Ceradyne: Case Study in Contingent Convertible Notes (CRDN)

| About: 3M Company (MMM)

More and more companies have been issuing contingent convertible notes in recent years. Such notes can interact with the overall capital structure in strange ways that investors should understand. Below, we provide a case study. In their recent 10Q, advanced materials manufacturer Ceradyne (CRDN) made the following disclosures regarding its debt:

6. Convertible Debt and Credit Facility

During December 2005, the Company issued $121.0 million of 2.875% senior subordinated convertible notes (“Notes”) due December 15, 2035.

Interest on the Notes is payable on December 15 and June 15 of each year, commencing on June 15, 2006. The Notes are convertible into 17.1032 shares of Ceradyne’s common stock for each $1,000 principal amount of the notes (which represents a conversion price of approximately $58.47 per share), subject to adjustment. The Notes are convertible only under certain circumstances, including if the price of the Company’s common stock reaches specified thresholds, if the notes are called for redemption, if specified corporate transactions or fundamental change occur, or during the 10 trading days prior to maturity of the Notes. The Company may redeem the Notes at any time after December 20, 2010, for a price equal to 100% of the principal amount plus accrued and unpaid interest, including contingent interest (as described below), if any, up to but excluding the redemption date.

With respect to each $1,000 principal amount of the Notes surrendered for conversion, the Company will deliver the conversion value to holders as follows: (1) an amount in cash equal to the lesser of (a) the aggregate conversion value of the notes to be converted and (b) $1,000, and (2) if the aggregate conversion value of the Notes to be converted is greater than the $1,000, an amount in shares or cash equal to such aggregate conversion value in excess of $1,000.

In looking for long-term (30 years) financing, the company made a choice between paying higher interest (which is recorded as an expense each quarter) and sweetening the pot. There is nothing wrong with this. In fact, it allows both companies and investors to customize the risks they are willing to take. Still, it is important for investors to understand how such instruments function and how their features can interact with the rest of the capital structure.

The deal Ceradyne made was to trade bondholders a call option on CRDN stock in exchange for a lower interest rate. By structuring the notes to pay in cash for the principal amount, the company was able to avoid reporting near-term share dilution by the added shares that would arise if the bonds were converted. If the stock begins to trade significantly above the $58.47 level, there would be a gradual dilution effect.

The call option was, at the time of issuance, fairly deep out of the money. Although CRDN shares had more than doubled during 2005 the shares were trading at $43.39 on December 15. The bond’s imbedded call option allows the bondholder to exchange each $1,000 bond for the equivalent value of a little more than 17 shares, which would be a profitable move if the shares are trading above $58.47 - roughly a 35 per cent premium to the share price at the time. The company was then able to pay a cash interest rate of just 2.875 per cent, at a time when the rate on long-term Baa corporate bonds was 6.36 per cent. For $121 million in bonds, that amounts to a cash savings of $4.2 million per year (which equates to nearly 10 cents of EPS.)

Even though the potential conversion was at a much higher price, this clearly had some value to the bondholders to make them give up more than half of their potential interest payments. Clearly they expect the stock to be selling for more than $58.47 in December, 2035, which would make their bond similarly worth more. In order to provide the equivalent value of a 6.36 per cent interest payment, the ending value of the bond will need to be $3,936.18. That equates to a share price of $230.14 on December 15, 2035.

It sounds crazy, but beginning with a value of $43.39 the stock only needs to grow 5.72 per cent annually to achieve that value in 30 years. It suddenly doesn’t seem so hard to achieve. In fact, it is a virtual certainty that anyone who currently owns shares of Ceradyne expects them to return more than 5.72 per cent annually. So it begs a number of questions:

1. Why did management issue these bonds to save interest payments in the short term when there is such a low threshold for long-term performance?
2. If management expects the stock to return more than 5.72 per cent per year shouldn’t they have chosen to pay the higher interest rate? Do they expect a lower return?
3. Is there a value to the flexibility of not having a fixed $4.2 million annual interest expense? If the company hits a rough patch, is it conceivable that they would be unable to pay the additional interest? If so, the tradeoff may be worthwhile - but equity investors should understand that that implies a year in which earnings drop to just 10 per cent of the 2005 level.
4. As a potential investor, should you buy the stock when you can get the bond, with its downside protection and nearly 3 per cent annual interest payments, and still participate in most of the stock’s upside potential?

Presumably every investor who owns a share of Ceradyne has answered these questions in a way they find satisfactory. After all, the markets are efficient, are they not?