This column will be really boring if you don’t own HAPN warrants. I apologize for that, but I promise to try to be less boring next week.

(What can I say? It took forever getting through security today, and then when I finally got to Gate A7 the flight was conveniently moved to gate D42, less than a mile away, and then they kept adding 20 minutes to the expected departure time – so never quite enough time to get set up with the computer – and then, my dog, which I thought I had managed to find a home for with Ellen DeGeneris, came back and ate my homework.)


So one of three things happens tomorrow:

1. HAPN’s deal to acquire InfuSystems is definitively nixed. The warrants go to a nickel. I require one of InfuSystems’ IV drips.

I don’t expect this to happen, but I didn’t expect America to elect George Bush.

2. The deal is delayed again. My hunch is that this may not happen – that we may actually, finally, be good to go. But my hunch was that ostrich burgers would be offered at McDonalds and that Ugly Betty would be off the air after one abbreviated season.

3. The deal gets done. There is a mad dash by the holders of 33 million warrants to take at least some of their money off the table . . . which means driving the stock down to around $5.40 or so for a while.

Here’s why.

With 3 years to run, the warrants should sell at a hefty premium to their intrinsic value. But there are so many of them, and so many people may want to take profits, that they may be willing to sell with no premium – or even for a penny or two below their intrinsic value.

So let’s say the stock bounces from its current $5.64 to $6.30 on news of the deal. (It may not bounce at all, it may dip.)

At $6.30, the intrinsic value of the right to buy it for $5 would be $1.30.

But if the best bid is $1.20, what would people do? They would exercise their options for $5 and immediately sell the stock for, say, $6.25. So now the stock is $6.25 and maybe the best option bid is $1.18 by a market maker who buys your warrants for $1.18, exercises them at $5, and sells the stock for $6.20.

And down and down it’s chased (or not, see below) until it gets to around $5.30 or $5.40 or $5.50.

At that level, a lot of warrant holders might reluctantly decide to wait for a higher pay-out. And some might even decide to buy more. After all, with the stock at $5.40, their theoretical value would be above a buck (but see below for some cautions).

Surely, at $5 or below no one would be exercising their warrants (why exercise your right to buy shares for $5 that you can already buy for $5 or less on the open market?). So at that level, while the stock could certainly fall, none of the downward pressure would be from warrant holders.

(Well, that’s not true. Some warrant holders might sell the stock short, figuring that if it went up they couldn’t lose – they could always cover at $5 by exercising their warrants – and if it went down, they’d make a profit on their shorts.)

What I’m trying to say is that if the deal does close, there would likely be a fairly strong pull on the stock to trade in the $4.75 to $5.50 range for a while, and a pull on the warrants to trade in the 40-cent to 70-cent range.

Of course, if the underlying business does well – or poorly – the stock good go a lot higher – or lower. But with 18 million shares outstanding and an overhang of 33 million warrants, it will face a headwind.

By the same token, with so long to run, the options should retain value even if the stock hits a downdraft. Even if the stock dropped to $3, the warrants’ theoretical value with 3 years to run could be higher than last night’s 35-cent price. Here’s the black box to play with again with that example plugged in. Notice that to get the warrants to be worth 46 cents, I used 40% as the volatility. Forty percent of what, you ask. I asked the asked the same thing of a friend who does this for a living. ‘It’s very complicated and truthfully, I don’t understand it either,’ he said. ‘Use 40%; that’s about right.’

(One of you, I know, will send in all the math and standard deviations.)

In using the black box, two of you sent in a good back-of-the-envelope way to adjust for the fact that the warrants don’t have unlimited upside, the way normal options would.

(With a normal option, if our HAPN went to $70, our profit would be $65. With these warrants, because the company can force conversion if the stock stays above $8.50 for a while, the practical upside is approximately $3.75 or $4. That’s still twelve times what we paid for the warrants, so not too bad. I have a rule: whenever I make twelve times my money in under three years, I don’t complain.)

The method you suggested was to use the black box to figure out what an HAPN warrant with an $8.50 strike price would be (since effectively you’re giving up all the gain above $8.50 or a little more) and then subtract that from the value of the warrant with a $5 strike price.

With the stock at $5.64, the $5 strike price warrant theoretically may be worth about $2.11, while using the same 40% volatility assumption, the $8.50 strike is $1.03, so subtracting one from the other gives you a theoretical value $1.08 for our warrants. If the deal gets done tomorrow and if the stock stays at $5.64. But with 33 million of them, I’d be surprised if they traded at their theoretical value.

So I guess even if tomorrow brings good news, it may not bring an immediate retirement on the Amalfi Coast.

But we might not want to take an immediate profit anyway – we’ve not held the warrants nearly long enough to qualify for long-term capital gains tax treatment.

Finally, let’s not entirely discount brighter scenarios.

The underlying business could do well, and the same institutions that liked it enough to pay $5.97 a share last week might buy more if it got cheaper – or might buy the warrants themselves. And others, seeing a fine business with an accelerating growth rate (in case that’s what InfuSystems turns out to be) might bid the price up regardless of the warrant overhang.

Anyway, let’s see what happens tomorrow.


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