DryShips Inc. (NASDAQ:DRYS) lost almost 20 percent of its market cap in response to a $2 billion mixed shelf filing. The stock now trades for $1.38 per share, and further downside is likely.
Economou Strikes Again
Yesterday was supposed to be a good day for DryShips. The stock closed its $200 million dilutive capital raise with Kalani Investments Ltd, selling 114.9 million shares for an average price of $1.74 and generating an enormous amount of liquidity.
The Street expected DryShips to stage a brief relief rally in response to the closing of the deal. The stock was under massive pressure from the millions of new shares being created every day, so it was reasonable to expect a rally as soon as this pressure abated. And DryShips probably would have surged if it had a different CEO.
Unfortunately for DryShips investors, George Economou doesn’t believe in creating shareholder value. And as soon as his previous dilutive capital raise closed, he created something bigger and worse: A $2 billion, yes billion, mixed shelf filing that opens the door for DryShips to dilute to its heart’s content for the foreseeable future.
What is a Mixed Shelf Filing
Despite the market’s panicked reaction, a mixed shelf filing is not as bad as it sounds. For a more reputable company, such a filing would barely register in the stock price. The problem, in DryShips’ case, is prior history. The market knows this filing is a premonition of future dilution. But what is a mixed shelf filing anyways?
A mixed shelf filing is a SEC document that allows a company to raise capital through multiple methods for the year. Capital can be raised through debt issuance, preferred stock issuance, stock warrants and common stock issuance. The last two, stock warrants and common stock issuance, are the most dangerous because they can inflate shares outstanding.
Debt issuance is off the table because no sane lender would lend a dime to DryShips. The company burns through millions of dollars every year, and its CEO owns its existing debt for crying out loud.
DryShips preferred stock is also unattractive to institutional investors because, while preferred stock is safer than common stock, a money manager who puts his client’s money in something as risky as DryShips preferreds would probably lose his job.
When it comes to the capital markets, DryShips’ best options are warrants and more common stock issuance. The deleterious effect of common stock issuance is evident in DryShips’ recent capital raise with Kalani Investments Ltd. However, if you think common stock dilution is bad, wait until you see warrants.
Warrants: How a Stock Sells its Future
Unlike common stock or debt, institutional investors may be interested in DryShips warrants. Warrants are like really safe options to create shares at will whenever the stock price is acceptably high or above the strike price of the warrant (often a penny). Warrants protect the holder from practically every risk except bankruptcy. And when the sharks give money to a struggling company like DryShips, they take their pound of flesh.
In a warrant-heavy capital raise scenario, I believe DryShips would give hundreds of millions of penny warrants to the outside investor. These warrants can be exercised at any time until they expire and will exert a long-term cloud of downward pressure on the stock.
While common stock dilution hurts, it ends quickly, and upside remains intact for new shareholders. Warrant dilution, on the other hand, crushes the long-term upside for the stock, and the stock becomes like a pile of radioactive waste that is very hard for retail investors profit from.
To illustrate the danger of warrant dilution, look at Palatin Technologies. Palatin is a biotech that passed Phase 3 on its lead candidate Bremelanotide, secured a multi-million dollar partnership, but trades for less than it did when its drug’s FDA prospects were a coin flip.
If Palatin didn’t have so many warrants, the stock could have tripled after such a string of good news, but Palatin faces limited upside because the warrant holders excise their warrants whenever the stock price goes up, and this dilutes the stock to the detriment of common stockholders. If DryShips raises capital through warrants, it could face long-term dilutive pressure just like Palatin.
DryShips has filed a mixed shelf that gives it authority to raise up to $2 billion in capital. Such a filing is not necessarily a bad thing, but the market is scared because George Economou’s shareholder-unfriendly management style makes future dilution likely.
DryShips doesn’t look likely to be able to raise debt, and very few institutional investors would be interested in DryShips preferred shares. Future capital raises will be through common stock and warrant issuance. If the struggling company sells warrants, shares should be avoided like a pile of radioactive waste because such a move would cripple upside, even in the event of a massive shipping recovery.