Convertible Tech Wreck
Many tech favorites are exposed to a significant cash flow risk few investors are discussing
“Everyone has a plan until they get punched in the face.”
A basic principle of equity investing holds that rapidly growing companies should sell for higher multiples of their earnings to reflect the expectation that the firm will “grow into” the high valuation if the growth keeps up. This explains that despite some of the air coming out of tech valuations in the last few months, one still has no problem finding sizeable companies selling for 50, 75, or 100+ times forward earnings. However, we believe there is a problem with the sustainability of a meaningful source of recent growth rates reported by many of the most popular names in tech. More importantly, for many of these companies, there is a significant future cash flow threat hiding behind the source of this growth.
The first level of the problem is that higher interest rates earned on the cash balances held by many tech companies have resulted in growth in interest income comprising 30% or more of the total growth reported by some in the last few quarters. While this is real income and real cash, investors aren’t paying 50+ times forward earnings for these companies to sit on their bank deposits, and unless interest rates double from here, this boost to year-over-year growth will start to dry up in the next couple of quarters.
However, the more serious part of the problem is revealed by looking a little deeper into why these companies have this cash sitting in the bank in the first place. For many, their cash balances are possible as a result of convertible debt issued in the last few years. Their financing strategy was fairly simple. When their stock price was low, they issued convertible bonds with conversion prices 30% or more above the current stock price. This allowed them to enjoy negligible interest rates- often less than 2%. This would provide cheap capital to grow, attractively low interest expense, and as the share price rose, the bonds could be settled in the future by issuing a reasonable number of shares. For an added layer of security, some purchased capped calls that would allow them to buy existing stock in the market at reasonable prices to settle bonds that holders converted to stock. This would limit their cash outflow and dilution in the event of conversion.
For example, consider a company with a current stock price of $20 and bonds convertible into 5 million shares of company stock at $30. The company could hedge its exposure to conversion by purchasing capped calls which would allow it to buy shares at $30 and limit how much it would have to pay to settle if the bonds were all converted. However, in practice, many of these hedging deals had upper limits. In our example, the capped call might only be good until the stock price reaches $50. If the bonds were converted to five million shares after the stock had risen to $40, the capped calls would deliver five million shares at $30. However, if the stock price was $60, the insurance would stop paying at $50 so the company would be effectively buying stock to convert the bonds at $40 - $60 stock price less the $20 band of insurance provided by the calls.
Companies with such convertible financing were doing fine until 2021-2022 when their stock prices took off as much as 400%-600% as the market began to see them as the next home run investment. This led to challenges for many as the stock prices shot past the upper bound of the covered calls. Again, consider our example company above in a world where the company’s stock jumped to $100. If it delivered new shares at $30 when the market price was $100 it would get sizeable dilution. If it used the capped calls it could mitigate the dilution, but it would have to pay much more in cash to settle the bonds as the stock price had run far past the upper limit of the calls. What many of these companies did in response to this problem was issue new, larger convertibles with the proceeds used to retire the original bonds. These came with a higher conversation price and given the recent stock performance – new capped call premiums had higher costs too.
Now, however, stock prices have come down considerably and many of these bonds likely will not convert at all. Regardless, the companies will face a cash outflow whether it calls the bonds, investors exercise their options before maturity, or the bonds become due. If bondholders exercise their options to receive shares, the company will have to buy them in the market and even if he hedges work, it still will require cash. If the bonds come due with the stock price below the exercise price, it will have to pay cash. The only option it has to avoid a cash payments is to issue new shares which will dilute existing shareholders. However, many of these companies do not have much if any positive free cash flow, and often those that do only do because a significant portion of their employees’ compensation is paid in stock. Should stumbling stock prices cause more employees to demand a higher percentage of their compensation be paid in cash, it will increase their repayment/refinancing risk. (We refer you to last week's piece The Hidden Tech Headwind where we explore how rising stock compensation is distorting recent earnings growth and available cash flow for some tech companies in more detail.)
Below, we document 38 companies that are likely to see a meaningful part of their recent growth dry up in the next couple of quarters as higher rates annualize. We then take a closer look at a dozen of these popular names that also face the added risk of convertible debt financing.
Let’s get “Behind the Numbers”…