Learning from Alibaba's "Capped Price Increase" Buyback: Can It Really Get Cheap Money and Prevent Dilution?
Dolphin Jun just shared the convertible bond repurchase operations of JD.com and Alibaba. Ctrip also officially announced the issuance of convertible bonds (CB). In addition, there are rumors in the market that Meituan may issue convertible bonds, although Meituan has denied it. However, Chinese concept stocks seem to be in a state of alert again, fearing that convertible bonds may become a standard operation for undervalued Chinese concept stocks in a high-interest environment.
In Dolphin Jun's article "JD.com, Alibaba: Dilutive Repurchases, Sincerity or Strategy?", the main explanation is about buying stocks from the company's perspective + selling call options, focusing more on JD.com and Ctrip.
Ctrip's repurchase has some sincerity in that: it emphasizes that the principal part of the financing will be fully paid in cash, while the excess part may be paid in cash, stock, or a combination of cash + stock.
Specifically, looking at Ctrip's financing information: a. financing of USD 1.3 billion; b. conversion price of USD 66.5 per ADS; c. interest rate of 0.75%; d. maturity date on June 15, 2028.
Simultaneously with the financing announcement: Ctrip will use USD 300 million to repurchase 6 million ADS (repurchasing at a market price of USD 50.16 per ADS). Ctrip's explanation for this repurchase is that when repaying the excess part with stock, this repurchase can offset the dilution of stock caused by the conversion of convertible bonds to shares to a certain extent.
For example, if before maturity, when the conversion price is USD 66.5, Ctrip's stock price is USD 100, and investors exercise all at USD 66.5, then the diluted shares from this financing would be USD 1.3 billion divided by the exercise price of USD 66.5 - 19.54 million shares.
And if these shares are calculated at a market price of USD 100/ADS, the amount Ctrip needs to pay would be USD 1.954 billion (USD 100 * 0.1954 billion shares). However, Ctrip stated that USD 1.3 billion of this will be paid in cash to prevent dilution caused by this part of the principal. The remaining USD 654 million Ctrip can choose to use stock or cash.
If Dolphin Jun assumes that the remaining amount needs to be paid entirely in stock, then the stock payment part would be USD 654 million / price per share of USD 100 = 6.54 million shares, which is equal to the 600 million ADS repurchased with USD 300 million needing to be returned in full, nullifying the repurchase effect, but to some extent preventing dilution of stock caused by the conversion of convertible bonds.
Of course, Ctrip also clearly explained the purpose of this CB financing: a. refinancing to pay off previous debts; b. pure overseas business expansion; c. supplementing operating capital.
In other words, the purpose of Ctrip's financing this time does not include reducing stock through repurchases. The simultaneous repurchase is mainly to hedge against the dilution of stock caused by the conversion of CB when the stock price surges.
To some extent, Ctrip seems more like a company in a period of reasonably high prosperity, conducting normal convertible bond financing to expand its business The focus of this article by Dolphin is to provide a detailed explanation of how the limit call options operate, the possible hedging effects, and corresponding costs in the context of Alibaba's convertible bond financing solely for repurchase purposes.
a) What are limit call options?
When Alibaba buys limit call options, it is equivalent to buying call options while limiting the profit when the stock price exceeds a certain level. Even if the stock price surpasses the limit price, the exercise is still done at the restricted price.
For example, if Alibaba sets the limit at $160, and the stock price goes up to $180, the profit from the call option is still capped at the price difference between $160 (the limit price) and the exercise price of $105 (usually the same as the CB exercise price for hedging dilution effects).
b) How to achieve the anti-dilution effect? And what are the corresponding costs?
The question is, in normal call option trading, buyers usually do not limit their profit potential. The essence of this combination of trades can be understood to some extent as preventing the dilution of convertible bonds and discounting the repurchase effect in the case of financing for repurchase purposes.
Here, Dolphin uses charts to summarize the key points of Alibaba's convertible bond financing:
In the final financing result, due to the exercise of the green shoe option, Alibaba actually raised $5 billion, receiving $4.93 billion after deducting issuance fees. However, Alibaba's initial allocation of funds for repurchase and call options was based on a $4.5 billion financing amount with $574 million allocated for limit call options.
Dolphin calculates based on this $4.5 billion financing amount. Note that this calculation includes the following basic "good faith" assumptions:
a. No longer concerned about the proportion of stock payments at settlement, based on the company's sincere anti-dilution purpose, assuming that the principal, interest, and call option purchase cost of the CB at maturity are all paid in cash;
b. The use of financing funds is solely for repurchasing stocks, so all repurchased stocks are cancelled; the reason for issuing CBs is because of the low financing cost;
c. Also, due to anti-dilution purposes, the $574 million spent on purchasing limit call options can precisely correspond to the exercise price, corresponding number of shares, and term of the CB issuance, fully covering them (as the company's announcement is not clear on this part, Dolphin assumes based on best intentions);
d. If CB investors convert, it is done at maturity;
Note, in the last assumption, besides the general tax changes/mandatory redemptions, Alibaba also has a provision for selective early redemption: although the convertible bond matures on June 8, 2031, starting from June 8, 2029, if Alibaba's stock price is not below 130% (137 USD or above) of the $105 exercise price for 20 out of 30 consecutive trading days, or a selective redemption notice is issued the day before, the redemption can be initiated If the stock price is at 130% or above the exercise price of 105, it can trigger selective redemption. In this case, the redemption only requires payment of the CB principal + unpaid interest.
Here, Dolphin assumes that the likelihood of Alibaba's stock price surpassing $137 in five years is very high. Assuming CB investors aim to maximize returns, they will try to exercise before 2029. For ease of understanding, let's assume June 8, 2029, as the actual maturity date of the CB, with an effective term of 5 years.
Next, let's look at how this complex design prevents dilution. Dolphin assumes three stock price scenarios and their corresponding costs:
a. If the stock price never exceeds the CB exercise price of $105 during the term: Alibaba only needs to repay the principal and interest at maturity; although Alibaba bought a limit call option at the cost of the option premium, it cannot be exercised in reality. The actual cost Alibaba has to pay mainly includes the CB issuance fee, CB interest during the term, and the cost of the limit call option.
In this case, since the issuance fee is known ($6.4 million spread over five years), CB interest during the term is known ($4.5 billion CB loan, $2.25 million interest per year), and the cost of the limit call option is known ($574 million spread over five years), based on the actual amount used to repurchase common stock - $3.86 billion, the actual cost of this repurchase is approximately around 3.8% simple annual interest rate.
b. If the stock price at maturity exceeds the CB exercise price of $105 but does not exceed the upper limit of the limit call option at $162: In this case, apart from using USD cash to pay the principal and interest, Alibaba will use stocks to pay the price difference between the market price and the exercise price at the time of exercise. The stocks paid can come entirely from the shares obtained by exercising the limit call option purchased by Alibaba.
In this case, as the exercise of the limit call option effectively hedges the dilution of CB's equity, Alibaba's true financing cost is the same as in the first scenario, still at 3.8%.
c. If the stock price at maturity rises above the upper limit of the limit call option at $162: In this case, Alibaba not only pays the principal + interest but also needs to use stocks for the difference between $162 and $105, as the part above $162 requires actual stock payment.
As the calculation is somewhat complex, Dolphin summarizes the key stock conversion part with a red diagonal line in the following chart:
From the above demonstration, it can be seen that by paying an additional option premium to buy the limit call option, Alibaba effectively raises the exercise price of the CB to above $162, avoiding equity dilution in the case where the stock price does not exceed $162, and the repurchase effect is not discounted However, it is important to note that there are too many constraints in this scenario assumed by Dolphin, and the most fundamental one is that Alibaba must have "best intentions" to repurchase, and the execution process must not distort or deviate from the original good intentions.
In this situation, listed companies can indeed finance repurchases in the current high-interest environment (above 5%) at a relatively low interest rate (cost below 4%), to replenish ammunition for repurchases.
Furthermore, the assumption of this relatively low cost is based on the premise that the buyers of CBs do not convert in advance. If they convert in advance, the actual term of the CB becomes shorter, and it still matches the 5-year term call options, causing the annualized cost of Alibaba's option purchase to increase, thereby raising the actual financing cost.
Moreover, at this point, some may ask, since using limit call options can effectively prevent dilution, why not raise the exercise upper limit ($162) even higher?
The reason is simple, the higher the upper limit price set for limit call options, the higher the protection of the Hedge overlay, but the corresponding option premium is also higher, and the company needs to consider its input-output ratio.
Dolphin estimates that many people may feel more confused after reading this explanation of limit call options. For simplicity, many may directly ignore the funding for repurchases, and the cost-effectiveness of studying these terms may not be as good as finding several companies with better fundamentals.
However, after completing the previous article, Dolphin did receive many inquiries about the hedging effect of limit call options. Dolphin will try to share some thoughts on this tool through supplementary interpretation, and welcomes feedback.
Related Chinese concept bond (CB) issuances of Chinese companies:
Risk disclosure and statement of this article: Dolphin Research Disclaimer and General Disclosure
