XOXO and GX Bonds:
Some Telecom Shares Soar,
While Bonds Stay Discounted
By KEN BROWN and MITCHELL PACELLE
Staff Reporters of THE WALL STREET JOURNAL
Bond and stock investors don't always see eye to eye on the companies they
follow, but these days they aren't even on speaking terms when it comes to
valuing the shares and debt of many upstart telecom companies.
Investors in the bank loans and bonds of companies such as Global Crossing and
XO Communications are valuing the debt as though the companies are in severe
trouble and could even be headed for bankruptcy, while the stock investors are
betting that the companies have valuable assets and are likely to survive and thrive.
During the past two weeks, the disconnection has grown as shares of many of
these companies have soared, some doubling in just a few days, while the bonds
remain steeply discounted.
The companies generally maintain their long-term prospects are solid, cash
stockpiles are large and bankruptcy isn't imminent. Yet if the debt markets are
right and these companies are unable to pay their debts in full, these shares are
likely to end up worthless. So why do investors continue to buy the shares of
distressed companies with huge amounts of debt?
"There is small base of stock investors who think that if they can buy a stock at
75 cents, it must be a good deal," says Henry Miller, head of restructuring at
Dresdner Kleinwort Wasserstein, a unit of Dresdner Bank AG. Even in cases of
companies already under bankruptcy-court protection, where it is clear to
specialists in the field that stockholders will get nothing, "you still have people who
will buy."
One basic tenet of Chapter 11 of the Bankruptcy Code is stockholders are on the
bottom rung of a company's capital structure, meaning they get paid only if every
other creditor -- including employees, suppliers, banks and bondholders -- is paid
off. Consequently, if the bank and bond debt of a company headed for bankruptcy
exceeds the value of the company's assets, its stock -- in theory, at least -- is
worthless.
In practical terms it isn't as simple as that.
Though bank debt takes priority in the
event of a bankruptcy workout,
bondholders frequently get some payment
-- often stock in the reorganized company
-- even if banks don't get paid off in full.
Stock investors are on much shakier
ground. Only when there is enough
remaining value in a troubled company to
pay off banks and bondholders do stock
investors get anything.
That is why most professionals who
invest in these companies buy the bank
debt or bonds and shun the stock. But
shares of these distressed companies
ricochet around the stock market, often
doubling in days, making them tempting
investments.
What else could explain the $1-a-share
price that Exodus Communications
fetched a month before it filed for
bankruptcy protection Sept. 26? Before it
filed, its bonds were trading around 15
cents on the dollar, an unequivocal sign
that the debtholders didn't believe the
company could repay a significant portion
of its $3.4 billion in debt. Nevertheless, at
$1 a share, investors were valuing the
company's stock, which would only be
worth something if the debt were paid in
full, at nearly $600 million.
"There are always people who just don't
do the fundamental analysis," says David
Resnick, head of restructuring at Rothschild Inc. They will see a big company
with cheap shares, he says, and "just pick it up as an option value. But it's a way-,
way-, way-out-of-the-money option. Most professionals wouldn't touch it."
One way to view this disparity is to take a walk down a company's capital
structure, starting with the bank debt and ending with the equity, and show how
each group values the entire company.
Consider Global Crossing. It has about $2 billion in bank debt, which is trading at
about 50 cents on the dollar, meaning the market is valuing the claims of the banks
at about $1 billion.
Global Crossing's bondholders are more optimistic. They assume the company
will pay off almost all of its $2 billion in bank debt and have cash to spare. They
value the company's $4.5 billion in bonds outstanding at 15 cents to 20 cents on
the dollar, giving the bonds a value of about $800 million. Since the bondholders
theoretically won't get a dime until the banks are paid in full, you can add the total
bank debt to the market value of the bonds to get about $2.8 billion, the value the
bondholders are placing on the company.
Then come the wildly optimistic stock investors. With its shares trading at $1.24,
more than triple an Oct. 9 low, the company has a market capitalization of $1.1
billion. Adding the $6.5 billion in total bank and bond debt to this market
capitalization tells you what stock investors think the company is worth: $7.6
billion.
Asked about the varying views, Global Crossing reiterates what its chief financial
officer, Dan Cohrs, said at an investment conference on Oct. 17, "Contrary to
what the market has been telling us, we feel that we have a very strong liquidity
position." He said the company has the cash to survive until it breaks even next
year and that its financial position should improve even more after the planned sale
of some company assets.
The same situation holds true, investors say, with other beaten-down telecom
names, such as XO Communications. Its bank debt trades at about 54 cents on
the dollar and bonds at about 21 cents. Although $3.4 billion of debt stands above
them in the capital structure, stock investors value the company at $433 million.
XO Communications wouldn't comment.
So why do investors buy the shares of these companies? Investors, particularly
individuals who don't have access to the prices of corporate and bank debt, may
not know how far these have fallen.
Another is speculation. The shares of beaten-up companies often fluctuate wildly
because they trade like options that are way out of the money, meaning the
company's fortunes would have to improve dramatically for them to be worth
anything at all. But if that does happen, "you can have a huge upside," says Rob
Gensler, who manages T. Rowe Price Media and Telecommunications Fund.
Some investors buy the stocks just to play the ups and downs, with no thought to
the long term. "It's a dangerous game ... but I can understand people playing the
volatility," Mr. Gensler says.
A typical play is to buy the stock after a big tumble, because at that point many
short sellers take their profits and leave, terrified of the volatility of stocks that
trade in the low single digits. As they buy shares to close out their short positions,
the stocks often rally, creating an opportunity for short-term profits.
Finally, investors might rationally believe there is some genuine value even if the
companies are forced into bankruptcy. That has been the case in a few recent
bankruptcies, including Finova, the lender that emerged from Chapter 11 in
August. Its shares traded at $2.08 before the filing and about $3.64 when it left
court protection, though they have since fallen back to $1.18. Experts warn that
few companies fit into this category; those that do are generally ones with solid
long-term business prospects that are facing a short-term credit crunch.
"You've got to remember that the last demon removed from Pandora's box was
hope," says William Repko, head of the restructuring and refinance for J.P.
Morgan Chase & Co. Global Crossing's stock investors appear to see all news as
good news. Earlier this month, when news reports said Global Crossing was in
talks to swap some of its debt for equity, its stock surged 68% in two days. But
swapping the debt for equity would allow Global Crossing to reduce its debt by
issuing new shares and trading them for bonds outstanding -- meaning the existing
shareholders would own less of the company, cutting the value of the existing
stock. |
