CoCo exchanges steadily trickle in, holders upset about lack of incentives

By Ronda Fears

Nashville, Nov. 1 - As expected, there have been a handful of exchanges launched to eliminate contingent conversion features from convertibles by issuers wanting to avoid having to report the potential dilution to earnings per share. The exchanges come after the Financial Accounting Standards Board adopted the new rule Sept. 30, but some holders are balking at the lack of incentives to participate in the tenders.

"Our feeling as an institutional investor is that we better see some quid pro quo to motivate us to exchange these issues," said a portfolio manager at a larger group of funds in New York City.

An exchange certainly benefits top management at the companies, he said, because it would allow them to continue to report "inflated" earnings per share by not showing the potential dilution from the convertible, and many top executives also receive bonuses tied to earnings per share.

"This doesn't seem right," the manager said.

Yellow Roadway Corp., for example, is proposing a change to a net cash settlement upon conversion, or Treasury stock accounting method, which has been the amendment of choice thus far in the CoCo exchanges. The trucking firm also is offering a cash takeover make-whole payment and 25 basis points in cash.

"The value of this inducement is minimal, given that YELL is an unlikely cash takeover target," said one holder of the Yellow convertibles. "We're going to hold out for more."

Yellow wants to exchange both its 5% and 3.375% convertibles.

Countrywide Financial Corp. recently completed a CoCo exchange that provided what market observers believe was an inadvertent windfall to holders. It also seems to have set precedent for the cash portion of exchange offers at a paltry 25 basis points.

"This exchangeable apparently was a fantastic situation of an odd provision for calculating the dollar portion of the conversion value, a provision that the market had not noticed, enabling an arbitrageur - in the true sense - to buy the bonds for less than effective conversion value," said the fund manager, who oversees several strategies.

"This sort of opportunity occurs very rarely. For sure, this blunder won't recur for 20 years or so."

Venu Krishna, head of U.S. convertible research at Lehman Brothers Inc., said that the 25 basis point cash offer seemed generically acceptable, but each case will have to be evaluated and the market will have to dictate terms.

"As an alternative to one-time cash payments, in some cases call/put dates are being adjusted to create more value in lieu of a one-time cash payment," Krishna said. "In some, additional features might be thrown in, such as dividend protection measures, cash take-out protection measures, etc."

The New York City fund manager said, though, that without appropriate incentives, holders of the CoCo convertibles will just allow the exchange offer to die. The fund manager said if the issuer has to conform to reporting diluted earnings per share, then it will likely create a buying opportunity because the company's stock would probably come under pressure and that would also impact the convertible.

But Krishna said there are some incentives that seem insignificant that may, in fact, be rather substantial.

In the case of added dividend protection, for example, he said that if the situation involves a company that is paying a dividend or is increasing its common dividends, then holders of the convertible might find it better to tender for new convertibles that have dividend protection, regardless of what other incentives are offered.

Along with Countrywide, there have been exchanges completed for the CoCo convertibles of Apogent Technologies Inc., which was mostly related to the Fisher Scientific International Inc. merger, Waste Connections Inc. and Kellwood Co. Waste Connections added dividend protection, but Kellwood neither paid nor made any incentives.

Others pending are for the CoCo convertibles of:

* Omnicom Group Inc., offering to sweeten the put and a cash payment of 25 basis points.

* HCC Insurance Holdings Inc., offering to add one year of call protection plus extra takeover protection.

* Reebok International Ltd., offering an extra year of call protection plus an additional put.

* PPL Corp., offering 25 basis points.

* Wells Fargo & Co., offering 25 basis points.

* Selective Insurance Group Inc., offering immediate conversion.

* Alliant Techsystems Inc., already modified, no incentive.

* Getty Images Inc., offering better dividend protection.

General Motors Corp. also has said it will seek to eliminate the CoCo features on its three convertibles, but nothing has been launched yet.

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