Rocket Lab: Reading The Tea Leaves Of The Convertible Note Offering

Summary:

• Rocket Lab USA, Inc. announced two related transactions: (i) a convertible note offering worth $300 million, and (ii) the purchase of capped call options to partially or fully offset share dilution.
• In this article, I take a closer look at these transactions and their potential consequences for Rocket Lab.
• My analysis suggests that Rocket Lab could see a range of outcomes, some positive, some negative, depending on the purpose for raising money (which we do not currently know).
• Overall, Rocket Lab USA, Inc. stock remains a strong buy for me.

Rocket Lab USA, Inc. (NASDAQ:RKLB) announced on Wednesday (January 31) that it would be making two significant and related transactions closing on February 6th: (i) a convertible note offering to raise $275 million (later raised to $300 million); and (ii) a purchase of capped call options for RKLB stock to partially or fully offset share dilution should creditors choose to convert their notes to shares. After close on Thursday, the company revealed further details about these transactions. We still don’t know the exact purpose of raising capital at this point in time, so it is difficult to say with confidence whether this move is good or bad for Rocket Lab. The market, however, has sold off the stock, with Rocket Lab shares down 17% at close on Thursday.

In this article, I begin by taking a closer look at the transactions that Rocket Lab is making and how they work. I also consider some scenarios about the purpose of raising capital. I then discuss the potential positives and negatives here. My analysis suggests a wide range of outcomes, from significantly negative to significantly positive.

I want to emphasize for this article that readers should take my analysis with a grain of salt. There are several unknowns here, and this is very new information, leading to a lot of uncertainty. I think we’re all trying to figure out what to make of Rocket Lab’s announcement and its future consequences for the firm, but things could turn out a few different ways. There is no very good way to decide which of these scenarios will materialize until Rocket Lab provides us more information. As always, readers should do their own research and make up their own minds.

I look forward to hearing reader views about Rocket Lab’s announcement in the comments. Maybe that will bring us closer to determining what to make of the move.

The Two Transactions

Rocket Lab is making two related transactions. The first is a (fairly ordinary) convertible note offering. Here is what Rocket Lab said about this transaction:

[The private offering consists of] $300.0 million aggregate principal amount of 4.250% convertible senior notes due 2029… Rocket Lab granted the initial purchasers of the notes an option to purchase… up to an additional $55.0 million aggregate principal amount of the notes…. The initial conversion rate is 195.1029 shares of common stock per $1,000 principal amount of the notes, which represents an initial conversion price of approximately $5.13 per share of common stock. The initial conversion price represents a premium of approximately 27.5% above the last reported sale price of the common stock on The Nasdaq Capital Market on February 1, 2024, which was $4.02 per share.

This is fairly straightforward. By my calculation, $300 million worth of notes are convertible for 59 million shares, and $355 million worth of notes would be convertible for 69 million shares. Prior to this transaction, Rocket Lab’s share count was 486 million). The potential dilution here is then 12%-14% of shares outstanding.

However, Rocket Lab seems to want to avoid this dilution, which brings us to the second transaction. Here’s what Rocket Lab is doing:

Rocket Lab entered into privately negotiated capped call transactions…. The capped call transactions will cover… the number of shares of common stock that will initially underlie the notes. The capped call transactions are expected generally to reduce or offset potential dilution to the common stock upon any conversion of the notes and/or… offset any potential cash payments we are required to make in excess of the principal amount of converted notes, as the case may be, with such reduction and/or offset subject to a cap. The cap price of the capped call transactions will initially be $8.04 per share of common stock, which represents a premium of 100% over the last reported sale price of the common stock…. If the initial purchasers [of the convertible notes] exercise their option to purchase additional notes, Rocket Lab expects to enter into additional capped call transactions with the option counterparties.

As I understand it, the call writers will cover the calls by maintaining holdings of Rocket Lab shares or derivatives (presumably 59-69 million Rocket Lab shares or equivalent in derivatives to offset the risk of writing the calls and selling them to Rocket Lab).

Rocket Lab has been advised that, in connection with establishing their initial hedges of the capped call transactions, the option counterparties or their respective affiliates expect to purchase shares of common stock and/or enter into various derivative transactions with respect to the common stock concurrently with or shortly after the pricing of the notes. This activity could increase (or reduce the size of any decrease in) the market price of the common stock or the notes at that time.

Rocket Lab is paying $36.5 million from the proceeds of the convertible for the capped calls. The net proceeds are expected to be $290-343 million before the capped calls, and $254-307 million after the capped calls.

How I Think This Will Work (Roughly)

Here is my understanding of the basic scenarios here:

1. RKLB stock price remains below the level where noteholders would convert to shares. Rocket Lab pays off the debt in cash (with this coming either from operating profits, or from further debt, or share issuance).
2. RKLB stock price crosses the level where noteholders convert to shares but remains below $8.04. When notes are converted, Rocket Lab exercises its capped call option for the required shares, paying the counterparty the strike price (with this payment coming either from operating profits, or from further debt, or share issuance).
3. RKLB stock price crosses the level where noteholders convert to shares and crosses $8.04. When notes are converted, Rocket Lab will not be covered beyond $8.04. They could issue new shares to the noteholders, or pay the difference past $8.04 plus the strike price for the calls to buy shares from the option counterparty (or equivalent moves) (with this payment coming either from operating profits, or from further debt, or share issuance). I am assuming that the capped calls do not auto-exercise at $8.04 and that there is a more complicated contract here.

As readers can see, not every scenario involves share dilution. Of course, the debt will come due at some point (there are no free lunches) and Rocket Lab will eventually either need to pay in cash directly to noteholders, or to pay the options counterparty the strike price (plus possibly the difference above the cap), or to issue shares, (or some combination of these).

Why Is Rocket Lab Doing This?

Whether this move is good or bad for Rocket Lab depends on its purpose. Rocket Lab remained quiet about the details, offering only the following vague explanation:

Rocket Lab intends to use approximately $40 million of the net proceeds… to repay a portion of its borrowings under its equipment financing agreement, including accrued and unpaid interest on such borrowings. Rocket Lab intends to use the remainder of the net proceeds for working capital or other general corporate purposes, which may include potential acquisitions and strategic transactions. If the initial purchasers exercise their option to purchase additional notes, Rocket Lab expects to use a portion of the net proceeds from the sale of the additional notes to enter into additional capped call transactions and the remainder of such net proceeds for working capital or other general corporate purposes, which may include potential acquisitions and strategic transactions. From time to time, Rocket Lab evaluates potential strategic transactions and acquisitions of businesses, technologies or products.

After the capped calls and the debt repayment, we still have $250-303 million left for the vague “working capital or other general corporate purposes, which may include potential acquisitions and strategic transactions.”

I expect that the market selloff happened because people are wondering if Neutron is delayed and Rocket Lab needs a longer runway. This is rocket science so delays are certainly possible, perhaps even likely. If the primary motivation for Rocket Lab’s move is a Neutron delay, then the proceeds could fund 1-2 years of runway, so perhaps investors are also worried about the note offering signaling a significant delay. If there is a delay, the length is crucial – a quarter or two is not a big issue considering this is rocket science, over a year would be more concerning.

What makes me a bit wary of accepting this explanation is that a Neutron delay doesn’t explain the timing of Rocket Lab’s move. Why do it now? Why not wait for the Fed to lower interest rates? Why not wait for both space systems and the launch business to keep growing, leading to a potentially better deal if the stock price is higher later in the year? Why offer convertible notes in the middle of a major slump in share prices across the space industry? Why not wait? Rocket Lab already had runway for multiple quarters.

The acquisition explanation would make more sense in terms of timing. Given the slump in valuations across the space industry, along with consolidation as some firms fail, perhaps Rocket Lab has found (what management sees as) a good deal for some space firm that management cannot yet speak about. Rocket Lab has made multiple acquisitions in the past few years, so an acquisition would not be a big surprise. Of course, whether this is good or bad for Rocket Lab depends on who they are acquiring and at what price. But, as noted, the slump in space industry valuations could present a good opportunity.

It is also possible that Rocket Lab is being more aggressive than previously anticipated with building out production or launch facilities or something along these lines. Rocket Lab did win a space systems contract worth $515 million for manufacturing 18 spacecraft due in 2027-2030, and there are various other space systems contracts due at various points in coming years. Perhaps Rocket Lab needs liquidity to set up production space and tooling for these project and could not wait for a better environment to meet contract timelines. Rocket Lab could also be acting aggressively on other fronts, including Neutron – beyond initial testing and initial launches, Rocket Lab could, for instance, be thinking about construction of a small fleet of Neutrons.

Rocket Lab’s move could also be motivated by more than one reason, e.g., both an acquisition and a Neutron delay.

Investor Takeaways

As now discussed, what we make of Rocket Lab’s convertible note offering depends on the underlying purpose behind the move, which we don’t currently know. The offering could be a negative if it is motivated by a significant Neutron delay or a bad acquisition, or a positive if Rocket Lab is being aggressive or making a good acquisition. It is impossible to say for sure until the company provides more information.

Sometimes it is better to reserve judgment rather than jump to conclusions. To me, the 17% drop in stock price over 12-14% dilution looks like either an overreaction or a response to uncertainty. Neither of these constitute a compelling reason to sell for long-term investors. Currently, I don’t see a good reason to assume the worst instead of the best, although I admit that I don’t know and maybe the offering will turn out to be a negative.

When I first initiated Rocket Lab with a strong buy rating in June, I argued that Rocket Lab’s potential as a long-term multibagger made it a compelling investment despite the high risk, including risk of bankruptcy. Here is what I wrote then:

Investors should therefore make no mistake: Rocket Lab is a high risk investment with real potential downside. But this risk comes with a great deal of upside, and in that context Rocket Lab is an attractive investment. If Rocket Lab’s market cap would, say, 5x or 10x upon Neutron’s success, then, say, a 50% chance of success would give the bet on Rocket Lab a strongly positive expected value even if the downside is potential bankruptcy. And so the investment seems to make good sense for investors who are looking for high growth and the potential of a multi-bagger. Not everyone looks for this in their investments, of course, and that is fine too.

I know my strong buy rating is going poorly at the moment, but I am going to stick to my guns on this one and not jump at shadows. I believe my thesis that Rocket Lab is a potential multibagger remains intact, and if anything the bargain bin share price today near all-time lows makes the potential investment returns larger. Rocket Lab also released preliminary Q4 2023 results earlier in the week, showing continuing space systems growth. Electron is also slated to have a busy launch schedule this year. Rocket Lab is still more or less on track.

I expect that most long-term investors already understand that Rocket Lab USA, Inc. is a relatively early-stage company that is gradually working its way toward profitability. Capital raises and volatility and positive and negative surprises are common for such firms – and plenty of successful technology firms go through all of them.

Overall, then, Rocket Lab remains a strong buy for me, and I wonder if, in time, the current drop in share price will turn out to be a great buying opportunity for long-term investors.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of RKLB either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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