Watson trades up out of gate, Provident plunges, call scare ripples throughout market

By Ronda Fears

Nashville, March 5 - News and events on several fronts prompted convertible players to get busy Wednesday, while stocks wobbled through most of the session in lackluster fashion before ending slightly higher.

Provident Financial Group Inc. and Costco Wholesale Corp. were the explosions of the day, and Northrop Grumman Corp. fell victim to a so-called "peace scare."

New issues also were still a major focus, trader said. There was buzz after the close of an overnighter, but nothing came of it.

Watson Pharmaceuticals Inc. sold an upsized $500 million at the rich end of talk amid very strong demand, and the new issue gained 1.25 points from par in the first day of trade.

The deal, on the heels of a new Teva convert and a widespread expectation of many biotech converts getting exchanged, has caused some speculation about potential issuers that may tap the convertible market.

Salomon Smith Barney convertible analyst Stuart Novick said there are several generic drug companies, similar to Watson and Teva, especially ripe to issue convertibles - Barr Laboratories Inc. and Forest Laboratories Inc., for example.

"I could see them coming to the convert market," especially if there are any acquisitions in the works, Novick said.

Moreover, convert players like the healthcare sector.

"We can't get enough healthcare," said Barry Nelson, portfolio manager at Advent Capital Management, who participated in the Watson deal.

"Long term, healthcare as a whole is an unstoppable growth story. Like tech, it periodically falls into disfavor. Unlike tech, healthcare does well over time. Most tech companies die young. You don't have to identify the next Microsoft to make money in healthcare."

Following the latest period of declining stock prices on the heels of a boom of biotech converts in 2000, it certainly is a sector seen fraught with out-of-the-money convertibles that are prime to be exchanged.

"The biotech sector really only has one market to go to - the convertible market. They really can't tap high-yield and don't want to issue stock down here," said Jeremy Howard, head of U.S. convertible research at Deutsche Bank Securities Inc.

"The convertible market is the only saloon in town they can drink in."

The market had no problem sopping up Watson's deal that was upsized from $450 million, as sources working close with the deal said orders were in excess of 12 times the deal size.

Watson sold the 20-year convertible senior notes at par to yield 1.75% with a 42% initial conversion premium - at the rich end of guidance - on extremely heavy demand.

Out of the gate, the paper headed north of par, closing at 101.25 bid, 101.5 asked. It had closed in the gray market Tuesday at a bid of 1.125 points over par with offers at 1.5 points over par.

Watson shares closed off 3c to $28.16.

Sellside analysts put the deal, at the aggressive end of price talk, 1.3% to 2% rich, but that didn't deter players.

"We did buy Watson," Nelson said.

"The coupon was a bit low and the premium was a bit high, but five years of call protection is nice, particularly since the stock has plenty of upside," he said, adding that Watson is a decent credit.

"As for new issues in general," Nelson said, "the more the merrier. We don't have to buy anything.

"We passed on the dot.com convertibles in 1999, we passed on the zero-coupon putable issues with the high premiums in 2001 and we had no regrets. The aftermarket has a way of creating attractive prices eventually."

Convertible players were not having to deal with those issues exactly Wednesday, although there was a call scare. There was plenty to keep players busy in the way of explosions, though.

Northrop Grumman Corp. took a beating after cutting its 2003 earnings outlook, saying interest expense will be higher this year than previously anticipated.

Northrop shares ended down $3.51 to $83.75. The 7.25% mandatory (Baa3/BBB-) lost 2.95 points to 96.3 and the 7% convertible preferred (Ba2) fell 5.35 points to 118.6.

The defense contractor said it expects net interest expense for 2003 to be about $100 million higher than its previous guidance of $370 million as a result of the anticipated timing and the composition of the debt to be retired.

The company now expects 2003 earnings of $3.65 to $4.15 a share, down from a prior estimate of $4 to $4.50 a share.

Northrop said it intends to retire debt in phases, the first of which will be announced shortly. No specific time frame for the disclosure was mentioned, but the company said it expects the debt reduction plan to be complete by the end of the second quarter.

Earlier this month, Northrop completed the sale of TRW Inc.'s automotive business to affiliates of the Blackstone Group for about $4.7 billion, saying proceeds would be used primarily to pay down debt and to meet corporate obligations.

"Defense stocks are vulnerable to 'peace scares,' and Northrop Grumman exaggerated the effect with its disclosure yesterday that some interest expense that management had intended to include as a discontinued item will instead be subtracted from reported earnings," said Nelson.

"This is much ado about nothing. Even if there's no war against Saddam [Hussein], there is not likely to be peace for many years. Defense spending has nowhere to go but up."

Costco sent a scare rippling through the convertible market, itself, after mentioning on its earnings conference call that it may make a cash call for its 0% convertibles. (See full story on Page 1)

It was an unforeseen event that would affect the value of the convertible - and others that are or are becoming callable soon.

"There was a re-evaluation and reappraisal on callable securities after Costco," said Jeremy Howard, head of U.S. convertible research at Deutsche Bank Securities.

"There was a lot of speculative flow in those names."

Anadarko Petroleum Corp.'s 0% convertible due 2020, Whole Foods Market Inc.'s convertible and Johnson & Johnson (Alza Corp.)'s 0% convertible due 2020 were among those immediately affected by the Costco news.

Just this week the Anadarko and Whole Foods converts become callable.

Costco's 0% due 2017 (A3/A-) plunged 2.375 points to 69.625 bid, 70.125 asked with the stock closing down 55c to $28.75.

Anadarko's convert (Baa1/BBB+), which becomes callable Friday at 55.441, closed down 0.75 point to 60 bid, 60.25 asked. The stock ended up 20c to $46.25.

Whole Foods' convert (B1/BB-), which became callable Monday at 47.674, was quoted ending unchanged at 58 bid, 58.25 asked. The stock closed off 11c to $50.46.

The Johnson & Johnson 0% due 2020 (Aa1/AAA), which is callable in July at 60.277, lost 1 point to close at 76.375 bid, 76.625 asked as the stock ended up $1.12 to $52.81.

A call or the refinancing of an issue due to a call can affect the value sharply.

A couple of weeks ago, Wachovia Securities convertible analyst Sri Nadesan noted that the Lamar Advertising Co. 5.25% convertible, which is currently callable, looked to be at fair value at 101.25 with the stock at $31.12, using a stock volatility of 40% and credit spread of 550 basis points over Treasuries.

But by using a 0% call threshold in valuing the Lamar convertible, he said it appeared 5% rich.

Provident paid a price for overstatement - to its earnings for 1997 through 2002 for a total of

$70.3 million - in the way of a mass exodus in its securities.

The Provident converts plunged alongside the stock, both losing nearly 20% on the day.

Provident's 9% mandatory was down by as much as 6 points during the session, but closed down 5.05 points to 23.2.

The common shares also recovered a bit, ending down $5.61 to $22.46 after being down by more than $7 at one point of the day.

Provident said that as a result of the restatement, which was due to off-balance sheet transactions, it revised its EPS outlook for 2003 to $2.30-$2.50 from its previous forecast for $2.50-$2.70. The company said the impact from this matter will be significantly less in 2004 and future years.

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