Steep Climb for Convertibles

Convertible bonds can keep lifting Internet companies only if their businesses don't stumble.

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.


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