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We recently admitted to being baffled by a series of financial transactions made by Symantec (NASDAQ:SYMC). As we were unable to figure out the intricacies of the deal, we said that “To us, this sounds like a way for investment banks to earn a fee and for hedge funds to get a sweetheart deal on the debt issuance.”

A commenter posited that we did not understand the deal (how true!) and explained what was happening on their website. We asked for a walk-through and they kindly obliged. We thank them for explaining the deal, which we now understand.

To us it sounds like a way for investment banks to earn a fee and for hedge funds to get a sweetheart deal on the debt issuance.

First let me give you a synopsis of their argument:

In our first post, we mentioned that Symantec entered into a form of derivative transaction, widely known as a call spread, which was structured to compensate for the dilution that would occur if convertible bonds holders exercise their right to convert into common stock.

Transaction Structure

So, what the heck is a call spread? In this case it was the the purchase of a call option at one exercise price and sale of another call option at a higher exercise price. Symantec did the following:

1. Purchased a Call: Symantec purchased a call option (from one or more of the underwriters) that gives Symantec the right to buy its own shares at a price 22.5% above the current stock price. That is $19.12, the same conversion price as the convertible notes. The number of shares underlying the call option was likely the same that would be issued if the convertible converts, 104,590,200 shares. This component is what Symantec refers to as “convertible note hedge transactions” in the press release.

2. Sold a Call: Symantec also sold a call option ( again, to one or more of the underwriters) that gives the purchasing underwriter(s) the right to purchase Symantec shares at a price 75% ($27.32) above the current stock price. Again the number of shares would have likely been something close to 104,590,200 shares. This component is what is referred to as “separate warrant transactions” in the press release.

Economic Cost

Symantec had to pay $ for the “convertible note hedge transactions” and got paid $ for the “separate warrant transactions”. So what are the numbers? According the the 8K, Symantec paid $592 million for the purchased call (#1 above) and received $326 million from the sale of the call (#2 above).

So, the net cost to Symantec was $266 million to create the call spread. $266 million amortized over the average life of the bonds (6 years) is $44 million per year. That equates to a 2.2% annual cost. Tack this imputed cost to the coupon on the convertible (.75% and 1.0% depending on the maturity) and you have an imputed annual cost of roughly 3%. So, simplisticly, Symantec is borrowing $2 billion and paying a 3% annual pre-tax cost. Not bad terms.

Sounds great. Only it omits one little detail: the company is still exposed to stock dilution above $27.32. And if you do the calculation right you take the present value of 1,734 (Symantec’s net proceeds), the future value of $2 billion Symantec must repay, the roughly 17.5 million in annual interest expense and the 6-year horizon to come up with a bond that pays a 3.4 percent coupon and is convertible into equity at $27.32 per share. Why not just issue that bond instead of entering into separate transactions?

On closer inspection, the call Symantec sold is superfluous. They could have issued a straight bond and sold the option, or a convertible bond at the $27.32 price, or no bond and just sold the option. It is non-essential to any other transaction being done.
Looking just at the convertible bond and step one, we see that there is a perfect hedge on the converts. In other words, without the second call option sale Symantec has created a synthetic bond that is not convertible. The question is whether this synthetic bond has a lower interest rate than a straight bond would have had. First to calculate the implied rate they are paying:

Their proceeds are $1,408 ($2,000 less the $592 they have to pay for a call that perfectly offsets the one imbedded in the convertible bond.) In six years they have to pay back $2,000 and in the meantime they must pay $17.5 per year in interest. Plugging all of that into a financial calculator gives us an implied interest rate of 7.11 percent.

So, is that better than they would have achieved simply by issuing non-convertible debt? It is hard to say, as S&P has not issued a credit rating for Symantec. However, their ratings of other software companies can be used as a proxy. We estimate that Symantec would be able to get a BBB+, the lowest investment-grade rating and similar to Moody’s Baa. This puts Symantec squarely between Oracle (A-) and Reynolds & Reynolds (BBB), which seems about right to us.

Conveniently, the Federal Reserve publishes the prevailing bond yield for the average Baa-rated bond. On June 12, when Symantec performed its financial hocus-pocus, the Seasoned Baa Corporate Bond Yield was 6.64 percent.

So in summary: Before issuing its superfluous call option, Symantec paid higher transaction fees to create a synthetic bond that cost them 47 basis points per year more than issuing straight debt would have cost. No wonder the investment bankers were popping their corks.

SYMC 1-yr chart:

SYMC 1-yr

Source: Symantec's Questionable Financial Management -- Writing Extra Calls, Paying Extra Interest (SYMC)