Bear Stearns sees Medtronic offering put sweetener but says convertible worth holding anyway

By Ronda Fears

Nashville, Tenn., August 20 - Medtronic Inc. is likely to offer some sort of sweetener to forestall the Sept. 15 put on its 1.25% convertible due 2021 but the securities are worth holding anyway unless the stock dives, said Bear Stearns & Co. head of convertible reseach Rao Aisola.

"It seems to us that in all scenarios, the debentures are worth holding," Aisola said in a report Tuesday.

"It does not seem that Medtronic needs to sweeten the put given current price levels. To ensure that the debentures will not be put, if management offers a one time sweetener, the debentures are definitely worth holding."

If Medtronic does not offer a sweetener for the current put but does not rule out future sweeteners, the bond is still worth holding, he said.

If Medtronic categorically refuses to pay a sweetener, one time or otherwise, he said fair value is still above par and bondholders still own the reset option. But, he added, this scenario is not as attractive and not as likely.

The reset option, due to contingent features in the Medtronic convert, is key to the put valuation.

"The last two years have seen a spate of new convertible security issuance with embedded contingent options," Aisola said.

"Medtronic 1.25% convertible debentures deserve attention because the debentures have an interest rate reset feature which requires the coupon to be reset upwards, contingent on the stock price trading below or equal to 50% of the conversion price, at or below $30.90, for 20 out of 30 trading days ending three days before the reset date."

Contingent conversion is an option where convertibility is conditional on the stock price being above a certain level relative to the conversion price.

Contingent payment, on the other hand, is an option where coupons are ratcheted up subject to stock price behavior, a feature that grants favorable tax treatment to the issuer.

"If this price condition is met, the coupon will be reset to a level equivalent to a two-year, hypothetical senior, nonconvertible, non-contingent, fixed rate debt security," Aisola said.

"Our capital markets team feels that such a security, issued at par, would have a coupon in the range of 2.65-2.70%, in the current interest rate environment. Further, the above option reoccurs in 2004, 2006, 2008, 2011 and 2016."

The Medtronic 1.25% convertible debentures are putable at par on Sept. 15 and subsequent dates when the coupons reset. The puts are payable in cash, common stock or a combination, and amount to a total outlay of over $2 billion.

Paying the put in common stock amounts to about 50 million shares based on current share price and results in a dilution of 4%, Aisola said. However, he added, capital markets may not look too favorably on the company's prospects if it decides to go this route.

Paying in cash by drawing down cash and credit lines is possible given Medtronic's cash and available lines of credit, he said, but not a very palatable alternative as it dries up liquidity.

To refinance with senior debt or convertible debt will be expensive in the current credit environment and a convertible might not be acceptable to Medtronic due to current stock prices, potential dilution and tax issues associated with the contingent convert.

Given the tax issue and other factors, Aisola said the alternatives for Medtronic to avoid the put seem to be adding a put in September 2003, offer a coupon sweetener or a future promise, or offer an additional put and lower coupon sweetener.

"The put is the easiest feature as it entails no cash outlay in September 2002," Aisola said.

"The crux of the issue then boils down to what the magnitude of the sweetener should be with and without the put. With a put, we feel that a sweetener of 140-145 basis points is an overkill but will ensure that majority of the bond holders will not put the bond back.

"Such an action would increase the interest expense by $30 million per year, but is easy to execute and does not require tapping the capital markets. However, even without an additional put management may be able to get away with a 145 bps sweetener."

Given that, he said there are trading strategies for investors to consider at current price levels, which he puts at above theoretical value.

"We are reasonably confident that the debentures will not be put back at current stock prices, and downside is limited to a bare minimum," Aisola said.

"However, if the stock trades down to below $40.50, there is a good chance that the note holders have an incentive to put the debentures back to the company."

Medtronic 1.25% due 2021

Price: 101.875

Stock: $41.50

Conversion Premium: 51.72%

Conversion Price: $61.806

Current Yield: 1.23%

Delta: 29.8%

Yield to maturity: 1.14%

100-Day Volatility: 36%

Call Price: 100.625

Spread: 125 basis points over Treasuries

First Call: 4.22 years

Credit Ratings: AA-/A1

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