Ignore the Bullish "Kitchen-Sink" Talk

Ignore the bullish kitchen sink writedown talk, that future earnings per share results on Wall Street will look better when compared to EPS figures coming out now, as they have been socked hard by colossal writedowns.

That's because shareholder dilution in the form of new stock issuance at Wall Street firms could keep earnings per share results down in future quarters.

To plug the holes in their damaged balance sheets, Wall Street has turned to the equity markets to raise capital.

Four of Wall Street's largest have raised at least $50 bn since last fall through such offerings. Citigroup(C), Merrill Lynch (MER), have issued a flood of new securities. Morgan Stanley (MS) and UBS (UBS) have, too. Lehman Brothers Holdings (LEH) plans to raise $6 billion more in capital, on top of the $6 bn it already announced, after disclosing a nearly $3 bn loss for its second quarter.

This is shareholder dilution on a massive scale.

Please do all you can to ignore the bullish "kitchen-sink" talk in the business media, that future earnings per share will look dramatically better when you compare them to earlier quarterly results that were hit hard by outsized writedowns.

This is off the mark. Because along with the common stock issued, once the preferred shares convert, that means more dilution. And that means future earnings per share figures may not look so hot when compared to earlier EPS results socked by write downs.

To arrive at earnings per share, you divide the number of shares outstanding into earnings. Since more stock is being issued, and more preferred shares will convert into common shares, that means the earnings number must be spread out over a much larger denominator of shares.

Future earnings per share comparisons may at best look flat, if not lower.

Also hanging up the financials' stock prices is this often ignored fear down on Wall Street. Whenever hedge funds hear about a common stock or preferred stock capital raise, they immediately plow into the market to short these stocks, knowing they can cover on the resulting equity offering.

So where are the potholes on Wall Street? Check out this table from Portales Partners, which sells independent research to institutional investors:

Want more?

Meredith Whitney, a top analyst at Oppenheimer, has parsed through the dilutive effects of any further equity capital raises by Merrill Lynch.

Specifically, Whitney looked at Merrill's $6.2 bn stock issuance last December to Singapore's Temasek investment authority and the investment company Davis Selected Advisors as well as the separate $6.6 bn convertible preferred stock issuance to the Korea Investment Corp., the Kuwait Investment Authority and Mizuho Corporate Bank last January.

Whitney says that just a $1 bn equity capital raise below $38 per share (Merrill's stock is trading at around $38) would be 80% additionally dilutive than a straight common offering due to the fact that Merrill would have to issue additional shares to Temasek "if it were to issue stock below its original investment price at $48."

A $3 bn equity capital raise at $38 per share would be 13.5% dilutive. A $5 bn equity capital raise at $38 per share would be 17.3% dilutive, she says.

Similarly, Citigroup raised a total of $20 bn in two deals earlier this year. The deals involve securities that are convertible into common stock at different prices. Those shares convert into 575 mn to 600 mn of common shares.

And check out the high rates Citi has to pay on its preferreds. For example, before they convert, Citi has to pay 11% before taxes on the $7.5 bn it sold to Abu Dhabi last December.

So where are the potholes on Wall Street? Check out this table: