Steep Climb for Convertibles

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

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.”

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