By Ronda Fears
Nashville, Tenn., Oct. 9 - WellPoint Health Networks Inc.'s call for its convertible is interesting on several fronts, but Deutsche Bank Securities Inc. analysts believe the company will decide to pay cash in the end. Meanwhile, they assert some arbitrageurs are paying up for the long put option when it is negated by the look-back provision related to the call.
Last week, WellPoint announced it was calling its 0% convertible due 2019 for cash at an accreted value of $717.57 per $1,000 principal amount at maturity, with a redemption date of Oct. 28 and final day to convert of Oct. 25.
Under the convertible prospectus, however, WellPoint may pay in cash or stock but can notify holders of what it will do up to two days after the conversion date, referencing the stock price on the trading day immediately prior to the conversion.
And WellPoint has expressed that it has not ruled out exercising the look-back option opportunistically.
There are a number of compelling reasons for believing the company will issue cash only to converting bondholders, the Deutsche analysts said, but it is an interesting situation.
"The long put redemption option is negated by a short 'look back' option. Whether or not WellPoint will act opportunistically and use this second option is now key to where the bonds will trade," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Wednesday.
"And, it is another data point in the ongoing debate about how issuers deal with call options on 0% convertibles. The evidence continues to mount that investors' optimistic assumptions may be disappointed by reality."
Also, if WellPoint elects to satisfy the conversion with cash, there may be important consequences for the stock, the analysts noted.
"Hedged investors will have to go into the market to physically buy back their shorts rather than simply deliver the shares resulting from conversion and the removal of dilution resulting from the convertible will likely boost EPS in future quarters," the analysts said.
The convertible now comprises two separate options, one positive and one negative from the holder's perspective - long a WellPoint put option at $52.79 expiring on Oct. 25 (the redemption price option) and short a WellPoint 'look back' option for 3 business days from Oct. 24, struck at WellPoint's closing price on Oct. 24.
"The first put is virtually worthless, at least theoretically. We had to use a volatility input of over 100% to get the put to be worth even 0.25 point," the analysts said.
"However, these are crazy markets, and many arbitrage investors will feel that the put is worth owning if the short 'look back' option can be negated in some way."
They simplified the 'look back' to be just the sum of short an at-the money three-day call because if the stock rises cash will delivered, plus short an at-the money three-day put because if the stock falls stock will be delivered.
Using a volatility of 38%, the combination of these two options is around $2.19 per share, or around 2.98 points per bond.
"We note that the bonds are not trading at parity minus 3 points in the market. So one of two things must be going on. Either investors are paying up hugely for the implied put in the convertible, or they must be assuming that WellPoint will not act rapaciously," the analysts said.
"Given that short dated listed puts trade on CBOE, clearly investors should not be paying up for the implied convertible put option only."
The analysts believe there is a good chance the company will deliver cash regardless of the stock price following the conversion date due to its healthy cash position, past redemption practices and favorable tax and accounting treatment.
There should be no risk to buying back the hedge, the analysts said, but the effect on WellPoint share prices afterward could be significant.
The number of shares underlying the outstanding convertible bonds now equals 2.956 million, according to the August 10-Q.
"As the bonds are concentrated in hedge fund hands (playing the short dated put), there is likely to be some significant upwards pressure on the share price around the time of conversion if the company delivers cash as opposed to stock," the analysts said.
"Delivering cash would actually have the same effect as a 2.956 million share buy back. Normally, converting hedge funds use the stock they are given on conversion to deliver against their 100% short stock position. If cash is delivered instead, hedged funds will need to go and buy back their hedges in the market. With WellPoint frequently trading less than 1 million shares a day, the short term affect could be quite pronounced."
WellPoint 0% convertible due 2019
| Ask: | 104.423
|
| Equity price: | $76.54
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| Parity: | 104.05
|
| Premium: | 0.251%
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| Conversion ratio: | 13.594
|
| Conversion price: | $73.56
|
| Put: | July 2, 2009 at 81.955
|
| Call: | Oct. 28, 2002 at 71.757
|
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