Analysis of Debt Capitalization: Read-Rite

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. 

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