A Deal With the Devil
By James J. Cramer
Originally posted at 8:50 AM ET 8/23/00 on
RealMoney.com
What if I told you there were a $4 stock out there in the rapidly
growing telecommunications industry that has roughly a $2 cash
value? What if I told you the company is growing by leaps and
bounds and provides advanced telco services to 45,000
customers, up 50% from six months ago? What if I told you
"Inside Wall Street," the BusinessWeek column, hyped this
thing at 25 a year ago and everything it said came true, except
the stock price plummeted anyway? And what if I told you that
Nortel (NT:NYSE - news) has a big investment in the company
and Robert Annunziata, former CEO of Global Crossing and
Teleport, two wildly successful companies, just joined the board?
Ah hah, but before you go buy Log On America (LOAX:Nasdaq
- news) this morning, what if I told you that it had issued a toxic
convert at 17 six months ago? Would you still be tempted?
Maybe you shouldn't be.
Log On America is one of those companies that should have
known better. I don't know how many times I have urged CEOs
in this column that they should not issue so-called floorless
convertibles because they will lose everything to their investors. I
have beaten myself up endlessly for failing to stop Hayes, a
now-bankrupt company, from issuing a toxic convert. At the time,
Hayes was one of my firm's largest positions, having gotten it as
part of a sale of Penril Datability's high-speed modem business
to Bay Networks (now Nortel).
I argued vociferously with the CEO of Hayes -- who shall go
nameless because, in the end, I am a better guy than he is --
not to do this trade. I predicted that the preferred holders would
short the common stock into oblivion as a risk-free trade, which
they did. I said it would put the company into bankruptcy faster
than a speeding bullet.
The preferred guys drove the stock down to zero and the
company filed for Chapter 11 protection. We lost everything. So I
have made it my mission since to shout it from the rooftops:
Don't do these kinds of deals, even if you think they will save
your company. They won't.
Log On America didn't listen. It took money from a couple of
savvy convertible preferred guys and the company now alleges
that toxic issuers systematically drove the stock down from 17 to
2 by selling short the common, knowing they had a risk-free short
because the lower the stock went the more shares that would be
issued against the convert.
It got shafted.
Now the only hope for this company, as I see it, is the suit it just
filed in Federal Court. And given the slow nature of the courts,
that may not be enough to save this company from oblivion.
I hope not. These folks seem like honest guys. Not very smart
about financing, but honest guys.
I don't want them to fail. That's probably now up to a judge
because these convertible preferred guys are smarter than
Shylock ever was. And nowhere near as visible, or as
sympathetic!
What I want you to do is avoid companies who make these deals
so you won't have a Hayes, which ruined my 1998, or a Log On
America, which, I am sure has ruined everybody's year who has
bought this otherwise high-growth CLEC company.
So I want to give you the details of what has happened to Log
On, and what occurred to Efax.com, Netplex Group, Auspex
Systems, MicroStrategy, General Magic, Intraware, Etoys
and Entrade, according to the plaintiff's document.
In February of this year, Log On entered into a deal with a
couple of firms to raise money through a convertible preferred
according to a "floating" conversion rate that was meant to offer
some downside protection to the holders. Thus the lower the
stock at the time of conversion, the greater number of common
shares to be received by the holders. (Hence , the floorless
nomenclature.)
What is so awful about that? For one, a floorless convertible
presents, as the brief from the Log On suit says, "a tempting
opportunity for market manipulation." To use the formula
provided:
[The holder of the security] can short sell the
company's stock at a price of "X" per share. A
high volume of short selling pushes the share
price down to X-1 or even X-2. The preferred
shareholder's conversion price is then reset to
a discounted percentage of X-2. The preferred
shareholder then converts at that lower
conversion price to cover the shares it sold at
X, delivers the shares necessary to cover the
short sales and has a large number of shares
left over, which it can then sell at X-2. ...
Further, the more the preferred shareholder
can push down the market price, the more
profit it makes on each conversion. If the
preferred shareholder short sells at X per
share, it will make much more if it can convert
its shares to cover at X-4, then it will make by
covering at X-2. Thus the more the preferred
shareholder can drive the market price down,
the more money it will make per share and the
more shares it will receive.
Hence the term "toxic," or the more colorful "death spiral
convertible." The lower the stock gets driven the more in the
driver's seat the convert holders are. In Log Onýs case they have
hijacked the whole car! Log On alleges in its brief that the
convert holders have driven the stock down so far through
massive short sales that they would now own 8,000,000 shares
as every peg down entitled them to more and more shares. How
much is 8 million shares? Heck, there are only 8,800,000 shares
outstanding!!! Management only owns 3 million shares.
Game over! Toxic convert holders 1, everybody else, zilch-mo!!
Isn't that an incredible story?
Of course maybe the holders didn't short it all the way down or
knock it down. For example, we know the telco market has
gotten tough. And maybe the business has gotten soft because
of the Verizon strike or because Verizon has lowered the price
of DSL. Who knows? But the simple fact of the matter is that this
company was relatively healthy before it took this suicidal
financing. Now it is on intensive care with a judge trying to figure
out whether the stock should be resuscitated. Don't let this
happen to one of your equities. If you own a stock with a
convertible preferred and it is floorless, you could soon be in this
position. Sell it now if you do, because it is a cinch that it will go
still lower if the ploy is still on.
What happened to Log On shouldn't be allowed to happen. But
it has happened. It may be too late to save it. Until chief financial
officers of the world wise up, we will keep having these toxic
converts. The bankers don't seem to want to stop them. The
issuers surely won't. And the government doesn't even seem to
know they exist.
What a crime! Hopefully for the last time: CFOs say "no" to death
spiral converts. They will kill your company more quickly than any
other former of financing. Better to just give up and sell the
company than to take one of these on. Don't say I didn't warn
you.
James J. Cramer is manager of a hedge fund and co-founder of
TheStreet.com. At time of publication, his fund was long Nortel.
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 send comments on his column to James J.
Cramer .
Send letters to the editor to letters@thestreet.com.
Read our conflicts and disclosure policy.
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___________________________
Just say NO to stock fraud!
AI
