In the summer of 2012, the Hadaway Company was planning to finance an expansion
ID: 2622454 • Letter: I
Question
In the summer of 2012, the Hadaway Company was planning to finance an expansion with a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise enough to make conversion attractive. They decided on an issue of convertible preferred stock, which would pay a dividend of $1.05 per share.
The common stock was selling for $21 a share at the time. Management projected earnings for 2012 at $1.50 a share and expected a future growth rate of 10% a year in 2013 and beyond. It was agreed by the investment bankers and management that the common stock would continue to sell at 14 times earnings, the current price/earnings ratio.
Explanation / Answer
Buying stocks always poses the risk of losing money, but avoiding stocks altogether means missing out on the opportunity to make good profits. There is one security, however, that may help solve this dilemma for some investors: convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. Here we review what these securities are, how they work and how to determine when a conversion is profitable.
SEE: Valuation Of A Preferred Stock
What Convertible Preferred Shares Are
These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company's common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the investors' capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in the share price.
Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.
The Opportunity for the Investor
To demonstrate how convertible preferred shares work and how the shares benefit investors, let's consider an example. Let's say Acme Semiconductor issues 1 million convertible preferred shares priced at $100 a share. These convertible preferred shares (as these are fixed-income securities) give the holders priority over common shareholders in two ways. First, convertible preferred shareholders receive a 4.5% dividend (provided Acme's earnings continue to be sufficient) before any dividend is paid to common shareholders. Second, convertible preferred shareholders will rank ahead of common shareholders in the return of capital if Acme ever went bankrupt and its assets had to be sold off. That said, convertible preferred shareholders, unlike common shareholders, rarely have voting rights.
By buying Acme convertible preferred shares, the worst investors would ever do is receive a $4.50 annual dividend for each share they own. But these securities offer the owners the possibility of even higher returns: if the convertible preferred shareholders see a rise in Acme's stock, they may have the opportunity to profit from that rise by turning their fixed-income investment into equity. On the reset date, shareholders of Acme convertible preferred shares have the option of converting some or all of their preferred shares to common stock.
SEE: Leverage Your Returns With A Convertible Hedge
Determining the Profit of Converting
The conversion ratio represents the number of common shares shareholders may receive for every convertible preferred share. The conversion ratio is set by management prior to issue, typically with guidance from an investment bank. For Acme, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of Acme stock.