Investors back Tata Motors' innovative CB

The truck and auto manufacturer raises $450 million from the sale of "CARS" that are structured to limit the dilution for the Tata Group.
Indian car and truck manufacturer Tata Motors last night raised $450 million for capital expenditures and overseas investments from a convertible bond issue that was structured to minimise the potential dilution for the controlling shareholder.

This will be achieved by having the five-year, zero-coupon bonds convert into a security with different voting rights û potentially none at all û than the companyÆs common shares and which consequently will be non-fungible with the underlying stock. The company doesnÆt yet have any securities of that kind, but the term sheet suggests it is looking to do such an issue before the bonds become convertible in 4.25 years.

Indian metals and mining company Vedanta Resources last year made a similar attempt to prevent dilution when it issued a $750 million 20-year CB convertible into non-existing GDRs with no voting rights. That attempt fell flat, however, as investors didnÆt like the idea of converting into what would in all likelihood be a highly illiquid instrument that would trade at a discount to the underlying shares. Also, the first person to convert into GDRs would have nobody else to trade with. Barclays Capital, which arranged the issue, was said to have been left with a large portion of the deal on its own books as the bonds traded down in the aftermarket.

To avoid a repeat of that, the Tata offering includes a few additional features. For one, there has to be an issue of the non-fungible securities into the market before the bonds become convertible. The size of this issue must be large enough to cover at least 75% of shares needed to meet a full conversion of the bonds and must be placed with at least 20 institutional investors outside the Tata Motors group.

In case the new securities trade at a discount to the common shares at the time of conversion (which is likely given that they are less liquid), the bond holders will also be compensated by a corresponding reduction in the conversion price.

ôThis allows the company to get a price that is more similar to a plain vanilla deal,ö notes one source familiar with the structure.

If there has been no issue of new securities with differential voting rights, the bonds will convert into the companyÆs common shares of American Depositary Shares, and the company can also choose to have the bonds convert into common shares or ADS if the new securities trade at a discount that is perceived to be too wide to justify the needed compensation to the bondholders.

The new structure, which fittingly has been named CARS, or Convertible Alternative Reference Securities, has been put together by Citi, who is the sole global coordinator for the offering. JPMorgan is joint bookrunner, but came into the deal quite late and is said to be getting less than half of the economics.

Deeming from the response to the offering last night, the structure seems to have worked with over 80 investors submitting orders and the deal being more than three times covered at the final price. However, the real test will come when the bonds (and the stock) start trading today. Perhaps because of the complex structure of the bonds, there was no clear price guidance from the grey market late last night.

The bonds were priced with a yield to maturity of 5.6%, after being offered in a range between 4.9% and 5.9%. The conversion premium was fixed at launch at 40% above TataÆs closing price of Rs686.40 on the National Stock Exchange of India yesterday. Given that the bonds arenÆt convertible until October 2011, there is no issuer call option.

The issue can be increased to $490 million if the greenshoe of $40 million is also exercised.

While not exceptionally high by recent standards, the premium still looks quite aggressive given how highly structured the deal is. However, sector specialists say the degree of attractiveness will vary from investors to investors, depending on their view on the credit and their access to stock borrow. The bookrunners didnÆt provide any credit bid as Tata is a well-known and liquid credit with credit default swaps that trade at about 85 basis points over Libor and asset swaps at 120-130 basis points over.

The underlying assumptions also included a dividend yield of 2.5% and a stock borrow cost ranging from 1.5% all the way up to 5%, depending on individual investor access. Based on this, a conservative valuation results in a bond floor of about 93.5% and an implied volatility of 29.5%, while a more aggressive use of the inputs gives a bond floor of 95.25% and an implied volatility of 26.25%.

The historic volatility is about 35%. TataÆs share price has gained 6.4% over the past couple of trading session, but has been on a declining trend after reaching a 2007 high of Rs964.55 in mid-January û partly as a result of rising interest rates having dampened demand.

However, in a research note issued in early June, Citi reiterated its ôbuyö recommendation on the stock citing the upcoming spin-off of the companyÆs auto finance business and stronger-than-expected growth in heavy trucks as a ban on overloading continues to be implemented.

ôKey reasons for a strong growth outlook in commercial vehicles include a sustained pick-up in economic activity, a focus on infrastructure spending and a strong replacement cycle,ö the analysts said, noting that 27% of the existing fleet in India is more than 15 years old and needs to be replaced both for commercial and environmental reasons.

ôTata Motors should also benefit from the launch of new products and international initiative, given a competitive cost structure,ö they added.

Citi has a 12-month target price of Rs1,029 on the stock, which implies 50% upside from current levels and is also above the conversion price of Rs960.96 on the new CB.

The mix of investors that came into the CB was fairly standard, although according to one source the demand from outright investors was a bit higher than usual. However, it was the ôsmarterö funds that understand the structure that drove the pricing. Citi is said to have done some investor education about the structure on a no-name basis prior to the launch and that seems to have paid off.

Tata Motors is about 30% owned by India's largest business conglomerate, the Tata Group.
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