Month: April 2015

Hybrid Security: Convertible Bonds and Convertible Preferred

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HybridAs the name suggests, the convertible bonds and convertible preferred (or convertibles, in short) are securities that offer the holder the option of converting them into or exchanging with a predetermined number of common shares in the issuing company. They are hybrid securities that demonstrated the features of both equity and bond. Convertibles are issued by a company (also referred to as borrower) when a lower interest rate or dividend is desired and the issuer is willing to suffer the potential dilution of the investor converting the hybrid into common equity of the issuing company. Also, refer my article Equity: Common Stock, Preferred Stock and Convertible Preferred here.

Historically, the interest rates or dividend rates on convertibles have been lower than that of a similar non-convertible debt. The investor funds the company with the believe that the value of the underlying stock, into which the debt will convert, will grow over a period of time to an amount that exceeds a market rate of return for the instrument. In other words, the investor receives the potential upside of the conversion into common equity while protecting the downside with cash flow from the interest payments and the return of principal amount at maturity. However, if the stock delivers an under performance, the conversion does not make sense and the investor is stuck with a sub-par bond rate.

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Equity: Common Stock, Preferred Stock and Participating Preferred

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stockA company’s equity capital is represented by common stock or preferred stock. A company can be capitalized with only common stock, but usually preferred stock is issued along with common stock. Both common and preferred stocks are entitled to receiving dividends, but where both of them are outstanding, preferred stock holders enjoy priority. Let’s understand the concept in detail.

Common Stock

Common stock is a type of equity security that represents an ownership in a company. It can be classified into voting shares and non-voting shares. The holder of a voting stock carries a voting right to elect Directors of the company and to vote company’s fundamental corporate activities (including M&A) and policies. A non-voting stock, on the other hand, has all the financial rights of the common stock, but is devoid of the power to choose directors or veto corporate transactions.

During liquidation, the common shareholders are entitled to receive residual claim on the company’s assets that is, they stand at the last behind all the corporate creditors and preferred shareholders for receiving the payment. When a company is forced into bankruptcy because of its inability to pay its obligations (debts), the common shareholders receive nothing. So, their returns are uncertain, contingent to earnings, company reinvestment, market efficiency and stock sale. Since their investment risk is high, common stockholders enjoy higher returns (with higher capital appreciation) compared to preferred stockholders when the company does well.

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Cost Cutting: Steps, Strategies and Precautions

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CostCuttingOften companies launch new products, expand businesses (globally), diversify their portfolio or start new businesses with the aim of enhancing growth and increasing profitability. But in industries which have low barriers to entry and exit, new players enter the market by replicating existing business models and offering similar products and services at lower cost, thereby making it difficult for the existing players to sustain their market share. As the revenue growth per player shrinks over the years, companies explore ways to maintain their profit margins, leading to a situation where cost becomes more important and price becomes one of the key differentiating factors in the market.

In such situations, senior management start hunting for measures to reduce their costs and expenses to improve profitability. Cost cutting (also known as cost reduction) is one of the steps initiated by the Business Managers to improve profitability. The Leaders make an effort to monitor, evaluate and trim their expenditures, and explore options to streamline processes, restructure their organization and cut down flawed expectations. Cost reduction can be a formal company-wide program or limited to a single department. It usually becomes a company-wide initiative during economic recession when their revenue growth struggles and profit margins shrink consistently for quarters.

In this article, I offer my views on few steps, strategies and precautions while taking up a critical project like cost-cutting and run you through some of my thoughts. I welcome your views and suggestions in the comments section below.

(1) First step in the entire process is to identify a target – how much to cut? This requires a lot of deep-dive, number crunching, hour long sessions with your Business Head(s) to determine how much would be an effective range. You might have to identify the broken strategies, half executed business plans or even stop promising opportunities. As we brainstorm the numbers, we need to look at them from the perspective of 5 year strategic plan.

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What is Diluted EPS? How is it calculated?

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This article is Part2 of my previous article on Earnings Per Share. In this article, I’ll discuss Diluted EPS along with different methods to calculate it. You may want to review Part1 of this article on Basic EPS here.

Part2: Diluted Earnings Per Share (Diluted EPS)

Diluted EPS is one which is calculated after all the convertible securities are converted into common stock. If a company has convertible securities (that is, if the company has complex capital structure), its basic EPS is greater than diluted EPS. And, if a company has a simple capital structure, its basic EPS is equal to diluted EPS.

Calculating diluted EPS

There are three scenarios that arises while calculating diluted EPS: (1) Convertible Preferred Stock, (2) Convertible Debt, and (3) Employee Stock Options. Let’s discuss them in detail.

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What is Earnings Per Share? How is it calculated?

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Earnings Per Share (EPS), an input to Price/Earnings (P/E) ratio, allows the shareholder to calculate his/her share of the company’s earnings. EPS can be classified into two – Basic and Diluted. Calculation of EPS requires that we have information on the company’s capital structure – simplex or complex.

A company is said to have complex capital structure when its securities (like convertible bonds, convertible preferred stock, employee stock options, etc) are convertible into common stock, and a company with no such convertible securities is said to have a simple capital structure. The distinction between the two is important while calculating EPS because any potential convertible securities can dilute (i.e., decrease) it. That’s why accounting standards like IFRS require public companies to disclose both basic and diluted EPS on the income statement.

In this article – Part1, I’ll discuss Basic EPS and in Part2, I’ll cover Diluted EPS.

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Information Technology Industry: Business Drivers, Strategies, Risks, Money-Making & Future Outlook

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ITWell, before we talk about the money-making process, let’s try and understand the key business drivers of the technology industry. And by technology, I’m referring to Computer Software and Hardware (excluding mobile handsets/cellular phones) industry. I’ll combine the money-making process along with the business drivers.

Key business drivers of technology industry

(1) Cost of sales

For a technology company, the cost of sales is fairly low. The Cost of Sales include

  • Cost of technology upgrades (including cost of development). Usually the upgrades are released every year.
  • Cost of hardware refresh: Usually, most of the technology companies have an enterprise wide agreement for their server and storage upgrade [like IBM (NYSE: IBM), HP (NYSE: HP), Dell and Oracle (NYSE: ORCL)] and networking equipments upgrade like Cisco (NASDAQ: CSCO). The refresh period is usually 3-5 years.
  • Cost of documentation, duplicating software, training, packaging (if media is supplied) and cost of maintenance (predominantly data center maintenance other than what has been specified in ‘Point b’ above): Now-a-days, most of the companies enable software download feature to avoid costs associated with documentation and media.

These three costs account for 15-20% of the sales revenue, leaving 85% for Selling, General and Administrative Expenses (SG&A), Marketing and Research & Development (R&D). Hence, it’s not surprising to see Technology companies investing handsome amounts in Marketing and R&D. To give you a perspective, in FY11, Oracle invested $ 4.5 billion in R&D. With $ 35.6 billion in total revenues, that’s 12%, a good investment for Oracle.

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