Jubak on WCOM valuation
investor.msn.com
Posted 8/14/98, Archived 8/21/98
Jubak's Journal
A buy in this market?
You betcha: That's what WorldCom's recent $6 billion bond sale says to
me.
By Jim Jubak
Want to get a handle on a company's future earnings? Try looking at its
bonds.
Most of the time, I don't pay a lot of attention to corporate bond issues
when I try to analyze a stock. But when the economic outlook is fuzzy,
the earnings picture foggy, and investor sentiment volatile, I can't get all
the information I need from the tools that I commonly use. So I cast my
net wider, taking whatever clues the financial markets are offering.
Last week, WorldCom (WCOM) sold the largest corporate bond offering in
history -- $6.1 billion. What I learned from that sale gave me the last bits of
information I needed to complete my analysis of the company and add the
stock to Jubak's Picks. Let me tell you how the bond deal helped me
reach a decision to buy this stock.
The window offered by the bond deal couldn't come at a better time.
Thanks to the recent rout in the market, WorldCom's stock has tumbled
more than 10% since mid-July, to $49.75 on Aug. 11. Is this the moment
to buy?
WorldCom is notoriously hard to value since the company's history of
growing by acquiring other phone and networking firms and then taking big
charges against earnings makes most standard measures virtually
useless. For example, the recent pullback in the stock took WorldCom's
price-to-earnings ratio down to a modest 260.
Details
Price
50 3/16
Change
-0.531
Company Facts
3-yr Chart
Press Releases
Earnings Estimates
Growth Rates
10-yr. Summary
Details
Price
60 15/16
Change
-7/8
Company Facts
3-yr Chart
Press Releases
Earnings Estimates
Growth Rates
10-yr. Summary
And valuing the stock is about to get even harder. With approval from the
U.S. Department of Justice and the European Commission finally tucked
under its belt, WorldCom is set to consummate its $37 billion acquisition
of MCI Communications (MCIC) sometime in the third quarter. WorldCom
will take a huge write-off from the deal -- some $6 billion to $7 billion if the
Securities and Exchange Commission goes along -- that would pretty
much wipe out earnings. Follow that with a likely stream of special
charges as WorldCom cuts and slashes overhead at MCI and investors
could wait years to see earnings numbers that actually mean anything.
While future earnings -- theoretically the reason that an investor is buying
the stock -- are pretty much at the mercy of the accountants, it's possible
to put together a reasonably accurate picture of the growth rates we can
expect from the combined company. Lehman Brothers did just that after
MCI reported its second-quarter earnings on July 30. Here's what the
combined company looked like:
Putting the pieces together (Q2 revenue)
Business
segment
MCI
WCOM
Combined
Yr. to
Yr.
Growth
Sequential
Growth
Voice
$3,934
$1,208
$5,142
11%
2%
Data and
Internet
$912
$1,062
$1,974
32%
13%
International
na
$299
$299
52%
15%
Information
Technology
$464
na
$464
21%
na
Other
-$29
$42
$13
na
na
Total
$5,281
$2,611
7,892
16.70%
5%
-- Source: Lehman Brothers
-- All figures in millions
-- Excludes MCI's Internet business sold to Cable and Wireless
Knowing the growth rate for the combined company helps me get a handle
on its relative value versus other telecommunications stocks. For example,
now I can compare not only the price per dollar of current sales at MCI
WorldCom to AT&T (T), GTE (GTE) and Sprint (FON), but I can also factor
the sales growth rate into my decision. Here's how the companies stack
up:
Relative value?
Company
Q2 sales ($bil.)
Q2 growth
Price-to-Q2-
Sales Ratio
AT&T (T)
$12.86
-2.80%
8.03
GTE (GTE)
$6.28
10.80%
7.60
Sprint (FON)
$3.97
8.40%
7.52
MCI WorldCom
$7.89
16.70%
12.17
Clearly, if I were just buying current sales, I'd never think of plunking down
my money for MCI WorldCom. A dollar of second-quarter sales at the
combined company is more than 50% more expensive than a dollar of
AT&T sales and more than 60% more expensive than a dollar of Sprint
sales. But I'm not just buying current sales for my money. I'm also buying
sales growth. And compared to Sprint, for example, MCI WorldCom gets
me almost twice the growth for my 60% premium. If I look at both sales
and sales growth, the combined MCI WorldCom is a buy.
If I look at both
sales and sales
growth, the
combined MCI
WorldCom is a buy.
It's dangerous to buy a stock just on sales, however. While some
industries, such as cable television, can apparently trade forever on just
the promise of earnings, most stocks have to actually produce earnings
sooner or later. And thanks to the uncertainties of all the write-offs to
come at MCI WorldCom, I don't have a clear sense of how good a job the
combined company will be at turning sales into earnings.
That's why I found last week's bond sale so interesting. Interest rates on
bonds reflect the risk that the borrower might not be able to repay the
loan. So U.S. Treasury bonds usually pay the lowest interest rates since
borrowers are certain that, short of a collapse that would take down the
entire global financial system, the U.S. government will pay its debts.
Corporate borrowers pay more since companies have a history of going
bankrupt more frequently than the U.S. government. And some corporate
borrowers pay higher rates than others because bond buyers assess the
associated risks as higher.
Bond investors
actually believe
management's
claim that it can
wring substantial
cost savings out of
the merger of these
two companies.
WorldCom, for example, once paid a pretty high rate on its debt because
the company's ability to cover payments of interest and principal were in
doubt. As late as last April, Standard & Poor's, one of the three major
bond-rating agencies, said that WorldCom's bonds weren't investment
grade. That's not terribly surprising. WorldCom does have more than $8.3
billion in long-term debt on its books. And it's not unusual for a
fast-growing telecommunications company to get such a rating. The bonds
of Level 3 Communications (LVLT), a new competitor to WorldCom,
currently have a similar "junk bond" rating -- when Level 3 sold its bonds,
investors demanded a 9.125% interest rate.
But when WorldCom went to the bond market last week to raise $6 billion
to cover most of the $7 billion owed to British Telecom as part of the MCI
deal, the company only had to pay 6.4% interest on notes due to mature
in seven years. (The offering also included three-, five-, and 30-year
maturities.) That's only about 80 basis points (or 0.8 percentage points)
more than the U.S. government pays on seven-year Treasury notes.
That narrow spread tells me a couple of important things. First, bond
investors, who have carefully looked at the company's books, see more
than enough cash flow to cover existing liabilities and the new debt.
Second, bond investors actually believe management's claim that it can
wring substantial cost savings out of the merger of these two companies.
I don't think
WorldCom will
trade on earnings
for some time
anyway. But I can
get comfortable
with buying the
stock at its current
price.
The upgrade in WorldCom's debt began with the deal to buy MCI -- the
bigger company had a better bond rating and that helped produce the
two-notch improvement to the BBB rating that WorldCom now enjoys. But
bond buyers were also willing to take such a modest interest rate premium
because they anticipate future upgrades in WorldCom debt. An upgrade
would increase the price of the bonds on the market so that investors who
already own the bonds would get not only the 6.4% interest, but also price
appreciation on the bonds.
In other words, bond investors, who care about cash flow before charges
and depreciation, are giving the management of this company a strong
"thumbs up." I can't turn that into a precise earnings number -- and I don't
think WorldCom will trade on earnings for some time anyway. But I can
get comfortable with buying the stock at its current price. In this case, at
least, I feel reasonably confident that the market has created a genuine
bargain.
And any little comfort one can get from today's market is a very nice thing
indeed.
Changes to Jubak's Picks
Details
Company Facts
1-yr Chart
Earnings Estimates
Add WorldCom
WorldCom (WCOM) is the first telecommunications company to put it all
together. After the purchase of MCI closes in the third quarter of 1998, the
combined company will be able to offer domestic and international voice
services, data networking, Internet access and management. The gems
here are the data business, where revenue grew by 32% in the second
quarter, and international, where revenue grew by 52%. The company also
seems to have earned new respect from institutional investors, who
snapped up WorldCom's record $6 billion bond offering at a very modest
interest rate. That's good news for the stock, since it means that shares
will become a key telecommunications holding in large portfolios. I'm
adding this stock to Jubak's Picks with a $75 price target for August 1999. |
