More Thoughts on the Vonage Mystery

Posted on November 10, 2009

After one has traded for some time, it becomes apparent that the biggest investment profits happen unexpectedly and are in retrospect not in the least bit correlated with underlying business conditions. The game of investment then becomes about positioning one’s capital in low-risk situations hoping for that unexpected success. Vonage typifies this investment strategy.

When I first bought the stock at $0.40, it seemed low risk, as there was no danger of imminent bankruptcy, and yet the stock was priced as if the company was already bankrupt. Then suddenly out of nowhere in late August, Vonage’s (VG) stock proceeded to climb up nearly 500% in a matter of days. Until the other day, I haven’t had a clue as to what caused this phenomenal rise, and naively I attributed it to some “market” discovery of the value inherent in VG’s stock. However, after reading VG’s 10Q, I have come to a different conclusion.

In the 10Q, VG says:

“From August 27, 2009 through September 8, 2009, we received Notices of Conversion from certain holders of our 20% senior secured third lien notes due 2015 (the “Convertible Notes”) indicating their desire to convert a portion of the Convertible Notes. The Convertible Notes were converted into shares of our common stock at a rate equal to 3,448.2759 shares for each $1,000 principal amount of Convertible Notes, or approximately $0.29 per share.”

Can it be a coincidence that VG’s stock started its meteoric climb about a week before Aug. 27th, and then peaked on August 26th, the day before VG was informed of the Notice of Conversion? I don’t think so. Since it is quite commonplace for convertible note holders to short the stock of the underlying equity for hedging purposes, it seems clear that VG’s convertible note holders were (and some still remain) short at least an equal amount of shares of VG (and likely much more), as the rate in which the notes convert. Surely, other funds recognizing the short pressure of the converts, played lemmings and shorted VG as well. As such when the decision was made to convert, a massive amount of shares needed to be covered, fueling an incredible rise in VG’s stock.

The question, of course, remains why the Convert Holders decided to convert when they did? Why exactly did they have to convert? Why not remain short VG equity and long the converts? I don’t really have an answer to these questions, except to say that apparently they no longer felt they should be hedged in VG. This implies that they foresaw greater upside, than downside, in a non-hedged equity position, then in a hedged convert. Given the preponderance of insider trading, you are free to interpret this statement, as you see fit.

As for myself, since I am currently still long some VG, I am naturally biased to bullish argument. However, I wonder whether the lack of artificial selling pressure from the convert overhang will help the price or will the lack of artificial buying pressure from short covering hurt the price? Or will new buyers emerge that actually believe in VG as an investment? As always, investing leads to circular reasoning and infinite loops of logic. The best hope is probably for another round of good luck!

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