In the quarter ended September, the company’s revenue dropped by 6.7% sequentially to Rs109.7 crore and its operating profit fell 26.7% to Rs10.9 crore. However, for the six-month period ended September, although Subex’s revenue declined 18% year-on-year to Rs227.3 crore, operating profit rose 39% to Rs25.9 crore. The operating margin has moved up substantially from the low of 6.7% in the first six months of the previous fiscal to 11.4% in the first half of this fiscal, signalling that the worst may be over for the company. In the fiscal year 2007-08, the firm had slipped into losses.

Subex’s shares have done well after the results were announced, rising 5% to Rs89.25, thanks to the company’s optimistic outlook on order intake as well as its steps to restructure debt. “We plan to focus on revenue ramp-up now which will contribute substantially to the bottomline," says Subash Menon, founder, chairman and managing director of Subex. Being a product company, it has a high operating leverage. Since many of the costs are fixed for product development, a large part of incremental revenues will trickle down to the profit.

But both revenue and margins need to rise much more for the company to be able to service its large convertible debt. This is because the company has foreign currency convertible bonds (FCCBs) worth $180 million (Rs841 crore) outstanding. The bonds can be converted into equity shares any time before March 2012 at a price of Rs656 per share.

The company had raised these funds in 2007 to acquire Syndesis Ltd, a developer of telecommunications operations’ support software. The company has explained to bondholders through a London Stock Exchange (LSE) filing that “the asset acquired by the company from Syndesis has been depreciating in value owing to the losses incurred by that business and the global market conditions".

However, since the company’s shares trade at far lower values, the possibility of conversion is near nil. On maturity in March 2012, the company’s ability to pay back the principal and interest on the bonds was always questionable.

Because of this, the company has offered its bondholders an exchange offer, whereby new bonds will be issued at a 30% discount to the face value. Assuming investors accept the new terms, the principal amount outstanding on the bonds would come down to $126 million.

Bondholders will be compensated via an increase in the interest coupon, from 2% for the existing bonds to 5% for the new bonds. More importantly, the conversion price has been set at Rs80.31, a fraction of the original conversion price. The details of the new bonds are based on announcements by the company to London Stock Exchange, where the bonds are listed. They were provided by a merchant banker who did not want to be identified.

The yield-to-maturity (ytm) for the existing bonds stands at 8%, which is after accounting for a large redemption premium. The ytm on the new bonds is not known, although considering that the coupon rate has been increased substantially, one can assume that the interest cost will be substantially higher.

According to an LSE filing, due to the lower conversion price, “the new bonds are more likely to be converted into shares of the company, and thereby further reduce the debt obligations of the company when the new bonds fall due for redemption".

From a bondholder’s perspective, the new terms make immense sense. But from the perspective of Subex’s existing shareholders, the conversion of bonds into shares will lead to a trebling of the company’s equity base from the current level of 34.8 million shares. If all the bonds are converted based on the new terms, 72.2 million new shares would have to be issued. For perspective, Subash Menon and his associates own 12.84% of the company currently. Upon full conversion of the new bonds, their holding will drop to around 4%.

Of course, bondholders will convert the debt into equity only if the company’s performance picks up, and they have the certainty that the share price is sustainable well above the conversion price of Rs80.31. Else, they’d just prefer not to convert and demand redemption instead. If that’s the outcome, Subex could be strapped for cash to pay its bondholders. Either way, the company needs to post a sharp rise in profit to avoid a debt trap.

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