Lehman: do not exercise Rational Software put, or sell on strength

By Ronda Fears

Nashville, Dec. 9 - Given the high likelihood that Rational Software's convertible will be called in February 2003, Lehman Brothers analysts recommend holders do not exercise the change-of-control put available as a result of IBM's acquisition of the company

Alternatively, the analysts say, those who could realize significant price appreciation should sell into the strength from IBM's acquisition of software firm.

"We recommend holders of the Rational 5% hold on to the converts and not exercise the change-of-control put given the high likelihood of realizing the call price of 102.857, which is around 0.857 points higher than its current trading price," said analysts Venu Krishna, Brendan Lynch and Jocelyn Picl in a report.

"Holders of the 5s who are unwilling to take this chance should sell into the convert's strength given that they would have already realized a substantial appreciation relative to the convert's closing levels on 12/05/02."

Rational's 5% convertible subordinated notes due Feb. 1, 2007 closed at 87 with the stock at $8.17 on Thursday and were quoted at 102 on Friday morning after the acquisition by IBM was announced, the analysts noted.

For those looking to sell into the strength, the analysts said the impressive 10.04% yield to call should make it especially attractive to arbitrage holders.

"Despite a relatively low point pickup of 0.857 points, the short duration of the call (roughly 60 days) causes the yield to be high. This also suggests that the yield to call will be highly sensitive to slight price movements in the bond," the analysts said.

"For example, if one purchased the convert at 102.25%, the yield to call would shrink to 8.43%, which is still compelling."

The convert's change-of-control put provision would allow holders to put the bonds back at par plus accrued interest.

"With parity at around 29.396% of par, the case for an exercise of the change-of-control put by the convert holders would appear compelling at first glance. This is so given the all-cash nature of the transaction that would effectively drain out all the optionality in the convert," the analysts said.

"However, with IBM's straight 5-year debt (rated A1) currently being quoted at Ts + 55 to Ts + 45 bps, the convert holds appeal as a pure credit play on IBM's credit."

Using a spread of 100 basis points over Treasuries or a 50 basis points subordination spread on the 5% convertibles, the investment value currently stands at 103.116, making it worthwhile not to exercise the change-of-control put since the pure bond value of the convert is worth more than the put price plus the accrued interest.

"However, the Rational converts are callable at 102.857 on 2/5/03 making it highly likely that the convert will be called since IBM could refinance the 5% subordinated debt at lower rates in the current low interest rate environment," the analysts said.

For example, with 5-year Treasuries at 3.03%, IBM could theoretically refinance 5-year subordinated debt at 4.03%, Treasuries plus 100 basis points, the analysts said, adding that the convert is worth more than the call price.

© 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.