Dilution from Convertible Debentures: NexGen Energy Case Study 

Convertible debentures are a popular financing tool that allows companies to raise capital while providing investors with the option to convert debt into equity. For analysts and investors, these hybrid instruments can complicate earnings per share (EPS) analysis, particularly in terms of dilution.

What is a Debenture?

A debenture is a type of long-term debt instrument used by companies to borrow money from investors. It is not backed by physical assets or collateral, but rather by the general creditworthiness and reputation of the issuing company.

Types of Debentures

Several different factors, including convertibility, security, and redemption terms, can classify debentures. Let’s look at each factor in a little more detail.

Convertible Vs. Non-Convertible Debentures

Convertible Debentures can be converted into equity shares of the issuing company after a specified period. Whereas Non-Convertible Debentures (NCDs) cannot be converted into equity shares and remain as debt until maturity.

Secured Vs. Unsecured Debentures

Secured Debentures are backed by the company’s assets, providing security to debenture holders in case of default. Unsecured Debentures are not backed by any collateral and are riskier for investors.

Redeemable Vs. Irredeemable Debentures

Redeemable Debentures are repayable on a specified date or after a certain period. Irredeemable (Perpetual) Debentures do not have a fixed maturity date and are not repayable during the lifetime of the company. This type of loan rolls into perpetuity unless the company winds up or goes into liquidation.

What is a Convertible Debenture?

Convertible debentures are a type of debt instrument that can be converted into a predetermined number of shares of the issuing company, usually at the discretion of the debenture holder. They combine the features of both debt and equity:

• Debt Features: they pay interest to the holder until conversion
• Equity Features: they can be converted into equity shares, providing potential for capital appreciation

Debenture Vs. Convertible Debenture

This table shows the differences between debentures and convertible debentures and the types of investors each may attract.

Benefits of Convertible Debentures

We can look a little bit closer at the benefits of the convertible debenture:

1. Firstly, it has a lower interest rate for issuers. Since investors have the option to convert to equity, companies can offer lower interest rates compared to regular debt. This may be attractive from a tax planning perspective for investors.
2. There is potential upside for investors as they can benefit from stock price appreciation by converting debentures into equity shares. This can offer a capital gain (or loss) as well as an income stream for investors.
3. Companies can delay equity dilution until conversion, which helps maintain control and earnings per share in the short term. This deferred dilution can be helpful during times of change or expansion.
4. Convertible debentures are attractive to a broader range of investors, as they combine the safety of fixed income with the potential for capital gains. This can appeal to both conservative and growth-oriented investors.
5. Convertible debentures are often traded on exchanges, providing liquidity to investors that they wouldn’t ordinarily get with some debentures.
6. Interest payments are tax-deductible for the issuing company, reducing taxable income, so they may be attractive for businesses that can issue convertible debentures.

Limitations of Convertible Debentures

However, there are also limitations with convertible debentures and some downsides which investors and corporates should be aware of:

1. When converted, existing company shareholders may experience dilution of ownership and earnings per share which may limit the attractiveness of issuing convertible debentures.
2. Pricing convertible debentures can be complex due to the embedded option to convert into equity. This can make valuations more difficult to understand and keep up to date.
3. There is market risk for investors – if the company’s stock underperforms, the conversion option becomes unattractive, and the investor is left with a lower-yielding bond.
4. There is also subordination risk for investors – in the case of liquidation, convertible debenture holders are paid after secured creditors, increasing risk.
5. Corporates may end up with uncertain cash flows – if many debentures are converted, the company may avoid cash outflows (interest payments) or if they aren’t converted, the company must continue to make payments. When converted, they also lose or dilute equity control.
6. Interest rate sensitivity, like other bonds, convertible debentures are sensitive to interest rate changes, which can affect their market value.

Real-World Example of a Convertible Debenture

Here we will explore the mechanics of dilution from convertible debentures using NexGen Energy Ltd.’s 2024 transaction as a real-life case study:

Case Study: NexGen Issues $250m of Convertible Debentures

In May 2024, NexGen Energy Ltd. issued $250 million of unsecured convertible debentures to purchase approximately 2.7 million pounds of uranium. Key features of the debentures included:

• Principal: $250 million USD
• Interest: 9% per annum
  • 6% payable in cash
  • 3% payable in NexGen common shares
• Conversion price: US$10.73
• Term: 5 years
• Maximum shares issuable on conversion: 23,299,161 (equivalent to c4.3% of the company)
• Establishment fee: 909,090 shares issued in lieu of a 3% fee

Essentially NexGen has issued convertible debentures to enable it to purchase a long-term supply of uranium when demand was extremely high and supply remained extremely tight. The deal will significantly improve the company’s development pipeline and facilitate future projects.

To pay for this, NexGen has issued US$250m of convertible debentures with a 5-year term. The debenture will pay a 9% annual interest over the term and has a conversion price of US$10.73, which was a 30% premium to the 5-day volume weighted share price of NexGen on the Toronto Stock Exchange prior to the issue date.

In terms of the interest payments, 6% will be paid in cash, and 3% payable in common shares (based on the previous 20-day VWAP prior to the payment date).

After 3 years, NexGen will be able to redeem the debentures at par plus accrued and unpaid interest if the 20-day VWAP (on the NYSE) exceeds 130% of the conversion price.

Download the NexGen press release detailing the convertible debenture issue.

How Do Convertible Debentures Impact Diluted EPS?

Under both IFRS and US GAAP, diluted EPS must always reflect the potential dilution from convertible instruments—but only if the impact is actually dilutive. Here are the key components analysts need to understand:

1. The “If-Converted” Method

For convertible debt, the standard approach is to assume that the debt is fully converted into common stock at the beginning of the period (or when issued, if later).

Impact on Diluted EPS

Numerator: net income is adjusted upward to reverse out the interest expense (net of tax)

Denominator: the weighted average number of shares will increase by the number of shares issuable on conversion

Example: Annual interest = $250m × 9% = $22.5m – Tax rate = 25% – Net interest = $16.875m

So, if we look at the impact of the convertible debenture on EPS, we can see that diluted EPS increases net income by $16.875m and adds 23.3m shares to the denominator. But this is only included if this results in a lower EPS than basic EPS (i.e., it’s dilutive). If not, it is excluded from the EPS calculation.

2. Interest Paid in Shares

Let’s look next at the impact of interest on the debenture being paid in common shares. NexGen has agreed to pay 3% interest ($7.5m annually) in common shares. These are considered share-based payments and will therefore always increase the denominator in diluted EPS.

Shares added = Interest / VWAP

For example, if we assume the NexGen stock price has a 20-day VWAP of $10, we would need to convert the $7.5m interest payment into stock:

This would equate to $7.5m / $10 = 750,000 shares annually (or 375,000 shares semi-annually)

These are deemed non-contingent shares and are treated similarly to stock-based compensation.

3. Shares Issued as Fees

NexGen also issued 909,090 shares as an establishment fee in lieu of a cash payment. These shares are already outstanding and included in basic EPS, so they do not cause incremental dilution.

Convertible Debenture Modeling – Analyst Takeaways

These are the key analyst takeaways when factoring convertible debentures into a model:

Model the EPS Accurately

Use the if-converted method and include share-based interest to ensure diluted EPS is correct. Be sure to model the share count and conversion rate carefully.

Watch the Share Count

Analysts should make sure they understand the maximum dilution scenario, especially if the conversion price is near or below market. This can have a material impact on EPS.

Check the EPS vs. Valuation Multiples

Always use the fully diluted share count when applying P/E or EV/EBITDA multiples if dilution is likely. This will give a more accurate valuation of the company and fully factors in the impact of the convertible debentures.

Be Forward-Looking in Forecasting

Analysts and investors should always include upcoming interest payments and potential conversions in forecast models. If the term is 5 years, then this should be fully reflected in the model for the appropriate time. It is also important to ensure the payment timings are accurate and fit into the company’s fiscal calendar, as this may highlight any potential issues.  If there are any material changes in market conditions, this will also impact the valuation.

Conclusion

Convertible debentures may offer companies flexible financing, but they come with the cost of potential dilution. NexGen’s 2024 deal demonstrates how both direct (interest paid in shares) and contingent (convertibility) factors affect diluted EPS. As an analyst, factoring in these effects ensures accurate earnings analysis and valuation modeling.

Additional Resources