Lehman: Gap convertibles mildly attractive but may face dividend risk; TJX put offers defensiveness

By Ronda Fears

Nashville, Oct. 28 - Lehman Brothers launched equity coverage on Thursday of the retail softline space, including Gap Inc. and TJX Cos. Inc., prompting Lehman convertible analysts to note that Gap's convertible offers some advantage to the stock but with dividend risk, while the TJX convertible offers some downside defense in the stock though is less appealing than the stock as an income source.

Lehman equity analyst Jeff Black on Thursday put an overweight rating on Gap shares and an equal weight rating on TJX shares. Gap has a $1.38 billion 5.75% convertible senior note due March 2009 (Ba1/BB+) that is callable at 102.46 in 2005, while TJX has a $374 million (accreted face value) 0% convertible subordinated note due February 2021 (Baa1/A-) that is putable/callable at 75.68 in 2007.

Of the two issues, Lehman analysts pointed out in a research e-mail note Thursday that only TJX carries a contingent conversion feature and that neither of the two bonds have dividend and cash takeover protection language common to more recently issued convertibles.

Gap may call, refinance 5.75s

Gap's 5.75s are deep in-the-money, quoted around 126.25 versus a stock price of $19.78, giving the issue a 4.6% current yield and modest 2.9% premium and making it fairly equity sensitive with an 83% delta. Based on a credit spread of 65 basis points over Libor and 28% volatility, Lehman analysts view the Gap convert fully valued to slightly rich.

The bond has an equity sensitive risk/reward profile of 97%/64%, which equates to an estimated total return of 24% to the upside and 16% to the downside for a 25% move in the stock.

Income pickup on the convertible relative to the common stock is attractive, at 410 basis points. The analysts said that while the convertible is likely to leak additional value as the call date approaches, the low premium, attractive income pickup and high bond floor (103%), also make it a good alternative to the stock over the next five months while providing a superior risk/reward profile relative to the common stock.

Investors should note, however, that a significant increase in the underlying stock's dividend over the next several months may negatively impact the convert's valuation.

Given the bond's low premium, high coupon and deep in-the-money status, Lehman analysts said the probability of a call by the issuer to "force conversion" come March 2005 is fairly high.

In addition, taking into account Gap's financial metrics - $2.9 billion of cash and equivalents and last-12-months free cash flow of nearly $1.7 billion as of July 30, and credit default protection quoted 64/69 basis points - the company likely has the ability to raise additional convertible financing at significantly improved terms relative to the existing issue.

TJX put offers some cushion

TJX's zeros are also in-the-money and were recently quoted around 84.25 with the stock at $23.41, suggesting a yield to maturity of 1.06% and a 10.1% premium. Yield to the 2007 put is a negative 4.57%.

Based on a credit spread of 35 basis points over Libor and a 25% volatility, the Lehman analysts see the issue about 0.67% rich. Projected upside/downside participation in a 25% move in the stock is estimated at 59%/49%, and the $0.18 annual dividend on TJX stock translates into a 77 basis point income disadvantage for convertible holders relative to the common stock.

Despite the low premium, the convert's current valuation, lukewarm risk/reward profile, negative income pickup and lack of dividend protection - which make it a fairly unattractive swap candidate for holders of the common stock - the Lehman analysts said the defensive nature of the convert due to the 2007 put provides a measure of downside support for holders concerned about the medium-term outlook for the stock.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.