How do we factor convertible bond in our valuation?

There are two major cost components associated with convertible bonds: i) fair

value gain/losses; ii) interest expenses. For fair value gains/losses, we believe

they should not influence the valuation of a company as they are non-cash items

and do not reflect operating fundamental of the company. We do note that the

fair value gain/loss affect reported earnings and consequently the company?s

ability to pay dividends. Nevertheless, the impact should be minimal as S-shares

are normally high growth companies that do not pay out 100% of their earnings

as dividends.

Interest expenses are non-cash items so they will not affect a company?s DCF

valuation. However, we believe they should be considered if the likelihood of

bond conversion into equity is low. In this case, EPS should be calculated based

on the company?s existing share capital (and not the expanded share capital upon

conversion). Conversely, the interest expenses should not be considered if we

believe conversion is likely. In this case, we should all bonds will be converted

into equity and calculate EPS based on the diluted share capital.

Convertible bond has its advantages?..

The issuance of convertible bonds minimizes immediate earnings dilution (as

compared to new share issue) as the bonds are converted at a later date and

typically at a conversion price higher than current share price. At the same time,

the convertible bonds usually carry lower interest rates (compared to straight

debt), which reduces interest and more significantly cash flow burden on the

company. The process of convertible bond issue is also typically faster than

applying for a bank loan especially for a large amount.

?..and its disadvantages

The need to recognize amortized interest expenses and fair value losses could

distort bottom-line and economic reality of company and consequently affect

market sentiment. The potential share overhang upon conversion could also

cap share price performance. Separately, bondholders are not likely to convert

if company?s results are weak, which would lead to poor share price

performance. It may worsen things for the company as it would have to fork out

a large sum of cash to redeem the bonds. In addition, some convertible bonds

may carry special conditions (e.g. reset clause) that could lead to further

earning dilution for existing shareholders.

Convertible bonds ain?t necessarily good or bad

In view of the above, we believe there is no clear answer whether it is good or

bad for a company to issue convertible bonds. We could generalize by saying

that the bond issue will tend to work in favor for the company as long as its

earnings fundamentals remain strong and vice versa. A close examination of the

terms and conditions, especially ?toxic? terms like reset clause, would also help

ascertain whether the bonds are in favor of the company or the bondholders.

Efficient use of capital is key

We reviewed the stock performance of selected S-shares after they issued

convertible bonds. On a short-term basis, we find that share price tends to be

depressed. One possible explanation could be due to the fact that bondholders

are shorting the stock to hedge their position in the call options. However, this

effect is only temporary. On a longer-term basis, we find S-shares that have

demonstrated efficient use of capital to grow will continue to have good share

price performance.