Secondary-Offering Price Draws Market Price Like a Magnet

by: Ivan Mutaftchiev

World Fuel Services (NYSE:INT) announced after the market close yesterday the pricing of an underwritten public offering of 8 million shares of its common stock at $25.00 per share. The stock opened at $25.50 (down .13) this morning and proceeded to decline towards the offering price, reaching a low of $25.10.

NPS Pharmaceuticals, Inc. (NASDAQ:NPSP) today announced the pricing of an underwritten public offering of 6.8 million shares of its common stock at $6.00 per share. The stock which had closed at $6.61 yesterday, reached a low of $6.20 today.

Evercore Partners (NYSE:EVR) yesterday after the market close priced the previously announced underwritten public offering of 2.5 million shares of its Class A common stock $27.50 per share. The stock price, which briefly bounced to $28.55 at the open, reversed almost immediately and by 2:30 had reached a low of $26.20.

Why is a secondary offering of a company's stock such a strong bearish event in the immediate term? What is the reason market price is drawn to and almost always reaches the offering price, but rarely continues lower? There are two main reasons, one technical and one fundamental:

1. The fundamental reason is that issuing new stock, dilutes the ownership of the existing shareholders. Every share of stock represents a small piece of the company, and the more shares out there, the smaller piece of the company each share represents. If 3 partners each own 1 share of their company, and the company only has 3 shares of stock, then each of the partners owns 1/3 of the company. Now, say they decide to bring in a fourth partner, and they print another share of stock and give it to the new partner. Now the company has 4 shares of stock, instead of 3, so each share represents 1/4 of the company. To put that in dollars, if the company is worth $40,000, with only 3 shares each share is 1/3 of $40,000 or $13,333.33. With 4 shares of stock, each share is 1/4 of $40,000 or $10,000.00. So bringing a new partner(s) maybe of great benefit in the long term, but in the immediate term the value of each share just went from $13,333.33 to $10,000. Of course, normally the new partners will pay some money for the new shares so the difference will not be so drastic, but some dillution will happen.

2. The technical reason is that new shares will always be priced below the market price. The purpose of this is to attract more buyers (new owners/partners). So if company ABC's stock is trading at $28 the company may say that the new shares will be sold at $27 to the subscribers of the offering. As soon as the price is public knowledge, investors start acting accordingly. Buying dries up because few buyers are interested in buying at $28, knowing that some other guy is buying the same shares at $27. Subscribers of the offering now knowing for a fact, that they will be buying their alloted new shares for $27 within a few days.

So why not take some profit right now with the price at $28? Knowing that they have secured a price of $27, it is perfectly legal and very prudent for the subscribers to the offering, to sell short some or all of their shares at $28 for a quick $1 profit. So with the buying drying up at $28 and the subscribers taking quick and easy profits by selling short, the price has no where to go but down.

Of course, as the price declines closer and closer to $27 some buyers step in and the selling dies down (a lot of the subscribers have already pre-sold their subscribed stock higher, and the remaining subscribers will rather not sell at $27.10 or $27.05 for an almost breakeven results). This is why the price will come very close to, or even touch the offering price, but usually bounce off of it. Unless there are other factors in force, there should be almost no buyers at $28 and no sellers at the offering price of $27.

So if the decline down to the offering price is such a sure thing, why isn't everybody doing it ? As with other good trading strategies, the problem is EXACTLY that everybody IS doing it. Very often when the offering price is announced pre-market, the stock will open at just 5-10c off the offering price.
EXLP Daily Chart
(Click to enlarge)

See above chart. On Sept 8, EXLP announced pre-open the offering price of $21.50. The stock opened at $21.60 (down more than dollar from the previous close). The move down had already happened in the pre-market.

Some traders and offering-subscribers fearing that they will miss the move down, start selling-short even before the offering price is announced.This could work out very well, or could lead to catastrpohic short squeezes, if when announced, the offering price is higher than or close to the recent market price.
RADS Daily Chart
(Click to enlarge)

See above chart. When RADS priced their secondary offering on Sept 10 at $17, this price level was already reached the day before. Subscribers didn't start selling at the open because there was no profit for them to make. Fearing that the subscribers, may have done all their selling the previous day, some short-sellers started to panic and cover their shorts at any price they could get. The resulting short squeeze pushed the price all the way up to $18. At this level smart traders and the subscribers stepped in and started selling. The volume in RADS the day before was less than a million shares - it was impossible that even half the offering of 4.5 million new shares had been already pre-sold by the subscribers.

Still a wise trader does not try to reason with the panicked
mob struggling for the exits or he will be trampled. Only when the crowd has exited (i.e. at $18 in this case) can you safely and profitably enter. When all the old shorts had covered their short-positions and the price was at $18, there were no more buyers just sellers, and the price retreated down to close at $17.40.

Bottom Line: To be successful at Magnet-Price short selling, Do NOT sell before the offering price is announced, and Do NOT sell unless the market price is at least 1-2% above the offering price. Always think how the rest of traders and subscribers in the stock are positioned.

Disclosure: No positions