Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

Tesla (TSLA) is proposing a $1.6 billion convertible bond offering

TSLA, the electric car company whose stock has risen over 12x since its IPO in late 2012, has just announced a $1.6 billion convertible bond offering.   Proceeds will be use to build the company’s “gigafactory” plant.   The deal could be being priced as I’m writing this.

The offering will be divided into two tranches, half of the bonds repayable in 2019, the other half in 2021.  Proposed interest rates will be negligible–around those of comparable Treasury securities.  The conversion premium for each will likely be about 40%, meaning the owners will only make money by converting into TSLA common if the stock price rises above $350 a share.

Two points:

–the deal could be transformative for TSLA, giving the company a large cash infusion at an earlier than expected date

–who would buy a bond like this rather than the stock?  After all, a convertible is just that–a deferred issue of stock.  It’s like buying TSLA at $350 today in return for the promise of a 1% dividend for each of the next few years.  For an equity investor, this sounds crazy.  But there are two groups of potential eager buyers.

—-bond fund managers, who are desperate for anything that can provide a little zip to their returns.  Even a deal like this one is better than buying a straight bond.  Putting the stock issue in a bond wrapper allows bond managers to buy it without violating their mandate to invest only in fixed income.

—-convertible funds.  They, too, have a mandate.  They can only invest in convertibles.  If they don’t participate and the Tesla bonds rise sharply, they may fall behind in the performance race to their rivals who do.  And there aren’t that many new issues in any given year.  So there’s considerable pressure on these managers to take part in every convertible offering,

In any event, this is good news for current TSLA holders.   (Note:  I bought the stock at $120 and sold it at $175.  If I still held it, I’d be selling now.)

(not so) “Happy Meal” convertible bond offerings

Pinky, the more astute of the two eponymous stars of the long-running documentary on genetically engineered miceonce opined that “if they called them Sad Meals, no one would buy them.”  So true.

Wall Street “Happy Meals”

Recently, the Wall Street Journal has been writing about a convertible bond offering technique, known as the Happy Meal, which has come under SEC scrutiny.   It shows what a colorful, inventive but cold-blooded place Wall Street is.

The Happy Meal is/was an offering of convertible bonds, in which the issuer arranged at the same time to lend large amounts of company stock to buyers so that they could sell the stock short.

Got that?  …probably not.

So let’s pull the pieces apart.

1.  A company issues convertible bonds.

Convertibles are bonds with a provision that allows them be exchanged for a specified number of shares of the issuer’s common stock under certain circumstances.  Until they are converted, the buyer collects interest income.

Generally speaking, a company would rather issue common stock or straight bonds, or borrow from a bank.  The fact that the firm is issuing a convertible almost always means these other, more attractive, avenues aren’t open to it.

2.  In the case of the Happy Meal companies, the convertible form wasn’t inducement enough.

Conventional long-only buyers turned thumbs down.  Who would these buyers usually be?  …specialized convertible securities funds, or bond funds looking to boost their returns by holding equities.  They avoid violating the letter of their investment mandates by buying stocks wrapped up in a bond package.

3.  That left hedge funds willing to do convertible arbitrage.

That is  to say, the hedge funds would simultaneously buy the convertibles and sell the stock short.  Exactly what a given hedge fund would do varies.  One technique would be to sell short enough stock to eliminate entirely any effect of stock movements (up or down) on the position–leaving the hedge fund to collect a stream of interest payments.  But a fund could also shade its holding to the positive or negative side.

4.  There’s more.

To sell stock short, you typically borrow the stock from a third party who owns it, using a brokerage firm as a middleman.  In the Happy Meal case, that wasn’t possible–either because there weren’t enough holders of the stock or because holders were reluctant to lend.  So the issuing company itself lent the stock that hedge funds dumped out into the market right after the offering.

What a mess!  A company would have to be really starved for cash, in my view, to contemplate serving up a Happy Meal.

not so appetizing any more

Companies have begun to turn sour on Happy Meals.  Two reasons:

–enough Happy Meal issuers have suffered significant stock price declines after their offerings that simply announcing a Happy Meal issue is now enough to make the common stock swoon, and

–according to the WSJ, a retired investment banker has turned whistleblower and reported the Happy Meal to the SEC.

His claim? …that issuers and their brokers are negligent by failing to disclose in the offering documents  how aggressive post-issue short selling is likely to be.

A concerned citizen, yes.  But one who also stands to collect a bounty under the Dodd Frank Act if the SEC investigation leads to significant fines.  In other words, a vintage Wall Streeter.

the strange-but-true convertible issued by Priceline (PCLN)

the PLCN convertible note

I read about this the other day in the Financial Times.

On May 30th, PCLN filed an 8-K with the SEC in which it outlined the terms of a $1 billion convertible note it sold as a private placement under Rule 144a (meaning to sophisticated investors, i.e., people with at least $100 million under management).

The complete terms aren’t available, but the broad strokes are that it’s:

–a seven-year note

yielding 0.35% per year (just for reference, the seven-year Treasury note yielded 1.5% when the deal was struck and 2.2% now)

–each $1000 note convertible into 0.7608 PCLN shares.  Conversion parity (the price at which the holder doesn’t lose money by converting) is therefore $1315.  That’s  a 66% premium to PCLN’s price at the time of issue.

a sweet deal for PCLN

The company is using the proceeds, $979 million after fees, to buy back its own stock.  It will cost around $600 million for PCLN to retire the shares needed to redeem the convertible.  The rest is gravy.   That’s assuming, of course, that PCLN’s stock can rise above conversion parity at some point between, say, 2015 and 2020, depending on the exact terms of the note agreement.  If it does, PCLN will presumably call the note, forcing conversion.

The only worry for PCLN is that under unfavorable conditions it might have to pay the money back.  But it can hedge that risk if it wants.

Who would buy this thing?

The conversion premium, 66%, is about twice what I’d consider normal.

If we look at the issue in an admittedly old-fashioned way, it would take just over 188 years of collecting interest at the 0.35% rate to recover the conversion premium.

Q:  If you were that enthusiastic about PCLN, why not just buy the stock at 60% (!!) of what the convert would cost?

A:  because you can’t.

Two classes of buyers:

convertible funds, which generally can’t hold straight stocks.  Many times, the difference between winners and losers among convertible fund managers comes down to how they handle new issues.  It will likely be impossible to build a position in the aftermarket, so managers may figure the safer course is to guard against the possibility that PCLN spikes upward by participating in the issue.

bond managers, whose contracts with clients prohibit them from buying stocks.  Their thought process probably goes something like this:

As the Fed normalizes interest rates, all fixed income is going to decline in price.  The PCLN convert is a seven-year instrument so that feature won’t cause it to decline by much.  If some academic model (a wacky one, in my view) can show that the option value of the conversion feature makes the note worth $1,000 today, that should be another reason not to mark down the price.  Maybe PCLN’s rocketship ride can continue–maybe even to the point that it exceeds conversion value.  HOME RUN!!!

No matter what happens, other than a PCLN visit to Chapter 11, the PLCN convert has got to be better than a straight bond.

my take

Shows what a weird world Wall Street lives in today.

a turning point for bond funds? …stocks, too?

I’ve been noticing commercials on financial TV and radio–why I turn on the functional equivalent of the WWE, I don’t completely understand–for gold.  They tend to go like this:  NOW is the time to buy gold!!!  Why?  …because it’s 4x the price it was ten years ago.

In other words, buy because prices are very high.  That’s crazy.

Bond funds have had a similar pitch over the past few years.  Faced with near-zero, emergency low, interest rates, which imply sky-high bond prices, bond fund managers invented a marketing pitch that became known as the “new normal.”  The thrust is that we are in a post-apocalyptic world, where the earth’s economy has been scorched and will be incapable of growth anywhere on its surface for, say, a decade.  Therefore, buy bonds, avoid stocks.

Interestingly, bond funds haven’t had much trouble popularizing this view.  Bonds, like gold, have performed much better than stocks for a long time.  So bond funds have collected lots of assets and are big advertisers in the media.  And, of itself, the fact that rich and successful people would be predicting a global “lost decade” is a newsworthy story.

As I’ve noted a number of times, one characteristic of this point of view is that it’s very self-serving for bond people.  It’s the only scenario I can think o of where it doesn’t make sense to rebalance your portfolio–to take money out of the strong-performing, high-priced asset, bonds, and put it into the weaker-performing, lower-priced asset, stocks.

Cynics would say that bond managers just told investors a story that would keep them from taking money out of bonds, thus reducing the managers’ income.  They’d probably also point out the quiet diversification of Pimco, the largest bond manager, into stock funds about a year ago.  But, however implausible the idea might have been, it’s possible that bond managers actually believed it.  After all, there’s a powerful psychological tendency, that professional investors have to constantly fight, to screen out facts that call into question the way your portfolio is set up.  And after twenty-five years of almost non-stop success, it must be very hard even to conceive that things might not go your way.

Four factors are beginning to call into question the new normal/by bonds thesis:

1.  Economic growth, which has been very strong in the emerging markets (40%+ of the world), is beginning to pick up in a meaningful way in the US as well.

2.  Stocks are starting to outperfrom bonds in a meaningful way.  According to Barrons, over the past year, actively managed bond funds are up 6%+and their US stock counterparts are up 18%+ (compared with the S&P 500 being up 12%+).

3.  Individual investors have stopped putting new money into bond funds.  For some time, they have been selling municipal bond funds on concerns about credit risk.  But the most recent data suggest withdrawals are spreading to taxable bond funds as well.

It’s not clear what people are doing.  Some data sources show funds beginning to flow into equities.  Others indicate most is being parked in money market funds.

4.  Last week, the Pimco Total Return Fund, perhaps the most famous bond fund in the world (as well as the home of the “new normal”), has announced it will change its investment guidelines so it can put 10% of its money into equity-linked securities, like convertibles.  According to Bloomberg, many other bond funds have been investing in equities for a while and ar leaving Pimco behind in the dust.

my thoughts

I think these developments are bullish for stocks.

In the counterintuitive way that Wall Street thinks, it’s a little worrisome to have the last great equity bear, Pimco, capitulate.  Still, stocks appear cheap, the US is growing again, and the flow of funds data don’t yet show a great deal of investor enthusiasm for equities. It’s not to soon to start to worry that the best may be behind us for this equity cycle (after all, we are about to enter year three of bull market), but it’s way too soon to act.

On a technical note:

If history is any guide, the current active manager outperformance of the S&P 500 can’t continue.  It would explain, however, why professional equity investors appear to have closed up shop for the year a couple of weeks earlier than usual.

I haven’t looked to see what kinds of equity-linked securities bond funds are buying.  But S&P companies typically don’t issue convertibles.  So the risk exposure the funds are taking on may be somewhat different (probably higher) than what one might expect.

MSFT is issuing an unusual convertible

the issue

Yesterday, MSFT announced it was selling, in a private (not registered with the SEC) offering, $1.15 billion in senior convertible notes, due (at a time not specified in the press release) in 2013.  The offering has the following terms:

–the notes are being sold at face value

–MSFT will pay no interest

the notes are convertible into MSFT stock at a price of $33.40 per share, a 33% premium to yesterday’s close

–under normal circumstances, the conversion feature can’t be used until March 15, 2013.

why do this?

a MSFT perspective

MSFT, a company I owned for more than a decade and have followed for over 20 years, is admittedly a quirky company.  But I can’t imagine that the idea for this deal originated with the firm.

As of the most recent 10-Q, MSFT has almost $40 billion in cash on the balance sheet.  It’s generating over $15 billion annually in free cash flow.

Yes, MSFT did try to buy YHOO for about $40 billion a few years ago, but thought better of it when YHOO was subsequently offered to it on a platter at about half that price.  MSFT seems to me much more careful with its money these days, so I don’t think a big acquisition is in the cards.  But even if it were, $1.15 billion–what the company earns every three weeks–would be just a drop in the bucket.  If motivated by the idea of a large purchase, the offer should have been a lot bigger.

I think MSFT sees the deal as free money, the equivalent of picking up a $100 bill you see on the sidewalk.

the buyer

My guess is that the buyer, whose name has not yet been disclosed–and who may remain anonymous–approached MSFT.  In all likelihood, it’s a professional investor who has contracts with some clients that require it hold only  fixed income instruments for them.  The holder forgoes a relatively small amount of interest income in return for the chance at a large capital gain if MSFT stock goes up more than 10% annually for the next three years.

To state the obvious, the buyer must:

–be very bullish about MSFT’s prospects, and/or

–think stocks will do relatively well and MSFT is a comfortable proxy for the S&P as a whole, and/or

–think making money from bonds will be hard over the next few years.

For its part, MSFT continues to buy back its own stock.  It will also try to offset potential dilution from the note offering through options.

oddity or harbinger?

It’s too soon to tell.  But I think it’s something to keep an eye on, as a potential source of support for stocks in general, and for bond-like stocks in the MSFT mold in particular.

Hybrid bonds and contingent convertibles

Investment banking “practical jokes”

Every upcycle, clever investment bankers devise exotic securities that they sell to gullible portfolio managers, who come to regret their purchase decision almost immediately.  They continue to rue their bull-market impulsiveness for the many months it takes them to find (if they can) some even more gullible person to sell them to.

One of my favorite issues of this type was a wildly oversubscribed issue made by Hong Kong property company New World Development in 1993, at the height of an emerging markets mania.  It was a zero-coupon bond, convertible into shares of a China subsidiary of New World that did not yet exist, except as a name on a certificate of incorporation.

The hybrid bond

This time around, a leading candidate for purchase blunder of the cycle is the hybrid bond, a type of security issued notably by financial institutions.

What made these securities hybrid?  They had terms of 40-60 years, or sometimes were perpetual, that is, principal was never returned–just like stocks.  Also, the interest payment could be reduced or eliminated without causing a default.

What made them bonds?  A good question. That’s what they were called on the front page of the prospectuses.  This naming made them eligible to be purchased by bond fund managers.  The inducement to purchase was a relatively high yield.  The instruments ranked below all other bonds, just above equities, in the pecking order in case of bankruptcy.

If bonds were food, I think the Food and Drug Administration would have been alerted to hybrids, just like it was when Aunt Jemima was selling “blueberry waffles” that had no blueberries in them.  In fact, some tax authorities or industry regulators do classify the hybrids as equity. But a couple of years ago, this was regarded as another beauty of the hybrids, because having regulators count them as equity bolstered the issuers’ capital ratios.

Fast-forward to the present

Lloyds Banking Group  of the UK has a bunch of these hybrids on its balance sheet.  It wants to swap them for a new type of securities, which it is calling contingent convertible bonds.

The idea is that under normal circumstances the securities will be bonds, paying interest and having a bond’s liquidation preference over equity.  But if Lloyds gets into trouble (again), the securities would convert automatically into equity, losing their bankruptcy advantage and presumably their income payment as well.  The trigger for conversion would be Lloyds’ tier 1 capital ratio falling below 5%.

Yes, this is kind of like having medical insurance that terminates if you get sick.  No, it’s not a joke.  On second thought, though, this could be a little more investment banking humor. Sometimes, it’s hard to tell.

I can’t imagine contingent convertibles finding any takers in an original issue, other than at the tippy-top of the business cycle.  But Lloyds and the EU are playing hardball with the conversion offer.   Unswapped hybrids are set to cease making interest payments after the swap period ends.

The offer situation isn’t as bad as it looks at first blush, however–it’s worse. Not taking it may be very difficult to do.  Depending on their current carrying value in portfolios, post-exchange, post-interest-elimination hybrids may have to be considered as further impaired and written down.   Also, it seems to me that any remaining hybrids have got to be much less liquid than they are now.  So they may be impossible to dispose of, thereby having to remain on the lists of holdings sent to clients for some time to come.

Moral to the story?

I’m not sure there is one.  If we consider hybrids and contingent converts as two parts to one story, the combo probably rockets to the top of my list of bull market follies.  My only other thought is that this is Liar’s Poker all over again.

An update from Nov. 22nd

Here’s the link.