Tuesday, March 23, 2010

The FCCB issue

If FCCBs offer advantages to both lenders and borrowers, why did they run into trouble during the credit crisis?

FCCBs were also a cause for the battering that stocks of some highly leveraged companies received last year. So what are FCCBs and how do they impact companies you invest in?

What is an FCCB?

FCCB is a foreign currency-denominated bond issued by an Indian company. The bondholder can either convert the bond into a fixed number of equity shares in the company (the price is preset) or give up the conversion option and retain it as a bond; in which case, it will be repaid at maturity.

If the market price of the stock, at a future date, manages to rise past the "conversion price" for the bond, the bondholders may grab the option to switch to equity shares.

FCCBs are usually issued with the expectation that the company's stock price will continue to rise with profits. However, if that does not happen and the conversion does not go through, these bonds are to be retired at a premium over their face value.

Consider the FCCB issue of Suzlon Energy. The company issued a zero coupon FCCB with June 2012 as redemption date. However, these zero coupon bonds would be redeemed at 150.24 per cent of the principal amount if the bond does not get converted into equity.

What went wrong?

If FCCBs offer advantages to both lenders and borrowers, why did they run into trouble during the credit crisis? Simply because the prices dropped heavily and became unattractive for conversion into shares.

For instance, Subex's FCCB initially had a conversion price of Rs 656.2 as against the current price of Rs 64 (as a result of the 2008 correction). At the same time, the due dates of these bonds were fast approaching conversion.

Now, if the companies are forced to repay on due date, they would have to pay a premium on such redemption. However, some companies did not put away a sum as premium redemption reserve, believing that their bonds would be converted into shares.

To make matters worse, fall in rupee inflated the oustanding loan amount and interest payouts. The company's ability to service its debt/repay its debt is a key indicator of its financial health.

In the 2008-09 financial scenario, quite a few companies were at risk of committing default if they did not restructure their FCCB terms. This was the key reason why companies with FCCBs due for redemption were beaten down by the market.

Given the 2008 crisis, companies were allowed to either pre-pay FCCBs or restructure them by replacing with new set of FCCBs having lower conversion price (which would involve issuing more shares causing equity dilution). The RBI also allowed them to pre-pay debt by raising external resources and extended the time-frame for such pre-payment to December 2009.

In the case of Subex, the company resorted to revision of conversion price toRs 80.31 from Rs 656.2 to bring it closer to the current market price.

While companies such as Reliance Communication and Financial Technologies took the prepayment route by paying part of their debt at a discount, Suzlon, Aurobindo Pharma and Subex are some instances where the companies drastically cut the conversion price.

Companies whose FCCB redemption did not fall within, say, the next two years, remained neutral and did not resort to restructuring.

So what does this mean for investors? If the company you are investing in has outstanding FCCBs, look at the following:

Has the stock price remained far below the conversion price? If so, what would be the interest outgo on the FCCBs and would that affect profitability?

FCCB, until converted, is a debt. Hence, when looking at the debt:equity position, or leverage, do not assume that the bonds will be converted.

If the FCCBs are being converted into shares in tranches, what would be the ultimate equity expansion and would it dilute earnings?

For what are the FCCB funds being utilised? If they are being used effectively for expansion purpose, chances are that any equity expansion (on conversion) would be compensated by earnings expansion.

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