With sales of anti-obesity drug Qsymia not progressing to the desired point, and cash burn at Vivus (VVUS) such that it was faced with either added debt, stock dilution through an offering, or finding a partner, Vivus seems to have chosen the former and came to terms on $220 million in 4.5% covertible notes due in 2020.
This route should not have been unanticipated by anyone. The company has wanted to avoid stock dilution, and the prospects of seeking out a possible partner is a recent development brought on by the actions of 10% stakeholder First Manhattan in its quest to wrestle away control of the Board of Directors.
What investors need to consider now is the actions that typically transpire with convertible notes. The usual play is that the buyer of these bonds shorts the equity. This locks in a gain while at the same time offering financial protection to the bond buyer. Think of it this way:
- The notes are bought for $220 million and deliver 4.5% annual interest. The deal closes on May 21st. The conversion strike price is $14.86 per share and there are 14,860,000 shares tied to the issue.
- Let's assume a stock price of $12 on the date of closing.
- The buyer of the note shorts 14,860,000 shares of the stock at $12. This nets the convertible bondholder $178,320,000.
- The bondholder now has a theoretical cash outlay of $41,680,000.
- The bondholder will receive $9,900,000 in interest payments each year between now and 2020. Over that period interest payments will total $59,400,000.
- The risk is now down to $41,680,000 and the interest alone over the term will cover that risk and deliver about $18 million in profit.
- The bondholder is essentially immune from exposure on the short position (upward price movement) because he never has to buy shares to cover. With the notes being convertible, the shares to cover the short position will be delivered by Vivus itself.
- If the company fails, and goes under, the short position becomes massively profitable. Essentially, the convertible bondholder has a pretty risk free transaction.
Shorting the equity tied to convertible bonds is a very common strategy. Investors now have a clue that the closing date on this deal is May 21st. There can and likely will be a lot of downward pressure on the stock between now and then. The average volume is about 2 to 3 million shares. It will take time to short the number of shares tied to this issue. The bond buyers are likely jockeying to do this type of shorting right now.
Please bear in mind that not all buyers of convertible bonds short. However, it is actually very common. It is likely safer to assume that this action will be taken than to not make that assumption. Essentially, downward volatility in the days surrounding this transaction is very likely. On top of all of this, competitor Arena (ARNA) is getting ready to launch its anti-obesity drug, Belviq. Stay tuned.
Additional disclosure: I have no position in Vivus.