Issuer: Deutsche Telekom
Size: e2.3 billion mandatory convertible
Bookrunners: Goldman Sachs, Morgan Stanley
Deutsche Telekom’s mandatory convertible looked like a great idea. The company had long been criticized for not tackling its e64 billion debt pile sufficiently quickly or effectively. The convertible was a chance of doing something positive and on a large scale.
Unfortunately, while the e2.3 billion deal, the largest-ever mandatory convertible in Europe and the US, was a big step in the right direction in fixing the balance sheet, it also had a deleterious impact on the share price.
The case for a mandatory deal
The deal was marketed as a way of issuing equity while limiting both the share price impact and dilution. But on the launch date, Deutsche Telekom lost more in market capitalization – e5.3 billion – than it raised through the convertible. Its market cap has subsequently fallen at least another e6 billion.
The bookrunners ran for cover. Goldman Sachs declined to be interviewed because of sensitivities surrounding the deal, and Morgan Stanley could not provide someone to comment before press time. Fear about being associated with bad press about the deal spread even beyond the arranging banks.
Arguments vary as to why such a large equity meltdown occurred. Analysts say that the idea that the deal limits dilution is misleading given that more shares will have to be issued when it converts into equity in 2006. “It is a dilutive security so nobody should pretend that it’s not,” says a convertibles analyst. “If they need equity there’s only one way they can do it and that’s by issuing shares.”
In this case there will only be 3% to 4% of dilution, so although this could have put selling pressure on the stock, it doesn’t seem to explain such a sharp fall.
As these securities are mostly bought by hedge funds that short the underlying stock when they buy the convertible, this effectively means that a large equity placing occurs immediately anyway. Share prices usually drop on the day of execution of mandatory convertibles for this reason. In Deutsche Telekom’s case, it looked like this was happening even more than usual.
“There was an absolutely amazing volume of trading on the first two days.It looked as if nearly everyone who bought the convertible also shorted the stock,” says equity analyst Mathieu Robilliard at Banc of America Securities. As the stock fell, its hedging ratio went up, exacerbating the price drop.
Analysts think a bigger reason for the share price fall was that it was considered as a sign that Deutsche Telekom wouldn’t meet its debt reduction targets through asset sales in time. “With all the deals that we have seen in the last year, whether it be Alcatel or Vivendi, equity investors might not have liked the transaction, but they liked the fact the funding solution was addressed and completed. Here the jury is still out as to whether they have solved the funding issue,” says one analyst.
At least credit investors have been positive on the impact this deal will have in enhancing the company’s liquidity, although as a refinancing it will not directly reduce debt. When it was issued, the company’s bond spreads tightened by 10 to 20 basis points.
Importantly, the company was able to raise funds without upsetting the ratings agencies, which give this issue 80% equity credit. In fact, credit analysts say this deal makes a downgrade by Standard&Poor’s from its BBB+ rating much less likely. Moody’s already rates it two notches lower at Baa3.
The fall of Deutsche Telekom’s share price should be put in context of other telecoms, such as France Telecom, and the German DAX index, which have also dropped a lot. However, analysts argue that the share price should not have traded so low. “If you look at what discount you would have to offer to have sold e2.3 billion of straight stock, the share price drop really shouldn’t be beyond that,” says one. Robilliard adds: “It was probably a bit of an overreaction, because we think they are on track with asset sales.”
Assessing the options
Mandatory convertibles avoid the much longer and more public alternative of a rights issue, and the inevitable shareholder resistance. In DT’s case some analysts say that a rights issue might have dented the share price less and contained the dilutive effects just among existing shareholders.
Yet the company and bookrunners argue that they broadened DT’s investment base, and other analysts still commend that strategy, given its funding needs. One says: “With mandatory convertibles, you can access that market quickly and in size. If you need equity content treatment, you need to be guided by how much you need to raise and how fast.”
For the size issued and the speed at which the funds were raised, the deal cannot be faulted. Indeed it was four times oversubscribed. Although mandatory convertibles have to offer a high coupon to compensate for the loss of some upside that investors get from outperformance of the stock in these deals, DT’s was still priced in the middle of the marketed range, at 6.5%. The conversion premium was at the top end of the range at 24%.
Analysts say the issue was priced aggressively compared with predecessors. Unlike some mandatories, where any dividend paid to shareholders gets passed through to holders, investors in this deal will only get partial pass-through of dividend payments.
The deal’s fallout is sure to influence future issuers. Rumours that HypoVereinsbank may issue a e4 billion mandatory convertible have already panicked the market. If HVB’s share price sold off as much as Deutsche Telekom’s, shareholders would be left with nothing as its market cap is less than e5 billion. You can only hope that HVB will have a rethink.
