Red-hot Red Hat deal bid up 3.625 points over par in gray market; Duke slides on dividend cut buzz

By Ronda Fears

Nashville, Jan. 6 - Convertible traders used phrases like "Catch 22" or the word "weird" to describe Tuesday's session in which stocks flat lined and the bond market rallied strongly, which was the saving grace for many convertible players.

Duke Energy Corp. slid on speculation that it will cut its common dividend, which the company will address in a conference call Wednesday.

Elsewhere, traders mentioned that Yellow Roadway Corp. convertibles moved up a point or so, without news. Sirius Satellite Radio Inc. went higher on a market rumor that Clear Channel Communications Inc. had targeted it for a takeover. However, the situation turned south and the convertibles were marked down alongside the stock without seeing much action, although the stock saw heavy volume.

In the primary arena, Red Hat Inc.'s new $400 million offering did not get tightened as many suspected, because it appears to be priced to sell. The issue started the day bid 3 points over issue price in the gray market and ended at plus 3.625 points on the bid side, plus 4 points on the offer side. However well after the close the company said it had priced the deal and upsized it to $500 million.

Then, after the close Coeur d'Alene Mines Corp. jumped into the market with a small $130 million offering of 20-year convertible senior notes talked to yield 1.5% to 2.0% with a 20% to 24% initial conversion premium.

Moreover, the market was better bid, but still there was not an overwhelming amount of trading.

"It's a Catch 22 situation: You'd like to sell some paper, would sell some, but you need somewhere to put the money," said one buyside trader at a huge hedge fund in New York.

"The market was rich to begin with, so it's not getting any better. A lot of people have new money to put to work, so we're just hoping the new issue market will pick up."

With nothing much on the table yet in the way of new deals it was a strange day in the convertible market, traders said.

"It was a weird day," said John Siebel, head of trading at Silverado Capital Management.

"I had a good day only because the bond market rallied so strong."

Like virtually everyone in the market, Siebel is hoping that issuance picks up quickly and in a big way.

He said it would make sense for issuers, as well, because they can raise some pretty cheap capital that might not be possible if the bond market backs up anytime soon. From a buyer's view, it would also serve to sop up some of the excess demand in the market, he said.

Red Hat's red-hot deal soars

Red Hat's is the first deal of the New Year, but it's not the jumbo that many speculate is still in the pipeline. The $400 million of 20-year convertible senior unsecured notes are talked to yield 0.5% to 1.0% with a 32% to 37% initial conversion premium. As well as upsizing by $100 million, the offering priced at the aggressive end of talk to yield 0.5% up 37%.

Lots of players expected that the guidance would be squeezed, but that did not happen.

While the issue soared in the gray market, some onlookers stressed that that did not mean it was cheap.

"Even new issues that are not priced very attractive will do okay in this market because people need to put money to work," said a convertibles trader at a big hedge fund in New York.

Deutsche Bank Securities analysts put the Red Hat deal 2.22% rich to 1.79% cheap, at the midpoint of guidance and the stock at $19.57 where it closed Monday. Deutsche used a credit spread of 450 basis points over Libor and a 45% stock volatility.

Merrill Lynch analysts put the Red Hat deal 3.65% cheap, at the middle of price talk and the stock at $18.60, about where it opened Tuesday. Merrill used a credit spread of 500 basis points and a 50% stock volatility.

Tatyana Hube, convertible analyst at Merrill Lynch, noted that Red Hat has no other debt outstanding and recently turned earnings and free-cash-flow positive, but its closest peers - Mercury Interactive Corp. and Serena Software Inc. - have been earnings and free-cashflow positive a lot longer than Red Hat.

"Given that the proceeds of a new deal will be partly used for acquisitions, we see it as a credit negative since the company is using its balance sheet, not revenue, for growth," Hube said in a new issue report.

In that light, she said the 500 basis point spread was conservative, noting that Mercury Interactive convertibles are trading at an implied spread of 200 to 250 basis points while Serena's convertible is trading at an implied spread of about 230 to 240 basis points.

Red Hat is the market leader in the Linux operating systems sector, and Merrill Lynch equity analyst Jason Maynard said in a report Tuesday that any acquisitions Red Hat may make would likely be small complementary technologies, with a focus on the value-add service layer.

"We continue to like the Linux market and believe that as the market leader Red Hat has significant opportunities to continue to show continued revenue and earnings growth and maintain its leadership position," Maynard said.

On a price-to-earnings basis, Red Hat currently trades at 98 times Merrill Lynch's fiscal 2005 earnings per share estimate of 20 cents. From a price-to-sales perspective the shares trade at 20 times, both of which are well above the industry average.

"Clearly investors are looking past most traditional metrics to find value in Red Hat," Maynard said.

"Taking into consideration the company's move to a subscription based model, and the huge Linux market opportunity, we agree that the stock should trade at a premium, however, we believe it is fairly valued at current levels."

Merrill Lynch has a neutral rating on the stock, which on Tuesday fell 87 cents, or 4.45%, to $18.70.

Duke to answer dividend buzz

Following a conference call by Merrill Lynch equity analyst Steven Fleishman on Tuesday in which he predicted that Duke Energy Corp. would likely cut its common stock dividend as much as 32% to 36%, as early as next week, the company scheduled a conference call to discuss the matter.

Before the company's response, which came after the market closed, Duke's stock and its three convertible issues suffered from a sharp selloff.

Duke said it would announce plans for its 2004 dividend and other financial actions in a news release at approximately 7 a.m. ET Wednesday. Then, chief executive officer Paul Anderson and acting chief financial officer David Hauser will discuss the decisions in a conference call for analysts at 10 a.m. ET.

Fleishman said he sees Duke cutting its common dividend to around 70 to 75 cents a share from the current $1.10.

"More likely than not, Duke will cut the dividend," he said.

"There's a scenario you could make that they keep the dividend where it is, but that would leave the company with very little financial flexibility."

Also, Fleishman expects the company to either mothball or sell off power plants in the Southeast due to a glut of generating capacity in the region and to accelerate its exit from the international arena.

Merrill Lynch has a neutral rating on the stock.

Duke shares dropped 29 cents, or 1.43%, to $20.03 in heavy volume.

The convertibles saw lots of action, as well, but traders said there was as much buying interest as selling.

"A dividend cut would be positive for the converts, but there was some sellers who just were taking an opportunity to get out of the name" to put their money elsewhere, one dealer said, who added the convertibles dropped more in tandem with the stock than on any underlying fundamentals.

"At least that was the case with the bonds," the trader added.

"The mandatories were a situation of a lot of selling, because they are more directly affected by the common dividend getting cut [as] they will eventually own it [the stock]."

Duke's 1.75% convertibles due 2023 dropped about 0.25 point, the trader said, to 103 bid, 103.25 offered.

Duke's 8.25% mandatory convertible due 2004 lost 0.24 point, or 1.74%, to 13.54 on heavy volume with 230,400 shares changing hands versus the running three-month average of 138,123.

Duke's 8% mandatory convertible due 2004 lost 0.37 point, or 2.59%, to 13.94 on moderately heavy volume with 149,100 shares changing hands versus the running average of 105,307.

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