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"The markets can remain irrational longer than you can remain solvent."
-John Maynard Keynes
For those that aren't aware, Gamestop (NYSE: GME), the video-game retailer, has seen its stock soar from $5 to $500 in the last few weeks.
Some people--mostly novice traders--have made a ton of money.
Many of them, working in concert on social media, intend to 'take GME to the moon'.
Unfortunately, it's unlikely that this story will end well.
Why?
There are many reasons, but perhaps the one that will shock and anger the online legions of Gamestop's supporters the most is one they don't expect.
Given the company's dire financial situation, it is likely (and perhaps inevitable) that Gamestop itself--not hedge funds, not RobinHood--will be the one to burst the bubble and reap a cash windfall at the expense of its recent devotees.
How?
First, let's examine Gamestop's finances.
Then, I'll explain:
a) What a secondary offering is and
b) Why Gamestop's leadership and board of directors would be foolish not to pursue one.
Background
Gamestop, like all publically listed companies, must report its financials to the SEC each quarter.
Their most recent quarterly report showed that the company had roughly $500 million cash on hand.
That might sound good.
But consider that the company has almost $1.2 billion in debt.
Obviously, not all of Gamestop's debt comes due at the same time.
So the company has (some) time to service their debt, and they do have $500 million in cash to pay their creditors.
But the company is also losing money every quarter.
In Q4 2020, Gamestop recorded a net loss of $18.8m. They also burned through $156 million in cash to pay debts, service leases, etc.
In other words, the company is bleeding to death.
More than anything else, they need cash to stay in operation, pay their debts, and buy time to adjust their business plan.
And that's where the secondary offering comes in.
Secondary Offering
Investopedia defines a secondary offering as:
"A secondary offering is the sale of new or closely held shares by a company that has already made an initial public offering (IPO). There are two types of secondary offerings. A non-dilutive secondary offering is a sale of securities in which one or more major stockholders in a company sell all or a large portion of their holdings. The proceeds from this sale are paid to the stockholders that sell their shares. Meanwhile, a dilutive secondary offering involves creating new shares and offering them for public sale."
Many people seem unaware that shares of stock are a store of value like any other. They can be created and destroyed.
Most large-cap companies (think Apple, FaceBook, Google) engage in what's called 'share-buybacks'.
Share buybacks are when the company goes into the open market and purchases its own stock.
This process reduces the number of shares outstanding, thus increasing the price of the remaining shares.
Basically, a dilutive secondary offering is the same process in reverse.
Rather than using the company's cash to decrease the number of shares trading in the open market, a secondary offering allows the company to increase the number of shares, raise cash, and lower its stock price.
Even though it is perfectly legal, there are obvious reasons why most companies wouldn't do this.
For one thing, it immediately lowers the share price, which is the exact opposite of what CEOs are paid to do.
However, dilutive secondary offerings are a great way to quickly raise cash, especially when a company's share price is well above what management thinks is sustainable long-term.
And that perfectly describes where we are at with Gamestop.
Not only would Gamestop benefit enormously from a dilutive secondary offering, but an argument could be made that the leadership of the company has a duty to issue a secondary offering.
Just do the math.
An issuance of 10 million shares (roughly 1/5 of the current shares outstanding), priced at $50/share would generate $500 million in cash.
That would double the company's cash on hand overnight.
It would also burst the stock price bubble, as it would be insane to buy GME on the open market at any price above $50.
In the end, people who are buying GME at the current levels are either confident the company will not issue a secondary offering, or they don't know that one is possible.
If the company decides to move forward, look for the bubble to pop quickly.
The company could announce the offering over the weekend.
Stop-loss orders likely wouldn't get filled at $200 or $100. The stock might open trading right at the secondary offering level--which could be anything--$50, $25, $10, etc.
People who bought in at current levels (as I write, GME is trading at $320/share) might lose 70, 80, 90% of their investment.
In other words, buyer beware.
JL Matthews is a freelance writer. He holds a degree in Business Management and worked in the financial services industry for more than a decade. He holds no positions in any of the stocks mentioned in this piece.
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