New accounting rule for CoCo convertibles adopted; exchanges anticipated; calendar now seen mounting

By Ronda Fears

Nashville, Sept. 30 - The Emerging Issues Task Force of the Financial Accounting Standards Board in what was described by a convertible market source as a "quick and painful" move on Thursday adopted a new accounting rule to require issuers of convertibles with contingent conversion features to estimate potential dilution when they report earnings per share, as if converted.

"CoCo is dead," as a result, the capital markets source lamented. "Now we'll start getting creative."

The rule, which is to be implemented by Dec. 15, also was expanded to include CoCo convertible preferreds although there are only an estimated dozen or so of those issues in circulation.

CoCo bonds, however, account for nearly half of the convertibles universe so the rule will have a profound affect on the market. Analysts estimated in early July when the task force proposed the new rule that there were 331 CoCo convertibles outstanding with a face value of $113 billion, compared with a total market value of an estimated $284.5 billion.

Exchanges to avoid dilution

In order to avoid the appearance of the dilutive effect to earnings per share that would result from the new accounting method for CoCo convertibles, market sources said a deluge of exchanges for those issues is likely.

Under the new rule, issuers will have to count the shares underlying the convertibles when calculating diluted earnings per share, whether the conversion threshold has been reached or not.

That could be weighty for some of the biggest convertible issuers, like General Motors Corp. and SLM Corp., or Sallie Mae. GM, which has $8 billion of CoCo converts outstanding, has already said it would address the issue by paying off its convertibles in cash. Sallie Mae, which has a $2 billion convertible floater in play, has estimated its earnings per share for 2004 would be lowered by 10 cents a share.

In July, just on the prospect of the proposed rule, Omnicom Group Inc. and Affiliated Managers Group Inc. convertibles were pounded lower with the underlying stock, along with several others.

Analysts estimate the new rule could reduce the reported earnings per share for companies by an average of 5% to 10%, but stressed it illusionary to an extent, based on the likelihood of the bond converting into stock.

"Issuers, investors and banks can only be disappointed that FASB reached a conclusion to look through contingent conversion," Richard Ng-Yow, UBS head of U.S. equity-linked origination, told Prospect News.

"We expect that companies who have CoCo convertible securities will soon take proactive actions to address the EPS dilution of the 'if converted method' and there will be a number of new issues or exchange offers soon flooding the convertible market."

Market changes yet under way

Since the proposed rule surfaced, there have already been measures discussed or taken to address issuers' reluctance, with mixed results.

GM's stated means of addressing the issue, or sidestepping the requirement to show diluted earnings per share, by paying the CoCo converts in cash has met considerable resistance from bondholders, who fear there could be other issuers attempting to do the same.

Indeed, already there have been other issuers say they are considering a similar move, including Quanex Corp. and CMS Energy Corp.

"There will be an uproar of protests if everybody just proposes to pay these off in cash, because then we're left just holding a bond, not a convertible," said a buyside analyst at a hedge fund in New York. "We're not opposed to an exchange that would modify the terms necessarily, but if you completely take away the stock component then you just hack off about half the market."

As a means of addressing issuers' concerns with the dilutive effects of convertibles on their underlying shares, which was the genesis of the CoCo structure, convertible bankers have already begun including on a majority of new issues lately - or at least since the new accounting rule for CoCos cropped up - a net share settlement feature.

Under net share settlements, the issuers pay the appreciation beyond the initial conversion calculation in cash. Buyside sources said this feature is not so unpalatable, since it preserves some of the stock option in a convertible.

Issuers can move forward now

Now that the accounting issue has been decided, although in an unpopular outcome, convertible issuance can resume, some participants said.

"At least a conclusion has been reached," said UBS' Ng-Yow. "This removes the accounting overhang that has dampened the convertible market, and we expect new issue volume to rebound in the next few weeks."

Venu Krishna, head of U.S. convertible research at Lehman Brothers, had expected the matter to detract from issuance marginally, but pointed out that there have been lots of other factors suppressing convertible issuance in 2004.

Issuance data compiled by Prospect News, which includes issues by investment banks exchangeable into another stock, shows that year-to-date issuance through Sept. 30 is running about half that of a year ago, or $39.6 billion versus $80.2 billion though Sept. 30, 2003.

The impact of removing CoCos from the total would be dramatic, however, as through midyear 2004 convertibles in that structure have made up 55.5% of new deals, according to Prospect News data.

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