Deutsche analysts say new convertible anti-dilution structures lure issuers

By Ronda Fears

Nashville, Feb. 19 - Convertibles designed to ensure shareholders are not excessively diluted at current stock levels could dominate issuance for the rest of this year, according to analysts at Deutsche Bank Securities Inc., who note underwriters have been using such structures to lure issuers during the present bear market.

Recent convertibles from Micron, McData, Freeport-McMoran and International Game Technology confirm this trend, similar to deals from Computer Associates and Navistar International in 2002, the analysts said.

"All convertible originators agree on one thing, if only one thing, that the single biggest hurdle to bringing more convertible issuance in the U.S. is corporate reluctance to issue equity at current depressed stock price levels," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Wednesday.

"A number of solutions have been proposed to address this problem. In rough order of management's bullishness on their own stock, they are: simultaneous stock repurchase, a call spread overlay or very high premium.

"In recent months, the call spread overlay structure is emerging as the best compromise between the needs of issuers and investors."

But other options are available to achieve a high effective conversion price and to minimize dilution, the analysts said, noting there is an impact on the secondary market for the new issues and overall convertible market.

Call-spread overlay convertibles, as issued by Micron, McData, Computer Associates and Navistar International are one way of achieving a higher effective conversion price for the issuer.

But Freeport-McMoran recently showed how a plain vanilla structure with a very high premium of 70% is also a viable alternative for achieving a super high conversion price.

Other convertible issuers, such as International Game Technology, have used a portion of convertible issue proceeds to repurchase their own stock in the market.

As an example of the enticement to issuers, the analysts looked closer at the Micron 2.5% due 2010, which was issued with a call-spread overlay structure.

Micron used $109.25 million of the $632.5 million deal, or over 17% of proceeds, for the call spread. The call spread has a lower strike of $11.79 - the conversion price - with an upper strike of $18.19. The conversion premium at issue was 40% but goes to 116% at the call spread upper strike.

By using the call spread, potential stock dilution from the convertible was 8.86% but the Deutsche analysts found that if Micron had taken the same amount of money repurchase stock the potential dilution would have dropped to 6.72%.

"But the potential dilution in numerical terms only tells part of the story," the analysts said.

"We need to consider at what stock prices this dilution occurs."

With the stock below the conversion price of $11.79, the convertible is not converted, the call spread expires worthless and there is no dilution.

But with the stock just above the conversion price, the analysts said dilution will be greatest because holders convert the convertible and the issuer achieves virtually no benefit from the call spread.

As the stock moves up through the call spread zone, between $11.79 to $18.19, the benefits begin to be felt. If the stock is at $15 at maturity, for example, the convertible is converted but the lower strike on the call spread mitigates dilution as Micron buys back stock with the proceeds of the long call at $11.79.

If the stock is above the upper strike of $18.19, dilution increases because Micron is short the call at $18.19.

"The simplest solution to a low current stock price is to issue a very high premium convertible," the analysts said.

"This is also the most bullish structure, because it is much less dilutive than either the share repurchase or call spread overlay structures."

But there are drawbacks, too, the analysts said, including higher fixed charges as the result of having to pony up a larger coupon.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.