One of the first things I do when I start researching a new opportunity is to check the company’s capital structure. That includes cash and debt, for obvious reasons, but also the shares outstanding and how many warrants and options remain unexercised. Why? Because this provides valuable forensic data on management’s abilities and track record.
The very first thing, by the way, is to look up management. I’m not alone in this. “People” was always the first of Doug Casey’s “Ps” of resource stock evaluation. The best rocks in the world can be messed up by the wrong people. And I don’t want to do business with crooks.
Problem is, crooks and incompetents don’t wear signs telling us what they are. Even with my years of experience and extensive industry network, if I don’t know them well, I can’t always tell if a management team has the right stuff.
That’s where the capital structure comes in.
“Paper,” after all, is another of Doug’s “Ps.”
The place to start is the number of shares issued and outstanding. The number outstanding can be less than the number issued if the company has bought shares back.
Key Point: the fewer the number of shares, the greater the gain per share when the company adds value.
A new junior explorer will often start out with about 30 million shares issued and outstanding. They’ll issue new shares in private placements as they go, paying for work that hopefully adds more value than the dilution shareholders suffer as the share count increases.
If all goes well, an explorer with a significant discovery in hand may end up with 50–75 million shares out. If it takes longer or there are setbacks along the way, they may reach 100 million or more shares out.
By the time a company is building its first mine (assuming it’s not taken over first), it has usually had to take on debt and issue a lot of stock to pay for construction, and it may have 200 million or more shares out.
For some strange historical reason, Australian companies are different. Early-stage explorers often have more than 100 million shares issued and outstanding. Advanced explorers often have 500 million or more. And so on.
Back in North America, if a company has hundreds of millions of shares out and no flagship project with significant deposits in hand, it’s clear evidence that the company has been very unlucky or management has been profligate. Bad luck is common in my experience, but incompetence is even more common.
On the other paw, it is fairly common, and not a sign of incompetence, if a company has one or more advanced assets and a high share count—if it got that way via a merger or acquisition. Sometimes a company has early exploration luck, raises a bunch of cash on great terms, and then later exploration disappoints. Meanwhile, another company makes a discovery but has run out of money and is in a poor position to raise more. A merger combines the money with the asset, and the new company has a shot at delivering for all.
Sometimes a series of transactions like this can result in an almost Australian number of shares issued and outstanding in an advanced explorer. That’s not necessarily a bad thing, if the combined assets are good enough.
Beware of Rollbacks
It’s a mistake, however, to just look at the number of shares and assume that a low count means management has done a great job making every penny count.
Because management may have done a rollback.
Share rollbacks, or consolidations, are fairly common. The rollback itself does no harm. Say a company does a 10-for-one rollback. We start with 10,000 shares at $0.1, worth $1,000. After the consolidation, we end up with 1,000 shares at $1, worth $1,000. Nothing changes.
The problems start cropping up when you ask why the rollback is necessary. In the junior mining world, companies often consolidate shares in order to increase their share price so they can raise more money without being branded a “penny stock.” But by the same math above, this does not reduce dilution for shareholders who’ve been consolidated. Fewer new shares may be issued to raise the money needed, but since each new share is equivalent to more of the previous shares (10x more, in the example above), previous shareholders face massive dilution.
Worse is what happens if the company needs more money in the future—which they always do. The new shareholders won’t object so much. The dilution for them is less. But previous shareholders keep getting diluted at a multiple based on the rollback.
This is why I always check for rollbacks as part of my due diligence.
Mind you, they can be necessary. If a company has hundreds of millions of shares outstanding that are trading for nickels and dimes, it’s very hard to raise money without doing a rollback first. The new money doesn’t want to be rolled back, so they insist the rollback be done first, then they’ll buy in.
Key Point: A bloated share structure a big red flag for me. That and low share prices present a clear danger of a rollback in the not too distant future.
But a lean share count after a history of rollbacks is another red flag. It’s one thing if a new management team comes in and consolidates shares in order for the company to move forward. It’s quite another if the same team has consolidated in the past and may do so again. It’s bad news if they keep having to raise money and blow out the share structure without making the discovery, building the mine, or whatever it is they propose to do. This destroys value rather than delivering it to shareholders.
A history of rollbacks suggests that management is either incompetent or very unlucky. And again, in my experience, incompetence is more often the explanation.
Warrants and Options
In our space, options are given to directors, management, and sometimes key contractors, to incent value-adding performance. Warrants are given to participants in private placements to incent them to buy (and tolerate the four-to-12-month hold on the shares in the placement). Both give their owners the right but not the obligation to buy shares in the company at a set price for a fixed length of time. When share prices rise above the price at which warrants and options can be exercised, it’s a guaranteed win for their owners.
It’s normal for resource-company executives to be given options as part of their compensation. Many of them, especially if they’re already wealthy, will work for peanuts as long as their performance is rewarded with options every year. There’s nothing wrong with this—as long as the options are priced at a level well above the current market for ordinary shares. This ensures that management will have to work hard and deliver value for all shareholders in order for their options to become worth anything.
Key Point: Watch out if management gets a whack of cheap options just for joining the team (or later, if shareholders aren’t paying attention). When this happens, there’s little or no incentive for performance.
As for the warrants, they too are normal and necessary for most junior explorers, which have no income. They have to raise money to drill somehow, and this is it. As existing shareholders, we obviously want management to raise money with as few new shares and warrants as possible. If we’re new to the story and want to buy into a private placement, we want the juiciest, lowest-exercise-price warrant we can get, with the longest life before it expires.
Key Point: If management can raise money in a private placement with no warrant, or only half a warrant with a short shelf life, it shows the strength of the team and the project. This is a good thing.
One more thing. Management’s jobs are always on the line, so they tend to be more careful about doing anything that could hurt share prices. This makes options less dangerous to shareholders than warrants.
Warrants are often held by outsiders who don’t care what happens to the company.
They may exercise their warrants and dump their shares on the market with little regard to what that does to share prices if they need cash in a hurry. So watch out if a company’s capital structure includes a large number of warrants with strike prices well below current market share prices (“in the money warrants” or “deeply in the money warrants”).
If you add the number of options and warrants to the shares outstanding, you get the company’s fully diluted share count.
I’ve never liked this term, as it implies that the options and warrants already issued are all the dilution shareholders need worry about. Not so. If a company is low on cash, there’s more dilution on the way. Even if a company is doing great and has a discovery it wants to turn into a mine, there’s still dilution ahead. As I’ve written regarding dilution, it’s not how much dilution one faces, but how much value one can expect in exchange for the dilution.
However, the difference between the number of shares a company reports as issued and outstanding (SO) versus what they report fully diluted (FD) can provide an important forensic clue.
If FD is 10% above SO, or less, great. No red flag.
If FD is 20–40% above SO, we need to have a closer look. If the warrants and options are well above current market prices (they’re said to be “out of the money”), then there’s no red flag.
Or, if the warrants and/or options are in the money but the company is delivering value and has plenty of cash in hand to turn into even greater value for shareholders, the threat is lower.
But if the company is low on cash or struggling in any way, those warrants (and possibly the options) are a clear and present danger to potential new shareholders.
If FD is 50% above SO or more, it’s a big red flag.
Unless there’s a very good explanation for how things got this way and the warrants and options are way out of the money, they are a clear and present danger to potential new shareholders.
Where to Look
Companies usually report their SO figures, and often their FD numbers as well. Sometimes they will report the number of warrants and options as well. But they rarely provide full details of their warrants and options, including the strike prices and expiry dates.
To find these details and complete our forensic analysis of a company’s share capital, we need to dig through their quarterly and annual regulatory filings. I know a lot of people find this boring, but it’s a great source of information.
By the way, the management discussion and analysis (MD&A) that accompanies these reports often contains useful details on company operations and developments not included in press releases and never mentioned in company presentations.
The pace to go for publicly traded Canadian companies is SEDAR.
And for US companies, it’s EDGAR.
The devil is in the details, of course, but these are the broad strokes of what I look for in my due diligence on “Paper.”
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