Cramer Rewrites 'A CFO Primer'
By James J. Cramer
Originally posted at 1:42 PM ET 7/1/00 on RealMoney.com
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Time for a chief-financial-officer primer. Others might want to follow along. But this is meant for beleaguered CFOs of dot-coms that are running out of money.
(Lots of convertible bond people took umbrage at this piece. But other people were thrilled just to find out how some of this stuff works. I think the convertible bond people failed to read the "beleaguered" CFO line. If a growth company with good prospects wants to issue convertible bonds, that's just fine. I have bought hundreds of convertible bonds for my fund. They are good for the issuer and good for the buyer. I am not talking about those kinds of converts. I am talking about companies that aren't doing well, where it is obvious that they are not doing well, and they can't seem to get any other form of capital. I am talking about companies that are at the mercy of the capital markets. They often think they have stumbled on a terrific way to invest and instead they have signed their own death warrants.
I think what bothered me most about the convertible complainers was that they thought they could buffalo me into thinking I didn't know what I was talking about, when the truth is that they didn't want this stuff written about or talked about because it would scare many other companies that could issue paper and these convertible traders need more issuers. Instead of focusing on keeping the dangers hidden, these grousing folk should join me in trying to clean up these cesspool converts and turn against the scum-sucking pigs who are playing this game. They certainly know who they are. Remember where I am coming from. I am a firm believer in the honesty of our markets. But for too long the bad guys in our game have hidden behind obfuscation, pseudo-mathematics and mumbo jumbo to screw over good but uninformed people who don't have much brush with the capital markets and are easily bagged.
How do I know this? Because I have been on the end where this stuff has gone down. I have screamed at people for not seeing the very trick that was about to happen in this piece. I have seen companies die because of this strategy. And I personally have lost millions of dollars because of these shenanigans. I know where I am coming from. I have reason to be outraged. And I am happy to throw the curtain back and show you -- particularly you neophyte CFOs -- how the game really works. I can tell you that your bankers, motivated by one-shot fees, won't even mention what is in this piece and for that they should be drawn and quartered.)
Pay attention.
OK, you are the CFO of NationalGiftWrap.com. (I use National Gift Wrap because that is my Dad's company. It is private. I don't want to hurt anyone's feelings. Lord knows I do enough of that already. This way I keep it nice and objective.) Your stock is at 30. Your bankers have told you that the capital markets are closed to you despite the fact that you are backed by idealab!, Benchmark, Sequoia, Amazon (AMZN:Nasdaq - news) and the guy from Starbucks (SBUX:Nasdaq - news) -- as well as the Internet Capital Group (ICGE:Nasdaq - news). (They bought their stake site/sight-unseen from one of their private jets after reading that NatGift was the category killer in the high-growth seasonal gift-wrap business.)
(So the setup here is one where the dot-com is hurting. It needs more capital. The assumption is that the initial backers are through with putting more money in. A secondary -- an underwriting of stock -- might be a possibility. In fact, it is more likely that the stock is much lower in dollar price. But I didn't want you to get distracted. My point is that the CFO knows he needs money and he wants to raise some and he can't do a common stock offering because the market doesn't want any dot-com paper. I put all of those big shot venture capitalists in because I am really jaded at this point and think that in the last year virtually everybody got stupid -- I call it the Collective Stupidity period, like Collective Security. It was a dumb time. You would think there would be a little more shame. But all anybody in this country lives for is to not get sued, and if you are honest it will come back and make you pay, so instead it pays to be dishonest or quiet as opposed to up front and candid. Only the truth can come back to haunt you. Lies can't. Something wrong big time with that, but it has to do with the litigation system.)
So, you take a call from Sisyphean Asset Management, which has offered to buy a convertible bond (This is like a bond. It pays interest. But it is attached to the stock and can be paid off that way if the stock rises. In other words, there would be some sort of contract which says that in the event that National GiftWrap.com's stock traded up 25% after the piece of paper is priced, National Gift Wrap.com can "call" the convert, or turn the convertible bond into common stock and no longer have to pay interest. It is a nifty idea because the holder gets a piece of paper that pays interest but also gets to participate in the upside. The issuer, National Gift, gets to pay a lower interest rate than it would normally because the convert has that upside. These can be great pieces of paper. They can give you downside protection as a convert holder because unlike the common stock holder, the interest on the bond is going to put a floor on how low it will go.
Remember how bonds work. If a bond sells at 100 and yields 5%, it is going to yield more if it goes down. Let's say the common stock goes to $20. The bond will not fall by a third, because it would be yielding so much other bond buyers would switch to it, provided you were confident that the issuer could make the payments.)
Hmmm, sounds good. The folks from Sisyphean are offering a good deal. In return for 5% of the company, in the form of a convertible bond, they will give you $100 million. Cool! (These terms are rounded. I would suspect that a company in trouble might get a rate like this, but it might be much higher. I kept it simple for this demonstration. The 5% of the company would be after the piece of paper is converted to the common stock, in the event of an increase in share price to the conversion level.)
So you do it. You don't know anything about convertible bonds, but you agree to pay 5% interest (that's the "coupon") on the convert and if your stock goes to 40 a share, (the conversion price) you can convert the bonds into equity. (The company can force conversion. It can do it pretty much when it wants, depending upon how much "conversion protection" is offered. Maybe it can't be called away for a couple of years. That allows the bond holders to participate in the upside and get the coupon. Win-win for the bond holders.)
What a great trade! How could you lose? It's cheap capital and -- if your stock goes up -- you can wipe out the debt!! (That was the perception of the management I once dealt with when they called me and told me they were going to do this. I almost reached into the phone and killed the guy. He didn't believe a word I said about what was about to happen to him. The only thing I got wrong was the time. I said this convert would wipe out the company in a matter of a couple of quarters. But the deed was done in a couple of months. My blood still boils when I think of the naivete of management. I didn't sue because I don't like that remedy.)
Wrong. Your stock ain't going up, you stupid idiot. (Many of you were about to get lost here. You couldn't think of why the stock wouldn't go up. But you are missing the point. Stocks go up or down based on supply and demand. But selling, hard selling, can send almost anything down. Especially when the situation is dicey and as I said up front, this is a dicey dot-com. If this company were doing great, you can ignore the rest of this article. But it isn't doing great. Nobody in this situation who is doing great would even take Sisyphean's call. Sisyphean is like a loan shark. A legal loan shark. A legal Tony Soprano. Everything that happens in this article is legal. In fact, it is brilliant. Because it works every time on unsophisticated CFOs who don't know how to play the short-selling game -- which is just about every CFO I ever met. )
Here's why. Immediately Sisyphean takes the convert; it starts slamming your stock down. It may use upticks, it may not. (When you short a stock, you are supposed to wait for a buyer who will pay a higher price. That keeps you from trading the stock down. But this is a rarely enforced rule. And the owner of the convert might think that he is actually entitled to sell stock short on the way down because he is long a "like" instrument. I would love to tell you that such thinking is wrong, unethical, immoral and illegal. But the fact is, it is done all of the time, so forget about the idea that it isn't. In the cases I am familiar with it happened every time. That's life. People do bad things. These holders of the National Gift convert are pushing this stock down because they want to break it and they can if they want to, believe me. You can break anything. Anything.)
But it will short your stock till oblivion. And why not? It is stopped out if the stock rallies by the conversion provision. If it can knock your stock down enough, people will panic and it will go down even further. Meanwhile, you are burning through the cash and you don't understand why there is so much pressure on the stock. (So, the goal here is to get short the common stock and then knock it down to profit from that short position. You don't have much fear of a squeeze up because the worst that happens is that your bond is converted into common stock and you are protected. It is a great deal for the bad guy! You profit from the short. You get protected from the squeeze, risk free, because of the conversion provision. You get income on the short stock, known as rebate income. That's the interest on the credit balance generated by the short. You get the coupon from the bond. And the worst that happens is that the company's stock plummets and it runs out of capital and you get 100% of the money you made when you shorted it, plus the interest that you picked up and you get wiped out on the bond. Big deal! You don't care. You have shorted $100 million worth of common stock. The same amount you gave to the company on the bond!!! It is a push plus huge interest return.)
You see, the convertible owners and the common stock holders are at war, and you have sold out your common stock holders because you did not put in an anti-short provision for Sisyphean. (They wouldn't have done the offering if you hadn't. Their whole point is to destroy your stock!!) How do they win? Let's count the ways. They get the hefty yield. They get the interest on the proceeds from the short side. (They sell the stock and earn income on those proceeds.) And if they can put you near bankruptcy, they can cover the short, make the profit and live off the yield. If they put you in bankruptcy, they never have to cover! But they do lose the dividend. That's OK; the short-side trade more than makes up from the losses from the bond.
How can this happen?
'Cause many CFOs are as dumb as wood. How do I know this? Because we once owned 8% of a company that did this stupid trade and we lost everything!!
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James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at jjcletters@thestreet.com.
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