This Is NVIDIA's Crazy New Financing Plan

Earlier this month, NVIDIA announced plans to return $1 billion to shareholders in its upcoming fiscal year. However, while NVIDIA has over $3 billion of cash, most of that is held outside the U.S.

Like many other tech companies -- most notably Apple -- NVIDIA would be hit with a significant tax bill if it repatriated its foreign cash to pay for dividends and share buybacks. Instead, the company plans to issue debt in order to finance its new capital return program. However, the type of debt NVIDIA is using -- convertible notes -- seems like a bizarre choice that could backfire for shareholders.

Convertible notes and warrants
Convertible notes are a type of debt that gives the holder an option to trade the debt for stock at a specified price. This conversion option gives debt holders a chance to profit if the company performs well over time. In return for sharing in this upside potential, debt holders accept a lower interest rate with convertible notes than they would receive for regular unsecured debt.

From a company's perspective, the main attraction of convertible notes is this lower interest rate. For a business with poor credit metrics, this is often the best way to make credit affordable. The downside is that existing shareholders will end up owning a smaller proportion of the company if its stock price rises and bondholders convert their debt to stock.

Companies issuing convertible notes often use financial derivatives to hedge this risk. NVIDIA is doing just that in a set of transactions that will effectively increase the price at which it has to start issuing new shares.

A strange choice
The strange thing in this case is that NVIDIA has very good credit metrics: the company has more cash than the amount of debt it is looking to issue. As a result, it should have been able to issue debt at a low interest rate without resorting to convertible notes.

Moreover, using convertible notes runs counter to the stated purpose of the debt offering: returning cash to shareholders. NVIDIA will use most of the cash it raises to buy back stock. This reduces the number of shares outstanding, increasing the value of the remaining shares.

However, if NVIDIA's stock performs well over the next five years, it will have to issue new shares to the holders of its convertible notes (and the holders of the warrants it is using as part of the hedging transaction). In other words, NVIDIA's buyback will reduce its share count for now, but some or all of those shares could "reappear" a few years down the road.

Foolish conclusion
I was a big fan of NVIDIA's decision to increase its share buybacks, but the way it's financing this program does not make sense. I can understand the desire to avoid a big tax bill by issuing debt rather than repatriating cash. However, by using convertible debt, NVIDIA could potentially be on the hook for issuing more shares, effectively canceling out the buyback.

Under these circumstances, NVIDIA investors would probably be better off with the company paying a higher interest rate for regular unsecured debt. The real beneficiaries of NVIDIA's financial engineering are the bankers arranging all of these transactions, not ordinary shareholders.

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The article This Is NVIDIA's Crazy New Financing Plan originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg owns shares of Apple and NVIDIA. Adam Levine-Weinberg has the following options: long January 2015 $390 calls on Apple and short March 2014 $17 calls on NVIDIA. The Motley Fool recommends Apple and NVIDIA. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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