Mercury rattles investors again; Chesapeake Energy prices, existing preferreds seen lower; Qwest mulled

By Rebecca Melvin

Princeton, N.J., Nov. 2 - Hitting the tape again Wednesday with another raft of rattling news was Mercury Interactive Corp., which said three top executives at the software company were relieved of their duties after an investigation found they were aware of past stock-option irregularities.

Mercury convertibles dropped by two points, a sizable move for the 0% convertibles, given that they are seen as one-year paper. But not as serious as the beating that the company's shares took in extremely heavy volume, tumbling as much as 35%, before recovering somewhat to close down about 27%.

Other names trading in the secondary market on Wednesday were Advanced Medical Optics Inc., which lifted after the medical device maker reported earnings. Medtronic Inc., another medical device maker, traded lower. Allied Waste Industries Inc. was another convertible name trading as its shares rose more than 2% on no particular news. Chesapeake Energy Corp. convertibles preferreds traded down ahead of pricing of two new Chesapeake convertible issues.

Late Wednesday, Chesapeake announced that it priced $600 million of contingent convertible senior notes to yield 2.75%, with an initial conversion premium of 30%. The pricing was cheaper than guidance of 1.875% to 2.375% for the coupon, with an initial conversion premium of 35% to 40%.

The Oklahoma City-based natural gas company also said it priced its previously announced offering of $500 million of cumulative convertible preferred stock to yield 5.0%, with an initial conversion premium of 30%. Price talk for the offering, launched Tuesday, was 4.125% to 4.625% for the dividend, with an initial conversion premium of 35% to 40%.

Another big focus of the day was Qwest Communications International Inc., which Tuesday launched $1 billion of 20-year senior convertible notes that were expected to price Wednesday after the markets closed.

"The sense is that it was not well priced. People didn't like the pricing," a Connecticut-based sellside analyst said of the Qwest deal.

The Qwest deal, being sold by bookrunner Goldman Sachs & Co., was talked to yield 3% to 3.5%, with an initial conversion premium of 30% to 35%.

The notes are non-callable for three years, and provisionally callable at a 130% trigger, with a coupon make-whole, in years four and five. Investor puts are in years five, 10 and 15.

One source valued the Qwest offering at one or two points cheap at the wide end using a credit spread of 350 basis points over Libor and a volatility of 28%.

Another source saw that credit spread as too wide, noting that the convertible paper with its first put in year five is essentially five-year paper. The source originally used a credit spread of 280 bps over Libor and a volatility of 27%, but moved the credit spread of 240 bps over Libor, putting the deal at fair value at the cheap end at 101.9 and at 100.1 at the midpoint, fully valued, which was slightly more attractive, he said.

He justified his assumptions, saying that Qwest's straight debt was up about two points on news of the new deal, and that they had a spread of Treasuries plus 280 bps.

A third analyst said, "Some of the straights justify 300." But she said that her credit spread was being reevaluated and might be widened. Her initial valuation was done at a credit spread of Treasuries plus 300 bps and a conservative 25% volatility, putting the deal at 2% cheap.

The Qwest notes have contingent conversion at 120%, and full dividend and change of control protection.

No gray market was reported for either the Qwest or Chesapeake deals. One reason posited for the lacking gray market was that so many banks are involved in the three deals that there were few other candidates to get involved in the gray.

Convertibles down in October, Citigroup reports

Looking back at October, U.S. convertible market posted a cap-weighted October outright return of negative 2.2%, while underlying stocks were lower by 3.8% according to a convertible monthly summary published Wednesday by Citigroup Global Markets, which referred to the October period as "giving some back."

As a result, the market's year to date return dipped into the red at negative 0.7%.

The Citigroup summary said convertible arbitrage strategy posted better results for the month, but for the year convertible arb results seem to range between negative 3.0% to negative 6.0%.

Citigroup said that some of the weakness seems to be coming from the bond market, especially from large, credit-sensitive telecom names. Also as the 10-year Treasury note lost 1.5% for the month, high-yield and high-grade bonds saw a modest expansion in spreads. For the month, high-yield and high-grade bonds posted results of negative 0.8% each.

Convertible preferred and mandatories were the worst performing security types due to the high number of issuers in the lagging utilities and cyclical industry groups, the Citigroup commentary said.

Mercury convertibles drop two points

The 4.75% and 0% convertibles of Mercury Interactive were down by a couple of points after the company's chief executive officer Amnon Landan, chief financial officer Douglas Smith, and general counsel Susan Skaer were replaced due to their alleged knowledge of stock-option irregularities.

But while Mercury shares were punished severely, the bonds were down just two points due to the fact that the company is considered "a good credit," and it's believed that "both bonds are money good."

"New management said on the call that the [investigation's findings] don't affect cash, cash flow or revenue. They also gave a cash and investments value of $1.37 billion," a New York-based sellside shop trader said.

"Investors are worried that maybe the cash number isn't real, but I don't think the new management team would have given that number if they didn't believe it was true," he added.

The company said Wednesday that its special committee formed in June to conduct an internal investigation relating to past stock option grants, in response to an inquiry initiated by the Securities and Exchange Commission a year ago, determined that from 1995 to the present there were 49 instances in which the stated date of a Mercury stock option grant was different from the date on which the option appears to have actually been granted.

In almost every such instance, the company said in its release, "the price on the actual date was higher than the price on the stated grant date. These instances represent the overwhelming majority of the grants between January 1996 and April 2002. The misdating occurred with respect to grants to all levels of employees."

In addition, the company said, on at least three occasions between 1998 and 2001, exercise dates for options exercised by chief executive Landan appear to be incorrectly reported, which would have had the effect of reducing Landan's income and exposing the company to possible penalties for failure to pay withholding taxes.

Mercury also said on Wednesday that because of the findings it wasn't able to report its third-quarter earnings, but said that it expects revenue to be $205 million to $210 million for the period.

The company also said its ability to file amended reports by Nov. 30 on Form 10-K and Form 10-Q with the SEC for these periods is "in serious jeopardy."

In addition, the company said it anticipates that the fourth quarter will be challenging and won't provide guidance.

Meanwhile, a delisting by Nasdaq is threatened if the restatements are not submitted to the SEC by Nov. 30.

The news follows a double whammy unloaded by the company on Oct. 5, when the software company lowered guidance for the fourth quarter and announced that the SEC probe had been upgraded to a formal investigation.

At that time, the convertibles held up close to par because investors expected that the paper would be put back to the company shortly due to a technical default.

On Wednesday, Goldman Sachs analyst Sarah Friar downgraded the stock to "underperform" on what she called "extraordinary new developments."

The company said Tony Zingale was named as its new chief executive, moving up from the post of president and chief operating officer. David Murphy was promoted to chief financial officer and director Giora Yaron was elected chairman.

Mercury's 0% convertibles traded at 99, and were seen later by one sellside shop closing at 97.6. On Tuesday, the bonds had been at 101.

The 4.75% convertibles traded early at 96, versus a stock price of $35. Later they were seen at 97, compared to a level on Tuesday at 99.125. Shares of Mercury closed down $9.34, or 26.69%, at $25.66.

Chesapeake cheaper than talk

Chesapeake priced its two concurrent convertible offerings wide of the price talk range.

Chesapeake's $600 million of contingent convertibles priced to yield 2.75% for the coupon with an initial conversion premium of 30%, according to a company release.

At launch on Tuesday, the issue was talked to yield 1.875% to 2.375%, with an initial conversion premium of 35% to 40%.

The $500 million of cumulative convertible preferred shares priced to yield 5% with a 30% initial conversion premium as well. They had been talked to yield 4.125% to 4.625%, with an initial conversion premium of 35% to 40%.

Bookrunners for both Rule 144A offerings were Deutsche Bank Securities, which was the stabilization agent, plus Banc of America Securities LLC, Credit Suisse First Boston, Lehman Brothers and UBS Investment Bank.

Proceeds from the two convertible offerings, together with proceeds from a concurrent offering of senior notes, will fund part of the company's previously announced acquisition of Columbia Natural Resources, LLC for $2.2 billion in cash.

The notes are non-callable for 10 years and have puts in years 10, 15, 20 and 25.

Chesapeake's $500 million of a new series of its cumulative convertible preferred shares are non-callable for five years, and the company may force conversion after year five on Nov. 15, 2010 subject to a 130% trigger.

Oklahoma City-based Chesapeake, a "serial convertibles issuer," already has a number of regularly traded convertible securities in the market, including an upsized deal priced in early September for $300 million of convertible preferreds that yield 4.5% for the coupon and had a 35% initial conversion premium.

Holders of the existing preferreds were said to be unhappy Wednesday as they watched the value of their securities drop after the new convertibles were launched Tuesday.

The 4.5% preferreds were down about 1.75 points on a dollar-neutral basis to 97 bid versus a stock price of $29.8, compared to a price Tuesday of 101.25, versus a share price of $31.17, according to one analyst.

The value was lower because the credit weakened and the spread widened by about 25 to 50 bps, according to the analyst, who called Chesapeake a savvy "serial convertibles issuer."

Also pressuring the price of the existing issues was that the terms of the new issues were seen a little better than the existing convertibles.

"A drop in demand is seen for the existing paper because there is all this supply," the analyst said, suggesting that of the investors that already have their oil and gas exposure, there will have to be picking and choosing, and new players will probably want the new paper.

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