. If you bother checking, you will find that previous ADM share buybacks were announced in conjunction with issuance of new debt. For example: "Archer Daniels Midland will repurchase $370M stock with proceeds of issue of $1.15B Convertible Senior Notes due 2014". According to CEO Patricia Woertz, ADM's latest quarterly results include a 42% increase in net on a 64% increase in revenue. Woertz attributes 85% of the above YOY increase to inflation. Analysts, pay attention!

 

Disclosure: none.

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This article has 1 comment:

  •  
    May 30 05:16 PM
    It could be even worse than this article suggests. In this so-called "second phase", ADM has not only issued future equity, but has also floated long-term debt, part of which is meant for current use. This will not only dilute the equity base starting 2011, but will also increase the company's financial risk starting now.

    The question is: Will ADM be forced to raise additional equity and/or debt, and if so, when?
    Reply
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