Delta charge brings out sellers of Northwest, AMR; Red Hat plunges 12 points on restatements

By Ronda Fears

Nashville, July 13 - High anxiety about this crop of earnings - misses, restatements, warnings, charges - has caused a torrent of summer clearance sales in convertibles, which may create some buying opportunity for bargain-hunters since the season is far from over.

"Everything is for sale," said a sellside convertible dealer. "With earnings, everyone's afraid."

On the buyside, traders fear it will get worse before it gets better.

"Intel [which reported higher quarterly earnings but cut its profit margin forecast for the year] is going down the tubes, and the rest of the market will go with it," said a convertible trader at a hedge fund in New Jersey.

In the technology space where the red ink has been gushing profusely in recent sessions, Red Hat Inc. and Fair Isaac Corp. were the latest in a string of earnings-related disappointments.

Delta Air Lines Inc. also intensified the ill-favored moods surrounding the carrier's future with the announcement of a $1.6 billion charge, and the angst spilled over into other airline names. Thus, traders noted heavy selling in AMR Corp. and, particularly, Northwest Airlines Corp.

Citizens Communications Co. continued to lose ground, too, following its stock dividend announcement plus the credit's downgrade into junk territory by Moody's Investors Service, a move which many believe will soon be mimicked by Standard & Poor's.

There were a few issues moving northward, however, including the auto issues. Also, Leucadia Communications Inc. convertibles got another nice pop in the wake of the conglomerate's plans to buy a controlling 50% stake in MCI Inc.

A sellside market source noted, too, that nothing remarkable was seen in the Allergan Inc. converts, despite a Food and Drug Administration advisory panel recommendation that the FDA not approve its psoriasis treatment Tazoral without further clinical trials, which sent the underlying stock down by 6.3%.

Volatility transient bright spot

A few fleeting bright spots have appeared by virtue of spikes in volatility for a few individual names, and that has been a pleasant surprise during the typical summer lull, although the spikes have been caused by the very thing that has cheapened the convertible market - earnings discord.

"There have been a couple of summer party favors, which is more than you could expect" amid traditional slow summer volatility, one convertibles trader at a hedge fund in New York said.

But, volatility plays are difficult to forecast and not something anyone can count on during the summer.

"Yes, individual vol is up, so if you own those specific bonds, you are in good shape. Otherwise, it is way too quiet and difficult to make money," said a portfolio manager at a multi-strategy fund in New York. "I'm not really surprised. Vol markets are always quiet in the summer. As a matter of fact, we are lucky we have had all the earnings misses we have had."

CoCo flap stills new-deal flow

Compounding the pain emanating from the secondary market, the spigot for new-deal flow has dried up. In fact, with nearly half the month past, there have only been a couple of new issues that barely register against months past, and the market is coming up on the second shut-out week in a row.

"I think the lower stock prices - the stock market is way off its highs - and the removal of CoCos [as a structure for new issues] has killed the new-issue market for now," said a fund manager in New York. "CoCos has to be a part of it, I am sure."

A new accounting rule is being considered by the Financial Accounting Standards Board that would require issuers of convertibles with contingent conversion features to estimate potential dilution to reported earnings per share.

Sources on origination desks say it might be a bump in the road for issuance, which is already lagging 2003, but it's not the major hindrance at this time as it just surfaced. Moreover, market sources say there are far more ominous factors impeding convertible issuance right now - rising interest rates, the earnings scene and general ambiguity about the economy.

"Between the contingent conversion confusion and the ongoing lack of clarity on the interest rate front, it looks like potential issuers are just sitting tight," said a source at one of the busiest shops for convertible underwriting.

"I still think it will pick up, eventually, although if issuance maintains its present clip, it will be the worst month for convert issuance since October '98 when a grand total of zero deals hit the tape generating a total of no proceeds."

Unchanged from a week ago, convertible issuance year to date stands at $32.35 billion versus $62 billion in the same time frame for 2003.

Hedges reversing on Red Hat

Red Hat said it would restate accounts for fiscal 2002, 2003 and 2004, amending the way it recognizes subscriptions to its increasingly popular Enterprise Linux product, resulting in "significant percentage changes" to operating profit and net income.

For fiscal 2004, ended Feb. 29, the restatement will reduce income from operations to between $2.5 billion and $2.9 billion from $3.2 billion, and net income will drop to between $13.3 billion and $13.7 billion from $14 billion, according to company figures.

The Raleigh, N.C.-based software firm also said it will restate results for the fiscal quarter ended in May and noted that the Securities and Exchange Commission has raised questions about a prior-year annual report although the SEC request may have nothing to do with the planned restatements.

In reaction to the event, there was a massive selloff in the Red Hat convertibles, which have been a darling since they were sold in January because of the rising interest in Linux and resultant spike in Red Hat stock.

A sellside dealer, however, said there was a strategy shift among arbitrageurs taking place with regard to Red Hat; specifically, he noted some convertible arbs were starting to set up a reverse hedge, or shorting the converts, which has been a successful ploy in recent months as well as a flop.

Some hedged players were also hoping to make a cheap volatility play on the sharp weakness in the stock.

Red Hat shares plummeted 22.7%, or $4.62, to close Tuesday at $15.73. The stock just hit a new 52-week high of $29.06 in late May.

Red Hat's 0.5% convertible bonds plunged 12 to 12.5 points, on an outright basis. The issue was quoted at 94 bid, 94.5 offered at one sellside shop and at 93.75 bid, 94.25 offered at another.

Fair Isaac warnings weighs

Fair Isaac, which last week suffered directly from the CoCo flap, on Tuesday was struck again after lowering its guidance for fiscal third and fourth quarters, blaming lower one-time software license fees.

For fiscal third quarter, Fair Isaac now expects earnings in a range of 38 to 40 cents a share versus its previous estimate of 40 to 43 cents a share. The company now forecasts revenue of $173 million to $175 million, down from its earlier estimation of $185 million to $189 million.

For fiscal fourth quarter, the company now has an earnings outlook of 25 to 27 cents a share compared with its prior guidance of 40 to 43 cents a share. The company now sees revenue of $185 million to $189 million, off from its earlier forecast of $205 million to $211 million.

Fair Isaac's convertibles traded actively Tuesday, with the 1.5% due 2023 issue quoted down 6.25 points to 93.75 bid, 94.25 offered. But a sellside source noted the old HNC Software 5.25% converts, which Fair Isaac assumed in a merger, "barely budged even with the stock down over $7" and ended roughly at 102.25 bid, 103 offered.

Fair Isaac shares, which were downgraded by equity analysts at several sellside shops, plunged $7.36, or 23.47%, to close Tuesday at $24.

Northwest, AMR follow Delta

Early Tuesday, Delta announced that it will take a second-quarter charge of $1.5 billion noncash to write off deferred tax assets and a $117 million charge relating to its pilot pension plan. That did nothing but elevate nervousness about the airline's prospects as a going concern.

"The whole lot [of Delta investors] were already trigger-happy," said a buyside convertible trader. "This just made everyone snap."

A sellside convertible trader said the Delta 2.875s were weaker by about a half-point at 55.5 bid, 56.5 offered and the 8s dropped with the stock to 51 bid, 53 offered. Delta shares slid 66 cents, or 9.78%, to $6.09. Delta's straight junk bonds were seen 2 to 3 points lower.

"There is a lot more downside than upside" risk with Delta, the convertible trader said, particularly ahead of its earnings.

Delta is scheduled to report earnings next Monday.

Moreover, convertible analysts have steered away from making a stance regarding Delta.

"I don't know how you value these [Delta converts]," said one sellside analyst. "This paper is just worth whatever anyone will pay, I guess."

S&P analysts said the Delta charges would have no affect on the B- rating for Delta bonds or the negative outlook, but were cautious about the situation.

Of greater concern than Delta's large noncash charges, S&P said, are its continuing heavy losses and cash outflow and the long delay in securing needed labor cost concessions from its pilots.

In addition, S&P said that even if the Delta pilots eventually agree to concessions, any restructuring plan that also includes renegotiation of payments, or a coercive exchange, on its public debt would be considered a default and cause the company's corporate credit rating to be lowered to D.

Northwest, AMR follow Delta

Delta's announcement seemed to take the top off of a powder keg, so to speak, triggering sell orders for Northwest and American Airlines' parent in rapid succession.

"Particularly, Northwest sold off," a sellside trader said.

Northwest also is scheduled to report earnings next week, on Wednesday.

Northwest's convertibles both slid about 2 points on the day, with one sellside shop pegging the 6.625s at 86 bid, 86.5 offered and the 7.625s at 73.625 bid, 74.125 offered. Northwest shares plummeted 59.5 cents, or 6.13%, to $9.11.

AMR's convertibles were about 2 to 3 points lower, according to another sellside shop, with the 4.5s at 72 bid, 73 offered and the 4.25s at 82.5 bid, 83.5 offered. AMR shares closed down 42 cents, or 4%, to $9.93.

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