It may not be healthy for kids to gorge themselves on McDonald's Happy Meals, but corporate America is certainly indulging.
The corporate "happy meal" has nothing to do with burgers, fries or movie-themed toys. Rather, companies are financing share repurchases via the convertibles market in sets of transactions nicknamed "happy meals." These deals provide companies with an efficient, low-cost way to buy back their stock without disrupting the market or dipping into their cash reserves. The only red flag may be the amount of debt some companies are taking on.
"Convertible bond transactions provide low cash/cost financing and the opportunity for issuers to buy back a significant amount of stock quickly," says Rizvan Dhalla, executive director in convertibles at Morgan Stanley.
Here's how the "happy meal" works: Companies raise money by selling a convertible bond to hedge funds, who then take a short position in the stock to hedge the risk of the conversion option embedded in the convertible security. Convertibles are hybrid instruments that act like debt and pay a coupon and guarantee principal, but may be converted into equity at the investor's option and under certain conditions. The short position protects the investor if the price of the stock declines. A fall in the issuer's stock price also drives down the value of the convertible and its embedded option.
The issuer then uses the proceeds of the sale of the convert to buy all the stock those hedge funds are selling. The investors get their short positions, while the company buys back a large chunk of its stock at market prices, and everyone's happy.
As a result, this deal structure "has become incredibly popular," says Derek Dillon, head of convertible capital markets at Banc of America Securities.
kicked off the craze in February when the California-based biotech company sold $5 billion in convertible bonds while simultaneously buying back $3 billion of stock from short-sellers.
From an issuer's perspective, the happy meal provides the best of all worlds. Companies buy back large positions in their stock, and they do so at a lower price than they would if they had gone out into the open market. The company also usually enters into a flurry of derivatives transactions that ultimately provide a tax benefit as well.
Typically, a company's underlying stock takes a big hit on completion of a convertible deal for two reasons. The hedge funds buying the security usually drive down the stock price because they are in the open market selling the stock short to establish their hedges. Also, stock market investors generally don't appreciate the dilutive effect of a convertible on the company's earnings per share. The happy meal removes both that selling pressure and the dilutive impact of the convert. By buying stock back all at once, the issuer lowers its cost of buying back shares. A company like Amgen can't just go into the market and buy $3 billion worth of stock at once, at one price, in one transaction. That kind of purchase would typically have to be done in pieces, which would usually drive up the share price.
Several companies have followed Amgen's lead, particularly in the last month, including
$2.5 billion offering,
$2 billion two-part offering,
Charles River Labs'
$300 million offering,
Advanced Medical Optics'
$450 million deal and
Equity Office Properties Trust's
( EOP) $1.3 billion offering. These companies' share prices did not fluctuate dramatically on the heels of the convertible deals.
Given the recent selloff, which resumed Tuesday, conditions are ripe for the surge in convertible issuance. It is beneficial for companies to sell convertibles when their stock prices are low, so the chances for actual conversion are slim. When the value of a convertible issuer's underlying stock crosses over the conversion trigger, investors may turn their securities into shares and dilute the issuers' pool of stock outstanding. Companies are able to structure the convertible to settle up with investors in a combination of stock and cash, which also helps minimize the impact of this dilution upon conversion.
In addition, some hedge funds are devoting more resources to convertible arbitrage since the investing strategy has proven its merits. According to Merrill Lynch, convertible arbitrage hedge funds have returned 4.44% year to date. This is rather solid compared with the 0.10% for equity long/short and the 1.36% for global equity long/short strategies.
"Volatility is up, and convertible funds are doing well, so demand for new issues is strong," says Dhalla. Convertibles perform well when volatility increases because investors capitalize on the differing rates of price movement of the issuer's convertible security and the underlying stock. A flat market is the worst possible environment for a convertible arbitrageur.
Thus far, 18 offerings amounting to $8.5 billion of new convertible deals priced in June, according to Morgan Stanley's ConvertBond.com. June is now the biggest month for new convertible deals since May 2003, when the seller's market for convertible bonds was peaking and 48 deals amounting to $15.1 billion priced. Year to date, the convertibles market has absorbed 63 deals amounting to $32.9 billion, more than double the $14.6 billion of activity by this time last year. In 2005, the market saw a total of 113 convertible deals amounting to $39.2 billion. In May, $5.8 billion over 13 deals was completed.
The danger here is that some of these companies are adding significant amounts of leverage to their balance sheets in order to buy back their stock. As companies come under pressure from shareholders to engage in such stockholder-friendly activities, the potential to tip the scales of too much debt may be a problem for some. For now, credit is still accessible and relatively cheap, but if the cycle accelerates and the
default rate picks up, these companies will be left standing with a lot more debt to service.
Symantec, for example, quadrupled its total debt levels with its happy meal. The company had only $62 million of total debt prior to its $2 billion convertible deal. Nabors nearly tripled its total debt, bringing its total debt to $3.8 billion. Thus far, however, the new debt has been nothing but special sauce heaped atop the meaty cash balances of most companies doing stock buybacks.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
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