Understanding Convertible Debt Funded Stock Buybacks - Cypress Semiconductor Case Study

Abstract

In 2006-2007, convert funded stock buybacks are popular. Why? Consider Cypress Semiconductor's complex transaction. In March 2007, its stock at $18.89, Cypress sells $600 million of converts, enters a $571 million VWAP (volume weighted average price) stock buyback contract, buys calls and sells warrants. It retires 28.9 million shares. Good profits! Bad deal? Six months post deal with its stock up 51.9% to $28.70, Cypress stands to reap a $180 million benefit at maturity, a $1.18 (4.3%) stock price boon for ongoing shareholders. Still, when it enters the deal, Cypress: - Needs 11.0% stock price appreciation to break even - Is exposed to 100% of any shortfall in its stock price from breakeven - Receives 100% of any stock price increase up to 28.7% above breakeven - Receives just 13.0% of any further stock price advance Simpler, superior structures are available. At 0-5% added cost, a call spread matches upside but cuts risk 83% or more. Other structures give lower cost with equal (or better) upside. Its deal choice (full downside; limited upside) suggests Cypress at execution is sure its stock is going up. Are selling shareholders adequately informed? Is earnings management an attraction? Real economic advantage through tax arbitrage seems blocked, but equity accounting lets deal losses (if incurred) and most fees bypass the income statement. A baseline settlement at current spot has Cypress receive a $180.2 million benefit through in part (40%) cash receipts, in part (60%) a 2.4% share count reduction. The only definite monetary trace in reported income is $27.0 million of tax deductible expense over the deal's life; Cypress can elect to show phantom income, but real tax then cuts the total real economic benefit. Also, stock buyback execution prices are seriously understated, but companies should not value this feature: The complex, syndicated deal itself exacerbates 10b-18 governance concerns, and misleading trade confirmations just put other anomalies in stock volume and pricing in a bad light. This analysis is tentative insofar as it fails to identify economic or governance advantages to explain the popularity of convert funded buybacks. Earnings cosmetics is not satisfying given the deal's poor risk/reward. Is there an overlooked tax advantage? The deal's popularity with banking syndicates is easy to understand, but, for now, we wonder, could the transaction be popular with companies because it is popular?