Analysis of Debt Capitalization: Read-Rite
INTRODUCTION
Read-Rite [RDRT] is one of the largest manufacturers of
magnetic recording heads for computer
disk drives, a highly competitive business characterized by
rapid technological change. In Au-
gust 1997, Read-Rite issued $345 million of convertible
subordinated notes. Over the next
three years, the company’s operating results and financial
condition deteriorated, bringing the
company close to insolvency. Early in 2000, the company
offered to exchange new notes for
the old ones. That exchange, accompanied by improved
operations, resulted in the retirement
of virtually all of the old notes in exchange for common
stock, with beneficial effects on the
company’s financial statements.
CASE OBJECTIVES
The objectives of this case are to:
1. Analyze the financial condition of Read-Rite over time.
2. Show the effects of the exchange offer on Read-Rite’s
financial condition.
3. Discuss the economic significance and the financial
statement relevance of the recog-
nized gain from the exchange offer.
4. Discuss the significance of the difference between
carrying value and market value of debt.
5. Analyze, from the note holder perspective, the decision
to accept the note exchange.
In August 1997, Read-Rite issued $345 million of 6.5%
subordinated notes, due in September
2004. The notes were convertible into Read-Rite common
shares at $40.24 per share. As shown
in Exhibit 10C-1, the company reported substantial losses in
1998 and 1999. As a result, Read-
Rite’s auditor opinion at September 30, 1999 had a “going
concern” qualification (Exhibit 1-3).
Because of its large losses, Read-Rite violated the
financial covenants of its bank debt facil-
ity, which it had drawn down in 1998 and 1999 to fund its
cash needs and provide adequate
liquidity. Threatened with default and the possibility of
having to file for bankruptcy, Read-Rite
made an exchange offer for the 6.5% notes. For each $1,000
of old notes, holders were offered
$500 of new notes, convertible into Read-Rite common shares
at $4.51 per share (15% above
the current stock price). Interest at 10% could be paid in
cash or Read-Rite shares, at the com-
pany’s election. The new notes were due September, 2004.
In March 2000, Read-Rite completed the exchange of $325.2
million of old notes for
$162.6 million of new notes, and sold an additional $61.2
million of new notes for cash. Read-
Rite wrote off $5 million of unamortized issuance costs of
the old notes.
The new notes provided for automatic conversion into common
shares if the Read-Rite
share price exceeded $9.02 for a specified time period. When
that condition was achieved,
Read-Rite invoked the automatic conversion provision and the
notes were converted to com-
mon shares in October 2000. The pro forma balance sheet at
September 30, 2000 reflects that
conversion as well as the sale of new common shares for
$18.9 million cash and $28.8 million
of bank debt repayments. The auditor’s opinion at September
30, 2000 has no qualification.
Exhibit 10C-1 contains Read-Rite financial data for the four
fiscal years ended September
30, 2000.
Use the information provided to answer the following
questions.
1. Compute each of the following ratios at December 31,
1997–2000:
(i) Total debt to equity (both as reported)
(ii) Net debt to equity (both as reported)
(iii) Total debt to equity (both at market)
(iv) Net debt to equity (both at market)
where net debt is total debt less cash and marketable
securities and equity is defined as
shareholders’ equity plus minority interest.