Merrill: Regal-Beloit, Axcan, Global Imaging convertibles would suffer biggest price correction in takeover event

Nashville, Sept. 10 - The convertibles of Regal-Beloit Corp., Axcan Pharma Inc. and Global Imaging Systems Inc. would be affected most severely in terms of a price drop, because of where they are trading now, in the event of a cash takeover event, Merrill Lynch & Co. analysts said in a report Friday.

Merrill analysts found 46 convertibles that could be among the worst losers in case of a cash takeover, a threat that has overshadowed the convertible since spring when Kroll Inc.'s takeover by Marsh & McLennan Cos. Inc. sparked a widespread scare in the market. Mandalay Resort Group's proposed takeover by MGM Mirage Inc. shortly followed the Kroll event, which exasperated fears, and the latest situation has been bidding for Grey Global Group.

The takeover situations "have rattled convertible investors both in the outright and, especially, hedge worlds," the Merrill analysts commented in the report. "Given that most stocks have been treading water lately, and some have dropped significantly, there are numerous potential takeover targets out there, and investors are getting increasingly uneasy about the negative effect of cash mergers on convertibles."

AtheroGenics Inc., Aquila Inc., WMS Industries Inc, AirTran Holdings Inc. and Silicon Graphics Inc. are perhaps the most vulnerable small-cap names in the convertible universe to a takeover, as those underlying stocks have fallen more than 20% in the last three months, the Merrill analysts said.

From a valuation standpoint, however, the analysts said Regal-Beloit's 2.75% notes due 2024, Axcan Pharma's 4.25% notes due 2008 and the Global Imaging 4% notes due 2008 would be highly susceptible to downward price adjustment since all three are trading at least 4% rich.

Convertible securities with highest conversion premiums, which would be most vulnerable to premium contraction, include MeriStar Hospitality Corp. Inc.'s 9.5% notes due 2010, Capstead Mortgage Corp.'s $1.26 convertible preferred series B, Artesyn Technologies Inc.'s 5.5% notes due 2010, ProAssurance Corp.'s 3.9% notes due 2023 and Veritas DGC Inc.'s floater due 2024.

The largest convertibles by market value, which are likely to be more widely held and therefore could leave a dent in more portfolios, include Aquila's 6.75% premium income equity securities, or PIES, and the Silicon Graphics bonds, as well as Kaydon Corp. 4% notes due 2023, Kansas City Southern 4.25% convertible preferred and the Cleveland-Cliffs 3.25% convertible preferred.

The Merrill analysts studied the small-cap universe of convertible issuers with underlying equity market capitalizations of less than $1 billion, as those could be considered prime cash-takeover candidates as opposed to stock-takeover targets, because of their small size. They included only convertibles that trade at least 10% above par - or accreted value in the case of discount converts - and removed deep-in-the-money convertibles with a conversion premium of less than 10%.

This left 46 convertible securities, which could potentially be among the worst losers in case of a cash takeover. The analysts also identified issues with cash-takeover protection in the form of a premium make-whole payment, which virtually encompasses all new issues brought to market since spring.

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