Zeev, below are Joe's third and fourth in-depth posts on YAHOO's HEC thread which were very likely indirectly prompted by the controversy you initiated here on S.I. I am very much looking forward to your comments.
Gator II
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Shorting with floorless [Headline]
Jul 2 1998/10:45PM EDT
"...Here's how I think a holder of the convertible preferred
could THEORETICALLY profit from shorting:
Imagine a $15 MM preferred issue with the stock trading at $5. The holder of the convertible calculates that he can convert at $5 and get $15 mm / $ 5 = 3 MM shares.
Let say he then shorts 1 MM shares, and let's assume that this drives
the price down to $4. At $4, the holder of the convertible calculates
that he can convert and get $15 MM / $4 = 3.75 MM shares. He's still net long 3.75 MM - 1.00 MM = 2.75 MM shares.
So he shorts another 1 MM shares, driving the price to $3. At $3, the
holder of the convertible calculates that he can convert and get $15 MM / $3 = 5 MM shares. He's still net long 5.00 MM - 2.00 MM = 3.00 MM
shares.
So he shorts another 2 MM shares (getting serious now), driving the
price to $2. At $2, the holder of the convertible calculates that he can convert and get $15 MM / $2 = 7.5 MM shares. He's still net long 7.50 MM - 4.00 MM = 3.50 MM shares.
So he shorts another 4 MM shares (getting REALLY serious), driving the
price to $1. At $1, the holder of the convertible calculates that he can convert at $1 and get $15 MM / $1 = 15 MM shares. He's still net long 15.00 MM - 8.00 MM = 7 MM shares.
So he shorts another 10 MM shares (it's a battle for the company at this point), driving the price to $0.50. At $0.50, the holder of the
convertible calculates that he can convert and get $15 MM / $0.50 = 30
MM shares. He's still net long 30.00 MM - 18.00 MM = 12 MM shares.
At that point, perhaps, the short lets the stock rally 1/8 (more than
15%), continues to offer enough shares at 5/8 to hold the stock down,
and elects to convert. IF THERE ARE NO RELEVANT RESTRICTIONS and IF THE COMPANY CAN'T PAY CASH, he receives $15 MM / $0.625 = 24 MM shares and elects to pay $15 MM to receive another 24 MM (the double up option) -- total 48 MM. [Actually, with premiums and discounts, he'd get more than that.] After delivering 18 MM shares to cover the shorts, he'd have 30 MM shares.
Now if the company is worthless, this seems all appears nearly
pointless. But if the company has billions of barrels of oil in the
ground, the preferred holder might end up owning a substantial piece of
the company -- 30 MM shares vs the intended 3 MM.
It has been pointed out that the short seller seems to risk a squeeze.
If the company has real value, other investors might aggressively buy at low prices, pushing the stock price higher.
But this risk seems mitigated by the conditions that tie the conversion price to a recent low stock price. So if a squeeze happens, it seems that the holder of the preferred can cover near recent lows. [I'm not sure that there isn't a scenario in which a squeeze may be a real threat. This is all off the top of my head.]
The point that should matter most to this board is that an option to pay cash to the preferred holder, rather than shares, seems to completely void this strategy. If the company has value, the cash will be there.
<< isn't the two step transaction in fact very similar
to if Harken had conducted a secondary offering but without the
dilution of having new shares immediately outstanding?
I think any way you cut it this is a tempest in a teapot.>>
I think this is right.
<< We are leveraged a bit more, although with some very complex rules.
The fundamental fact remains that if Harken CONTINUES to be successful
in their Colombian projects us common folk are going to do OkeyDokey,
and if they flop we will do NOT OkeyDokey. >>
"Right again, I believe."
Joe
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Shorting w/ conv preferred (II) -- a DEFENSIVE strategy [Headline]
Jul 2 1998/11:16PM EDT
"My previous post assumed that the target of the short-selling
is a company with material intrinsic value. Let's consider, now, a
situation in which the company's value is doubtful."
"The convertible preferred is equity. If a company fails, the convertible will be worthless. As I argued earlier, the holder of the preferred buys it as a bullish strategy. The buyer's best outcome is a stock >15% higher in about 3/4 year.
But what if the buyer of the convertible is wrong? What if he comes to
believe that the company's fundamentals are deteriorating and his equity investment is at risk? He can protect his investment by shorting the stock.
Suppose he has paid $15 MM and the stock is at $5. He can TRY to protect his investment by TRYING to sell 3 MM shares at $5. But suppose he manages to sell only 1 MM at $5, which drives the price to $4. He manages to recoup only 1 MM x $5 = $5MM of his $15 MM investment.
With the price at $4, he can TRY to protect the remaining $10 MM of his investment by TRYING to sell 2.5 MM shares at $4. But suppose he manages to sell only 1 MM at $4, which drives the price to $3. He manages to recoup an additional 1 MM x $4 = $4MM of his $15 MM investment, $9 MM total.
With the price at $3, he can TRY to protect the remaining $6 MM of his
investment by TRYING to sell 2 MM shares at $3. But suppose he manages
to sell only 1 MM at $3, which drives the price to $2. He manages to
recoup an additional 1 MM x $3 = $3MM of his $15 MM investment, $12 MM
total.
With the price at $2, he can TRY to protect the remaining $3 MM of his
investment by TRYING to sell 1.5 MM shares at $2. But suppose he manages to sell only 1 MM at $2, which drives the price to $1. He manages to recoup an additional 1 MM x $2 = $2MM of his $15 MM investment, $14 MM total.
So maybe he recoups the remaining $1 MM by selling additional shares at $1, or thereabouts. The point is that the holder of the convertible is driving the stock of a bad company lower MERELY TO PROTECT HIS INITIAL INVESTMENT. There's nothing sinister here.
The so-called "death spiral" happens because (1) the holder of the
preferred comes to believe that the company may be dying, (2) he takes
sensible steps to protect his investment, and (3) other investors don't disagree with his assessment -- at least not strongly enough to support the stock price.
Short-selling by the holders of the convertible preferred would
therefore appear to be a SYMPTOM of a deteriorating company. Perhaps the short-selling hastens the company's demise. But fundamentally, the
short-selling is a correlate rather than a cause of the company's
weakness.
It has been observed that short-selling by holders of convertible
preferreds has been a feature of the demise of many companies. We should not erroneously conclude that the selling caused the demise."
Joe |
