Lehman report: On stock run-up, Carnival's cash-to-zero, Royal Caribbean's February 2021 converts look like best plays

By Ronda Fears

Nashville, Dec. 11 - In the face of the rise in Royal Caribbean Cruises Ltd. and Carnival Corp. stocks, a report Thursday by Venu Krishna, head of U.S. convertible research at Lehman Brothers, shows that perhaps the best considerations among the five convertible issues of the two cruise lines are the Royal Caribbean 0% due February 2021 and Carnival's newest cash-to-zero convertible.

Lehman equity analysts upgraded Royal Caribbean and Carnival stocks on Thursday, and both rallied nicely. Thus, Krishna took a view of the convertibles linked to those stocks.

Royal Caribbean shares gained $1.32, or 4.16%, to $33.02.

Carnival shares gained $1.06, or 2.86%, to $38.13.

Royal Caribbean has two 0% senior convertible bonds (Ba2/BB+) outstanding, the 0% due February 2021 with a face value of $1.5 billion and the 0% due May 2021 with a face value of $883 million. The combined accreted value of the two convertibles is around $1.05 billion.

Despite a fairly levered balance sheet, both the convertibles trade at relatively tight spreads, Krishna noted. The 0s of May 2021 have an option-adjusted spread of 203 basis points while the OAS on the 0s of February 2021 is 193 basis points.

The 0s of May 2021 have a put coming due on May 18, 2004 at 45.02% of par for a put value of $397.5 million. The put is payable in cash, stock or a combination of the two at the company's option.

The Mays are quoted at 55.75 with the stock at $32.80, around 1.9% rich according to Lehman's valuation. These convertibles are fairly equity sensitive with a 74% delta.

On a risk/reward basis, the Mays do not appear to be an attractive alternative to the common. Relative to a 25% move in the common over the next year, Lehman estimates an upside/downside participation for the Mays of 68%/59%.

The Februarys have a $694 million put coming due on Feb. 1, 2005, payable in cash or stock.

"Investors should view this as short-term debt," Krishna said, because he estimates the stock threshold level below which investors are likely to exercise the put at $35.75. So, "with the current stock price at $32.80, the probability of the put being exercised appears reasonable."

The Februarys were quoted at 47.375 with the stock at $32.80, around 1.4% rich as per Lehman's valuation. These convertibles are a lot less equity sensitive, Krishna said, although they have a very defensive risk/reward profile.

Relative to a 25% move in the common stock over the next year, Lehman estimates the Februarys to provide a total return of +5.5% and -2.9%, respectively or a 21%/12% participation. Common holders who have realized healthy returns, could consider the 0s of February 2021 as a defensive alternative.

Carnival has three senior convertible bonds (A3/A-) outstanding - $541 million (accreted value) of 0% due October 2021, $600 million of 2% due April 2021 and $575 million of 1.132% cash-to-zero accreting convertibles due April 2033.

"We note that default protection on Carnival was recently quoted around 50 bps, reflecting a significantly better credit relative to Royal Caribbean," Krishna said.

The most equity sensitive of the three is the 0% due Oct. 24, 2021, currently in the money, with a 2.24% yield-to-maturity and a 9.3% premium.

But, Krishna said, "We estimate the security to be 1.02% rich on a valuation basis and similarly rich on an implied volatility basis. We also estimate a relatively unattractive risk/reward profile of 64%/52% for a 1 year, +/- 25% common stock move."

Terms on the 2% notes stand at 1.77% current yield and 19.2% premium, and the analyst estimates the security to be fully valued at current levels. Risk/reward profile on the 2% is similarly lackluster at 53%/41%, yet carries a relatively high bond floor of 99.3%, he said.

The 1.132% cash-to-zero accreting note appears the most attractive of the three Carnival issues, he said. The analyst estimates it is 1.8% cheap to theoretical value, with a relatively attractive 2:1 risk/reward profile of 67%/30% for a one-year 25% move in common stock.

Krishna said investors should note that the cash-to-zero note structure includes an incremental warrant component.

"Investors should be aware, however, that none of the three issues carry dividend protection features, common to virtually all converts issued since June 2003," Krishna added. "This fact makes their valuations vulnerable to future common dividend increases."

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