NEW YORK, Nov 16 (IFR) - Say what you want, but the business
of manufacturing cigarettes is a highly lucrative one that lends
itself to repeat customers.
Vector Group, the fifth-largest manufacturer in the US, is
known not only for innovation in the manufacture of smokes but
its unconventional use of the capital markets as well.
The latest example came in the form of a highly-structured
US$200m, 6.2-year convertible bond that featured a full
pass-through of common stock dividends and a stock-loan
facility. Both the pass-through mechanism and stock-loan
arrangement make the security easier to sell - but also appear
to drive up costs for the issuer.
Here is how the situation played out.
Vector Group agreed to lend Jefferies up to 6.1m
Treasury shares, half up-front at a fixed price and the
remainder depending on need and at then-prevailing prices.
Jefferies, sole books on the CB, placed the initial 3.05m
shares long into the market like a typical stock offering. But
unlike a typical stock offering, the shares placed are to be
returned to the issuer on maturity of the CB.
The stock sale, which occurred last night at US$14.80, a
2.6% discount to last sale and setting the reference price on
the CB, creates a synthetic short position that is offered on
swap to buyers of the CB. Stock loan facilities are common in
situations where borrowing may be problematic because of costs
The pass-through mechanism, the second unorthodox feature,
entitles CB holders to the proportionate share of dividends paid
out to common stock holders. At the current US$1.60 annual
payout, a 10.1% yield at pricing, the additional consideration
is not insignificant - typically, CBs provide protections on
dividend increases through upward-adjustment to the conversion
The net result is that, although the security priced with a
2.5% coupon, CB investors could receive an 11.2% return annually
if the current dividend rate remains the same: US$25 on the base
coupon and US$86.50 pass-through dividends per US$1,000 par
bond. Juxtaposed against a 25% conversion premium, the security
looks ridiculously cheap.
"If you're an outright investor that believes in the
company, you would much rather own the convertible over the
common," said a rival CB banker. "The return profile is so much
more preferable and you are more senior in the capital
JUST PASSING THROUGH
The logic of issuing this security rather than common stock
is not straightforward.
Accounting changes in the treatment of stock-loan
arrangements are one complicating factor. Such arrangements
gained popularity among troubled companies such as Calpine in
2004, before the independent power producer went bankrupt.
Accountants have subsequently required companies to flow
through the economic benefits gained from the arrangement in the
form of higher interest expense.
Instead of 2.5%, in the case of Vector Group, the interest
deduction might be 3.5% or 4%, suppressing EPS. A source at
Jefferies did not know the actual rate that Vector Group would
deduct on the CB.
"You have to assign a fair market value. You wouldn't have
gotten 2.5% without the borrow facility," the rival banker said.
"What rate would you have gotten [without the facility]?"
The higher interest deductibility of the CB, over common, is
the principal motivation. Because of the pass-through mechanism,
the CB is deemed as a participating security in that it is
effectively equity. While it hits net earnings, the higher rate
of deduction shields cashflows.
"This is a unique company. Realistically, no one else would
issue this security," said a source close to the situation.
"What people are missing is that all these guys care about tax.
On an after-tax basis they are better issuing this than equity."
Vector Group, which in the early 1990s unsuccessfully tried
to champion a low-nicotine cigarette made from genetically
modified tobacco plants, is using deal proceeds for general
corporate purposes, including to repay debt. As of September 30,
the company had US$530.6m of long-term debt outstanding.
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