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$NFLX Convertible Bonds – Act of genius or desperation?

November 27, 2011 3 comments

In my previous post I noted my experience working at a hedge fund called Stark Investments.  One of the core strategies of the firm was finding opportunities in convertible bond arbitrage, and Netflix news on Monday gave me a reason to talk about them in a post.  There are several strategies that can be employed with the use of convertible bonds, but I won’t get into those details this time around without a background in what they are constructed and what it all means.

Last week Monday, $NFLX shares continued their downward spiral another 8% when news came out that the company offered $200Million of Zero Coupon Convertible Subordinated Notes due on December 1st, 2018 to Technology Crossover Ventures, a  late-stage venture-capital firm.  If converted, the offering will add approximately 2.3M shares to the float This is equivalent to an initial conversion price of about $85.80 / share.  There are currently 52.5M shares outstanding, and the additional shares would dilute the stock by about 4.4%.

Convertible bonds have been given the label complex derivative, but they really aren’t that complicated when you take a few minutes to see how they are constructed.

A Convertible is basically a bond issued by a corporation that gives the holder the right to exchange the bond for a fixed number of ordinary stock shares.  If the bond is not redeemed by expiration, the value of the bond can be redeemed at the cash redemption value or market value of convertible shares.  In the case of a zero coupon bond, the value of the bond at maturity is par.

Let’s take a look at a basic hypothetical example:

Company Widgetron wants to raise cash by offering bonds that pay a 4% annual coupon that matures in May 19, 2015.  The first settlement date was May 19, 2010.  The bond holder reserves the right to convert the bond into

We can break that apart by looking at the terms:

* Coupon: 4%
This is basically the annual interest payment paid on the bond, which can be paid annually, semi-annually or quarterly.  This amount is generally a fixed rate for the life of the bond, but there are exceptions.  A 4% coupon on a 1,000 nominal value bond equates to .04 * 1000 = $40/year in payments.  Interest accrues according to the market convention used.  The UK, Asia Pacific, US and Latin America typically use 30/360 day convention, while Japan uses Actual / 365 days and continental Europe is actual/actual.

* Maturity
The date upon which the bond matures and the issuer must offer convertible shares. Again, if the value of the shares underlying at maturity exceeds the redemption amount, the holder will opt to convert into the common shares.

* Conversion Ratio
This is the number of shares the bond can convert into. For example, a conversion ratio of 31.0463 means that each bond can be converted into 31.0463 ordinary shares. The conversion ratio remains fixed for the life of the instrument, but may be adjusted to account for stock splits or special dividends.

* Conversion Price
This is a computed value, derived by taking the nominal value and dividing by the conversion ratio.  1000 / 31.0463 = 32.21.  This is the implied price that the shares would “cost” to the holder if conversion takes place.

Most convertible bonds are issued with a period of call protection during which the issuer may call the bonds early. Hard call protection is a period of time in which the bonds may not be called at all, while provisional protection is subject to the share price being above a certain level. For example, an issuer may want to reserve the right to call the bond if the underlying stock gets above 140% of the conversion price in order to protect themselves from a massive implied yield hit. Greater the call protection, the greater benefit to bond investors.  Shorter the call protection, the greater benefit to the issuer.

Therein lies the rub:
At maturity, the holder of the bond simply figures out if the value of (share price * conversion ratio ) > (conversion price * conversion ratio).  If it is, the holder would convert shares and score an instant profit.  This is effectively the ‘strike price’ of the bond.

In the concrete example for $NFLX, the bond is actually a zero coupon bond, and in theory the private buyers of the bonds today may be getting a deal in the long run, with faith that the value of the common stock will rise significantly over the next 7 years in exchange for taking the risk of getting a 0% coupon.  At this point, the stock would have to rise 35% from the current stock price of 63.86 in order to be made-whole on the deal.  The notes will convert at a rate of 11.6553 per $1,000, an implied price of 85.80.

For $NFLX, it could be viewed as both a smart move to lock in interest-free financing of international expansion, but it comes at a short-term cost.  The market has acted negatively as current holders continue to take a beating on the once pumped up momo stock that is momo-no-mo.  Netflix has shown poor management of available capital by over-spending on content, losing content providers like Starz through failed negotiation, and even repurchased its own stock with an average price of $222 per share.  The recent issuance of this convertible bond deal will either prove to be an act of genius or an act of desperation to continue its global dominance in streaming content.

This is a painful lesson for those that continue to catch this falling knife or planned on holding on short term but got locked in to a now long term position.
Obviously for the holders of the bonds, the long term view must be very bullish, but it could still be a very costly bet.

Let me know your thoughts by leaving a comment.

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Categories: Uncategorized

What difference does one teacher make?

What difference does one teacher make? The timing of this question could not be more relevant than now.

Does learning a wide array of subjects over the course of first twelve years come naturally?
Does every student see the importance in following through on a syllabus filled with diverse subjects?
Can each individual student latch on to every single subject they will take during the course of a high school education?

Learning from the lessons and mistakes of human history, the mysteries that lie underneath the biological and chemical surfaces that touch us on a daily basis, discovering the mathematical beauty behind the golden ratio or the fibonacci sequence, feeling in tune with multivariate game theory of economics and business, finding freedom of expression by observing the colors painted outside the lines, or jumping outside the comfort zone of one’s natural spoken language.

All of these subjects are part of compulsory education. Each student is required to attend.
Do they like it? The answer is more likely no. Every student usually does not find all of the above subjects relevant. The chances of a student succeeding in a subject they find no interest in is slim.

On the first day of most high school classes in America, we assign seven or eight 900-page hardcover books to a student, and send them home with a backpack used to shlep material they don’t want to read.

Or worse yet, the books end up collecting dust in a cold, dark locker. The elected officials have the luxury to look on at their ‘mission accomplished’; in their minds, another successful year is beginning. In their minds, the work is done. The students are on their way. It is almost as if we as a society are setting up our youth for failure. We’ve led them to the water, but we haven’t even shown them how to drink.

So what makes the difference? What puts the odds in favor of the player instead of the house?
The answer is passion.

Teachers with passion inspire students. They turn a boring subject into something, at a minimum tolerable, and at best a new hobby that the student owns. Passion gets a classroom to transform from cacophony to harmony. To the average teenage boy in high school, it can transform a piece of Shakespeare from a dull story into the highlight of the day when done just right.

Getting students interested is the first step. Keeping them interested is the challenge. Good teachers have mastered this skill. If we are to value a well-educated society that is capable of making incremental improvements in the world, we must first find the value in our nation’s coaches, teachers and mentors. They are our first line of defense to poverty. They are our last line of defense to ignorance.

The passion I’m speaking of cannot be faked. Passion is rare. Passion is valuable. If you know a passionate teacher, thank them. Support them. Some day they will be supporting your children.

Today, I recognize Tim Nelson, the Passionate Teacher, coach, leader and friend.

Happy Birthday, Tim.

P.S. Thanks for the English writing skills.

Categories: Uncategorized