Idiots.
thestreet.com
A Deal With the Devil
By James J. Cramer
Originally posted at 8:50 AM ET 8/23/00 on RealMoney.com
What if I told you there were a $4 stock out there in the rapidly growing
telecommunications industry that has roughly a $2 cash value? 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? 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?
And what if I told you that Nortel (NT:NYSE - news) has a big investment in the
company and Robert Annunziata, former CEO of Global Crossing and Teleport,
two wildly successful companies, just joined the board?
Ah hah, but before you go buy Log On America (LOAX:Nasdaq - news) 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.
Log On America is one of those companies that should have known better. I don't
know how many times I have urged CEOs in this column that they should not
issue so-called floorless convertibles because they will lose everything to their
investors. 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 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 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 to
shout it from the rooftops: Don't do these kinds of deals, even if you think they
will save your company. They won't.
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.
It got shafted.
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 hope not. These folks seem like honest guys. Not very smart about financing,
but honest guys.
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!
What I want you to do is avoid companies who make these deals so you won't
have a Hayes, which ruined my 1998, or a Log On America, which, I am sure has
ruined everybody's year who has bought this otherwise high-growth CLEC
company.
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.
In February of this year, 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.)
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 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.
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
Onýs 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 8 million shares? Heck, there are only
8,800,000 shares outstanding!!! Management only owns 3 million shares.
Game over! Toxic convert holders 1, everybody else, zilch-mo!!
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.
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.
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. |
