Dilution risk from contingent conversion triggers on convertibles rising: Lehman analyst

By Ronda Fears

Nashville, Jan. 30 - With a healthy pickup in the equity markets recently, Lehman Brothers convertible analysts revisited the dilution risk on convertibles with contingent conversion (CoCo) features, particularly in the event of an earnings surprise, noting in a report Friday that there is a higher probability of those triggers being hit.

The research team, headed by Venu Krishna, first looked at the matter in mid-September.

"Gains in stock prices suggest that stocks are closer to their CoCo trigger levels, making it important for investors to track the issue of potential dilution," Krishna said.

"Also, the CoCo feature is now fairly standard and most new issues that came into the market after our earlier report have this feature. One may recall that two companies in our 'high risk' category were in the news recently concerning CoCo-related earnings dilution - Brinker International and Mercury Interactive."

Using a combination of risk characteristics, the analysts identified high-risk common stocks and convertibles as those susceptible to a valuation decline driven by a potential equity market surprise vis-à-vis contingent features.

In the high-risk category, the latest analysis identified 25 stocks, versus 16 in September. These stocks have relatively high volatility and dilution potential, in addition to being reasonably close to the contingent conversion trigger levels.

The analysts identified 41 CoCo convertibles as being susceptible to a valuation decline should a "surprise" factor materialize, up from 29 in September. These converts have relatively high deltas and stock dilution potential, in addition to the underlying stocks being reasonably close to the CoCo trigger levels.

Assuming a surprise factor, the analysts stressed, it is important for investors to recognize that the earnings impact of a CoCo feature will not be triggered until the stock level is hit and it will not always be dilutive, and even if it is dilutive, it only kicks in when the probability of the CoCo trigger being hit is high.

Lehman defines high-risk CoCo convertibles as ones that are susceptible to a valuation decline largely due to a potential decline in their underlying stocks, driven by a "negative surprise" on account of earnings dilution. The top 10 on the high-risk list were the following:

AirTran Holdings' 7% convertibles, AmeriCredit ACF's 1.75% convertibles, Advanced Med Optics' 3.5% convertibles, Axcan Pharma's 4.25% convertibles, Beverly Enterprises' 2.75% convertibles, Cable Design Tech's 4% converts, Countrywide Credit's 1% converts, Electronics for Imaging's 1.5% issue, FEI Co.'s 0% convertibles and Navigant International's 4.88% converts.

The analysts also overlapped the two subsets of high-risk stocks and high-risk CoCo converts to isolate a set of convertibles that contain relatively high volatility, relatively high delta, relatively high earnings dilution risk and stocks trading close to CoCo trigger thresholds.

For these converts, the analysts said arbitrage investors should consider increasing their stock hedge relative to their long convert positions to account for the estimated stock impact due to earnings dilution.

The top 10 on the overlap list were the same top 10 in the high-risk list. Others were the following:

Integra LifeSciences' 2.5% convertible, Invitrogen Corp.'s 2% issue, Juniper Networks' 0% converts, Lennox's 6.3% issue, Mercury Interactive's 0% convertibles, New Century Financial's 3.5% issue, NII Holdings' 3.5% issue, Providian Financial's 4% convertibles, QLT Inc.'s 3% converts and Serologicals Corp.'s 4.8% issue.

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