Tom Konrad, CFA
A light at the end of the PIPE? Photo by Tom Check
In my last article, Axion Power’s Potential For Explosive Growth, I outlined a number of near-term business opportunities for Axion Power International, (OTC:AXPW) any one of which could catapult the company into profitability in 2014, and more than one of which could produce significant revenue growth this year. While I’m quite bullish about Axion’s prospects, I concluded with a skeptical comment about Axion’s stock:
[I]f I owned the stock today, I would be a seller at the current price of $0.17.
Down the PIPE
How can I be so bullish about the company’s business but still want to sell the stock? It’s all because of the recent private investment in public equity (PIPE) convertible note financing. This is an unconventional convertible financing, because the conversion price of the notes falls with the market price. Convertible financing of this type is variously known as “ratchet,” “toxic”, or “death spiral” because as the stock price falls, the convertible notes convert into more shares. Because the convertible note holders end up owning more shares, existing shares represent a smaller percentage ownership of the company, and are worth less. This sets up a vicous cycle, which frequently ends with the original shareholders owning only a small slice of the company.
There is also an element of the self-fulfilling prophecy: Because existing shareholders expect to be diluted, they sell the stock, which depresses the share price and leads to further dilution of those shareholders who held on. It’s a sort of prisoner’s dilemma: if all shareholders would just hold on, or even buy into price declines, they can prevent the financing from creating a self-fulfilling death spiral.
Could Be Worse
That said, this is far from the worst such convertible financing I have seen. For one thing, the conversion option is held by Axion: they can choose to pay in cash or shares. For another, the note is payable in nine equal installments over nine months . The conversion price is 85% of the lower of the price on the previous trading day, or the average price over the 20 trading days (approximately one month) for which the price was lowest out of the last 40 trading days (two months) before each payment. Many toxic convertibles are payable all at once . This makes it very easy for the holders of the convertible to sell a large amount of stock during the period the conversion price is being set, artificially reducing the conversion price and awarding themselves more shares at conversion.
There was also a $1 million subordinated convertible note sold to company insiders. Unlike the $9 million of convertible notes described above, this entire note (principal and interest) is payable at the end of the term, in cash or shares, at the company’s option. Both sets of investors also received approximately 50% coverage of the notes with warrants that can be exercised after six months and before five years at $0.302. If there is a future financing at better terms over that period, the exercise price on the warrants is reset to the price of the future financing.
The Next Round
According to Axion’s CEO, Thomas Granville, Axion has enough cash that it won’t need to return to the markets for additional financing until 2014. If things go well (I recently argued that they could,) Axion may not need to return to the markets for additional financing any time soon.
On the other hand, if new business is slow to materialize, the prospects for an additional round of financing could put more pressure on the stock.
The first convertible payment was made on July 3rd, at a conversion price of approximately $0.136 (by my estimate.) That means the investors were paid with approximately 7.1 million shares of stock. The second payment will be on August 3rd, and, given the 40 day look-back, we know that the conversion price will be at most $0.131, with a minimum of 7.4 million shares issued.
AXPW trades an average of less than 10 million shares a month, so the market is simply not liquid enough to absorb all of this stock if they choose to sell. That means that the investors have enough shares to force down the price of Axion’s stock quickly. Since they can force down the price of Axion stock, it’s helpful to ask: Do they want to?
The reason to reduce the stock price is so that they will get more shares in future payments. On the other hand, if the stock price remains low at the end of the nine months, most of the new stock issued will go to the company insiders who bought the $1 million subordinated notes. A low share price at the end of the nine months would also likely mean a low share price in early 2014, when Axion will most likely need to raise additional funds. If the share price is low then, Axion will likely be forced into another, even less favorable deal, and they will find themselves diluted just like Axion’s long term shareholders are now.
Finally, if the convertible note holders force the stock price “too low,” Axion might choose to pay them in cash rather than shares, betting that it will be able to raise cash from other sources on more favorable terms. Management might also be forced to pay in cash because Axion is only authorized to issue 200 million shares without a shareholder vote. 114 million shares were outstanding in the first quarter, and an additional 5 million are reserved for options. This leaves at most 81 million shares for payments to the note holders.
The 81 million authorized shares may not prove to be a hard limit. If Axion were to run up against this share issuance limit, the company has the option to make the remaining payments in cash, or ask shareholders to approve the issuance of additional stock. If cash were unavailable, as is likely, and shareholders were to fail to approve the issuance of additional stock, Axion would be forced to default on the notes. Any default would likely lead to bankruptcy or a negotiated settlement with the note-holders. Either would probably be worse for shareholders than the expected dilution from additional share issuance.
Axion shareholders should not be comforted by a seemingly parallel situation at ZBB Energy Corporation (NYSE:ZBB). While ZBB cancelled plans to hold a shareholder meeting needed to sell shares to Aspire Capital Fund because of lack of share
holder support, failure to obtain shareholder approval does not lead to default under ZBB’s agreement with Aspire. It is the threat of default which would most likely lead shareholders to agree to additional share issuance, if necessary.
In the chart above, I’ve run three possible scenarios of what might happen to Axion’s stock price over the next 8 months, and the resulting likely dilution of existing shareholders.
In my first scenario, the share price stays roughly where it has been for the last month (purple lines.) In this case, the convertible note holders will end up owning approximately 79 million shares, or 41% of the company for their $10 million investment, or about 13 cents a share. I don’t think this scenario is at all likely, but I included it as a baseline.
In my second scenario, which I consider most likely. the note holders will attempt to drive the share price down in the short term, when there are a lot of convertible payments ahead of them, but ease up in the later months to avoid destroying the value of a company they will own a substantial portion of. In the scenario I modeled, they succeed in driving the price down below 6 cents in the September-October time frame, after which it begins to recover. This would result in the issuance of 131 million new shares, more than are currently authorized. However, as discussed above, it seems likely that shareholders would approve additional share issuance if the only alternative is bankruptcy. This scenario would result in the note holders being issued nearly 54% of the company for their $10 million investment, or about 7.6 cents a share.
In my third and final scenario (green lines,) a positive business development triggers a quick share price recovery in the near future. Fears of dilution wane, creating a virtuous cycle, and the share price quickly rises above $0.31, at which price note holders can choose to take payment in shares priced at $0.264 at their option, not the company’s. This scenario results in the issuance of approximately 58 million shares (34% of the company) at 17 cents a share.
I think the most likely result is some combination of scenarios 2 and 3. The note holders will succeed in driving down Axion’s share price in the short term, but this process may be interrupted by positive news resulting from one of the business opportunities I outlined in the last article.
Hence, I think a small investors’ best approach is to sell or stay out of the stock now, and buy back in at the first sign of significant positive news. If there is not any significant news in the next few months, I expect the stock will be considerably lower in the September-November time frame, at which point I will consider buying the stock.
Since the liquidity of the stock is limited, larger shareholders will have to sit tight. There is also a concern that if all small shareholders rush for the exit at the same time. John Petersen, a large shareholder and frequent Axion commentator, put it this way:
[A]ny significant incremental selling can only serve to drive the price down in the short term and exacerbate the problematic aspects of the financing. … [I]t’s like yelling fire in a crowded theatre. Sometimes the only thing long investors can do is suffer through what may prove to be a difficult period.
For myself, I’m fortunate not to own the stock, which I sold last year (at a loss) when it became clear to me that Axion would be in no position to negotiate favorable terms on this financing.
I realize that this article could be construed as yelling “Fire” in a crowded theater, but I feel my first priority with my writing should be to give you, my readers, my honest opinion. You’ll have to decide for yourselves if you want to find out if the light at the end of the PIPE is an all-electric NS 999 switcher locomotive, or get out now before being sucked down a death spiral.
Disclosure: No position in any of the securities mentioned.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.