Hybrid securities such as convertible bonds, which allow investors to exchange the bond for a pre-determined amount of stock, offer investors elements of both equity and fixed-income investments. As a result, they also present particular investment challenges. Here is a case study, originally presented at Stock Market Beat, on one such hybrid security.
Finisar’s (FNSR) announcement that it was exchanging some of its convertible notes for contingent convertible notes generated some interest in our case study on contingent converts. Given the interest, we figured we would reward it with a study of the specific Finisar transaction. We’ll start with the company’s spin:
Overall, the exchange provides the Company with more flexibility to utilize its cash flow from operations between now and 2010, while also minimizing dilution to shareholders.
If you think this sounds too good to be true, you would be correct. Let’s start by looking a little more closely:
The New Notes contain provisions known as net share settlement which require that, upon conversion of the New Notes, Finisar will pay holders in cash for up to the principal amount of the converted New Notes. Any amounts in excess of this cash amount will be settled in shares of Finisar common stock.
What this means is that the old notes were convertible into stock (270 shares per $1,000 of bond principal) or the company could settle in cash if it preferred. The new notes, by contrast, require the company to settle the first $1,000 of each bond’s ending value in cash rather than shares. This does not provide the company “more flexibility to utilize its cash flow.” In fact, just the opposite. So we can surmise that some cash flow covenants were restricted “between now and 2010? to give the company more flexibility in the short term. Specifically:
The New Notes do not contain the put option provisions of the Outstanding Notes which provide the holders of those notes the one-time option to require the Company to repurchase the Outstanding Notes on October 15, 2007.
So instead of being required to repurchase the notes next year, they get a reprieve until the notes expire in 2010.
Now let’s tackle the dilution aspect. The company tells us:
The New Notes also are convertible into 35 more shares of Finisar common stock per $1,000 principal amount than the Outstanding Notes.
Hmm. Instead of 270 shares, the bondholders can get 305 shares worth of value for their bonds. That doesn’t exactly sound like “minimizing dilution to shareholders” to us. What they really mean is that, because the principal will be settled in cash, the reported diluted share count will be lower. This is just accounting sleight-of-hand. The economic reality is that bondholders are getting more value for their money, and this value will come directly out of shareholder’s pockets.
What Finisar has done is this:
- They agreed to settle the first $1,000 of each bond’s value in cash in exchange for being able to reduce the reported (not the economic) dilution to shareholders.
- They sweetened the notes by making them convertible into 35 additional shares (a $125 value per bond.)
- In exchange, bondholders have to wait until 2010 to cash in the bonds instead of having the option to do so next year.
Who do you think got the better end of this deal?