Komag convertibles could yield small windfall for investors, Lehman report says

By Evan Weinberger

New York, July 2 - Western Digital Corp.'s takeover agreement with Komag Inc. should reward investors in Komag's outstanding 2.125% convertible bonds due 2014 with a solid, if unspectacular, return, according to a July 2 Lehman Brothers report.

Western Digital, a Lake Forest, Calif.-based hard drive maker, agreed to take over Komag, a San Jose, Calif.-based maker of disks used in hard drives, for $1 billion June 28.

According to the report, the best-case return on the Komag (Nasdaq: KOMG) convertibles is 9.3% while the worst-case return is 5.5%, with a mid-range of 6.6%. Lehman Brothers risk-arbitrage analysts put a tentative closing date of Aug. 10 on the deal, and the terms of the bonds state that all outstanding Komag bonds must be redeemed in the event of a takeover between 15 and 75 days after the takeover is finalized.

Using the Lehman Brothers estimated closing for the deal, the best-case time horizon for returns is Aug. 25, while the worst case is Oct. 10. Western Digital (NYSE: SDC) will be responsible for redeeming Komag's bonds.

"The earlier investors receive the put-related cash-flows the higher the return would be," the report, written by Lehman convertibles analysts Venu Krishna, Manoj Shivdasani and Brendan Lynch, says. "It is difficult to predict the timeline that the company will choose. Our worst case scenario returns match the funding rate and any improvement in timing would enhance returns."

The current takeout price of the bonds is $32.25, according to the report, while the make-whole minimum threshold is $32.76. Komag stock closed down $0.07, 0.22%, at $31.82 July 2.

The report says outright convertible investors would yield "decent but unspectacular returns." The upside of the convertibles doesn't compare well with the upside of Komag stock, assuming the Aug. 10 closing of the takeover. The convertibles are, the report continues, far more defensive on the downside.

Risk-arb investors will be at the mercy of time, the report says, but advises risk-arb investors to steer towards stocks. "We believe the benefits of enhanced upside in the case of stock outweighs the better downside characteristics of the convert which is also subject to horizon extension risk."

Although they say they don't find Komag convertibles attractive relative to the stocks, the Lehman analysts say they would be buyers at a lower price.

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