Convertible Bonds and the Bull Market

The overhang from contingency convertibles can go undetected.
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One threat to corporate earnings this year comes from a most unlikely place: contingent convertible bonds.

A host of companies, from

Interpublic Group

(IPG) - Get Report

to

Watson Pharmaceuticals

(WPI)

, could see earnings reduced by a significant amount this year, thanks to the dilutive effects of these so-called CoCos.

Contingent convertible bonds are similar to ordinary convertible bonds in that they have a strike price at which the investor can convert the bond into stock. The difference, however, is that CoCos can't be converted into stock until a contingency requirement is met. Some companies, for example, might require the stock to trade at 110% of the conversion price for 20 out of 30 trading days.

CoCo issuers are not required by the Financial Accounting Standards Board to include any of the dilutive impact from these bonds in the calculation of earnings per share until the contingency requirement is met, according to David Haushalter, a forensic accounting analyst at Susquehanna Financial Group. But with the stock market showing signs of life over the past year, an increasing number of these requirements are being met or are close to being attained.

Companies such as Interpublic,

Cendant

(CD)

,

Yahoo!

(YHOO)

and

Carnival

(CCL) - Get Report

have already exceeded their contingent conversion prices, while Watson and

Manor Care

(HCR) - Get Report

are close to hitting their thresholds, Haushalter found in a recent study.

If these firms' CoCos were to be exercised, Watson would see earnings fall by more than 9% this year, while Interpublic would see earnings shaved by over 6%, Haushalter noted. Cendant would see a 3.5% reduction in profits, while earnings at Yahoo!, Manor Care and Carnival would be cut by more than 2.5%.

These numbers were derived by assuming that 100% of the convertibles are exchanged for stock and by adding after-tax interest payments from the bonds to the firm's earnings.

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) - Get Report

. 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) - Get Report

,

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.