Merrill: M&A surge may impact convertibles of Toys R Us, ExpressJet, Roper, Electronics for Imaging

By Ronda Fears

Nashville, Feb. 1 - From among a crop of small cap companies considered prime candidates as takeover targets, Merrill Lynch & Co. convertible analysts have come up with at least two dozen convertibles that could be impacted - good and bad.

Awash with liquidity following an onslaught of balance sheet repairs over the last couple of years, the stage is set for a surge in merger and acquisition activity in 2005 and has, indeed, already begun with gusto. But it has unleashed a load of anxiety on convertible players, as stock mergers can erase the option value of a convertible, manifested in a loss of a conversion premium. Cash mergers equally hurt as they also erase the option value and oftentimes reduce market value of the security based on straight bond features.

In a hedged position, leverage only compounds the impact of the loss.

Counter measures include the proliferation of cash takeover protection language in convertible indentures. Also, the Merrill analysts said convertible holders can threaten litigation on older convertibles without the now standard anti-takeover language to hold up a deal.

"The convertible issue doesn't even have to be sizable to make some noise," the analysts said, as was demonstrated just a few days ago by holders of the $150 million Grey Global Group Inc. 5% convertible due 2033, who have blocked its merger with WPP Group.

Change-of-control put back language can actually benefit convertible holders when the target is a company whose converts are busted trading below par, the analysts pointed out.

Targets over par may cheapen

In some cases companies that are attractive takeover targets have convertibles that are trading above par that are at risk of cheapening due to the situation.

"If too low a probability of takeover is priced into these securities, they could become cheaper in the case of a cash or part-stock takeover, as the premium would contract and/or disappear," Merrill convertible analyst Tatyana Hube said.

Those include the Amerada Hess Corp. 7% mandatory, Pride International Inc. 2.5% due 2007 and 3.25% due 2033, Micron Technology Inc. 2.5% due 2010 and Toys R Us Inc. 6.25% mandatory.

Targets below par could richen

Conversely, companies that are attractive takeover targets that have convertibles trading below par could see some price appreciation as a result of the situation.

"If too low a probability of takeover is priced into these securities, they could become richer in the case of a cash or a part-stock takeover, since the change-in-control put would likely become triggered," Hube said.

"This feature is very important for potential targets with convertibles securities trading below their principal par values, since an acquisition will induce holders to put back their bonds back to the company, effectively accelerating their maturity. This can impose a sizable extra cost for an acquirer."

In this category, the Electronics for Imaging Inc. 1.5% due 2023 was highlighted. The issue is trading at about 96.5.

Some rich issues may richen

Some takeover targets may have convertibles that the market has already priced in that risk. The Merrill analysts categorized those as probably too expensive for acquisition but said that while the converts are trading above par, a takeover offer could push them even higher.

"If too high a probability of takeover is priced into these securities, they could become richer in the case of a cash or part-stock takeover, as a premium loss would be less likely," Hube said.

Among that group were the Wabash National Corp. 32.5% due 2008, Shuffle Master Inc. 1.25% due 2024, Roper Industries Inc. cash-to-zero due 2034, Apria Healthcare Group Inc. 3.375% due 2033 and CenterPoint Energy Inc. 3.75% due 2023.

Cheap issues risk cheapening

On the contrary, takeover targets with convertibles for which the market has already priced in the risk but for which issues are still trading below par may see further cheapening in the event of a takeover attempt. The Merrill analysts categorized these also as probably too expensive for acquisition.

"If too high a probability of takeover is priced into these securities, they could become cheaper in the case of a cash or part-stock takeover, as valuation reset to normal levels," Hube said.

These include the ExpressJet Holdings Inc. 4.25% due 2023, Goodrich Corp. (Coltec) 5.25% convertible trust preferreds, CSG Systems International Inc. 2.5% due 2024, Bisys Group Inc. 4% due 2006 and Mercury Interactive Corp. 4.75% due 2007.

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