Merrill analysts see small cap, busted converts most vulnerable to proposed CoCo dilution rule

By Ronda Fears

Nashville, July 9 - Small cap issuers, particularly those with busted convertibles, would be most vulnerable to the proposed accounting rule changing the treatment of convertibles with contingent conversion features, said Yaw Debrah, Merrill Lynch & Co.'s head of U.S. convertible research, in a report Friday.

If adopted, the change would require issuers to estimate potential dilution when reporting earnings per share as if the bonds were converted. At present, an issuer's stock has to reach the trigger price before contingent convertibles are treated on an if-converted basis.

Merrill Lynch origination officials introduced the contingent convertible structure to the market in November 2000 with the $3.5 billion Tyco International 0% due 2020. As of June 30, Merrill tallies 317 CoCo convertibles with a market value of $123.9 billion.

"It is important to note that the underlying operating fundamentals of companies with CoCos will not have changed from the date the proposals might be adopted," Debrah said in the report.

"However, for companies that are valued relative to their peers using price/earnings ratios, increasing the number of shares by which earnings are being divided will make these companies appear more expensive than previously. This could lead to a sell-off in the stocks of companies that now appeared overvalued on a price/earnings basis."

As might be expected, on a single name basis and where the stock underlying the convertible is trading below the conversion price, he said the largest potential dilution would take place in the smaller cap, speculative-grade credits such as Serena Software Inc., Sunterra Corp., Lattice Semiconductor Corp. and Emulex Corp.

Busted convertibles feature strongly in that list.

Issuers face dilution

Serial issuers of convertibles such as Lucent Technologies Inc., Providian Financial Corp. and Invitrogen Corp. and Mesa Air Group Inc. show significant potential dilution.

Among the better credits, he said serial issuers such as Omnicom Group Inc., General Motors Corp., Royal Caribbean Cruises Ltd. and Apogent Technologies Inc./Fisher Scientific International Inc. show greater amounts of potential dilution.

"However, we would note that investment-grade issuers typically have larger cash positions and access to bank lines, which provide flexibility to settle in cash in the event of conversion," Debrah said.

"Companies with such financial means have a number of other options available to them to avoid the dilution from the convertible such as stock buybacks, debt tenders and exchange offers."

The Financial Accounting Standards Board's Emerging Issues Task Force on July 1 made a tentative decision proposing that issuers of CoCo convertibles use the "if-converted" methodology to calculate their reported GAAP earnings per share, irrespective of the CoCo trigger being hit.

Merrill analysts expect that FASB will post an abstract of the task force recommendation on its website around mid July with a probable comment period of 45 days. The EITF next meets to discuss the issue Sept. 29 and 30, at which time a final decision could be made. If that is the case, it could be effective in mid-October.

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