03/26/2013 11:07 EDT | Updated 05/26/2013 05:12 EDT

Mega Brands shares surge as key investors exchange warrants to reduce debt

MONTREAL - Shares in Mega Brands hit their highest level in more than three years Tuesday after the toymaker announced a deep cut in its debt load as three key investors agreed to exchange their warrants for shares.

The Montreal-based toy and arts supply company said the principal amount of its outstanding debentures will be reduced by $62.4 million to $52.2 million under the plan. That's down 63 per cent from the $141.7 million of outstanding debt it faced when the debentures were issued three years ago.

"This significant debt reduction strengthens our financial position and will contribute directly to net earnings through lower interest expenses beginning in the second quarter of this year," said president and CEO Marc Bertrand.

Mega Brands (TSX:MB) shares hit $14.60 in intraday trading before closing up 5.5 per cent or 76 cents to $14.56 in Tuesday trading. That's the highest level since January 2010.

The debentures pay 10 per cent in interest annually and Mega Brands expects the recapitalization will reduce pre-tax cash interest expenses by about $6.2 million annually, or about 22 cents per share on a diluted basis.

The company says three significant shareholders — Fairfax Financial Holdings Ltd. (TSX:FFH), company chairman Victor Bertrand Sr. and Trimark Investments — have agreed to buy a total of $53.3 million in shares by exercising purchase warrants issued in 2010.

In addition, four investment firms have agreed to exchange all of their warrants for shares of Mega Brands in a cashless option.

Other warrant holders will also get the opportunity to take part in the debt-for-stock swap but retain the option to use the warrants to buy additional shares at the exercise price of $9.94 per share.

Gerrick Johnson of BMO Capital Markets said the decision by the majority investors to exercise their warrants sends a bullish signal to the market about their confidence in Mega Brands because they are giving up 10 per cent interest from debentures in return for company shares.

"It signifies confidence on the part of Trimark and Fairfax in the business to enter into this agreement and the cashless portion of this agreement is confidence on the company's part in their cash flow generating ability over the next couple of years to pay down remaining debt," he said in an interview from New York.

Johnson said Mega Brands will be able to reduce its debt faster than had been expected because of the improved financial performance of the company as it continues to recover from several recalls of a magnetic toy that hampered its reputation and dramatically cut sales.

"It wouldn't be able to be done if the share price was under $9.96," Johnson said. "No one would exercise anything."

The warrants and debentures were issued in early 2010 as part of a major recapitalization of the company following several difficult years. Since then, its fortunes have improved.

Once the warrants are exercised, Fairfax will own 29.2 per cent of Mega Brands shares, followed by Trimark at 18.4 per cent and Victor Bertrand at 10.4 per cent.