As is his wont, Cramer rewrites "A Deal With the Devil," and publishes some responses.
The recently added parts are in parans (), but it is easier to read at the Street.com site, where they are also bolded.
Doc
thestreet.com
thestreet.com
thestreet.com
--------------------------------------------------------------------------------
Cramer Rewrites "A Deal With the Devil," Part 1
By James J. Cramer
8/24/00 10:03 AM ET
People loved this article. Some had questions about how toxic convertibles work. Others had insight. Still others begged me to go through it again. Normally, on Saturdays I rewrite pieces that people seem confused or fascinated by to get rid of the trader-speak and the jargon. But I don't think enough of you know about my rewrites on weekends, because our readership drops off significantly on those days. Every Friday, I pick a piece from the week and give it a thorough going-over. I am also asking Todd to do one about some of his harder stuff. In order to show you what it is like on weekends if you never tune in, I am doing a rewrite on a Thursday.
--------------------------------------------------------------------------------
What if I told you there was a $4 stock out there in the rapidly growing telecommunications industry that has roughly a $2 cash value? (To figure out cash value, all I did was take the cash-on-hand -- available in the most recent quarterly financial report -- and divide it by the shares outstanding. Can you believe this stock was at 2 last week, when I first got wind of this problem?) What if I told you the company is growing by leaps and bounds and provides advanced telco services to 45,000 customers, up 50% from six months ago? (While this is great growth in almost any industry, in this one, wiring homes and businesses with high-speed lines, it is not-bad/not-great. I don't think this stock would be ramping if it hadn't done this convertible preferred. I think it would still be hanging in there in the high single digits/low teens. But it sure wouldn't be here. And it would have made a much better takeover target without this financing. Now that seems out the window.)
What if I told you "Inside Wall Street," the BusinessWeek column, hyped this thing at 25 a year ago and everything it said came true, except the stock price plummeted anyway? (Well, this is par for the course. I used to criticize that column every Friday, but it was like shooting fish in a barrel, frankly. And it sure did irritate those BusinessWeek guys. So I knocked it off. It was really funny when the editor of BusinessWeek, in introducing a midweek Net version of that column, mentioned that it was so important to read it that Jim Cramer writes about it every week in TheStreet.com. Man, that was a brilliant stroke; it shut me up for good! Touche, Steve! Always liked that guy.)
And what if I told you that Nortel (NT:NYSE - news - boards) has a big investment in the company (This was actually no big deal, as it is typical vendor financing. In fact, it was really a straw man. After I wrote it I figured someone would sell Nortel for doing stuff like this! I love Nose Tackle, as we call it, and I hope you do dump it (LOL).) and that Robert Annunziata, former CEO of Global Crossing (GBLX:Nasdaq) and Teleport (two wildly successful companies) just joined the board? (I like Annunziata, whom I met several times during my stint on Squawk Box. He is a straight shooter. He got a ton of options for joining this board. Maybe he has some clout and can get some money out of the bankers that advised on this deal -- First Boston -- for the company. First Boston is not a defendant, but it didn't do the company any favors either.)
Ah ha, but before you go buy Log On America (LOAX:Nasdaq - news - boards) this morning, what if I told you that it had issued a toxic convert at 17 six months ago? Would you still be tempted? Maybe you shouldn't be. (I found Log On America when I was looking through Mary Meeker's excellent tables on the dot-com universe, although this company is hardly a dot-com. After I found it, I read about the lawsuit, which is why you are reading this article.)
Log On America is one of those companies that should have known better. I don't know how many times I have urged CFOs in this column that they should not issue so-called floorless convertibles, because they will lose everything to their investors. (We have an amazing readership. We may not have as many buy-and-hold mutual fund types as I would like, but we have a ton of senior execs and decision makers. I heard from 10 CFOs after I wrote this piece, all subscribers. I suspect I will hear from many more in the ensuing days.)
I have beaten myself up endlessly for failing to stop Hayes, a now-bankrupt company, from issuing a toxic convert. At the time, Hayes was one of my firm's largest positions, having gotten it as part of a sale of Penril Datability's high-speed modem business to Bay Networks (now Nortel). (I often talk about 1998 because it was a terrible year for me, just terrible. Many many things went wrong. The worst, though, was watching Hayes go from 6 to zero in no time flat, as it was shorted to oblivion. It was not a good company, but it was helpless in the face of these sharks. It took me three months to convince the CEO that the short stuff was even happening. I do not have a deceitful mind, but as soon as I heard the terms of the deal, I said to the CEO, "Are you crazy? They will short your stock to zero now." He said that would make no sense, that they were good guys, that they had given him their word that they would work with him and not do that, and that they were going to help save the company.
I cannot repeat what I said to him on this site because I really lost my temper -- and I have a very bad temper. But the whole office was shaking. I told him that I knew we were about to lose $14 million and we would be helpless. I said it would happen overnight. We lost $14 million overnight. I am still very angry. It destroyed our performance for the quarter and set back our year. It helped lead to massive withdrawals.)
I argued vociferously with the CEO of Hayes -- who shall go nameless because, in the end, I am a better guy than he is -- not to do this trade. I predicted that the preferred holders would short the common stock into oblivion as a risk-free trade, which they did. I said it would put the company into bankruptcy faster than a speeding bullet. (The preferred guys denied they were doing this all the way down. They said I was making it up. There was no way to prove it until finally when it was too late and they admitted they had been doing it all along. Thanks guys!) The preferred guys drove the stock down to zero and the company filed for Chapter 11 protection. We lost everything. So I have made it my mission since then to shout from the rooftops: Don't do these kinds of deals, even if you think they will save your company. They won't. (These deals only happen to companies in trouble. But I don't buy that they are last-recourse financing. You can always sell the company. The guys who get screwed here, by the way, aren't management. It is the common shareholder. It is you. Management will get another job. You will lose everything invested.)
Log On America didn't listen. It took money from a couple of savvy convertible preferred guys and the company now alleges that toxic issuers systematically drove the stock down from 17 to 2 by selling short the common, knowing they had a risk-free short because the lower the stock went, the more shares that would be issued against the convert. (I could have added some caveats here. Management was given an incentive to bring in financing, for example. They did well for bringing in the sharks. But I think that misses the point. They lost the whole shooting match in the end, didn't they? And yes, I think it is the end. Also, with ICG Communications (ICGX:Nasdaq - news - boards) down to 4 and NorthPoint (NPNT: - news - boards)-Covad (COVD:Nasdaq - news - boards)-Rhythms (RTHM:Nasdaq - news - boards) doing terribly and lots of these Earthlink (ELNK:Nasdaq - news - boards) types stumbling along at lows, you could argue that these guys are dead meat too.
Again, though, remember that they ended up giving the company away. Clearly, they could have sold it for something earlier on when it was at 17. Also, I am cognizant that they were brought public by Dirks, instead of by a major firm. Nevertheless, they hired First Boston last year for help on this. That's a major firm.) It got shafted.
--------------------------------------------------------------------------------
thestreet.com
Cramer Rewrites "A Deal With the Devil," Part 2
By James J. Cramer
8/24/00 1:27 PM ET
Editor's note: This is the conclusion of a two-part rewrite column. Please be sure to read Part 1.
--------------------------------------------------------------------------------
Now the only hope for this company, as I see it, is the suit it just filed in Federal Court. And given the slow nature of the courts, that may not be enough to save this company from oblivion.(I don't think lawsuits save growth companies. They tend to be too slow.)
I hope not. These folks seem like honest guys. Not very smart about financing, but honest guys. (Again, some of you pointed out they were well-compensated for bringing in this financing. I said, big deal. They were definitely over their heads. Maybe even greedy. But they deserved better than this.)
I don't want them to fail. That's probably now up to a judge because these convertible preferred guys are smarter than Shylock ever was. And nowhere near as visible, or as sympathetic! (That's the takeaway I keep hearing from other guys who have dealt with these firms. They are slick and smart. They have a game and they know it. I found myself thinking, hey, I ought to invest with them? But I also found myself thinking that hey, I ought to invest with Tony Soprano when he was doing that bust out of Dave's sporting goods place in last season's "Sopranos" episodes. However, neither is really investing the way I do it.).
What I want you to do is avoid companies that make these deals so you won't have a Hayes, which ruined my 1998, or a Log On America (LOAX:Nasdaq - news - boards), which, I am sure has ruined everybody's year who has bought this otherwise high-growth CLEC company. (That's the point of this piece. I don't want you to ride your position to certain oblivion. Some companies have beaten the convert monster. Not many, though.)
So I want to give you the details of what has happened to Log On, and what occurred to Efax.com, Netplex Group, Auspex Systems, MicroStrategy, General Magic, Intraware, Etoys and Entrade, according to the plaintiff's document. (I took this list from the complaint. A member emailed me and said that Auspex Systems deserved better than to be included by me. He proceeded to trip down some pretty interesting facts about Auspex and I found myself building a file on it immediately. Hopefully, I will have more tomorrow. Couldn't believe that eToys did one of these. I mean, I didn't know they were that desperate. They should have sold the company to somebody instead.)
In February, Log On entered into a deal with a couple of firms to raise money through a convertible preferred according to a "floating" conversion rate that was meant to offer some downside protection to the holders. Thus the lower the stock at the time of conversion, the greater number of common shares to be received by the holders. (Hence , the floorless nomenclature.)
(I tried to get a list of the companies that had done these from the NASD but they didn't have one. I am trying to compile one by going through filings but it is taking forever, my apologies. Remember, it is not like they title the document "Toxic" and burnish a big skull and cross bones on it. It looks like any financing for convertibles -- many of which are fine instruments that I have owned from time to time.)
What is so awful about that? For one, a floorless convertible presents, as the brief from the Log On suit says, "a tempting opportunity for market manipulation." To use the formula provided: (The document has dozens of little snippets about how bad these are, which makes me say to myself, hey jokers at Log On, if it was so easy to find out what poison these are, what they heck were you thinking? A simple search on the web would have stopped this financing in its tracks. I am hoping other cfos will see this and know better but they keep doing them. If the Journal wrote this up, they wouldn't, but there is nothing I can do about that.)
[The holder of the security] can short sell the company's stock at a price of "X" per share. A high volume of short selling pushes the share price down to X-1 or even X-2. The preferred shareholder's conversion price is then reset to a discounted percentage of X-2. The preferred shareholder then converts at that lower conversion price to cover the shares it sold at X, delivers the shares necessary to cover the short sales and has a large number of shares left over, which it can then sell at X-2. ... Further, the more the preferred shareholder can push down the market price, the more profit it makes on each conversion. If the preferred shareholder short sells at X per share, it will make much more if it can convert its shares to cover at X-4, then it will make by covering at X-2. Thus the more the preferred shareholder can drive the market price down, the more money it will make per share and the more shares it will receive.
(You have to get this picture of an instrument that gives you more and more shares the lower the stock goes.)
Hence the term "toxic," or the more colorful "death spiral convertible." The lower the stock gets driven the more in the driver's seat the convert holders are. In Log On's case they have hijacked the whole car! Log On alleges in its brief that the convert holders have driven the stock down so far through massive short sales that they would now own 8,000,000 shares as every peg down entitled them to more and more shares. How much is eight million shares? Heck, there are only 8,800,000 shares outstanding!!! Management only owns 3 million shares. (In the document the whole thing seemed ridiculous. How could this kind of Trojan Horse be legal? Who checked off on this? What lawyers would not have seen that this company could lose control of the company if the stock plummeted? How could they not have seen this coming? I know I did two years ago and I have told everybody I know about it, and I know a lot of people. Someone did NO homework here. None. )
Game over! Toxic convert holders 1, everybody else, zilch-mo!! (Remember, it is the common stock holders I care about. That would be you and me.)
Isn't that an incredible story?
Of course maybe the holders didn't short it all the way down or knock it down. For example, we know the telco market has gotten tough. And maybe the business has gotten soft because of the Verizon strike or because Verizon has lowered the price of DSL. Who knows? But the simple fact of the matter is that this company was relatively healthy before it took this suicidal financing. Now it is on intensive care with a judge trying to figure out whether the stock should be resuscitated. Don't let this happen to one of your equities. If you own a stock with a convertible preferred and it is floorless, you could soon be in this position. Sell it now if you do, because it is a cinch that it will go still lower if the ploy is still on.
(A lot of people wrote to me and said that Log On was crummy. But how crummy could a company be that got through the Business Week machine? You don't think Gene Marcial picks those names out of the Yellow Pages do you? This was pumped up after Marcial did his thorough, solid research as I am sure the editors insist on or they wouldn't keep him, would they? Do you think Annunziata doesn't know what he is doing? I wouldn't bet that way. Such a bet has wiped out a lot of people! I could see ICG doing one of these deals. That would have been typical, but now it has new management, so maybe it won't.)
What happened to Log On shouldn't be allowed to happen. But it has happened. It may be too late to save it. Until chief financial officers of the world wise up, we will keep having these toxic converts. The bankers don't seem to want to stop them. The issuers surely won't. And the government doesn't even seem to know they exist.
(I would think that the issuers of these converts must be laughing themselves silly about how dumb corporate America is. I can see them smoking some Cubans and drinking Macallan 18 years old, neat, and cackling about how they fooled Toby Lenk or the folks at Log On or dozens of other players. Here's to you! You remind me of the scene in "The Godfather, Part II" with the corrupt Cubans passing around that gold telephone from United Tel and Tel! By the way, I expect nothing from the regulators on this protecting common stock holders. I know the NASD looked at it and did nothing. Oh well! Caveat emptor, boys!!).
What a crime! Hopefully for the last time: CFOs say "no" to death spiral converts. They will kill your company more quickly than any other former of financing. Better to just give up and sell the company than to take one of these on. Don't say I didn't warn you. (Right now, at this very minute, I am sure there are a half-dozen dot-coms talking with floorless convert lenders right now, getting all sorts of comfort about how it won't happen to them. Maybe it won't. Maybe the sun won't come up tomorrow, either. But I wouldn't bet that way.)
----------
thestreet.com
Tales From the Toxic-Convert Castle
By James J. Cramer
Originally posted at 8:34 AM ET 8/25/00 on RealMoney.com
I am addicted to learning more about these death-spiral converts. Below are two letters from readers that shed more light on the topic. The first is a simply fantastic letter that balances my words on these converts with insights from a true insider, someone who trades this kind of paper. I am printing it in its entirety.
I am a hedge fund trader who used to traffic in toxic converts. I handled and traded dozens of these converts, mostly small as we limited ourselves to a couple million size (I no longer work for that firm and no longer trade these instruments). I completely agree that any CFO is a fool to get involved in these deals, however, I would argue with your characterization of the buyers of these instruments as devils incarnate and the sellers as hapless victims. I can't tell you the number of times companies blamed us for their stock decline (even when we agreed to or were not able to short the stock).
In many cases they did not give us shares upon conversion because they didn't want to. They got our money and then we never heard from them -- they did not live up to their agreements to deliver our shares. The characterization that we ever wanted to short the stock to pennies so we could take over the company is a joke. Sure, we hedged whenever possible, but we never tried to hammer the stock down, in fact we wanted the stock to go up.
I was involved in maybe 50 deals. We made the most money in the few cases where the stock went up, not down. Rarely could you actually get 100% hedged and if the stock did crap out, all kinds of bad things happened -- like the company not fulfilling their promises. I will admit, there were probably more unsavory characters out there buying these instruments, but my point is -- except in a few cases -- we were much better off with the stock going up. The thing I learned after maybe six months of trading these instruments is that the primary reason the stocks tended to go down was the company sucked and should not have been public, as well as conversion pressure (similar to a lock-up).
So, we started shorting almost all deals we were not involved in. In fact, we made a couple million shorting Hayes. We thought the deal size was way too large relative to the market cap. (Editor's note: This is the deal Cramer lost a boatload on.) Even if the buyers did not short, they would be selling upon conversion -- and in large size. And, I thought the stock was worth 1, not 5. I think the company goes bankrupt without the convert, as the modem biz died.
My point in this letter is there is scum all around these deals. The leading scum are the selling agents (these are the biggest whores on Wall Street), certain buyers are scum -- we were not because we lived by the spirit and letter of any agreement we signed -- and also the sellers were often scum. They wanted your money. This money often was used for payroll (on smaller companies, not the size of eToys (ETYS:Nasdaq) or Log On America (LOAX:Nasdaq). Once they had your money, you often had to get the lawyers involved to get your shares -- even in cases where you did not short and the stock was not crushed.
Lastly, eToys and Log On America did have options, probably. Their CFOs should be fired. But the sellers of these bonds usually have no other options. Their company is worthless and the only option is to allow a sophisticated hedge fund to get the value that is embedded in the stock by borrowing it from the fools that own it at 1 and sell their stock.
The second letter is one of several true confessions I received from the toxic-convert front. Looks like some folks are feeling remorseful about their actions and don't want any other common stock holders to get hurt. Seems fair to me. The following letter is from inside the toxic fortress, written by someone who actually structured this kind of paper:
I enjoyed your article on death-spiral converts. I used to work in this crummy business -- as soon as I understood what was going on, I got out and went to work for a real investment bank to help, not hurt companies -- so please do not publish my name, email address or firm, not that you would.
Why not expose these guys and name names? Entrade (ETA:NYSE - news) (again, a decent company run by nice, but unsophisticated guys) got crushed by a toxic deal where not only did the convertible preferred securities reset, so did the warrants!
The worst part is that they were represented by a supposedly legit investment bank, J.C. Bradford -- what were they thinking? Another lovely feature of these deals is that, typically, the company cannot issue more equity without a full rachet reset on the convert. This is after the investors have shorted the dickens out of the stock and driven the price down! Many times these companies only trade 100,000 or so shares a day, so as you sat, the conversion process itself buried the stock as the bids dried up.
There are a ton of moving parts, resets, "liquidity penalties", rights of first refusal -- you name it on these deals -- all of which serve to allow the investors to suck every drop of juice out of the company, leaving a dry husk behind.
You hit the nail on the head when you said (I paraphrase here), "Rather than do a toxic deal, just sell the company." Why leave all the shareholder equity in the hands of these bloodsuckers? Anyhow, these "investors" like to hide in the shadows. They don't want anyone to know who they are. They create shell companies with different names to disguise their identity and their participation in these deals. ...I think you could do a lot to publicize what these guys are doing -- the more the awareness level goes up, the more CEOs, CFOs and boards of directors will avoid these toxic deals.
No one benefits from these deals but the toxic convertible holders.
Again, a recurring theme: Shed sunlight. I could not agree more. Billions have been lost in this style. It must end. |
