Capital Markets

Steep Climb for Convertibles

Convertible bonds can keep lifting Internet companies only if their businesses don't stumble.
Hilary RosenbergDecember 1, 2000

Last February, E-Trade Group, the online securities trading company, made a bold move into the markets. The Menlo Park, California, company, which had gone public four years earlier, charged into a seemingly crowded convertible bond market to raise $500 million. “It was a very tough market,” recalls CFO Len Purkis. “We wanted to get our name out there in another investment class and to get that BB+ investment rating.”

Pleasantly surprised by the strong demand for its bonds, the company sold $650 million worth. To Purkis, this success “raised the barrier to entry in this space,” as the convertible bond market has become much tougher since then. After paying down $145 million in short-term debt, the company is using the rest of its winnings to finance its expansion.

E-Trade was one of 34 convertible bond issues by Internet-related companies over the past two years raising more than $13 billion. These securities appear to be well suited to such businesses, because they offer a way to issue stock for the price of a relatively low interest rate and a good deal of flexibility in terms. Even though most of the issuers’ stocks are now in the dumps, delaying conversion of the bonds into stock and the resulting reduction in interest costs, the issuers are paying rates that are generally 400 to 700 basis points lower than those of straight bonds. What’s more, most have several years to go before the bonds mature, giving the stocks lots of time to recover.

On the other hand, there’s always the risk that they won’t–at least for a long time–forcing the companies to pay more interest than they had anticipated. In issuing convertibles, “you’re betting on your common stock,” says Ravi Suria, a convertible securities analyst at Lehman Brothers. “If the stocks had gone up [since issuance], the bonds would have been converted by now.” It’s no secret that investors have turned skeptical about dot-com business models. That increases the risk that a convertible issuer’s debt load will prove too heavy.

Take Corp., a Sunnyvale, California, builder and operator of Web stores for businesses. In November, it issued $55 million in convertible bonds, and by the end of this past summer the Nasdaq
National Market had warned the company that it no longer met the standard for net tangible assets and could soon be delisted. Fortunately, in September, the company managed to accomplish an exchange offer that reduced the principal on its 2003 convertible bonds by $21 million and gave it the option of paying interest in stock. In the exchange, bondholders received securities with a higher interest rate (a whopping 10.88 percent versus 7.25 percent) and a lower conversion price ($2.88 versus the previous $18.34). Recently, the stock was trading well below $1.

Or consider Inc. Suria, for one, has been particularly dubious about the company’s credit quality after it issued two 10-year convertible bonds for a total of nearly $1.9 billion, as well as $264 million worth of high-yield bonds.

Crunch Time?

As of the end of the second quarter, notes Suria, Amazon’s coverage ratio–EBITDA/interest–was minus 12.1. As he wrote in his June report, “If a company with weak operating cash flow was only equity financed, then it would be a lot easier to survive, as there would be no fixed interest charges and a bullet payment at maturity.” Fortunately, the bullet payments are a long-term proposition, with the high- yield debt maturing in 2008 and the convertible issues in 2009 and 2010. In his view, however, the company’s cash, although it was a hefty $908 million at the end of June, will hold out only through the first quarter of 2001.

So far, however, convertibles appear to be ideal for fast-growing, immature Internet companies that are constantly hungry for capital. Companies that have already sold stock have three options for getting new financing: sell more stock, which would dilute the outstanding shares; issue debt, which because of these companies’ unproven track records would have to be very high-rate junk bonds; or settle on a compromise–convertible bonds.

In issuing convertibles, companies can effectively sell stock at a premium. They do this by offering investors a debt security that delivers interest payments and the security of principal repayment. The company can raise more funds than it would by selling its stock at current prices because the bonds are convertible to stock at a premium of 20 percent to 30 percent of the current stock price. For instance, last March, when Redback Networks Inc.’s stock was trading at around $155 (it’s now trading at $99), the firm, in Sunnyvale, which manages Internet traffic, issued $500 million of 5 percent convertible subordinated notes, due 2007, convertible at a rate of 5.243 shares per $1,000 once the stock reaches $190. In other words, once the stock hits that conversion price, the company could theoretically have 2.6 million new shares. If instead the company had issued those shares at the time of the convertible offering, it would have raised only $403 million.

Although there is a price to be paid in the form of interest payments, those payments are relatively light, at 5 percent to 7 percent. Convertibles are also a much quicker sale than a secondary offering because they are usually limited to institutions. That means they aren’t subject to the months-long Securities and Exchange Commission review that secondary offerings often undergo. Furthermore, unlike straight bonds, convertibles are free of operating covenants that are meant to protect investors but can push an issuer into technical default.

Home Runs

Probably the two most successful Internet convertible issues have been Exodus Communications Inc. and America Online Inc. “AOL is truly a growth credit,” says Suria. “It has the cash flow, and it will not have a problem raising capital.” What’s more, AOL is awaiting regulatory approval on its plan to acquire Time Warner, which would automatically convert the bonds to stock.

In March 1999, Exodus, a Web-hosting company based in Santa Clara, California, issued $250 million of 5 percent convertibles due in 2006 with a split-adjusted conversion price of $1.42. Then, in December 1999, it issued $500 million of 4.75 percent convertibles due in 2008 with a split-adjusted conversion price of $35.20. Until recently, the stock traded well above the conversion price, so much of the first issue converted.

Only $72 million of the first issue remains outstanding, and if the stock recovers from its recent decline to $26, the rest would probably convert shortly after the March 2001 call date. (Most convertibles are callable within three years, and then can be redeemed by the company, either for cash to retire the debt or, if the stock is above its conversion price, common stock.) With a 25 percent conversion premium on the first issue, the company issued 25 percent less stock for the same amount of capital and paid 5 percent for two years. So, “it’s 15 percent ahead,” says Nick Calamos, managing director of research and portfolio management at Calamos Asset Management Inc., in Naperville, Illinois. “That’s a home run.”

Or consider SportsLine USA (now called Inc.), one of the early convertible bond issuers. An Internet sports-media content provider based in Fort Lauderdale, the company had ambitious plans. After seeing the positive response to the Amazon issue in February and global media company CNET Networks’s issue as it was being marketed also in February, says CFO Kenneth Sanders, “our board felt it was cheap financing, and believed that our stock would continue to appreciate.”

Right away, Sanders began talking to bankers at Robertson Stephens Inc., who were able to bring an issue by March 19, a $150 million, 5 percent note due in 2006. At the time, the stock was trading at 521/8, and the 25 percent premium put the conversion price at 651/8.

That summer of 1999, however, SportsLine’s share price was hurt by the general malaise of Internet stocks, dropping into the 20s by August, and the convertibles dipped below 60 cents on the dollar. Because SportsLine had plenty of cash–a total of more than $250 million from the convertibles issue and from cash already on the balance sheet–it suddenly faced an opportunity to buy back bonds and book a profit on the transaction. “We called a special board meeting about going into the open market” to buy bonds, recounts Sanders. “Even though it was only a few months, we thought it was a good thing to do for the equity holders.”

First, in August, the company bought $60 million worth of bonds for $36.4 million, or 60 cents on the dollar, in the open market (convertible rules allow the acquisition of up to 40 percent without a tender offer). Then, in October, the company made a formal tender offer to buy bonds at 76 cents on the dollar, and ended up buying $70.3 million worth, spending $53.7 million. The upshot: The company sold bonds for $150 million, kept $20 million worth, and bought the rest back for $90.1 million. Hence, it got to keep $39.9 million–or $36 million after amortized issuance costs, which it booked as an extraordinary gain in income. The company also saved a bundle in interest expense. For the year 1999, SportsLine paid $4.4 million in interest compared with just $118,000 for 1998.

“We got free cost of capital of $36 million,” says Sanders. “A great result from something that wasn’t planned.” Today, the company has more than $140 million in cash. Of course, Sanders concedes, “It’s going to be difficult, if not impossible, to go back to the convertible market anytime soon, given what we did.” Fortunately, SportsLine has had other avenues for fund-raising.

Hoping for the Best

Like Sports-Line, most Internet issuers have seen their stocks–and their convertibles–fall precipitously. As of October 31, the average Internet convertible was off 33.1 percent and the median issue was down 34.3 percent, says Calamos.

Of course, unlike SportsLine, most Internet issuers do not have the wherewithal to buy back their bonds: They need the cash to finance their business plans. They just have to hope that Internet stocks liven up before too long. In the meantime, for companies that are still not making any money, the interest payments add up to big costs. For example, Redback Networks is paying $30 million in interest annually, and E-Trade is paying $39 million.

To get the debt off the balance sheet as quickly as possible, some convertible issuers have included clauses that take advantage of Internet stock volatility. Online bank NetBank Inc. and Internet messaging company Inc. are among those that have a “make whole” clause in their terms that gives them the flexibility to wipe away the debt if the stock spikes up, while offering some protection to bondholders. The clause allows issuers to call the bonds and convert before the official call date if the stock holds at 140 percent to 150 percent of the conversion price for 20 trading days in a period of 30 consecutive trading days. In that case, the company would compensate bondholders for their loss of interest with payment of the present value of future interest. “It makes the sale a lot easier,” says Lehman’s Suria. So far, however, of those issuers that have included the clause none has been able to use it. And if volatility gives way to a sustained slump, they may never get the opportunity.

Indeed, it’s quite possible these stocks will not recover, making the interest and even principal payments burdensome, if not unbearable. Suria is sticking by the negative reports he issued last June on E-tailers eToys Inc. and EarthWeb Inc., as well as Beyond and Amazon, maintaining that they still have the negative operating cash flows, working capital deficiencies, and steep leverage that concerned him then.

If distressed, they would have a last resort: reduce the conversion price below the market price by just increasing the number of shares into which each $1,000 worth of bonds can convert. However, this strategy sharply dilutes the value of current equity holdings.

Since last March, moreover, the convertible bond market has been effectively closed to many Internet companies. In June, two issues–from Akamai Technologies Inc. and Allied Riser Communications Inc.–came to market. But analysts and investors say these could be aimed only at hedge funds, which can use the convertibles to short the stock. 

Hilary Rosenberg is a freelance writer based in New York.

Bad and Worse

The six best and worst performing convertible bonds this year (to October 31).
Source: Lehman Brothers

Company Coupon Maturity End price of convert. % loss on convert. End price of stock % loss on stock
NetBank 4.75 6/1/04 $74.50 -5.2% $8.69 -53.0%
America Online 0.00 12/6/19 $50.75 -10.2% $50.43 -33.1%
Critical Path 5.75 4/1/05 $80.13 -19.7% $48.56 -42.9%
E-Trade Group 6.00 2/1/07 $83.88 -20.1% $14.56 -33.8%
Exodus Communications 4.75 7/15/08 $107.63 -22.1% $33.56 -24.4%
Ameritrade 5.75 8/1/04 $65.13 -22.5% $14.63 -32.6%
USinternetworking 7.00 11/1/04 $38.75 -86.7% $2.31 -95.0%
Rhythms Netconnections 6.75 3/3/12 $15.63 -84.3% $2.19 -93.9%
DoubleClick 4.75 3/15/06 $67.88 -78.1% $16.25 -87.2%
Ventro 6.00 4/1/07 $21.50 -71.7% $4.81  -91.5% 5.25 2/1/05 $30.25 -69.8% $3.25 -79.8%
Internet Capital Group 5.50 12/21/04 $48.25 -66.9% $13.25  -92.2%

Up the River

Can Amazon afford the interest payments on its convertible bonds? Not unless its cash flow or stock price improves, or it finds alternative financing.

The company issued one bond in January 1999 for $1.25 billion at 4.75 percent and another last February for 690 million euros at 6.75 percent. For the first issue, the conversion price was set at $78 when the stock was trading at around $60. By the time of the second issue, Amazon’s stock was trading at around $76. The euro bonds have a higher conversion premium–about 36 percent, which puts the conversion price at 104.9 euros (about $102 at the time). This includes a higher rate and a reset feature. On the first two anniversaries of the pricing date, if the stock is below the issue price, the company must reset the conversion price down–to a minimum of 84.9 euros ($72.40 as of October 30)–keeping the conversion within reach for investors.

“Amazon said, pay us a high premium and, in return, if the stock doesn’t do well, we’ll reset the price,” says one investor who asked not to be identified.

But even if Amazon resets the price, conversion is so far away at the stock’s current price of $33 that it could face interest payments for much longer than it originally anticipated. So if the company’s prospects don’t improve soon, which requires a very merry Christmas season, Amazon may have to seek alternative financing from private investors, or face a default on the bonds. At that point, its only choice would be to take drastic measures and increase the number of shares available for conversion. That would wipe out the debt, staving off bankruptcy, but hugely dilute shareholder value. —H.R.