Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.
Two days ago I highlighted an ongoing plunge that had already begun at Biolase (NASDAQ:BIOL). Prior to my article, the shares had already dropped by 50% in a few days due to the markets' concern over Biolase's solvency and an upcoming financing.
The shares had been trading at $1.81 prior to my article and then quickly plunged to as low as $1.16. When the price was $1.20, Biolase took the unusual step of halting its own stock while it arranged to put out a series of positive press releases to boost the price back up. The halt and the press releases served their purposes, and when trading resumed, the stock quickly rebounded back to $1.86, right in line with where it sat before my article.
Biolase has defaulted on its loan covenants and now has just 17 trading days remaining to renegotiate with its bank (Comerica). During this time, Biolase absolutely must issue stock at whatever price it can. As a result, it is very important to understand if the announcements from Biolase will be enough to support the stock at above $1.20. It is also important to determine if Biolase will actually be able to issue enough stock, at what price, and what the real net proceeds will end up being.
It is clear that some of the "news," which boosted the share price, has been widely misunderstood.
The "dividend" is not a dividend
Biolase was quick to announce a "stock dividend" after the halt. But we can see from many online comments and message boards that many people mistakenly interpreted this as an actual "dividend."
This is not the case. A real dividend would result in a cash payment to investors. This would be a good justification for a higher share price. In addition, it would show that Biolase has ample cash to pay such a dividend, which would boost confidence in the company.
Unfortunately, neither is the case. What Biolase announced is a simply stock dividend. This is in all respects 100% identical to a standard stock split. For every 200 shares owned, an investor is given 1 additional share. But the total share count is increased by an equal amount. There is no cash benefit to shareholders whatsoever and there is no impact on the company. This is why we have seen very few companies conduct stock dividends over the past few decades.
For those who wish to clear up the confusion, it is easy to refer to Google Finance. Viewing a 1-year stock chart will reveal this type of "dividend" being disclosed as a 201:200 stock split. It is not displayed as a dividend. The dividend is disclosed as zero.
The confusion over a "dividend" did contribute to the substantial rise in the stock price. But once investors fully understand that there is absolutely no benefit or impact from a "stock dividend," this rise may prove to be short-lived.
Given the widespread confusion that this caused, investors may wish to ask Biolase management what was their intention when they chose to put out this news at such a critical time.
Is Biolase in a liquidity and solvency crunch ? Or not ?!
Biolase halted the stock in order to prevent investors from selling more stock. During this time, Biolase released a statement which stated quite categorically that Biolase is not in a liquidity crunch.
Management is entitled to express their own opinion. But given the potential consequences, investors should likely evaluate the facts for themselves.
Prior to my article, the market had already come to the conclusion that there was a liquidity and solvency crisis. Biolase's stock quickly fell 50% after earnings, even though the earnings miss was fairly moderate.
The facts which indicate a liquidity crisis are as follows:
- Biolase has continued to lose money and is down to just $2 million in cash
- But Biolase has a cash burn of $3 million per quarter and owes the bank $6 million more
- Biolase has already violated its bank covenants (is in default) and has been given only 17 more trading days to repair the situation
- The loan can be recalled by the bank at any time, but Biolase doesn't have the cash
- The bank has already taken as collateral ALL of Biolase's assets - there is nothing left to pledge
- The bank has even taken the drastic step of placing ALL of Biolase's receivables into a "lock box" - Biolase cannot even touch its own revenues until they are released by the bank
- The bank has already begun cutting its loan exposure to Biolase, reducing credit lines
Each of those facts clearly supports the notion that there is a severe liquidity crunch and solvency crisis.
The only evidence against this is the single statement from management that everything is fine. It is not the first time that management has failed to acknowledge the severity of the company's liquidity position.
In Q1, Biolase was down to $1 million in cash. The company was losing money and burning cash. It was already dangerously close to violating its loan covenants. At this time, the stock was at a multi-year high of over $6.00. Biolase did not issue stock and did not even file an S3 registration statement.
Only after it had already defaulted on the loan and burned through its cash did it even file an S3 to issue new stock. As a result, it was 100% transparent to all investors that a large stock offering would be necessary at a significant discount and within a very short time frame. A stock offering is now Biolase's only source of much needed cash. Investors got spooked and the selling begat more selling. This was a predictable result that should have been avoided.
When Biolase fell to $1 million in cash and began to default on debt covenants, it is inexplicable how management could refrain from raising money - especially with the stock at multi-year highs. Then, like now, management seems to have believed that everything was just fine. But it wasn't.
In addition, management continues to communicate a "glass is half full" view to investors. This has been the case even when the glass is nearly empty. As a result, it is important to read the disclosures from Biolase quite carefully.
When Biolase first disclosed the default on debt covenants, they could have made a clear statement (and warning) such as "Biolase is now in violation of its EBITDA debt covenant."
Instead, Biolase made a very positive statement that
As of June 30, 2013, the Company was in compliance with these covenants with the exception of the earnings before income tax, depreciation and amortization ("EBITDA") covenant.
This sort of language is the equivalent of saying that one owns a perfectly good balloon, with the exception of just one hole in it.
Investors did not fall for it, and the stock plunged 50% after this was disclosed.
Undaunted, Biolase tried again by issuing a reassuring press release stating
Biolase Receives Waiver From Comerica Bank
This was their first attempt to boost the stock once it fell below $2.00.
The contents of the press release were actually identical to the previous disclosure which had already been released in the 10Q. Releasing it as a new and separate press release was therefore a very curious decision by management.
Once again, beneath the positive spin, the message was simply that Biolase was actually in default and had just a few weeks to renegotiate with the banks. But once again, investors were not fooled. Following this press release, the share price declined by a further 8% and hit $1.80, a new low for the year.
In contrast to the bullish spin which Biolase had hoped for, The Orange County Business Journal released an article which stated "Biolase Shares Crash on Bank Waiver News."
Investors should therefore regard with great caution the assurances from management that liquidity is just fine. The facts do not support such a view and the market has clearly come to a drastically different conclusion. Statements from management continue to put a positive spin on circumstances which are in fact visibly dire.
From $30 million to $5 million - what happens next?
When the share price hit $1.16, it was quickly becoming apparent that Biolase would not be able to complete much (if any) of an offering. An equity offering is Biolase's only possible source of cash, and the cash is needed imminently due to the bank covenant default.
In order to boost the share price, Biolase cut the size of the S3 offering to just $5 million down from $30 million. The purpose of this was to assure the market that dilution would be far less than expected.
The gambit worked and Biolase soared by as much as 60% from $1.20 back to over $1.80.
Once again, Biolase appears to have been very shortsighted in taking this step. Biolase management and board members no doubt conferred and discussed the size of the S3 offering for weeks before determining that $30 million was necessary for funding needs. Yet they quickly cut the size to just $5 million with only a few hours' notice. Similar knee-jerk moves and shortsightedness have been costly to Biolase in the past.
When Biolase waited until after earnings and a loan default to issue stock, the result was a very predictable "death spiral" in the company's stock. The death spiral would have occurred regardless of the size of the S3.
Cutting the size of the offering did successfully inspire heavy short covering (a squeeze) along with heavy interest from headline driven day traders. This was clearly the intention of management.
But once again, just like the death spiral, we can see that this action has negative consequences which are very predictable.
It should be clear by now that raising $5 million will not fix Biolase's problems. Biolase last raised $18 million in 2011, but through very consistent cash burn and losses, the money is now all gone and money is owed to the bank.
The company has just $2 million in cash, but burns $3 million per quarter. The company owes the bank $6 million and is in default on its loans. All assets have already been commandeered by the bank. There is nothing left.
Biolase has already issued disappointing guidance. It will not make a profit or generate cash in 2013.
The investors who sold during the death spiral acted like rational participants. They knew that an offering would come and the share price would fall. As the share price kept falling, they kept selling. It was the rational thing to do.
Likewise, potential investors in a Biolase equity offering should be expected to act like rational participants.
If $5 million is not enough to fix Biolase's problems, then investors will feel 100% certain that they will ultimately lose all of their $5 million if they invest. This is because Biolase will simply burn through the $5 million and quickly become insolvent again. By capping the size at $5 million, Biolase has virtually guaranteed that investors will not want to participate in the equity offering at any reasonable price.
Had Biolase kept a size of $10-15 million, they could have likely persuaded investors that this was enough to give the company at least a year of breathing room to recover. But instead, Biolase was shortsightedly focused on creating the biggest share price squeeze. This is why they cut the size of the offering down to $5 million. The $5 million registration statement has already been filed with the SEC and the share price soared by 60%.
But now investors need to decide why institutions would want to put in $5 million. By the end of the year, the cash will be gone, the loans will still be in default and Biolase will once again be struggling to raise more money in yet another distressed equity offering.
This near-term outcome will be easy for potential investors to see. Just like they did during the death spiral, they will act like rational market participants. As a result, completing a successful financing will be far more difficult than management understands.
But as we can see below, a $5 million shelf may only yield $2 million in proceeds. This will dramatically reduce investor appetite for any such deal. This is why management and the board had originally approved a $30 million S3. The knee-jerk reaction to cut the size to $5 million will likely prove to be another very costly mistake for Biolase.
How much will the net proceeds really be?
It is clear that Biolase needs more than $5 million to get past the end of the year. But in fact, a $5 million S3 will not even raise the $5 million in proceeds that Biolase is hoping for.
Offerings for distressed micro-cap companies typically require a 10% fee to the investment bankers. This is far higher than for mid-large cap, stable companies.
So even if Biolase could raise the entire $5 million, it will find itself coming up $500,000 short. When a company is struggling to remain solvent, the extra $500,000 is actually a very material amount of money. But more importantly, it must be realized that an offering for a distressed micro-cap with a sub $2.00 share price will almost always require warrants to be offered alongside the stock.
For example, in Biolase's last equity offering in 2011, the company had to issue 812,973 warrants in order to sell 1,625,947 shares of stock. This was 50% warrant coverage at a time when the stock was being sold at $5.55, the market cap of Biolase was triple where it is now. That 50% coverage was still required even when Biolase was not facing a solvency crunch. With the stock trading 70% lower and the company in financial distress, it is quite clear that greater warrant coverage will be required. The standard is typically 1:1 warrant coverage.
Just like the stock, the warrants need to be registered within the S3. However, Biolase will not receive proceeds from the warrants until a few years later when they are exercised.
This is very important! The cut in the size of the S3 came within just hours of the plunge to $1.16. In its haste to boost the share price, Biolase cut the S3 size by far too much. Biolase did not anticipate the consequences of this.
So with a $5 million S3, Biolase is likely to be able to issue $2.5 million of stock which will be accompanied by $2.5 million of warrants. The warrant proceeds will not be realized until years in the future, and then only if the share price rises above the warrant strike. From that we will subtract the banker's fee.
As a result, with a $5 million shelf, Biolase will end up realizing around $2 million in proceeds from an equity offering. This is insufficient to pay the bank or even survive for one more quarter.
Again, regardless of any warrant coverage, potential investors will act like rational, profit maximizing participants. They are not in business to act as charities. They are well aware that Biolase now has a finite number of days in which it must raise money. As a result, they will be sure to extract the deepest discount possible from the company. And Biolase will have no alternative but to comply.
Biolase will certainly attempt to raise $5 million within the next 17 trading days. But it remains to be seen how much the company will actually realize in upfront proceeds and just how deep of a discount will be required.
Much of this depends on how the stock performs over the next few days. If the stock starts to fall again, then Biolase will be right back to the death spiral where it was a few days ago. If the stock stabilizes, the company will likely attempt to market a deal with a discount of 20-25% vs. the prevailing share price along with 100% warrant coverage.
Earlier in my career I spent nearly a decade at one of the largest investment banks in the world. As a Director in Equity Capital Markets, I managed over $30 billion worth of equity and equity linked offering by small and mid-cap companies. This included a number of issuers who would clearly be considered "distressed."
I am well aware of the mechanics and processes by which these types of offerings are done. I am also aware of what needs to happen to make these deals work and what can and cannot be done.
Many times, stock market predictions take years to unfold. But in the case of Biolase, we know for certain that the company must issue equity as soon as possible and certainly within the next 17 trading days. We also know that a significant discount will be required in order to attract any buyers.
Biolase made an epic misjudgment when it waited to issue stock until it had already defaulted. Biolase assumed that it would be free to issue a substantial amount of stock at its leisure, even once it ran out of money. But investors are neither naïve nor dumb. They acted like rational market participants and a death spiral ensued. That is how we got to where we are now.
Once again, Biolase made another epic misjudgment in reducing the size of the S3 to just $5 million. The move (along with the "stock dividend" and management's reassurances) did result in a massive 1 day rise in the stock. But like the death spiral, management has failed to realize that investors are neither naïve nor dumb. They will once again make simple and calculated decisions that are rational.
In order to complete this offering, Biolase will now have to offer a very deep discount to investors. But it may also be the case that investors simply refuse to participate because they know that $5 million will not fix Biolase's problems. If that is the case, then there may be no price at which rational investors will finance Biolase. Solvency then becomes a very near-term issue.
I continue to expect that Biolase will attempt to raise money at around $1.00 within the next few days. It remains to be seen if they will be able to do this successfully and what the actual net proceeds will be.
But given Biolase's current cash crunch, $5 million will clearly not be enough. If Biolase does succeed in raising money at these levels, then we should expect a second offering (via a subsequent S3) to be completed by year end. As an alternative, we could also expect Biolase to attempt to file a 4th amendment to the S3, which raises this size of the offering to at least $10 million.
In any event, we now have just 17 days left to find out what happens here.
I am heavily short Biolase.