Lehman still likes GM convertibles - 4.5% issue as a yield play, 5.25% and 6.25% issues as stock swaps

By Ronda Fears

Nashville, March 18 - Lehman Brothers Inc. convertible analysts still like the General Motors Corp. convertibles, although the firm cut its rating and price target on the underlying stock on Thursday after GM warned of a net loss for first quarter and halved its earnings outlook for 2005. There are three convertible notes, each with a par of $25, totaling $8 billion.

GM on Wednesday said it now expects a loss of about $1.50 a share for first quarter, well below its previous projection for breakeven results or better. For 2005, GM scaled back expectations to earnings per share of $1.00 to $2.00 from $4.00 to $5.00 forecast previously. On that event, Lehman downgraded GM shares to underweight from neutral and lowered its price target to $25.00 from $36.00, which is based on an 8 times multiple of its reduced 2006 EPS estimate of $3.10.

GM 4.5% issue a yield play

GM's 4.5% convertible is a relatively short-dated security, with a put in March 2007, and is busted with a 7% yield to put and 139% conversion premium. Lehman analysts estimate it would likely provide a one-year total return of about 6.6%, despite the weakened equity and credit outlook.

The 4.5s are trading at around 24. The Lehman analysts estimate theoretical value at 23.85, using a credit spread of 275 basis points and 20% volatility.

"Though the [4.5%] security is fairly insensitive to movements in the common, its defensive attributes (driven by its short effective maturity) and our 6.6% one-year return expectation make it a good yield play," said Venu Krishna, head of Lehman's U.S. convertible research, in a report Friday.

5.25s, 6.25s equity swap ideas

Equity oriented investors meanwhile should consider the GM 5.25% and 6.25% convertibles as alternatives to the common stock given their higher degree of equity sensitivity, the Lehman analysts said.

At the current price of about 18.65, the 5.25s have a yield to put of 9.55% and 72.8% conversion premium. The issue is putable in March 2014. Lehman analysts put the theoretical value at 19.61, based on a credit spread of 450 bps and 25% volatility, with GM shares at $28.00.

The 62.5s, at the current price of about 21.55, have a yield to put of 7.97% and 46.3% conversion premium. The issue is putable in July 2018. Lehman analysts put the theoretical value at 21.31, based on a credit spread of 475 bps and 27% volatility, with the stock at $28.00.

"Outright convertible and equity investors should consider the 5.25% issue as an attractive swap candidate given the current valuation (nearly 5% cheap, by our estimates) and our estimate of positive total return should the common weaken further," Krishna said in the report.

"Though arbitrage investors seem to prefer the 6.25% issue due to the higher delta and carry, we think that the [5.25s] offer an interesting alternative as well given their current valuation relative to [the 6.25s]."

Dividend cut in half a big boon

Both the 5.25s and 6.25s are likely to benefit should GM lower its common dividend, as it would translate into greater yield pickup on the convertibles and enhanced option value.

"In a common dividend cut scenario, we find the [5.25%] convert especially compelling," Krishna said.

Lehman analysts estimated one-year total returns for both issues if GM cut its common stock dividend in half, under scenarios of a possible common stock price decline and widened credit spreads.

Returns on the 5.25% convertible, at a 450 bps spread and 25% volatility, could be lifted to 12.1% if GM halved the dividend and the stock held at $28.00, versus 11% under the current dividend rate and a $28.00 stock. With GM shares declining as much as 25%, or to $21.00, the analysts estimate the return would edge to 8.5% if the dividend were cut, versus 8.2% at the current dividend rate. At a wider spread of 500 bps, accompanied by the 25% decline in the stock, the analysts estimate that the lower dividend would boost the return to 5.8% from 4.6% at the current dividend rate.

Returns on the 6.25% convertible, at a 475 bps spread and 27% volatility, could be lifted to 9.3% if GM halved the dividend and the stock held at $28.00, versus 7.2% under the current dividend rate and a $28.00 stock. With GM shares declining as much as 25%, or to $21.00, the analysts estimate the return at 1.1% if the dividend were cut, versus a 2.3% decline at the current dividend rate. At a wider spread of 525 bps, accompanied by the 25% decline in the stock, the analysts estimate that the lower dividend would limit the decline in the return to 2.3% compared with a 4.5% decline at the current dividend rate.

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