Deutsche analysts see Alcatel mandatory as a "golden opportunity"

By Ronda Fears

Nashville, Feb. 18 - Alcatel's mandatory convertible is a "golden opportunity," according to Deutsche Bank convertible analysts, particularly for arbitrageurs but also for traditional stockholders in the French telecom.

"The Alcatel ORAs provide investors with an excellent opportunity for low risk profits with minimal capital requirements," said Deutsche Bank Securities convertible analysts in Europe Michael O'Connor and Clodagh Muldoon in a report Tuesday.

"There is no embedded optionality, and investors should view the notes as deferred equity with full dividend rights," they said, adding, "Long term equity investors in Alcatel should switch out of the shares into the notes as the discount simply represents a cheap way in."

Alcatel's ORA mandatory notes due December 2005 convert into new or existing Alcatel shares. Nominally the notes pay 7.917% interest annually but this was prepaid on Jan. 2, 2003, so holders will receive no further interest payments.

However, the analysts noted that any common stock dividends are passed on to mandatory holders based on a one share per note basis. The notes are convertible but the conversion ratio accretes from 0.76 shares per note to 1.00 share per note at maturity.

The mandatory was quoted closing Tuesday in Europe up 0.14 point to €7.28 bid, €7.31 asked with the stock ending up €0.14 to €7.54 on the Paris exchange. In the U.S., Alcatel shares were at $8.02 at mid-afternoon.

"Arbitrage investors can take advantage of the discount on which the notes trade," said O'Connor and Muldoon.

"There is no dividend or takeover risk and so this trade will be profitable as long as the discount exceeds the total stock borrow costs together with any financing costs."

High correlation between stock and convertible reduces the risk, the analysts said, so buyers may be able to obtain a margin requirement as low as 2% of the long par amount. This means the margin is constant and will not change with equity prices, leaving stock borrow as the only variable.

"At current prices investors don't need to put any capital into the position, and yet will receive a profit with an NPV of over 2% of the underlying shares, effectively giving an infinite return on capital," the analysts said.

A 98.5% delta will hedge the investor against any change in borrow costs caused by fluctuations in the share price, the analysts said.

"The current breakeven level in terms of stock borrow is 123 bps, and as long as the average borrow costs for Alcatel until maturity is below this level, investors will turn a profit despite not putting initial capital into the trade," the analysts said.

"If the breakeven stock borrow level was to fall to 75 bps, the notes would rise to €6.73. Even at this level if the actual borrow cost came in at 50 bps, investors would make 0.75% of the value of the underlying shares despite putting no initial capital into the trade."

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