When I was commenting on DryShips' (NASDAQ:DRYS) seemingly unstoppable ascent two days ago, I already urged investors to "prepare for a spot secondary offering at any time now as the company will most likely try to take advantage of the recent share price increase."
In addition, I characterized the company's colorful chairman, Greek shipping magnate George Economou, as being "notorious for his disregard of outside shareholders and repeated self-dealings."
Picture: Panamax bulk carrier "Rapallo" - Picture: shipspotting.com
Obviously, my concerns were well founded as this morning DryShips announced a highly toxic financing. Moreover, the offering was custom-made for a single, somewhat suspicious investor, British Virgin Islands-based "Kalani Investments Limited" (Kalani). Not surprisingly, the entire internet offers zero information about this ominous investor, and while the press release claims Kalani not being affiliated with the company, I very much suspect it to also be controlled, at least indirectly, by George Economou thus enabling him (or some of his close buddies or relatives) to profit in several ways.
Actually, given the giant jump in the company's share price over the course of the week, there would have been no need for DryShips to enter into a toxic financing agreement, not even sweetener warrants would have been necessary to raise just $20 mln in fresh funds. Aggressive hedge fund investors would have queued up for the shares, basically a ticket for printing free money given their usual approach to short the stock in advance and later cover the position with the shares received in the offering.
Still, a highly complex, custom-tailored toxic financing agreement was hammered out with a single, previously unknown investor which actually incentivizes the investor to short the shares immediately.
In return for estimated net proceeds of $19.9 mln, the company issued to Kalani:
- 20,000 newly created Series E-1 Convertible Preferred Shares.
- 30,000 warrants to buy additional E-1 Convertible Preferred Shares.
- 50,000 warrants to buy newly created Series E-2 Convertible Preferred Shares.
- A warrant to purchase 153,960 common shares.
- A warrant to purchase 218,914 common shares.
Based on the offering terms, the face value of both the Series E-1 and E-2 preferred shares can be assumed as $1,000 per share.
For simplification purposes, I will focus only on the Series E-1 and E-2 Preferred Shares here.
Conversion terms for the E-1 series:
(...) convertible at any time at the option of the holder into common shares at a fixed conversion price of $30.00 per common share; provided, however, that if the volume weighted average price of our common shares on the Nasdaq Capital Market is below $30.00, subject to certain adjustments, then the holder may convert the Series E-1 Convertible Preferred Shares at an alternate price equal to the higher of (NYSE:X) 77.5% of the lowest daily volume weighted average price on any trading day during the 14 consecutive trading day period ending on the trading day immediately prior to the conversion date and (Y) $1.50.
Conversion terms for the E-2 series:
(...) convertible at any time at the option of the holder into common shares at a fixed conversion price of $30.00 per common share; provided, however, that if the volume weighted average price of our common shares on the Nasdaq Capital Market is below $30.00, subject to certain adjustments, then the holder may convert the Series E-2 Convertible Preferred Shares at an alternate price equal to the higher of 85% of the lowest daily volume weighted average price on any trading day during the 21 consecutive trading day period ending on the trading day immediately prior to the conversion date and $1.50.
The conversion terms are basically identical except for the discount applied to the lowest daily volume-weighted average price.
Applying the conversion terms for the E-1 series, Kalani would receive roughly 6.5 mln common shares upon full conversion of their 20,000 Series E-1 preferred shares for an average price of slightly above $3. Suffice to say, Kalani just needs to short as much shares as possible in order to maximize its profits from the deal.
If they will be able to sell or short sell their entire 6.5 mln common shares at an average price of $10, their gain would calculate to a whopping $45 mln.
But Kalani has far more to offer - next in line would be the exercise of the warrants to purchase another 30,000 preferred shares of the E-1 series and subsequently convert them into new common shares. Assuming the same conversion price as for the initial 20,000 preferred shares, Kalani would be entitled to another 9.75 mln common shares.
At this point, the company's share count would have already increased by 1,500% from current levels and accordingly Kalani's profit margin from this second tranche is expected to end up much lower. Assuming an average selling price of $5, Kalani would still record a gain of roughly $20 mln.
The third tranche would consist of the 50,000 E-2 series preferred shares (after exercising the respective warrants). At this point, I would expect the shares to already trade lower than at the beginning of November, so according to the conversion terms, Kalani will most likely be able to convert at significantly lower levels than $3 but not lower than the floor price of $1.50.
Just for illustration purposes, let's assume Kalani converts at an average price of $2 for an additional 25 million common shares and manages to sell them at $2.50 on average, this would result in another $12.5 mln gain for the company.
While I don't think Kalani will get to the third tranche anytime soon, there's a good chance they will make it through the first and most of the second tranche until the stock will be literally dead in the water again.
So let's move on with our scenario:
Assuming Kalani manages to sell both the first and the second tranche into the market at the terms detailed above, this would provide DryShips with roughly $50 mln in fresh funds and leave Kalani with a gain of up to $65 mln.
Given the company's stated intent to:
(...) use the net proceeds from the sale of the offered securities for general corporate purposes and/or to repay indebtedness under one or more of our existing credit facilities and/or to repay indebtedness incurred under the Revolving Facility with Sifnos Shareholders Inc., an entity controlled by our Chairman, President and Chief Executive Officer, Mr. George Economou (...)
DryShips might very well use a portion or even all of the cash to repay some of its roughly $70 mln in debt obligations to George Economou.
So, IF Economou is indeed somehow pulling the strings behind Kalani, he would have basically squared the circle one more time here as he not only would be entitled to a large gain from Kalani, he would also get back up to the entire $50 mln initially provided by him to Kalani.
As for DryShips under this scenario:
The company's debt balance would come down by roughly 25% but DryShips would still be left with a small fleet of mostly old Panamax vessels and its six, recently acquired offshore service vessels.
Attentive readers might now point to the pro forma ownership limitations set forth in the offering conditions which prevent Kalani from owning more than 4.99% of the company's common shares (or 9.99% under a special exception) at any time. I don't expect this to be an issue for Kalani, as they will most likely short the common shares in the first step before converting the amount of preferred shares necessary to cover their position.
If my suspicion will prove true, George Economou has just delivered another masterpiece of financial engineering to the disadvantage of outside shareholders.
Given the terms of the offering, expect DryShips' share price to approach the $1.50 floor over time and the share count to balloon by more than 1,000%.
Unfortunately, unlike Kalani, you will still need to somehow borrow the stock for a short sale which will remain difficult until Kalani has converted and sold millions of new shares into the market.
Lastly, today's events should also be considered a major red flag for investors in DryShips' former offshore drilling subsidiary Ocean Rig (NASDAQ:ORIG) which has also seen its shares rally in sympathy with DryShips over the last week. As evidenced once again today, George Economou couldn't care less about the outside shareholders of his companies but he always manages to come out significantly on top of them.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in DRYS over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.