Convertible Bonds and the Bull Market

Of course, it's not certain that 100% of the bonds will be converted this year, and it's possible that these numbers overstate the impact of the dilution to earnings. That's why Haushalter devised a methodology to adjust profits based on the level of dilution that he really expects this year. In estimating this dilution, he looks at market conditions, interest rates and the specific terms of the bonds.

On the basis of these data, he found that earnings at Watson and Interpublic still could be reduced by 6%. Lucent(LU), which has also exceeded its contingent requirement, could see earnings shaved by 4% this year, although the company said its guidance reflects the possible dilution. Yet the dilution to Yahoo!, Manor Care, Cendant and Carnival would be 1% or less.

Another stock at risk of earnings dilution this year is General Motors(GM). Goldman Sachs analyst Gary Lapidus downgraded the stock recently, saying that potential dilution from convertible debt, with a trigger price of $57.14, could limit upside at the firm.

If all of GM's CoCo debt were converted into stock this year, Haushalter said, earnings could be reduced by 11.5%. Based on the expected level of conversion, however, the company's earnings are likely to be cut by just 1.4%, according to the study. Still, General Motors isn't in danger of hitting its contingency requirement just yet since it was last trading for $48.88.

Omnicom(OMC), Health Management Associates(HMA) and Mercury Interactive(MERQ) also have some breathing room, which is fortunate, given that these companies could see earnings reduced by 9% or more if the full amount of their CoCos were exercised.

The trigger prices for Omnicom, Health Management and Mercury stand at $123.60, $35.81 and $56.86, respectively. Omincom is currently trading at $83.10, while Health Management is sitting at $23.59 and Mercury sells for $47.61.

In all, Haushalter examined 58 companies in the S&P 500 whose contingent convertible bonds have not yet been included in diluted EPS. "The dilutive effect of including these bonds in the calculation of EPS can be substantial," he said.

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