Baidu (BIDU) converts on Trip.com (TCOM) and random thoughts
Weird converts
“I don't know if you're a detective or a pervert” - Blue Velvet
Last week, after the sell-off upon release of TCOM’s earnings, I wrote a quick pitch on why I thought TCOM was a good buy, especially if one wanted exposure to China. In essence, I thought TCOM was a growing platform that had a dominant market share in China and was growing rapidly in emerging markets, especially the SEA region. Yet despite guiding to decent teens growth, likely sandbagged, for FY25, the stock traded at an EBITDA-CAPX, on par with EXPE, which was guiding to a mere ~5% growth, whilst sporting inferior margins…
On that front, both BKNG and EXPE are down MSD-HSD% and TCOM has bounced 8-10% or more from last week, after the mid-gruesome sell-down.
Anyway, a funny thing, just yesterday, Baidu (BIDU), which owns 21% of TCOM’s HK listing share capital, announced plans to raise ~$2b of debt via the form of interest-free convertible bonds exchangeable for its own TCOM shares due 2032, at a strike price of HK$702.13 or ~US$90 per share (stock trades at ~$64 now).
Note* the exchange can only be done with HK-listing and not with the TCOM ADRs but I’ll just use TCOM as a simplified proxy.
A good way to think about a convertible bond is a bond with an embedded call option on a stock since bondholders can monetize their bond into TCOM’s stock, in this case, at $90 per share.
I thought this transaction was interesting and a good example of bankers’ shenanigans.
My first initial thoughts were, if BIDU wanted to raise cash (on top of a net cash balance sheet, probably to ramp up AI spend bigly), and not dilute themselves, they should’ve just sold TCOM shares via block sale, kind of like what Tencent did last year. But the bull in me also reasoned that perhaps if TCOM was below fair value here, then this would be a way to lock-in a sale price for BIDU, whilst collecting the cash first, foregoing any upside past $90. In simple terms, if a convertible bond has an embedded OTM call option, then the issuer is selling an OTM covered call.
Secondly, most convertible bonds tend to be struck with an OTM call option on the issuers’ stock. In this case, a typical convertible bond would be struck with BIDU’s stock maybe at ~$124 strike, a ~30% premium to the current trading price ~$95. BIDU did not do it in this case, and apart from the fact it is dilutive, BIDU’s stock hasn’t really gone anywhere at all despite the stock market renaissance in China right now. And a stock that isn’t hot is not what the convertible bond buyers want, I suppose.
Which brings me to my next point. Who are the buyers of this converts? They’re convertible bond arbitrageurs who aren’t necessarily interested in the $90 strike price but rather in arbitraging volatility, typically done by stock hedging. In fact, BIDU’s press release forewarns the arbitraging that will take place.
How this is done is simple in a nutshell:
Graph from UBS
The principal amount of bonds is US $100k with an exchange ratio of 1,107 TCOM shares per bond.
Convertible arbitrageurs are hedging out stock price risk. If TCOM’s stock price is high, the bond becomes equity-like and typically has a high exposure to the underlying stock as measured by delta i.e. “hedge ratio”, think north of 70%. If TCOM’s stock price is low, the delta might be much smaller, e.g. 30-40% or even negligible, in that case, a $1 move in TCOM’s stock price would not require much hedging at all (see example below). Naturally, as a bond, convert holders have downside protection in that if the company is not in distress, the bond floor holds itself and eventually, bond holders will be paid back their principle.
Example:
High TCOM stock price, high delta of 80%:
A $1 move in the stock price, will lead to a 886 shares sold short (80% * 1,107)
Low TCOM stock price, low delta of 30%:
A $1 move in the stock price, will lead to a 332 shares sold short (30% * 1,107)
In simple terms, when a stock goes up, you are to sell more stock, and when the stock goes down, you are to buy it back. Buy low, sell high!
The volatility is the opportunity for convertible bond shops to make their money.
Additionally, delta is not linear but the most convex when the stock is sort of mid-range where it is both bond and equity like (refer to middle section in chart above).
In other words, the implied meaning of the converts are that the stock will be volatile through the ranges of 60-80 in the medium term, at least as per the bankers - that’s the only way for convert shops to milk the delta convexity - whilst with the possibility for a realization on the call option. If TCOM keeps putting up mid teens growth over the next seven years and takes their margins up to that of BKNG, $90 is an easy target, barring any global geopolitical catastrophe.
Again, this was also happening at MSTR - Matt Levine covers it nicely here. I just found this whole BIDU thing really odd, hit me up if you have examples of the outcomes of convert issued by companies tied to their own equity investments. It’s all really weird especially when you consider how TCOM’s vol (figure 1) is not much higher than BIDU’s (figure 2).
TCOM Fundamental updates
Sell-side has spoken to TCOM’s management post the earnings release and key points are as follows:
Trip.com to grow 50-60% YoY, taking share from offline travel agencies which dominate the Asian market. Trip.com generated somewhere between negative MSD to positive HSD operating margins in 2024.
Next 3-5 years would be priority around Thailand, Malaysia, Japan and South Korea, before moving to Europe and Middle East markets.
Take rates will ramp up for international business - rising to 9-11% from the current 8-9%. Global peers take rates are ~15-20%.
Domestic C-trip is doing ~40% operating margins.
Trip.com entered the Singapore markets in 2021 and is already doing HSD operating margins with north of 10% market share. The HK market generated double digit operating margins with 20% market share.
Again, as much as I hate to admit it, I guess a major part of TCOM doing well would be dependent on strong performance in the HK market - though there is some idiosyncrasy here, TCOM’s correlation to the HSI and derivations of, is between 0.6-0.7, lower than HK giants such as BABA, JD and TCHEY.
On a fundamental level, I feel the stock is a justified long, at least up till the mid 70s or 80s where its valuation converges closer to that of BKNG.
I mentioned in an earlier piece, subtly calling out the China bull after the Bloks IPO, of which I guess I was too shy to really pound the table on. I’ll be back on that.
Moving forward, consider what’s happening in the HK markets and decide if you feel it’s positive:
Mixue’s IPO has just been insane and it’s a pretty pricey stock. This one was so hot, hearsay a fund that did incredible bottoms-up due diligence on the company was only allocated ~$100k at IPO.
BYD raising a US$5.6b placement last week. The last time they did such a placement was in 2021, ~$4b. The firm was net cash and though they’re trying to expand abroad, I think this implies strong capital appetite on this side of the planet.
TikTok upping their internal share buyback price by ~5% from 6 months ago.