Effect of Convertible Bond Issue on EPS

Description
The document explains the effect of convertible bond issue on EPS with the help of example of Ranbaxy.

Effect of Convertible Bond Issue on EPS EPS is the ratio of a company’s profit and number of shares outstanding. Number of shares owned represents the extent of a shareholder’s ownership in the company. Basic EPS = (Net Income – Preference Dividend)/(Weighted avg. no. of shares outstanding) If convertible bonds are issued, investors have an option to convert them into equity at the time of maturity of bond. Thus increasing the number of shares outstanding and diluting both the EPS and ownership of the existing. This dilution in EPS is reflected in the diluted EPS and that’s why convertible bonds are one type of Dilutive Securities. Diluted EPS is calculated under the assumption that all convertible securities will be exercised. Thus this represents a worst case scenario as all convertible security holders are unlikely to exercise all at once. On the other hand, if company’s performance is good and other macro and micro economic being favorable there is a god chance that all convertible bonds be converted into equity. Other instruments that contribute to dilution of EPS are: 1. Convertible preference shares 2. Warrants 3. Options Individual dilutive effect of each of these (including convertible bonds) has to be calculated before including the effect of conversion to common stock is incorporated into the calculation of diluted EPS. Calculation of Diluted EPS: • If convertible bonds are dilutive (EPS decreases after converting), the after tax interest expense [interest payment * (1-t)] is added to the numerator of the basic EPS equation If convertible bonds are dilutive, then while calculating diluted EPS, the equivalent number of common shares are added to the denominator of Basic EPS equation



Diluted EPS = [Net Income – Preference Dividend + Convertible debt interest *(1-t)] [Weighted avg. no. of shares + Shares from conversion of conv. Bonds]

Ranbaxy Laboratories

Ranbaxy in 2006 issued 5-year Zero Coupon Foreign Currency Convertible Bonds (FCCBs) priced at par value and raised $ 400 million with a Greenshoe option of $ 40 million. The bonds mature in 2011 and the capital raised would be used for financing international acquisition, capital expenditure and others. These FCCBs were listed on Singapore Stock Exchange. The yield to maturity of the bonds is set at 4.8 per cent per annum The Bond holders had the option to convert these into Common Shares or Global Depository Shares, at a price of ` 716.32 per share (@ 60% premium to the previous day’s issue price) with a fixed exchange rate of ` 44.15 per US $ 1, at any time on or after April 27, 2006 and but before March 9, 2011. The Bonds may be redeemed, in whole, at the option of the Company at any time on or after March 18, 2009, but before February 6, 2011, subject to satisfaction of certain conditions. The Bonds are redeemable on March 18, 2011, at a premium of 26.765 percent of their principal amount unless previously converted, redeemed or purchased and cancelled. The company plans to utilize the capital raised through FCCBs to fund acquisitions and had set aggressive revenue targets of $2 billion by 2007 and $5 billion by 2012 at the time of the issue.

Developments since the issue: • • Ranbaxy missed the revenue target of $2 billion for 2007 Ranbaxy acquired the entire share capital of Mundogen Farma SA, generic business of GlaxoSmithKline (GSK), in Spain, through its Spanish subsidiary, Laboratorios Ranbaxy S.L. for a total cash consideration of $ 5.73 million funded by FCCB proceeds FCCB proceeds were utilized for acquisition of Romania’s Terapia SA, and other acquisitions in Italy, Belgium and South Africa Company makes application for early redemption before March 18, 2011 which was not granted by RBI

• •



On 28 October 2008 Daiichi Sankyo acquired majority stake in the Company and resets the conversion price of its FCCB issue. The new conversion price is now ` 555 per share. The new conversion price is at a discount of approx 20% to the current stock price (as on Aug 13, 2010) of Ranbaxy The new price was arrived after adjusting for the equity dilution from fresh shares issued to Daiichi Sankyo on a preferential basis, the average price of the previous six months or six weeks, and factoring the advancement of the conversion date through a complex formula, said Malvinder Singh, chairman and managing director, Ranbaxy Laboratories In 2008, RBI allowed buyback of issued bonds on or before 31st Dec 2009 to help pharma companies tide over losses arising due to currency fluctuations and mark to market during the financial meltdown by lowering the interest payment burden Ranbaxy was not able to avail this scheme to buy back its FCCBs as its available fund (infused by Daiichi Sankyo) cannot be used for the purpose as per guidelines. Also, its outstanding amount of $440 million is way more than the max allowed of $50 million







Analysis: Dilution of EPS: As seen from the figure below the FCCB issue hasn’t had much of an impact on the EPS of Ranbaxy. In fact in the years 2006 and 2008 the option of FCCB was anti dilutive i.e. it increased the EPS. The major dip in EPS in 2008 can be attributed to the financial crunch, the forex losses suffered by Ranbaxy because of a weak currency and patent and legal troubles in the EPS.

Figure 1: Dilution of EPS after FCCB issue

In 2007 and 2009 the FCCB option was dilutive in nature but in 2007 because of a buoyant industry and a string of acquisitions the EPS and fully Diluted EPS were still high at `20.77 and `15.22 respectively. All of this dilution in EPS cannot be attributed to the FCCB as ESOPs were also issued which also lead to equity dilution.

Debt Position: Figure 2 below shows Ranbaxy’s Debt Equity ratio and Interest Coverage Ratio over the period 2005-2009. The D/E ratio increased from 0.43 to 1.35 in 2006 because of the FCCB issue but it is still not very high and should not be an issue in case Ranbaxy wants to raise more debt from the market. D/E ratio further reduced to 1.05 in 2008 after Ranbaxy retired debt amounting to approx `3,400 crore after the stake sale to Daiichi Sankyo. Interest coverage ratios are also very high ranging 6.6-9.29 from 2005 to 2009 when compared to the alarm levels of 1.5. Interest coverage ratio was negative in 2008 as Ranbaxy reported a loss owing to the reasons mentioned above but this can be regarded as a one off case and should not have much of an impact as the ratio improved to an impressive 27 in 2009.

Figure 2: D/E Ratio and Interest Coverage Ratio

Thus Ranbaxy has a healthy position as far as debt is concerned. Stock Price: FCCBs provide investors the option of converting their bond at a fixed conversion price into common stock after maturity. The conversion price is at a premium to the existing market price at the time of issuing debt so that the investors convert their debt into equity and can make capital gains by selling the stock in equity market. In this way the issuing company is saved the burden of redemption of debt which can place a huge strain on its cash position at the time of maturity.

Ranbaxy’s FCCB had a conversion price of ` 716.32 per share at the time of FCCB placement but it was revalued to ` 555 per share in 2008. The stock price at maturity i.e. March 2011 should be higher than ` 555 for the investors to convert their FCCBs into equity otherwise they would want to redeem their bonds at par value, putting a huge cash burden on Ranbaxy ` 19.5 billion (approx) Ranbaxy stock’s price slipped to the levels of `133 in March 2009 but since then has staged a strong rally to trace `500+ levels in Dec-Jan after which it has shown consolidation in the 430-450 range. Therefore, Ranbaxy stock has to appreciate nearly 20% from now till March 2011 (when the FCCBs mature) to make it attractive for conversion. With the economy on the rise and Ranbaxy showing strong performance in the first half of 2010 (42% revenue growth and posting profit after loss in 2009 YoY) the prospects for the stock looks good.

Figure 3: Ranbaxy's Stock Proce post FCCB placement



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