I do not believe that the converts were a means to an end, nor do I think my reasoning about the transaction has it backwards. Remember, the equities market is a "zero sum" game. Money is neither created or eliminated by the market. Disregard all the terms of the convertible which are important but for clarity I wish not to consider it now. When RGC and Orbital signed their debenture agreement, OE had a market value let say for simplicity $4 per share. Again for this illustration, let's assume the entire 20 million dollars is funded in one tranche. RGC deposits the note with a broker to obtain collateral because they plan to short the stock. To hedge their position they short immediately "against the box". This is difficult because there is no real box to short against. When they established their account, they needed to have a broker that had a store house of OE shares that could be lent to RGC for shorting. Shorting without the box would have put RGC at risk should the shares shoot up on news. You may ask, how many shares would the broker need? To figure this out, the terms of the note provides for 5 million shares (20 million dollars divided by 4 dollars per share). With this, RGC opens a position with the broker to short 5 million shares. The short transaction is done off the flow of the exchange so it doesn't get reported in the NYSE short interest tables. Transactions off the NYSE exchange is active as exhibited by the composite tape. Now RGC waits and collects 3% on the terms of the note. This may sound low but if RGC believes that they have a risk less position, it's a dame good return when there is zero to 2% inflation. Orbital at the time expected good news to appear in December which they speculated that the markets would carry the stock higher. Not only did the markets in general implode, the good news everyone expected did not occur so the stock continues to drop. What does OE and RGC to do? RGC sees a potential profit and Orbital sees a potential gain. How can both parties gain? Simple!
Let's say the stock is at 2 dollars. All the shareholders are pulling their hair out for staying in. Some sold out of frustration is why OE is at 2 dollars. Remember RGC did not short the stock on the open market, they set their position against "The Box" which contained the shares. It was also a private transaction with their broker. OK, at 2 dollars, RGC decides to convert. Again for simplicity sake, they do this in one step which in fact is limited by the terms of the note. At 2 dollars, the conversion creates 10 million shares (20 million dollars dividend by 2 dollars). RGC decides now to close its position by returning the original 5 million shares to their broker. Their broker is happy because of the fees they charged for providing the service. RGC is happy because they now own 5 million shares free and clear. What do they do now with the shares? If they sell them, the stock will drop and they won't be able to maximize their return or could vanish quickly because OE is thinly traded meaning that the market cannot efficiently absorb 5 million shares in a relatively short period of time. Who comes to the rescue? Drum roll please….Orbital Engine Corp., Ltd. If they didn't spend the money GRC originally gave them, they can buy back 5 million shares at an agreed 1/8 premium to the market. RGC sells their remaining 5 million shares at 2 1/8 , closing out their position and Orbital retires half the issued shares for $10,625,000. They get to keep the remaining $9,375,000, and tax free. At a Corp. tax bracket of let's say 30%, the effective funding becomes $13,392,857. Why tax free? If the tax laws are similar in Australia, the money Orbital received was from a debenture which was repaid with tangible assets, equity. Does the tax man lose out? No, it just maybe which tax man, Uncle Sam or Aussie Sam. I'm sure the Australian Tax authorities have this covered.
So the who loses? It appears that the OE shareholder is holding the bag, but he would have anyway. Why? Because the short selling that occurred early on did not force the stock price down, it was a paper transaction between RGC and the broker and the share quantity involved was based upon the then current stock price. The price decline is because the market did not get the news it wanted to stimulate buying so shareholders sold again out of frustration. The other issue is that dilution did occur but not at the apparent amount from the 10 million shares. With the conversion, a 25% dilution was possible, but because of the share buy back, the dilution is cut in half.
What has caused trouble for many firms who used converts is that they needed the money to continue operations. It appears that for Orbital, the converts were not for maintaining current operations so they should still have the money in the bank. In the experience I had with Koo Koo Roo, management spent the money outside their core business that would have generated cash flow and market expansion. With the news that was reported on this thread that Orbital is filling to the SEC with the intention of buying back shares is very positive in light of my illustration above. |
