Virgin Galactic Holdings: Early Cashless Redemption Provision On Warrants Could Cause A Stock Price Crash
Summary
- SPCE warrants are trading below their intrinsic value, but don't represent an arbitrage opportunity.
- SPCE has been unable to register the warrants in a timely manner, meaning that they cannot yet be exercised for cash over three months after listing.
- Warrant holders are in a unique situation where they might be forced into cashless exercise of their warrants for less than their intrinsic value.
- SPCE would be smart to avoid forcing the cashless exercise of warrants until full registration of securities is effective.
- The company should issue a press release to clarify its intent for early redemption of the warrants prior to them being exercisable to calm fears over this issue.
Editor's note: this article was updated on 2/25/20 to reflect a corrected calculation.
Virgin Galactic Holdings, Inc. (NYSE:SPCE) has been on an absolute tear recently. The stock closed up 21% to $28.68 last Friday and has tripled in two months with apparently no end in sight. The warrants (SPCE-WT) also followed suit by closing up 38% to $15.69 but sit $1.49 below their $17.18 intrinsic value. I have written about several special purpose acquisition corporations, or SPAC deals in the past. These include Repay Holdings Corporation (RPAY), Akerna Corp. (KERN), The Peck Company Holdings, Inc. (PECK) and most recently Vivint Smart Home, Inc. (VVNT).
Most of these listings had warrants that traded below their intrinsic value shortly after completion of their business combination with their respective blank check listing. This created an arbitrage opportunity where one could buy the warrants and short the stock while waiting for the securities to become registered and the warrants exercisable. However, unlike these other listings, SPCE and its warrants do not present an arbitrage opportunity. There is a very good reason why SPCE's warrants trade at a discount to their intrinsic value. The early redemption clause on a cashless basis combined with management's inability to register the warrants in a timely manner have created a unique situation which could result in significant downward pressure on the stock should management opt for the cashless provision.
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Unique situation caused by SPCE's slow action to register warrants
Like all SPAC deals, SPCE has issued warrants with a strike price of $11.50 and a time to expiry of five years. Per the prospectus agreement, these warrants were supposed to be exercisable 30 days after the completion of the Business Combination. These warrants should have become exercisable by late November but aren't yet as management has dragged its heels in getting it done. An S-1/A was filed with respect to the 30,998,625 outstanding warrants on February 14. This incomplete preliminary prospectus filing confirms that the registration statement for the warrants to be filed with the SEC is not yet effective and they cannot be exercised.
While the nearly three month delay is annoying, that in itself would not necessarily cause a problem. Especially since shareholders and warrant holders alike should be pretty happy with the performance since SPCE started trading. However, an additional provision in the warrant agreement could present a problem:
Under the terms of the Warrant Agreement, we are obligated to file and maintain an effective registration statement under the Securities Act, covering the issuance of shares of our common stock issuable upon exercise of the warrants. We cannot assure you that we will be able to do so if, for example, any facts or events arise that represent a fundamental change in the information set forth in the registration statement or prospectus, the financial statements contained or incorporated by reference therein are not current or correct or we are required to address any comments the SEC may issue in connection with such registration statement. If the shares issuable upon exercise of the warrants are not registered under the Securities Act, we are required to permit holders to exercise their warrants on a cashless basis. However, no warrant will be exercisable for cash or on a cashless basis, and we will not be obligated to issue any shares to holders seeking to exercise their warrants, unless the issuance of the shares upon such exercise is registered or qualified under the securities laws of the state of the exercising holder or an exemption from registration is available. If and when the warrants become redeemable by us, we may exercise our redemption right even if we are unable to register or qualify the underlying shares of common stock for sale under all applicable state securities laws.
The company is allowed to force early exercise of warrants on a cashless basis if the closing price of the common stock is $18.00 or higher for 20 out of 30 trading days. SPCE closed above $18.00 for two days on January 18 and 19 and has closed above that level for another ten days between February 3 and 14. Assuming that it stays above that mark over the next two weeks, February 27 would represent the 20th day out of 30 and management could force cashless exercise of the warrants.
In a cashless exercise scenario, in lieu of warrant holders paying $11.50 per warrant to get one share, they would get a net amount of shares that represents the intrinsic value of the warrant exercise. For instance, if someone owned 1,000 shares and the stock price was $15, instead of paying $11,500 to receive $15,000 worth of shares and profiting $3,500, they would get 233 shares worth $3,500. If the stock price is $30, the investor would get [(30000-11,500)/$30] 617 shares worth $18,500 in the cashless exercise scenario.
Management can force cashless exercise at a "fair market value" which is determined by the average closing price for the 10 trading days ending on the third trading day prior to the date on which the notice of warrant exercise is sent to the warrant agent. This is why the warrants trade at a discount. The warrants cannot be forced into redemption yet, but if they were, the average price of the last 10 trading days running from February 3 to 14 is $21.24. If an investor held 1,000 warrants, that would lead to a forced redemption for 459 shares (9.74/21.24) which leads to a value of $13,164 based on Friday's closing price. The intrinsic value of each warrant wouldn't be $17.18 but $13.16 under the cashless exercise provision in this hypothetical scenario where cashless exercise could happen today. That would understandably anger a lot of people who paid $15 for these warrants.
While the situation is only hypothetical for now, it becomes much less hypothetical as early as next week. The fear of the cashless exercise provision is what is keeping the warrants below their intrinsic value. If the stock price continues to go parabolic, the warrants will trade at a deeper and deeper discount to their intrinsic value as the gap between SPCE's closing price and the previous 10 day average widens.
None of this would be a problem if the warrants were exercisable for cash. Warrant holders would simply exercise the warrants for shares and sell the shares on the open market if they wanted to exit the position.
SPCE should avoid the early redemption provision on the warrants and should clarify its intent to the market
The possibility of forced early cashless exercise on the warrants should be an obvious red flag for warrant holders. But it can also be quite negative for shareholders. There are 31 million warrants outstanding. Cashless exercise would decrease the overall dilution but it would wreak havoc on the near term float. Using $30 as a hypothetical fair market value, 617 shares would be issued for every 1,000 warrants. That would lead to 19.1 million shares being added to the float from people who just got forced out of their warrant position early and below market value.
The company would save 12 million shares worth of dilution in a cashless exercise scenario with a fair market value of $30. However, with a speculative and volatile stock like SPCE, short term float considerations may be of more pressing concern than long term shares outstanding. The release of 19 million shares onto the float immediately would be a lot more treacherous than the slow and steady release of 31 million shares onto the float over five years.
If SPCE continues with its parabolic rise, there is an even greater advantage to not forcing cashless exercise in order to maintain that strong price. Higher prices result in more shares issued during cashless exercise which results in more immediate term dilution to the float. A forced early redemption of the warrants on a cashless basis after a parabolic run would be a shorters dream!
While the dilution advantage of forced cashless exercise gets smaller and the float pressure gets larger as the stock price moves up, one thing that stays steady is the cash the company can receive upon cash-based exercise of the warrants. If all 31 million warrants were exercised at $11.50, that would bring in $356 million of cash. SPCE has over $400 million in cash and the company has stated that it has enough cash runway for at least two years. While it has made bold predictions of becoming EBITDA positive as early as 2021, certainly the cash from the exercise of warrants would be a welcome cushion in case results don't meet those optimistic projections.
SPCE would be smart to release a press release clarifying its intent for cashless exercise prior to the warrant registration becoming effective. It's company's fault that the warrants still haven't been registered after over three months of listing and can't be exercised yet. It should provide some clarity to the market for its stock and warrant holders in order to reduce any jitters over this unique situation. I recommend that anyone who owns stock or warrants to contact the company and voice their displeasure over the possibility of early forced exercise on a cashless basis. That may entice management to make a public statement about the issue and lay it to rest.
I have no position in SPCE securities with no plan to purchase a position until the warrants either become registered or there is clarity around the possible early redemption of warrants on a cashless basis. If the company does enact the early redemption clause on the warrants, I may consider buying put options as I would expect a heavy drop in the stock price under this scenario.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.