VPHM-What will be the maximum derivative liability cost?
I was reading through the 10Q verbage on the sr. convertible notes trying to quantify how much the charge to earnings might be in the current and coming quarters. From what I read, I believe it is directly related to the fact that in the event of early conversions of the notes to stock at $2.50/ share, the company also agrees to pay an additional 3 years worth of interest. The notes carry a rate of 6% so that would be an additional 18% charge. The higher the stock price, the greater the likelyhood that the notes will be voluntarily converted by note-holders. Since no-one knows what the stock price will be in the future it is impossible to know exactly how many will be converted and when. The monte carlo stimulation model is a statistical probability model to calculate what the rate of conversion could be. As the price of the stock rises, one would expect more and more conversions. In fact, with the price of the stock currently nearing $7, virtually all of the notes may well be converted. If we assume that all of the notes will be converted in the current quarter, what will that cost be?
There were 62.5 Mil in notes but 3.2Mil were already converted in the first quarter, leaving a $59.3 Mil note balance. 3 years worth of additional interest at 6% would cost $10.67 Million. However, the company still carries $3.77 Mil worth of derivative liability on its balance sheet. $10.67 Mil less $3.77 Mil = $6.9 Mil in additional expenses. That would be the maximum and again that assumes that the entire expense would occur in the current quarter based on all of the bondholders converting their shares in the current quarter. Based on 52 Million fully diluted shares outstanding, that would amount to a 13c charge against earnings and then there would be no more charges. Many expect this stock to earn about $1 per share this year, so while significant it is certainly not a stock killer by any means. This is all IMO, and if someone has a differing view on this, then please share it.
Here is the verbage from the 10Q:
Notes to the Unaudited Consolidated Financial Statements (continued)
Senior Convertible Notes
The senior notes and the warrants were automatically exchanged in January 2005 for the senior convertible notes following stockholder approval of the issuance of the senior convertible notes. The $62.5 million value of the senior convertible notes, which are due in October 2009, is in an amount equal to the aggregate principal amount of the senior notes for which the senior convertible notes were exchanged. The senior convertible notes rank senior in right of payment to the Company’s existing and future subordinated indebtedness and are secured by a first lien on the vancomycin assets which are primarily related to the manufacture, production, preparation, packaging or shipment of vancomycin products and all proceeds of such assets, including accounts receivable generated from the sale of such vancomycin products. The carrying value of the Vancocin assets as of March 31, 2005 that secure the senior convertible notes was $115.2 million. In April 2005, the initial investors in the senior notes exercised their purchase option and acquired an additional $12.5 million of the senior convertible notes with identical terms.
Subject to certain limitations, the senior convertible notes are convertible into shares of common stock at the option of the holder at any time prior to maturity at a conversion rate of $2.50 per share, subject to adjustment upon certain events. The Company may elect to automatically convert in any calendar quarter up to twenty-five percent of the principal amount of the senior convertible notes into shares of its common stock if the daily volume weighted average price of the Company’s stock exceeds $3.75 per share, subject to adjustment upon certain events, for 20 trading days during any 30 trading day period, ending within 5 days of the notice of automatic conversion. If the investors voluntarily convert the senior convertible notes or if the Company effects an auto-conversion of the senior convertible notes prior to October 18, 2007, then the Company will make an additional payment on the principal amount converted equal to three full years of interest, less any interest actually paid or provided for prior to the conversion date. In the case of a voluntary conversion by the investors, the Company must make this payment in cash. If the Company effects an auto-conversion, the Company may, at its option and if certain conditions are satisfied, make the additional payment with shares of its common stock. If the Company elects to pay the additional payment in common stock, then the stock will be valued at 90% of the volume weighted average price of the stock for the 10 days preceding the automatic conversion date. Through March 31, 2005, investors have converted $3.2 million of senior convertible notes into shares of common stock and have received $0.6 in related make-whole interest payments, which reduced the derivative liability.
In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, or “Statement 133”, the make-whole provision contained in the senior convertible notes is not clearly and closely related to the characteristics of the senior convertible notes. Accordingly, the make-whole provision is an embedded derivative instrument and is required by Statement 133 to be accounted for separately from the debt instrument. As a result, the Company recorded a $7.9 million derivative liability upon the conversion of the senior notes into senior convertible notes in January 2005, which was the fair value based on a Monte Carlo simulation at the time of conversion. Consistent with our policy, we reduced this liability for interest payments on conversions during the first three months of 2005 and further adjusted the liability for changes in the fair value of the derivative liability as of March 31, 2005. Changes in the fair value of the derivative liability are measured using a Monte Carlo simulation model and are recorded as change in fair value of derivative liability in the consolidated statement of operations. In addition, the resulting discount on debt of $7.9 million is being accreted over the life of the senior convertible notes, which is recorded as additional interest expense of $0.3 million for the three months ended March 31, 2005 and has been reduced through additional paid-in capital by $0.4 million to reflect the conversions of $3.2 million of senior convertible notes to common stock.
