Mispricing of high premium convertibles offers buying opportunities, Merrill says

By Ronda Fears

Nashville, Sept. 8 - A lack of understanding and inadequate valuation models has created buying opportunities in high-premium and high-premium cash-to-zero convertibles issued with warrants, Merrill Lynch & Co. convertible analyst Marc Malloy said in a report Monday.

Merrill introduced the structure in February with its deal for Affiliated Managers Group Inc.

The structures offer issuers high premiums and low interest costs, but compensate investors by effectively increasing the conversion ratio with the addition of non-detachable warrants.

But demand for the product has been muted due to its complexity, Merrill noted. Furthermore, the warrants increase the sensitivity of the structure to volatility, which has declined sharply since the end of March.

However, Malloy said the run up in stocks since the end of March means that stock prices have moved closer to the strike prices of the warrants, sharply increasing the equity sensitivity of the convertibles. And, he added, the bottoming of volatility in the summer puts these converts in a strong position to benefit from any increases in market volatility.

"Everything has a price and when things get cheap enough it becomes worthwhile to make the effort to value these securities," Malloy said.

Valuing these structures is daunting, however, as the warrant feature makes it tough for most convertible models to handle. Investors also underestimate the equity sensitivity (delta) and sensitivity to volatility (vega), Malloy said.

Many were put off by the structure due to the high initial premium, which typically means that the stock price has to rise significantly before the benefits of the warrants really kick in.

But he said that as the stock price rises the convertible becomes "turbo charged" in appreciation relative to a convertible with a lower premium and no additional warrants. The warrants also make these issues particularly sensitive to changes in volatility.

"As volatility dropped sharply from the end of March 2003, the HiPr structures were unduly hit," Malloy said in the report.

"The flip side of this is that if we are seeing the bottoming of volatility, the HiPr's structure is in a unique position to benefit from higher volatility."

The report focused on five Merrill Lynch deals - those for AMG, Carnival Corp., Mandalay Resort Group, Valassis Communications Inc. and Wells Fargo & Co.

Other deals with the same structure include Getty Images Inc. and Lin TV Corp.

Merrill finds the AMG, Carnival and Wells Fargo convertibles undervalued at current prices, with the Mandalay and Valassis issues at about fair value.

AMG floater due 2033

At its current level of 116.5, the AMG convertible is trading at a 4-point discount to Merrill's sum-of-the-parts valuation of 120.48, with fears the company will introduce a dividend keeping it low. Merrill estimates that if a 2% dividend was initiated, the theoretical valuation would drop 5.8 points.

The implied volatility of the sum of the parts valuation is 21.4% compared to a long term historical vol of 46.3% and at-the-money long dated call options (Jan. '06) of 28%. With a very high vega of 1.06, for each 1% increase in implied vol, the convert will rise by 1.06 points, providing substantial upside potential.

The convert was issued with AMG shares at $45.70. At the current $67.29, the stock is only 17.2% below the conversion price, so the effects of the warrants are kicking in (delta shares of 1.25). The convert will participate in about 80% of a sharp upside move in the stock.

Merrill's conclusion is that for a 2% dividend increase, there is more upside from buying the low implied vol and the effects of the warrants kicking in than would be lost by a potential dividend increase.

Carnival discount CATZ due 2033

The convertible was issued with Carnival shares at $27.30, with a conversion premium of 90.6%. At the current stock price of $34.57, the premium has contracted sharply to 55.9%.

At the current price of 65.63, the convertible is trading at a 0.3 point discount to Merrill's sum-of-the-parts valuation of 65.92, calculated using a conservative vol of 25%. Thus on a conservative basis, it would appear to be at fair value.

However, Merrill notes the implied vol of the sum of the parts valuation is 24.6% compared to a long term historical vol of 36.6% and at-the-money long dated call options (Jan. '06) of 27.8%. Also, Carnival's 2% convertible due 2021 and 0% convertible due 2021 are trading at implied vols of 26.7% and 27.1%, respectively.

Despite the high apparent premium, delta (shares) of the discount CATZ of 0.9 compares favorably to the corresponding figures for the 0% convertible and 2% convertible of 1.1 and 1.2 respectively. Also, the vega of the discount CATZ of 0.63 is superior to the equivalent vegas for the 0% convertible and 2% convertible of 0.43 and 0.37 respectively.

Merrill recommends swapping into this issue from the outstanding 2% and 0% Carnival convertibles.

Mandalay floater due 2033

The convertible was issued with Mandalay stock at $27.35, with a conversion premium of 100%. At the current stock price of $39.95, the premium has contracted sharply to 50.06%.

At the current price of 104.63, the issue is trading at a 0.9-point discount to Merrill's sum-of-the-parts valuation of 105.5, calculated using a vol of 25%.

Merrill notes that the implied volatility of the sum-of-the-parts valuation is 24.1% compared to a long term historical vol of 43.9% and at-the-money long dated call options (Jan. '06) of 21.9%.

Despite the high apparent premium, the convert has a high delta (shares) of 1.39 and a vega of 0.94.

Nonetheless, Mandalay's announcement that it was commencing an annual 3% common dividend caused much pain in the convertible hedge fund universe. And with the second dividend increase by the company in three months, Merrill said that due to the uncertainty of further dividend increases, it would label this convertible fairly valued.

Valassis discount CATZ due 2033

The convertible was issued with Valassis shares at $26.67 at a conversion premium of 65%. At the current stock price of $29.5, the premium has contracted to 45.88%.

At the current price of 65.25, the convertible is trading at a 0.54-point discount to Merrill's sum-of-the-parts valuation of 65.79, calculated using a vol of 23%.

Despite the high apparent premium, it has a high delta (shares) of 1.2 and a vega of 0.63.

Merrill notes the implied vol of the sum-of-the-parts valuation is 22.1% compared to a long-term historical vol of 40%. The company does not have any call options.

However, Merrill notes that while the company does not pay a dividend it certainly has the capacity to do so. Merrill estimates that if a 2% dividend was initiated, the theoretical valuation would drop 2.3 points. For that reason, Merrill considers the convertible to be fairly valued.

Wells Fargo floater due 2033

At is current stock price of $50.90, the premium on the convertible is 91.43%, so it is considered a fixed-income instrument. Five-year credit defaults swaps for Wells Fargo are offered at Libor plus 37 bps. That credit spread gives a fixed-income valuation for the convert of 97.37, which is essentially where it is trading.

At the current price of 97.44, the convertible is at a 0.6-point discount to its theoretical value of 98.07 but that completely ignores the value of the embedded option.

Fixed income investors should consider swapping the straight debt for the convertible, which offers the following advantages over the straight paper:

* The convert is a senior note, ranking pari passu with other senior debt.

* An investor gets a free, albeit out-of-the-money, option on the stock.

* With almost five years of call protection, a buy-and-hold investor has ample time for the stock to rise and the free option to come into the money.

* The vega of 0.32 increases the value of the free option if the volatility of the underlying stock increases.

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