Lehman: First Data call a sober reminder of call risk on contingent payment convertibles

By Ronda Fears

Nashville, March 18 - Inherently, there is less call risk for convertibles with contingent payment features due to the tax benefits for the issuers, but First Data Corp.'s recent call was an alarm for the market, said Venu Krishna, head of U.S. convertible research at Lehman Brothers.

"We estimate that over the next 12 months, $43.8 billion of convertibles will become callable. Of these, $20.9 billion have their underlying stocks within 10% of their conversion prices.

"Clearly, call risk remains high."

The 11 largest of the contingent payment, or so-called CoPa, convertibles currently callable or becoming callable over the next year are the Danaher 0% (2.375% yield to maturity) due January 2021, XL Capital 0% (2.625% yield to maturity) due May 2021, Starwood 0% (3.25% yield to maturity) due May 2021, Best Buy OID (2.75% yield to maturity) due June 2021, XL 0% (2.875% yield to maturity) due September 2021, Apogent 2.25% due October 2021, L-3 Communications 4% due 2011, Cendant 3.875% due November 2011, Quest Diagnostics 1.75% due November 2021, Radian 2.25% due January 2022 and Advanced Micro Devices 4.75% due February 2022.

Call risk has plagued the convertible market for more than a year and has effectively put a lid on valuations of issues with limited call protection. The persistence of low interest rates and an easy refinancing environment has contributed to heightened call risk, Krishna added.

Convertibles with contingent interest payment features have generally been perceived as having lower call risk. Yet, recently First Data called its $542 million 2% convertible due 2008, which had a CoPa feature. Following the call announcement, the convertible lost around 2.625 points.

Krishna said it appears First Data incurred a tax recapture liability of around $26.8 million on account of the call and gave up $68.1 million in tax shield it would have received had it kept the convertible outstanding through maturity.

Given that, it would appear that the call exercise was uneconomical from the issuer's perspective, but Krishna added, "historically the convertible universe has been replete with instances of inefficient call exercises by issuers." Thus, the First Data case was an alarm resounding through the market.

The reasoning from First Data's perspective, he said, appeared to be that by calling the convertible at par, the company was effectively buying back stock at $40.95, a modest 3.2% premium to the average price the company paid in its stock buyback program in 2003.

Any analysis of the tax benefits to gauge call risk should be viewed in the context of every issuer's overall financial health and objectives, he said, with consideration given to overall debt levels with respect to targeted debtloads, cash on hand, the extent of free cash flow generation, debt and stock buyback plans, and recent or expected financing activity.

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