Salomon recommends Mercury Interactive convertible as good yield play

By Ronda Fears

Nashville, Tenn., Dec. 18 - Given that Mercury Interactive is currently cash flow positive, has low spending requirements and a dominant position in the software testing market, plus a substantial cash hoard, Salomon Smith Barney convertible analyst Venu Krishna recommends the 4.75% convertible notes due 2007 for a good yield play sporting a 10.2% yield-to-maturity.

The converts are cheap based on conservative assumptions and carry an attractive risk/reward profile of 46%/5%, Krishna said in the report. Mercury's stock has snapped back and is up 39% since early November, outstripping the Nasdaq's gain of 11% significantly, the report added, noting that the stock now appears richly valued with a P/E of 47.5 times to the Salomon estimate for 2002 earnings per share.

"The stock's valuation is of concern to us since its huge out-performance comes at a time when there hasn't been any new news or catalyst about the company's prospects over the coming quarters,' said Krishna, the head of Salomon's convertible research team, in the report. "The company's financials however are sound making its 4.75% of '07 convertible worthy of active consideration at their current trading levels."

While the overall slowdown in technology-related spending has affected software companies and weakened demand for new applications, Krishna said Mercury's dominant market share of over 50% in software testing positions it well should the macro IT spending environment improve. Against the backdrop of an uncertain macro environment and renewed optimism regarding a potential pick up in the technology sector, the analyst said Mercury's access to liquidity and its financials remain fairly sound.

In the first nine months of 2001, Mercury generated positive operating cash flows of $53.7 million, although down sharply from $94.9 million in the comparable period in 2000. While leverage appears high at 60.2%, Krishna noted that the only debt on the company's balance sheet is the $500 million 4.75% out-of-the-money convert. Cash and short-term investments at the end of September stood at a healthy $423.23 million, the analysts said, and the company has $237.6 million in long-term investments, largely in high quality financial, government and corporate securities. Capital expenditures over the first nine months was relatively small at $19.3 million versus $18.4 million in the comparable period of 2000.

"No major spending needs are expected over the coming quarters. We would however watch out for any cash acquisitions by the company since in the current environment liquidity is important, especially from the convertible's perspective," Krishna said in the report. "The likelihood of an acquisition by Mercury, especially in the APM (applications performance monitoring software) area, is reasonably high, we believe, since valuations in general have come down."

The Mercury 4.75% convertible subordinated notes due July 1, 2007, which are not rated, were quoted at 77.375 with the stock at $33.75 on Friday, which Krishna said translates into a 10.20% yield to maturity and 155% premium. Using a conservative credit spread of 600 basis points and a volatility assumption of 50%, the convertible is 2.23% cheap relative to its fair value. At the end of November, the Salomon high yield bond index for BB- grades with 1- to 7-year maturities showed a spread of 561 bps. Historical volatility on Mercury stock is 90% and its July 2002 calls trade at a 67% to 70% volatility level.

"So, both of our assumptions are indeed conservative. Further, without changing our assumptions on the upside but substantially widening the spread on the downside (assuming a credit deterioration, say triggered by an acquisition), we estimate an upside/downside leverage of 46%/5% for a +/-25% move in the common stock over a one-year investment horizon," Krishna said in the report.

"Given this risk/reward profile and the security's yield, the 4.75% convertible is worthy of consideration. Arbitrage investors should consider owning the issue on a heavier hedge than the convert's implied delta would suggest since the stock is trading at a fairly rich valuation."

Mercury Interactive 4.75% due 2007

$500 million (face), not rated

Convertible price: 22.375

Common price: $33.75

Cheapness: 2.23%

Conversion price: $111.25

Parity: 30.34

Fair value: 79.1

Investment value: 76.06

Conversion premium: 155%

Conversion ratio: 8.9888

Current yield: 6.14%

Yield-to-call: 24.95%

Yield advantage: 613 basis points

Spread: 600 basis points

Delta: 23%

Upside/Downside: 46%/5%

Breakeven: 9.9 years

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