Understanding Zip Convertible Notes: Impact on Share Value

Jul 29, 2023

For the full Stock Analysis released on 31 July 2023, (click here)

In June 2023, Zip conducted a substantial liability management exercise aimed at reducing its liabilities related to zero coupon convertible notes. The exercise resulted in a reduction of these liabilities by $192.2 million, bringing the total down to $137.8 million. The reduction was achieved at an effective rate of 47.5 cents in the dollar, meaning that for every dollar of the liability, only 47.5 cents remained after the exercise.

Zip co

Understanding convertible notes is essential for investors to comprehend how Zip’s strategic move may influence the value of their shares in the short and long term.

What are Convertible Notes?

Convertible notes are hybrid financial instruments issued by companies to raise capital. These notes function as a form of debt initially, as the issuing company borrows money from investors with the promise to repay the principal amount at a specified future date. However, what sets convertible notes apart is their conversion feature. This means that at a later time, the note holders have the option to convert the value of the notes into a predetermined number of shares or equity of the company, instead of being repaid in cash.

What are Convertible Notes?

Convertible notes are commonly used by startups and early-stage companies as a means of raising capital because they offer certain advantages over traditional equity financing or standard debt instruments:

  1. Flexibility: Convertible notes provide flexibility for both the company and the investors. The conversion terms, such as the conversion price and conversion event, are negotiated between the company and the investors, allowing them to find mutually agreeable terms.
  2. Delayed Valuation: Startups may face challenges in valuing their business accurately, especially in the early stages when financial metrics may be limited. By using convertible notes, valuation discussions can be deferred until a later funding round when there is more data to support a fair valuation.
  3. Lower Interest Payments: Convertible notes often have lower or no regular interest payments, which can ease the financial burden on the company during its early growth stages.
  4. Attracting Investors: Convertible notes can be an attractive option for investors, as they provide an opportunity to participate in the upside potential of the company while offering some downside protection in the form of a debt instrument.
Impact on Zip’s Share Price:
  1. Potential Dilution: When convertible notes are converted into shares, new shares are issued to the note holders. This increases the total number of outstanding shares in the market. If the conversion price is lower than the current market price of the shares, existing shareholders may experience dilution, as their ownership stake in the company decreases.
  2. Managing Capital Structure: Companies, like Zip, may undertake liability management exercises to strategically manage their capital structure. By reducing convertible note liabilities, Zip aims to improve its financial position and reduce interest expenses. This move may be viewed positively by investors as it strengthens the company’s balance sheet.
  3. Balancing Growth Initiatives: Convertible notes are often used by startups and early-stage companies as a means of raising capital. For Zip, the funds raised from convertible notes was used to fuel growth initiatives, fund expansion plans, or invest in new projects. This practises definitely contributes to the company’s long-term growth and value.
Impact on Share Prices in the Short Term:
  1. Market Sentiment: The announcement of a liability management exercise may impact market sentiment and trigger reactions from investors and analysts. We deemed it has seen positive market reactions, which could lead to an increase in share prices in the short term, indicating investor confidence in Zip’s strategic move.
  2. Perception of Dilution: Investors may closely scrutinise the terms of the liability management exercise, particularly the conversion price and the potential for dilution. Any perception of significant dilution may lead to short-term negative impacts on share prices, in this case, strengthening its balance sheet and leading to positive EBTDA in 2024, most likely had positive impact.
  3. Market Response: The market’s response to the liability management exercise will depend on various factors, such as the overall economic climate, the industry’s performance, and Zip’s financial results. Positive market conditions may further boost share prices in the short term, hence it is critical to see the FY23 full results to see the actual impact on the overall year result.
Impact on Share Prices in the Long Term:
  1. Financial Performance: In the long term, Zip’s share prices are likely to be influenced by its financial performance and growth trajectory. Successful execution of growth initiatives funded by convertible notes may drive shareholder value and positively impact share prices.
  2. Company’s Position in the Market: Zip’s competitive position in the market and its ability to adapt to industry changes will play a significant role in determining long-term share price performance. A strong market position and a clear sustainable growth strategy can attract investor confidence and drive share value over time. While most analysts are not at all confident about the sector, keep in mind that these very same analysts were so bullish during the so called “gold times” where most BNPL were in much worse financial positions and huge share values.
  3. Economic Conditions: External economic factors, such as interest rates, inflation, and overall market conditions, can influence share prices in the long term. Investors will closely monitor these macroeconomic indicators to assess the company’s potential for sustained growth. In this case we deem that the worse of interest rates cycle is now behind and the market could start pricing a possible decline by the time of this article is written. Remember, the market prices within 12-18 months in advance, which means we are now at the likely peak of interest rates hikes, but it would not be a surprise if the market start pricing rates cuts into the sector at the current period; if that is the case, and in combination to positive than ever financial performance, we could see share price rising in the upcoming 12 months.

Overall, the liability management exercise was a strategic move by Zip to strengthen its financial position, improve its balance sheet, and potentially reduce future interest payments or obligations related to the convertible notes, but what really dictates the share price movement is the overall business performance and the macroeconomic conditions the market is set to be pricing in.