Randomly Noted

In my travels around Asia the past couple of weeks, I’ve been meeting with various banks and investors to learn more about the FX market in connection with our big initiative there. Stopped in to see a decent sized U.S. hedge fund and was fascinated by the investment strategy.

Among other tings, these folks invest in convertible bonds issued in local currencies in home countries. They end up with three factors that can affect returns: credit exposure, changes in interest rates and changes in currency values. The manager relayed an interesting anecdote that explained the benefit of such a strategy: the bond and underlying stock hadn’t moved much in price but the currency had to the point it allowed him to convert the bonds into stock and then sell the stock, convert the currency to dollars and make a handsome return. In other words, currency fluctuations in transactions like this can help take an out-of-the-money convertible and all of a sudden bring it in the money.

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After the market closed on Sept. 16 (this past Wednesday), Eastman Kodak Co. announced a plan to refinance $575 million of its 3 3/8% convertible notes through two separate private placements. Good news for the holders of these bonds because they would get paid par, or the full $1,000 for each bond they held. But somebody may have known something about this deal before others.

The plan to retire these bonds would be especially good news for holders because these bonds were what are called broken convertibles. Convertible bonds do just what the name sounds like – they convert into a company’s common stock at some point in the future if the holder elects to do so. They become broken when the conversion price is significantly higher than the common stock price, making it very unlikely to convert. So, the bonds then trade more like a bond rather than the equity.

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Once upon a time when people talked about Kohlberg Kravis Roberts, you thought of takeovers – some hostile and some friendly. The business has certainly changed and even more so by the credit crisis over the past year. Today, KKR essentially played the role of lender, if not of last resort, pretty close to it.

KKR agreed to loan Kodak up to $400 milli0n and along with the between 10% and 10.5% annual interest KKR receives for 8 years, it gets warrants to purchase up to nearly 20% of Kodak. This deal shows how difficult times have become for Kodak. Not only is it paying a higher interest rate on the loan, but it looks like it is a pay-in-kind loan – meaning Kodak doesn’t pay KKR cash interest but instead, new securities. So, the principal it owes when these bonds come due will balloon. Payment on these bonds become tomorrow’s headache, not today’s.

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Hospitality Properties (HPT) Stock Performance

It hasn’t been easy in the hotel business these days. Business travel is down sharply. So is leisure travel. Not a great recipe for highly leveraged companies. One, Extended Stay, fell into bankruptcy court this week because of a suffocating debt load. Another, which has more flexibility and has been prudently trying to manage its debt, is Hospitality Properties and it hopes to sell stock and use the proceeds to pay down debt. Shareholders of the REIT may not like the dilution the new offering of 15 million shares will cause (the REIT has 94 million shares outstanding).

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As the above chart shows, shares of Rio Tinto have been on a tear since it confirmed in early February a complex deal that would have raised cash to help it pay down a suffocating debt load. But that deal was at a cost some couldn’t take – a Chinese controlled miner would have significantly increased its equity stake in Rio Tinto and through a series of joint ventures, would have had a more direct stake in some iron ore projects, something many in Australia felt could be a national security issue by letting another country dominate a commodity market. So, Rio Tinto called off the deal with Chinalco yesterday and announced instead a $15.2 billion rights offering and a big joint venture with competitor BHP Billiton.

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It looks like they took down the “Gone Fishing” sign that had been taped to the front door of the Wall Street corporate finance factory ever since the credit crisis started.  Deutsche Bank becomes the latest bank to have successfully executed a very complex corporate finance transaction that will raise almost $700 million for Cephalon Inc. through an equity-like offering that minimizes dilution to current shareholders. And it is a transaction that is yet another signal that risk and risk taking is working its way back into the markets. The deal mixes a traditional stock and convertible debt offering with hedging contracts and warrants that lowers Cephalon’s cost of capital through tax breaks and at the same time, provides an opportunity for Deutsche Bank to profit handsomely. Here’s roughly how this head-spinner works:

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I look at this as another sign that investors are creeping back into the risk game. Not that these securities are necessarily risky – it’s just that you couldn’t sell even the most plain vanilla securities a few months ago. And now here we are with a synthetic convertible bond. FPL Group said today it will sell $350 million of units that combine equity and debt but not in the traditional way a convertible bond does. It is an offering that allows the company to sell both equity and debt – convertibles typically start out as debt and “convert” into equity in the future; the bond in essence is one big equity call option. Continue reading…

A Brutal 1Q Earnings Report

It shouldn’t be a surprise that a company so tied to commodity prices and which sells its products to some of the more troubled industries would report a loss in the first quarter. It’s the sheer size of the declines at Alcoa, though, that are a little startling. Sales in the first quarter were off 27% from the fourth quarter. That’s a stunning sequential drop. Sales for this quarter were off 36% versus the year-ago first quarter. Thus, a loss of $480 million in the first quarter of this year. Alcoa sells its products to the automotive, transportation, building and construction and aerospace industries. That’s a Who’s Who of industries that have gotten whacked hard by the recession.

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One area of the bond market that has been tremendously underwater is the convertible market. That’s because many of these hybrid securities are “broken,” meaning that because the stock market has fallen so much in recent months, there is little to no chance anytime soon for these securities to be converted into equity. But there has been keen demand recently for new issues, including an offering today from Alcoa.

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You wouldn’t know that investors remain risk averse. Johnson Controls today came to market with what on the face of it looks to be two very risky securities offerings. Yet they were so successful that the company was able to raise much more money than originally planned.

Here is a company that has close to 50% of its sales tied to the extremely sick auto industry. It’s sales in the 1Q fell 23%. In its 1Q conference call, it used this kind of language to describe the state of things: “Our industries remain volatile.” “Uncertainties remain.” “Will not be reinstating guidance at this time.” So why the successful offerings in a still tight capital markets?

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