Electronics for Imaging convertibles appealing based on big gamma, small takeover risk, Lehman Brothers says

By Evan Weinberger

New York, Nov. 1 - Active gamma traders and investors willing to risk a leveraged buyout should look to Electronics for Imaging Inc.'s 1.5% convertible senior debentures due June 1, 2023, a new report from Lehman Brothers said Thursday. The company issued $240 million worth of the convertibles in June 2003.

On Oct. 23, Electronics for Imaging released its earnings for the third quarter. And despite turning a 13 cents per share profit, after a 49 cents per share loss in the third quarter of 2006, Electronics for Imaging missed Wall Street's estimates. The Foster City, Calif.-based printer and digital imaging maker posted third quarter revenue of 34 cents per share when Wall Street expected 36 cents per share.

The stock (Nasdaq: EFII) dropped immediately, losing nearly 20% of its value on Oct. 24.

Electronics for Imaging said it missed estimates because the bulk of its earnings are moving to its lower margin inkjet products division and away from other, higher margin sectors.

That volatility is where Lehman Brothers analysts Venu Krishna and Manoj Shivdasani think a play can be made.

Electronics for Imaging's convertibles closed Wednesday at 102.25 versus a stock price of $22.80. The analysts peg the convertibles at a fair value of 102.22 with an 18.5% premium, a 36.1% delta, a 1.51% gamma, a 33.1% implied volatility, a 97.5 bond floor using a Libor plus 100 credit, a 33% vol and a one call trigger on the first call date.

"Given the continued unpredictable outlook for EFII's dominant high margin controllers business which supplies components for big ticket discretionary products linked to the capital spending cycle and the health of the broader economy, we expect continued volatility in EFII's stock especially around earnings," Krishna and Shivdasani wrote. "Because of the attractive gamma, we recommend an actively managed gamma capture trade strategy with particular emphasis on the trade around the next couple of earnings releases."

The convertibles are callable and puttable on June 1, 2008. The analysts do not think it is likely Electronics for Imaging will call the convertibles when they come due. Electronics for Imaging enjoys significant tax benefits that would be harmed by calling the convertibles and may want to hold off on calling the convertibles anyway, at least until the stock has a significant cushion over the conversion price.

At the same time, the analysts think that since Electronics for Imaging usually chooses to have significant amounts of cash on hand, the company would consider putting some sweeteners into the deal to keep holders of the convertibles from putting them on June 1. The analysts say that Electronics for Imaging did not mention a possible put sweetener in their Oct. 23 conference call, but given other statements it is something they may consider later. "Perhaps it hasn't been considered so far but given the company's preference for balance sheet liquidity and the tax benefit of the CPDI (contingent payment debt instrument) convert it could be one of their options as the put date approaches," they wrote.

The combination of the potential for a put sweetener and a potential change in the call trigger significantly increases the valuation of the convertible, the analysts said.

One final risk is that of a leveraged buyout, which the analysts say is especially problematic for hedged investors. The analysts said given the current credit environment, Electronics for Imaging was a far more attractive buyout candidate in the summer of 2006 when the stock was trading below $20. They don't say that an LBO is totally out of the realm of possibility, but that the chances are relatively low. If it does happen, then the analysts' model would be blown up because there are no takeover protections for the convertibles. "This trade is not suitable for investors not willing to take on that risk," they said.

Krishna and Shivdasani point out that they are only analyzing the future of Electronics for Imaging's outstanding convertibles through June 1, 2008.

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