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Convertible Securities - Death Spiral?
“Death spiral convertibles” have increasingly become a more popular form of financing for cash-strapped companies. However, issuing these type of securities must be done with caution. Many companies have learned the hard way that these securities have been named “death spirals” and “toxic convertibles” for a reason. In the past two years, OTC-BB companies issuing convertibles have experienced a drop in their stock prices of nearly 15.8% in just the first thirty days. It was also found that as the stock prices of companies caught in a “death spiral” dropped, they experienced specific fluctuations in their trading volumes. This 24 page report also takes a closer look at five companies that were all caught in a “death spiral.” INTRODUCTION A convertible security is one that typically gives its holder the right to exchange each bond or share of preferred stock for a fixed number of shares of common stock, regardless of the market price at the time. However, in recent years, a number of companies have issued convertible preferred stock or debentures with a floating conversion ratio—in other words, the number of new common shares distributed varies with the stock price. Therefore the more the common stock price drops, “the more shares the owner of the convert [can] claim on converting.” This, in turn, dilutes the stock’s value and drives down its price. Short sellers further amplify the downward pressure on the stock price, thus giving these securities the name “death spiral convertibles.” These type of convertible securities have also been given names such as “floorless convertibles,” “future priced convertibles,” “discounted convertibles,” and “toxic convertibles.” BACKGROUND History and Performance “Death spiral convertibles” first gained popularity in the mid-1990s.1 According to Red Herring, in 1995 there were only “36 death spiral deals worth a combined $264 million, [and i]n 2000, 220 companies accounted for $2 billion of these deals.” Of those 220 companies that issued “floorless convertibles,” only 5 ended up in better shape. This idea that the stock price tends to decline after issuing such securities is supported in a number of sources. For example, according to PlacementTracker.com, between 1995 and 2001, of the 925 “death spiral” transactions, the stocks of only 230 companies increased “during the six-month and one-year period after the transactions closed.” Also, in a study done by Pierre Hillion and Theo Vermaelen for UCLA, from a sample of 487 issues between 1995 and 1998, it was found that “an investor who buys the common stock of the issuer loses, on average, 34% of his wealth one year after the issue.5 This occurred despite that the sample coincided with one of the strongest bull markets in US history. Also, according to Fortune, companies that issued future priced convertibles in the years 2000 and 2001 saw their stocks plunge by an average of 80%. Issuers Typically, the companies that issue “toxic convertibles” are smaller companies in desperate need of cash. Specifically, a number of the companies embracing these types of securities have been struggling dot-com companies. Given that these companies desperately need cash, whether it is used to fund a growth plan or to just survive, a question may arise in regards to issuing more common stock. However, according to Alexander Cappello of Cappello Group—a Santa Monica, California, firm specializing in floating-price convertible deals—“many managements believe their share prices are too low to issue stock or a conventional preferred security.” [continued...] Want to know more? Download the White Paper "Convertible Securities - Death Spiral?" for just $89.95. |
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