Alibaba issued CB, a perfect option hedging strategy it offered

$Alibaba(BABA)$ announced the pricing of a private offering of $4.5 billion in 0.50% Convertible Senior Notes due 2031.I am very interested in “capped call transactions”. Let's have a quick look together.

Key details are:

1. Offering Details:

   • Total: $4.5 billion (with an option to purchase an additional $500 million).

   • Maturity: June 1, 2031.

   • Interest: 0.50% per year, payable semi-annually.

   • Conversion: The notes can be converted into cash, ADSs, or a combination thereof, at Alibaba's discretion.

   • Conversion Rate: Initially 9.5202 ADSs per $1,000 principal, equivalent to a $105.04 conversion price per ADS, a 30% premium over the $80.80 closing price on May 23, 2024.

2. Use of Proceeds:

   • Estimated net proceeds: $4.436 billion (or $4.93 billion if the option is fully exercised).

   • Uses: Repurchasing approximately 14.8 million ADSs at $80.80 each, further share repurchases, and funding $573.75 million in capped call transactions.

3. Redemption and Repurchase Terms:

   • Redemption: Possible under specific conditions like tax law changes, if less than 10% of the original amount remains, or if ADS price meets certain thresholds from June 2029.

   • Holder Repurchase Rights: On June 1, 2029, or in case of a "fundamental change."

4. Capped Call Transactions:

   • Aim: Reduce potential dilution and offset cash payments over the principal amount upon conversion.

   • Initial cap: $161.60 per ADS (100% premium over $80.80).

5. Market Impact:

   • Initial hedging activities related to the capped call transactions may affect ADS market prices.

   • Further repurchase activities may also impact market prices of ADSs and the Notes.

A detailed description of Capped Call Transactions

A capped call is an option strategy where a company buys call options with a strike price equal to the conversion price of the convertible notes it issues. These call options have a cap (or upper limit) on the potential benefit the company can receive, which is set above the conversion price.

How Alibaba Uses Capped Call Options to Hedge？

Issuance of Convertible Notes: Alibaba issues convertible notes, which give noteholders the right to convert their notes into Alibaba's ADSs at a specific conversion price (in this case, $105.04 per ADS).

Purchasing Call Options: Concurrently, Alibaba purchases call options at strike of $105.04 , and sell call options at $161.60 per ADS.

How to hedge Dilution and reduce costs？

If the ADS price rises above the conversion price but remains below the cap, the call options offset the dilution from the conversion of the notes because Alibaba can buy back its shares at the conversion price.

If the ADS price exceeds the cap, Alibaba benefits up to the cap, reducing the effective cost of conversion to the capped price. It also helps in managing the potential cash outflow if the company chooses to settle conversions in cash.

Different Scenarios

1）If Alibaba's stock price is below $105 when the notes expire,

For noteholders：

• No incentive to convert

• principal repayment and 0.5% interest (175 million US dollars in total)

For Alibaba：

• Return the principal and pay the total interest ($175 million) ,574 million option costs and transaction fees

• Worthless options and no additional benefit

2）If stock price is between $105.04 - $161.6

For noteholders：

• 0.5% interest (175 million in total)

• Convert their notes, make extra income from the spread of stock prices (may be paid in cash)

For Alibaba：

• Reduced dilution or cash outflow: Options transactions allow Alibaba to buy shares at the conversion price up to a cap ($161.60). This reduces the dilutive effect of issuing new shares due to the conversion of shares.

• Value of Capped Calls: these call options provide additional income. For example, if the ADR price is $130, the call options are in the money and Alibaba can buy ADRs at $105.04, reducing the effective cost of settling the notes.

• The above benefits effectively offset the costs

Therefore, if the ADR price is between $105.04 and $161.60 at maturity, that provides the best financial balance. Noteholders will convert their notes, Alibaba will use capped call transactions to manage the financial impact, and the company will settle the conversions at an effective cost closer to $105.04 per ADR, reducing potential dilution and cash outflows.

3）If stock price is above $161.6

For noteholders：

• 0.5% interest (175 million in total)

• Convert their notes, make extra income from the spread of stock prices (may be paid in cash)

For Alibaba:

• Stocks are repurchased at a low price to obtain excess returns. Through option transaction, the impact of dilution can be effectively alleviated.

• However, capped calls limited the price cap, and additional costs were incurred in excess of $161.6, resulting in some unhedged financial exposure.

  $Alibaba(09988)$