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Issuing More Shares: Good or Bad?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Buckeye Partners (NYSE: BPL) recently announced plans to issue additional limited partnership units. Citigroup (NYSE: C) issued preferred shares to the government in 2008 during the financial meltdown. Simon Properties Group (NYSE: SPG) issued shares in early 2012 and again in late 2012. How can you tell if these corporate actions are good or bad for shareholders?

Same Pie, More Slices
When a company issues shares of stock, it is, basically, selling ownership in the company and, thus, a right to the earnings of the company. It's a pretty basic concept that underpins modern finance. In simple terms, a company is taking its earnings pie and cutting slices to give to shareholders. Eight shareholders, eight slices. Eight million shareholders, eight million slices.

With a secondary offering, however, the pie is the same size, but there are more slices being made. So if earnings are $100 and there are 10 shares, each shareholder is entitled to $10 of earnings. If the company doubles its share count to 20, then that same $100 pie is now cut into 20 slices, leaving shareholders with $5 each. That doesn't sound like a good thing at all.

It All Depends
The answer is that it depends on why the shares are being issued. In most situations, the company receives cash from a stock issuance. The question to ask is what's that money going to be used for?

For example Citigroup's sale of preferred shares to the U.S. government was, essentially, an effort to ensure the company's solvency. On one level that's great, but the cost was quite high. After several machinations, the government wound up converting the preferred shares into common stock and was then a major company shareholder. When it sold its shares to the public, all that happened was the pie got cut into more slices. Investors probably would have been better off just moving on from Citi than sitting tight.

In early 2012, Amicus Therapeutics (NASDAQ: FOLD) sold $62 million worth of stock to help fund its research efforts. That seems like a good thing, but, in late 2012 Amigal, a drug being developed with GlaxoSmithKline (GSK), performed poorly in a phase III trial. The shares fell almost 50%.

Although issuing shares to fund research is normal for biotech firms, those new shares are simply more claims on potential future earnings (most biotechs suffer through years of losses while trying to bring new drugs to market). If Amigal, or the company's other drugs, don't make it to market, investors are only getting hurt by additional share sales. Biotech is a high stakes investment world, so new share issues aren't looked on as bad, but they should be something investors think about in relation to a company's drug pipeline and the drug approval process.

The Business Model
Real estate investment trusts (REITs) are another area in which new shares are frequently issued. For example, in early 2012 Simon Property Group issued shares to help pay for a pair of acquisitions. In the normal course of business, REITs use credit facilities to pay for purchases and, once the acquisition closes, issue shares to raise cash to pay down the credit facility.

That's a good thing, since the company is growing the business. It also forces these companies to get the market's approval every time it buys something. A poor market reception to a stock issuance can be a sign that the market isn't pleased. However, not all stock sales benefit a company.

For example Simon also sold nearly 6 million shares in late 2012 on behalf of Melvin Simon Family Enterprises Trust. One sentence in the prospectus told the entire story: “We will not receive any proceeds from the sale of the shares offered by the selling stockholder." This transaction wasn't nearly as desirable as the previous one.

Other Industries
There are other industries where issuing shares is a normal part of business. For example limited partnerships and business development companies (BDC) both frequently issue new shares to build their businesses. Buckeye Partners recent issuance was to pay down debt it accumulated from recent expansion efforts. A BDC might use the money raised from a stock issue to lend out more money to small and middle market companies or pay down debt it took on to do that same thing.

No Easy Answer
The stock market tends to have knee jerk reactions to things, and selling more stock is right up there. In fact, many limited partnerships see their shares slump on such news only to recover when investors regain their senses. So, from an investors standpoint, you need to understand why the new shares are being issued and decide if it’s a good reason or a bad thing. Then act, but not before.

Yours,

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ReubenGBrewer owns units of Buckeye Partners. The Motley Fool owns shares of Citigroup Inc . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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