By Ronda Fears
Nashville, May 15 - Acknowledging that there has been a run-un in convertible valuations, particularly in technology names, Lehman Brothers has made a comprehensive study of semiconductor issues and of 28 convertibles has picked six to recommend.
Those are Nvidia Corp.'s 4.75% due 2007, Micron Technology Inc.'s 2.5% due 2010, LSI Logic Corp.'s 4% due 2006, Atmel Corp.'s 0% due 2021, Lattice Semiconductor Corp.'s 4.75% due 2006 and RF Micro Devices Inc.'s 3.75% due 2005.
Focus was restricted to semiconductor names only and excluded semiconductor equipment names.
"Given the run-up in semiconductor valuations, we have to admit that we were hard pressed to identify reasonable values," said Venu Krishna, head of U.S. convertible research at Lehman Brothers, in the report.
"Our goal is to identify best relative values among semiconductor convertibles within the context of an arguably rich primary and secondary convertible market. Thus, while most of these are unlikely to provide substantial returns, they do offer a high single digit to low double-digit return prospect over the next year."
Year-to-date, the Philadelphia Semiconductor Index is up 16.8% but is still down by more than 29.7% over the last 12 months, he noted, and a fair degree of uncertainty exists regarding the outlook for the sector.
However, Lehman has a sanguine longer-term outlook for the sector, driven in part by low inventory levels, an eventual uptick in U.S. business investment indicated by preliminary signs of a modest revival in IT spending and potential wireless 2.5/3G deployments next year.
On the flip side, in addition to macroeconomic concerns, uncertainties include a lack of clarity around end-demand pickup, continued weakness in U.S. telecom capex spending and uncertainty regarding PC sales.
In all, Lehman identified 21 semiconductor companies with 28 outstanding convertibles with a face value of over $11.7 billion. As a subgroup, these had a weighted average yield of 6.87% and a massive 507% premium.
"The significantly lower yields are a function of the massive rally in semiconductor convertibles over the past few months," Krishna said in the report.
"An ongoing rally in the credit markets, a lack of yield in the convert market, too much money chasing too few deals, an aggressively priced new issue market and increased risk appetite" are factors in the rally, he added.
Semiconductor converts have provided a total, non-weighted return of 14.22% year-to-date as of May 8, outperforming their common stocks that have returned 8.43% over the same period. As of April 30, the Lehman U.S. convertible index has returned 9.09% year-to-date with the tech subsector index returning 16.03%, both on a weighted basis.
The approach to the semiconductor industry was four-pronged - evaluating every company along a scoring scale, views on a particular semiconductor sub-sector, company-specific financials and outlook, and individual convertible investment characteristics.
"We approached the sector from a credit and liquidity perspective," Krishna said. "Our objective was to identity not only the best relative values but also the most optimum (i.e. risk-controlled) investments in the context of current and expected market conditions over the next two years."
Micron Technology
Despite a high cash burn that caused Micron to rank low on the scoring scale, the 2.5s are one of the few high delta (76%) names in the semiconductor universe that have an attractively valued stock, making it an attractive means of gaining exposure to a potential increase in the stock's valuation should the PC upgrade cycle materialize. The company's $1.2 billion cash position and leading position in the depressed DRAM market are near-term positives.
Micron 2.50% convertible due Feb. 1, 2010
| Amount outstanding: | $633 million
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| Convertible price: | 106.88
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| Common price: | $9.10
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| Conversion premium: | 38.4%
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| Fair value: | 106.15
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| Volatility input: | 60
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| Credit spread: | 600 basis points over Treasuries
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| Yield to maturity: | 1.42%
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| Call: | February 2006 at 101.43
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| Yield to call: | 0.49%
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| Delta: | 75.5%
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| Ratings: | B2/B
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| Nvidia
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| The company ranked highest in the scoring scale, suggesting limited liquidity concerns. The convert presents an interesting trade-off between a 4.85% current yield and the yield-to-call, the analysts said. While on a valuation basis the security appears optically rich, the analysts believe the attractiveness of the security lies in its interesting terms when one factors in the call risk. Given the low interest rate environment, it is reasonable to conclude that the risk of a call is relatively high. Yet in this case, call risk is not threatening. So, investors are looking at a security that provides a current yield of 4.85% against the backdrop of a low yielding convert market and if called will realize a healthy 15.8% yield. Clearly, the value appreciation potential is limited given the massive richening recently. Yet, as a low risk means of realizing value, we think it continues to hold appeal.
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| Nvidia 4.75% convertible due Oct. 15, 2007
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| Amount outstanding: | $300 million
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| Convertible price: | 98
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| Common price: | $16.05
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| Conversion premium: | 183.0%
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| Fair value: | 94.52
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| Volatility input: | 55
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| Credit spread: | 450 basis points over Treasuries
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| Yield to maturity: | 5.26%
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| Call | October 2003 at 102.71
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| Yield to call: | 15.86%
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| Delta: | 19.0%
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| Rating: | B
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| LSI Logic
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| With a reasonable price, the LSI 4s of '06 provides a decent 7.8% yield on a short dated instrument, the analysts said. The company scored fairly high on Lehman's scoring sale suggesting a reasonable liquidity and credit profile.
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| LSI 4% convertible due Nov. 1, 2006
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| Amount outstanding: | $490 million
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| Convertible price: | 88.5
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| Common price: | $5.14
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| Conversion premium: | 353.5%
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| Fair value: | 88.30
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| Volatility input: | 55
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| Credit spread: | 600 basis points over Treasuries
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| Yield to maturity: | 7.84%
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| Call: | October 2004 at 101.6
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| Yield to call: | 13.81%
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| Delta: | 12.1%
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| Rating: | B
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| Atmel
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| The company's ability to generate cash should keep its financing options open as the put draws near on the 0s of '21, allowing investors to realize value along the way, the analysts said. Of the two Atmel zeros, the 0s of '18 were putable on April 21 at 44.315, and by Lehman's assessment the option should have been exercised. At its current run-rate, Atmel should generate close to $90-$100 million in free cash flow in 2003. Should it continue to generate cash, then the 0s of '21 look reasonably interesting at current levels. Absent any additional financings, the company would need to generate close to $200 million per year over the next two years to meet ongoing obligations, including the put on the 0s of '21. However, ongoing cash generation should allow it to access capital markets.
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| Atmel 0% convertible due May 23, 2021
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| Amount outstanding: | $512 million
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| Convertible price: | 37.00
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| Common price: | $2.21
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| Conversion premium: | 628.5%
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| Fair value: | 37.84
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| Volatility input: | 55
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| Credit spread: | 700 basis points over Treasuries
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| Yield to maturity: | 5.66%
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| Put: | May 2006 at 49.45
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| Yield to put: | 10.04%
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| Delta: | 5.7%
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| Ratings: | Not rated
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| Lattice
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| Lattice ranked in the middle of Lehman's scoring scale. A decent cash cushion, relatively low leverage and free cash flow generation make it an interesting play similar to Nvidia with an interesting trade-off of a 5% current yield and a 20.8% yield-to-call with a reasonable probability of call exercise. From a risk/reward perspective, the convert is fairly defensive with an estimated 29%/+28% participation relative to a +/-25% move in the stock over the next year. This translates into a +7.4% and +3.3% total return estimate, respectively.
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| Lattice 4.75% convertible due Nov. 1, 2006
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| Amount outstanding: | $175 million
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| Convertible price: | 95
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| Common price: | $8.75
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| Conversion premium: | 125%
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| Fair value: | 94.25
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| Volatility input: | 55
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| Credit spread: | 600 basis points over Treasuries
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| Yield to maturity: | 6.37%
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| Call: | Callable at 102.71
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| Yield to call: | 20.76%
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| Delta: | 21.8%
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| Ratings: | Not rated
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| RF Micro
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| This is the contrarian pick, based on a decent cash balance of $257 million, minimal to no cash burn over the last 12 months and ability to control capex costs, the analysts said. Assuming RF Micro can generate even minimal free cash flow going forward, it should have sufficient financial flexibility to manage the outstanding convert obligation. Due to the short maturity and high bond floor, risk/reward is estimated at 34%/+25.6%, suggesting a total return of 8% to 8.5% on the upside, and outperformance on the downside with a positive 6% to 6.5% total return, for a one-year, +/- 25% move in common stock. Accordingly, it is considered a conservative way to play the wireless sector.
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| RF Micro 3.75% convertible due Aug. 15, 2005
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| Amount outstanding: | $297 million
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| Convertible price: | 91.5
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| Common price: | $4.92
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| Conversion premium: | 738.5%
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| Fair value: | 92.79
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| Volatility input: | 60
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| Credit spread: | 550 basis points over Treasuries
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| Yield to maturity: | 7.93%
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| Call: | August 2003 at 100.94
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| Yield to call: | 43.9%
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| Delta: | 2.0%
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| Ratings: | Not rated
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