ATP Preferred Convertible: For the More Risk Averse Investor, Worth a Serious Look

| About: ATP Oil (ATPAQ)

ATP Oil & Gas closed its offering of Series B 8.0% convertible perpetual preferred stock on Monday. See the prospectus here.

This offering gives investors who are more risk averse than those that typically buy the company's common stock an opportunity to collect some income while waiting for the upside potential. There has been a lot of discussion about the direction of the company recently, including here: Significant Upside in Growth Potential and here: It Is Never Ever Boring For ATP Shareholders.

In my opinion, the preferred shares should be looked at by two different types of investors. The first is those who have fallen in love with the ATP Oil & Gas (ATPG) story, but have begun to question when the execution is going to result in share price appreciation. The other type could be investors that own calls and would like to extend their time horizon on the company without giving up their upside by selling calls to create a spread, or buying expensive puts for protection.

Some of the highlights about the recent offering: the convertible preferred will receive dividends at a rate of 8% per annum and has a liquidation preference of $100. Each share of the preferred can be converted into common at a rate of 4.5045 shares, which makes the conversion price approximately $22.20.

From the prospectus:

On or after October 1, 2014, if the daily volume-weighted average price of our common stock equals or exceeds 150% of the then-prevailing conversion price for at least 20 trading days within any period of 30 consecutive trading days, we may, at our option, cause all or a portion of the Series B Convertible Preferred Stock to be converted into common stock at the then-applicable conversion rate.

The first dividend is expected to be announced October 1, 2011 for $2.24, and is expected to be $2.00 per share every quarter starting on January 1, 2012. Dividends can be paid in cash, common stock, or a combination of both.

ATPGP (preferred) closed yesterday at $92.15, while ATPG (common) closed at $15.54. Taking the conversion ratio, the preferred has an intrinsic value of $70 currently, and a premium of $22.15, or 31.6%. A potential concern is that this premium drops, and even if the stock trades flat over the next few months the preferred may drop. If the common trades up to $16 for example and the premium drops to 25% the preferred will be at $90.09; a small decline from yesterday's close. The 8% dividend guarantees that the preferred will trade at a premium to the conversion ratio.

As ATP can not force conversion of the stock until very late 2014, there will be plenty of time to find out if Israel in fact turns out to be a game changer or not. This is where the 8% dividend can take the sting out of the stock trading aimlessly as it awaits for further details on the opportunity.

As discussed in a Recent Presentation on page 30, EBITDA and cash flow are expected to increase dramatically this year as new production is brought online. The stock has also gone on sale again recently falling faster than the general market, and really being punished for falling commodity prices as they await the production boost expected to potentially increase revenues by 30% early in the 3rd quarter.

The market is truly waiting to see the production hit the bottom line, they are not being given credit for it as it has not been priced in. When ATP received a permit to drill their next well at Telemark on March 18th, they closed at $18.31. I would like to think this 15% haircut would grow back rapidly if they can deliver the expected production. Below is a 3-month chart from Yahoo Finance, click to enlarge:

Click to enlarge

Some of the drawbacks to the preferred are that the premium will decrease as the common increases. When the share price is above the conversion ratio, no one will be paying a 30% premium for an 8% annual dividend when they can simply convert to the common stock. If the stock is to increase rapidly past the conversion price, then there will be very few dividends collected, and the preferred will not see as much of an upside move as the common as the premium drops. A risk averse investor that is looking more for capital preservation with income and some upside potential will not mind this forgone opportunity cost as much.

Below is a comparison of the return between owning the common and the preferred. In this example I used a conversion period in the first quarter of 2015, giving an investor 13 dividends for an estimated total of $26.24, and then multiplied the common price times the conversion ratio of 4.5045 to get the total proceeds, and then divided by yesterday's closing price of $92.15.

As expected, the preferred does give up some upside potential, but it still packs a pretty decent punch. Obviously if the conversion were to happen sooner, this favors the common more than the preferred as there are fewer dividends paid out. However, if the dividends end up being paid in common stock, these will also have to receive a return as the price increases to the point of conversion.

ATPG ATPG Return ATPGP Return
23.00 48.01% 40.90%
24.00 54.44% 45.79%
25.00 60.88% 50.68%
26.00 67.31% 55.57%
27.00 73.75% 60.46%
28.00 80.18% 65.35%
29.00 86.62% 70.23%
30.00 93.05% 75.12%
31.00 99.49% 80.01%
32.00 105.92% 84.90%
33.00 112.36% 89.79%
34.00 118.79% 94.67%
35.00 125.23% 99.56%
Click to enlarge


Another option is to sell 2013 calls above the conversion price (Jan 2013 $25 for example) on top of the preferred. Some brokers may consider this to be naked call selling which would require the proper trading level, so that must be researched first. In this example, for every 100 shares of preferred purchased, 4 calls could be written as the conversion ratio would turn this into around 450 shares of which 400 would get called away. These calls can be sold for approximately 1.70 each right now which lowers the net cost to around $85.35.

If the stock is above $25 close to expiration in January, these shares could then be converted. At this point in time $12.24 will have been collected in dividends, along with a conversion price of at least $112.60. This results in a return of approximately 46% with another 50 shares of common still open to either be held onto or sold.

Again, I am not suggesting to go right out there and buy the preferred shares tomorrow. This is just a compelling opportunity for some of the ATP bulls that may be unsure of when they expect that share appreciation.

To those who expect oil to rise well above $100 again in the next few years but don't want to stomach wild volatility swings on the common or in options, this will give a nice opportunity to collect dividends in the meantime and not fret over the day to day issues. The premium ratio between intrinsic value and the current price of ATPGP may also come down, though it is hard to tell without following its trading pattern for a while. After a few months it may become more clear approximately what this ratio may be. If the recent soft patch continues it could also give an even better opportunity to pick this up cheaply.

Disclosure: I am long ATPG. I do not have any plans to initiate a position in the preferred stock right now, but this may change in the future.