Some (nearly) real-time analysis of whether Schering-Plough’s preferred is fairly priced at $190 per share, today with its common at about $19.80

Last week, a kindly anonymous commenter (below) here, asked after the wisdom of buying Schering-Plough’s 6% preferred stock, due August 2010, to collect the $3.75 (per quarter, or $15 annual) dividend. I think that’s a sucker’s bet, and below I’ll explain why — but first, let’s re-read the commenter’s questions:

Anonymous said. . . .

Do examine the dividend per share that has been announced for owners of Schering common stock – $.06 and contrast it with the preferred dividend of – +-$3.75.

Am I wrong or should I run right out and buy some Schering common so I can get my $.06, while the few can get their $3.75? The preferred likely meets legal requirements for advertising but who really knows about it except the top execs? My understanding is that the price is expensive but contains a guaranteed rate of return. Is this all on the up and up?Many at the top own this preferred and are cleaning up at the rests’ expense. NO?

July 1, 2008 10:51 PM

Now, my rather longish answers — parts of the below were prepared for answers to other boards’ questioners — so this may be overly-inclusive. The background will likely be useful, though. Note also that Schering’s common dividend per quarter is actually 6.5 cents, not a flat 6 cents. And rememeber, I am not giving investment advice. Use your own advisor — make your own decisions — after doing your own due diligence:

In a word — No.

[A preliminary note: In this discussion, I’ve assumed the investor buys the preferred at close to recent prices — say, around $190 per preferred Schering-Plough share.]

I’d not buy the preferred. It is a suckers’ bet. And here’s why:

The preferred — trading now at around $190 a share — will automatically covert into a variable number [bracketed by buckets] of shares of Schering common stock in August 2010 (at an implied price of no less than $27.50 per common Schering share). That single fact is why the preferred trades a fair amount like Schering equity (common), and not so much like debt.

Now, if Schering’s common is below $27.50, in August 2010, then Schering’s issuance of the shares will be dilutive — Schering will have to pay out $27.50 worth of value when the market is pricing the stock below that. That’s a bad thing, for Schering, and a good thing for the preferred holder.

Between the Schering common prices of $27.50 and $33.69, in August 2010, it will be a straight exchange/convert. (That’s a generally-neutral thing.)

If Schering common shares are above $33.69 in August 2010, the issuance will be non-dilutive to common-holders. And that would be a good thing, to Schering, all other things being equal, and a bad thing (absent some special tax situation, unique to a given holder) to the preferred holder.

But, from where I sit — there is almost no chance of this stock being north of $33 by August 2010. I think it most likely will be nearer $16 to $22 by then. So, let’s look now at some more-likely scenarios, given this.

At August 2010, the original $250 invested, by the first person who purchased the Schering-Plough preferred, is supposed to be returned by Schering-Plough to the person then holding the preferred (sorta’ like the principal on a debt, with a balloon payment at the end). Remember though, that Schering-Plough common was trading at $27.50, back in August 2007 — so, you are taking some very real “principal” risk, by buying the preferred when you know that the underlying Schering-Plough common has declined by 35 percent since August 2007. [A good chunk of that particular loss — for people who bought in the new issue market — may be unavoidable, if they hold to maturity.]

So, regardless of what you originally paid for the preferred, be it $190, or $220 or $150 or even $250 — at August 2010, assuming that Schering-Plough common is trading at anything less than $27.50, then for every preferred share, the holder will get 9.0909 shares of Schering-Plough common. [$250 divided by 9.0909 = $27.50]. With me so far?

So, if you paid $190 for it (about today’s price), you’ll get 9.0909 Schering-Plough common shares. And, that seems a little too risky, to me, for these perils (the issuer-specific risks Schering-Plough now faces).

The key question is whether, on that day, in August of 2010, Schering-Plough common is trading at $25, $22, $20 or $15.

If Schering-Plough common is trading at $20, you can sell those new 9.0909 common shares to get $181 (before calculating your periodic return on the dividends, and before paying your capital gains tax). If you bought the preferred at $190, then you “lost” $9 of principal value. Importantly, though, you will have collected dividends (and paid the higher ordinary income tax rates on those dividends) for the period from today to August 2010 — about $30 (pre ordinary income tax on the dividends paid) — as there are now just about two years left on the preferred.

So, your all in net after tax gain might be $11 — if you are in the 33 percent tax bracket [Your $30 of dividends, less taxes of $9.90, equals $20.10 of income, less the $9 capital loss you suffered in August 2010 by receiving $181 worth of common, for a preferred you paid $190 to acquire, at today’s prices — leaves $11.]

If you bought the preferred at $190 (say, last week), then “all in, you made” $11. So your two-year rate of actual return was 5.78 percent, or your annual rate of return was 2.89 percent. Rather anemic for these risks, I’d say. Again, throughout this example I assume a purchase of the preferred at near today’s preferred market prices, and a August 2010 common price of around $20, or up 5 percent from today’s Schering common prices.

If you buy the preferred at anything over $200, you’ll very-likely “lose” on this bet. But notice — if you originally bought in at $250 (the intial public offering price, in August of 2007), you are already sitting on an unrealized 30 percent loss (on the underlying decline in common stock). Yikes — so, much of the “loss” in that case already existed prior to today, in 2008.

To further complicate matters, if Schering-Plough common is trading at $18 in August of 2010, then again, you lose “principal” — unless you bought the preferred at less than $174. Who knows where Schering-Plough common will be in August 2010? No one. Make your own guesses, here — and work it out.

So, it all depends on where you bought into the preferred, and where Schering-Plough common is, at August 2010.

Now — and of the most interest to me — personally, if Schering-Plough common is below $27.50 at August 2010, the new common shares will dilute the older Schering-Plough common holders. And they won’t like that one bit. It will cost the company, in both money, and reputation.

Given all of the above, you can work out what happens at the high end — above $33.69 (using a fixed convert of 7.4206 common shares for each preferred). Make your own guesses about what Schering-Plough preferred will trade at, in 2010, and what Schering-Plough common will be then — [just over the fix-spot, at] $34, or way over at $40, or up huge at $45.

However — Remember that if Schering-Plough common trades above $50.53 for a period of time, the company may force the preferred out of your hands, and convert it, at the fixed 7.4206 rate, into Schering-Plough common.

Whew — so, there are very-few absolute statements that may be made about Schering-Plough’s — or any Fortune 200 company’s — mandatory convertible preferred stock issuances. I do think the deck is stacked, at the moment, against Schering-Plough preferred being a worthy risk-to-return investment.

Now, more on the Schering-Plough (dilution) side:

These instruments are generally touted by the company’s bankers, to the company, as being low-cost financing vehicles (from the company’s point of view). This argument runs along the lines that, as Schering-Plough common rises, the company will likely be able to force conversion early, and produce exactly the savings you point out (lower dividend, mostly).

What Schering-Plough seemed to overlook, back in August of 2007, was that, if its common stock fell significantly, it would have to issue a lot of shares in August 2010 — over 104.5 million shares of common (11.5 million shares of preferred issued at August 2007, times 9.0909 equals 104.54 million shares of common), and it must cover those new Schering-Plough common shares with earnings sufficient to meet Schering-Plough’s expected EPS numbers in 2010, and every year thereafter. . . else, the per share of Schering-Plough common will fall, even more. So, one man’s “well, that’s only 5.6 percent dilution” is another man’s “can’t get there, from here” on the expected 2010 Earnings Per (Common) Share line.

But it is true that the running cost of the dividends line — for Schering — decreases, “all in” upon conversion — when the conversion ultimately comes, at the start of the third quarter of 2010.

I might suggest that a more meaningful comparison (v. the dividend-rate differences) might be to look at what would have been the August 2007 Schering-Plough “pure debt interest rate” — the rate at which Schering-Plough could have sold straight-vanilla unsecured debt.

I suspect that number was well-south of 6 percent. So, given the ENHANCE disclosure, the preferred looks like a bad deal, even for Schering-Plough, from where I sit.

Now as to this suggestion of yours: “. . . .Second, isn’t there a one time gain since Schering-Plough booked the sale at a value of 2.500M (assuming a conversion of $27.50) and if they convert at any price under that figure, Schering-Plough could buy the common back and book a one time profit on the difference?. . . .”

In a word, no. This would likely be a “manipulative practice“, generally prohibited by the federal securities laws, and rules promulgated thereunder.

There are some very complicated SEC rules about when and whether Schering-Plough may repurchase its own common shares during a so-called “tender period” — a period of time governed by the Williams Act’s rules on not manipulating the market for one’s own securities.

See, when the forced conversion comes, Schering-Plough will need to be out of the market of its own common (generally speaking — there are some largely-esoteric exceptions) for a period of time.

So Schering-Plough can’t just plan, with any degree of certainty, on buying back Schering-Plough common to fund the preferred/forced conversion issuance of common.

Moreover, it is my experience, that in low interest rate environments (like this one), and in situations where the underlying common is trading at low values, relative to recent history (again, like this situation) — and where that is due to real uncertainty about future results (like here). . .

that a preferred will be more volatile (show wilder price swings) than the underlying common — it just has so much futher to fall — so, I’d shy away from it. I don’t think a yield of 7.8 percent will adequately compensate you for the real probability of “loss of principal” I’ve alluded to above.

But you may feel differently. Obviously, if a capital loss of this kind has tax-appeal for your personal situation, that might make a difference on your risk/return calculus hare, too.

So, if I were convinced that Schering-Plough common was a reasonable purchase, at this price (~$19.60), I’d go buy the common, book the dividend on it (it is bigger, as a percentage, at these lower common prices), and leave the risky-volatile preferred for others to chew on.

But I am not convinced that Schering-Plough is a good buy at these levels, so you should probably seek advice elsewhere, as I cannot see the preferred as offering any real kind of hedge.

These opinions are all a function of time and tide. Time and tide. Yours may differ.

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