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Tuesday, 12 December 2017

The convertible alternative

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Recovery of the credit markets has opened up new funding sources for cash-rich technology companies. One less apparent vehicle that has surfaced in recent years is the long-dated, deeply-subordinated convertible bond. By taking advantage of structural enhancements unique to the asset class, such securities provide significant tax shield of straight debt but at a lower cash costs. Stephen Lacey reports.

To view the digital version of this report, please click here.

A strengthening global economy at the beginning of 2011 fueled expectations of consolidation among semiconductor manufacturers. Acquisitions and rationalisation of capacity seemed to be the obvious answer to high fixed operational costs and deep cyclicality inherent to the industry.

In April, Texas Instruments, agreed to acquire National Semiconductor for US$6.5bn in cash. This was quickly followed in May by Applied Materials’ proposed acquisition of Varian Semiconductor Equipment Associates for US$4.9bn. Both partially funded the purchases by selling straight debt, and in both instances the offerings were their debuts.

At the time, Novellus was viewed as both a potential acquirer and a target. Instead, the smaller rival undertook a leveraged recapitalisation by using proceeds of a US$700m, 30-year convertible bond offering to repurchase US$360.2m of stock, to the benefit of shareholders. The reaction was immediate: the issuer’s share price climbed 6.5% to US$32.92 over the one-day marketing period in May.

The ability to repurchase a large amount of stock – almost 15% of outstanding – at a fixed price was only part of the appeal for Novellus.

“The benefit of the [contingent convertible] is that the issuer pays a low cash coupon, but gets to deduct at its straight debt rate for tax purposes,” explained Jeff Zajkowksi, head of equity-linked capital markets at JP Morgan. “The combination of safe, flexible long-term capital, coupled with a relatively attractive interest tax shield, makes the security an interesting source of funds for a number of companies.”

In other words, the issuer pays investors at a lower, stated coupon on the CB, but deducts interest expense as if it had sold 30-year, subordinated debt. Depending upon the performance of the underlying, the issuer may be on the hook for the tax savings upon maturity or conversion, which can put-off some companies due to the long-dated nature of the security.

JP Morgan and Bank of America Merrill Lynch underwrote the Novellus CB, which priced at a 2.625% coupon and 20% premium to the underlying share price at the time, versus talk of 2.5%–3% and 15%–20%.

“The issuer does need to be aware of potential for tax recapture,” said Zajkowksi. “What we’ve tried to do to help issuers manage contingency is to provide a long window where they can force conversion, when the stock price is up to manage risk of tax recapture.”

The inclusion of contingent payment allows for deductibility at the ordinary straight-debt costs. For example, Novellus’ CB is a 30-year senior convertible that cannot be put for life and features 10 years of call protection. After that period the company can call the CB if the underlying trades at a 150% premium to the conversion price. Alternatively, instead of calling the CB, the company can make a contingent payment to investors at or above certain prices as an incentive not to convert, as well as below certain prices.

The fact that the economic payout is uncertain allows for straight-debt deductibility. In the case of Novellus, the company pays out interest at a rate of 2.625% but is allowed to deduct at 8%-9%. The level of the straight-debt deduction is capped at the average federal financing rate plus 500bp, and is based upon credit analysis conducted by the lead underwriter – one of the benefits of the CB alternative is that it does not need to be rated.

When combined with net-share settlement, which limits dilution consideration to levels above the conversion price, the tax deductibility enhancement can be a powerful financing solution. Novellus, for example, repurchased 13.2m shares, almost 15% of outstanding, under a US$1bn program. This is consistent with the company’s policy of buying back stock in prior cycles – in 2007 and early 2008, it bought back 27.5m shares.

Intel was the first to issue a long-dated, subordinated CB structured with contingent conversion in 2005, and returned with a similarly structured security in 2009. Xilinx, Verisign and Microchip Technology issued securities in 2007; Vishay Intertechnology in 2010; and Vishay and Novellus in 2011. All of the offerings are part of liability management.

One rub, say some detractors of the product, is the long-dated nature of the security and the large, potential tax liability created. The assumption is that appreciation of the underlying – say, for example, Intel’s stock returns 5% annually – would offset that differential, but that is not a given. If those returns are not met, the tax liability created likely would be inherited by a different management than the one whom issued the security.

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