D.R. Horton convertibles' valuation overly rich following recent rally: B of A-Merrill analyst

By Rebecca Melvin

New York, Sept. 18 - D.R. Horton Inc.'s 2% convertibles due 2014 are trading at a 4.2% premium to their theoretical value, using a volatility assumption of 35% and a credit spread assumption of Treasuries plus 450 basis points to reach a theoretical value of 120.9, according to a research note put out by Bank of America Merrill Lynch analysts.

The D.R. Horton paper traded at 125 versus a share price of $13.30 on Friday, compared to 123.5 versus a share price of $13.00 on Thursday and 126.5 versus a stock price of $13.60 on Wednesday.

"At its current level, we are struggling to see upside in the credit and are concerned about a volatility drop should the housing fundamentals finally turn the corner," analyst Alan Yu wrote in a research note.

"While outright investors may still consider it an equity surrogate, we believe it is too risky for hedged investors to change this issue and recommend staying on the sidelines and, or closing out existing hedged positions," he said.

The D.R. Horton 2% at 126 versus a share price of $13.55 doesn't provide much yield advantage over the common stock since its 1.6% yield compared to 1.1% for the stock.

"Since its issuance in May 2009, the convertible has returned +26% versus an underlying stock return of +36%, which is also beyond expectation because the delta would suggest a lower return on the convert side," Yu wrote.

The analyst's negative view was mainly based on the risk of a decline in volatility and lack of upside for hedged investors to balance risk/reward. He expects volatility to revert to about 35% once the housing market stabilizes, which compares to almost 43% of implied volatility currently commanded by the convertible.

The analyst went on to say that the negative view is not based on fundamental credit quality. On the contrary, he was "encouraged" by the company's moves in the past to focus on generating cash from inventory reduction, to opportunistically buy back debt at a discount, and to raise additional liquidity when capital markets started to function.

"We are comfortable with D.R. Horton's ample liquidity and healthy debt maturity profile despite still very weak housing demand across the country and believe there is room for credit metrics to further improve once the housing market starts to recover."

But, he said, "I don't think it sits well for hedged guys."

Not only will an eventual vol coming in hurt, but if another homebuilder brings a convertible deal to the market, the support from outright investors will fade, the analyst said.

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