As an investor, it is always important to keep an eye on a company's share count. A good company should always have rising earnings, but if the number of shares outstanding rises even faster, earnings per share will decline. In short: you will find yourself with a smaller piece of the pie. A company's share count most often grows when it issues stock options to employees. However, companies can also issue additional stock (or give other people the right to buy additional stock) in order to raise capital, or for other reasons.
In the case of Ford (NYSE:F), the company has entered a number of potentially dilutive transactions in recent years. In large part, this was necessitated by the automaker's goal of avoiding bankruptcy. Most importantly, in 2010, Ford issued 362.4 million warrants to the VEBA healthcare trust which pays health expenses for union retirees at Ford, General Motors (NYSE:GM), and Chrysler. The warrants allow holders to buy Ford stock at a specified price (currently $9.01 for 1.0212 shares), and expire at the end of this month. Making the VEBA trust responsible for future healthcare costs will help keep Ford's future costs more predictable. However, as of January 1, Ford shareholders will own a somewhat smaller piece of the company.
As of last quarter, Ford had approximately 3.81 billion shares outstanding. As a result of adjustments to account for dividends, Ford warrant holders now have the option to buy approximately 370 million shares of Ford stock for less than $9/share (well below the recent trading price of $11.40). Ford also has over $900 million in outstanding convertible debt, with conversion prices around $9/share: this could result in the issuance of another 100 million shares when the debt matures. At first glance, it appears that Ford's warrants (and to a lesser extent, its convertible debt) could result in the share count increasing by 10%. This would significantly dilute EPS going forward.
However, Ford will settle the warrants in "net shares", which vastly reduces the number of shares to be issued. This means that Ford will not collect any money from warrant holders, but will only issue shares equivalent to the value of the warrants. For example, someone holding 1000 warrants will not pay $9010 for approximately $11600 in stock; instead, they will get $11600-$9010=~2600 of Ford stock (and not make a payment). Another way to think about it is that Ford is essentially using the proceeds from the warrant exercise to buy back stock from the warrant holders at the market price.
Based on Ford's recent trading price, the net share settlement method will result in Ford issuing approximately 83.5 million shares. This amount will increase if Ford shares rise before year-end, and will fall if Ford's stock price drops. Nevertheless, the dilutive impact should be fairly minimal, as the share count will rise by roughly 2.2% based on the current share price. Moreover, Ford's recent earnings statements have already accounted for much of the dilution in calculating the "diluted EPS" figure. In Q3, Ford estimated the dilutive impact at 59 million shares, somewhat lower than my estimate. The reason why dilution is a little higher now (the difference is less than 1% of the overall share count) is that Ford's stock has gone up since the end of September: something shareholders should be happy about.
Thus, while the headline number of over 360 million warrants seems ominous, the dilutive impact on Ford shareholders will be relatively minimal (barring a rapid share price appreciation in the next three weeks). The positives for Ford shareholders are much more weighty at this point. Ford has generated record operating margins in North America recently. While industry watchers are understandably worried about the fiscal cliff, Ford recently reported strong November U.S. sales, and announced an 11% year-over-year North American production increase for next quarter. While Europe remains weak, Ford has taken advantage of recent Chinese backlash against Japanese automakers like Honda (NYSE:HMC), Nissan (OTCPK:NSANF), and Toyota (NYSE:TM) to rapidly gain share in China. Ford has posted three consecutive months of record sales in China, with wholesales up more than 56% last month. This is particularly important as China is the world's largest auto market, and Ford has a goal of doubling production and sales there by 2015.
If Ford keeps posting solid operating results as it has been over the past few years, 2.2% dilution should not be a major concern for shareholders. Ford has been approaching my year-end price target of $12, and I think the shares have upside to $15 by mid-2013. I continue to think the stock is attractive at current levels.