360networks could be a short seller's dream or nightmare
Eric Reguly
03:33 GMT-04:00 Saturday, April 21, 2001
Okay, boys and girls, it's time to play "Who wants to be a short seller" and today's target is 360networks. You're going to have to have courage to play because this opportunity comes with a nasty little twist: The stock, unloved as it is, has an unlikely ally in the form of index fund managers.
It's finally payback time for short sellers -- investors who bet that a stock will fall -- after years of getting gored by the bull. In 1998 and 1999, a few summoned the nerve to gamble that stocks were on the verge of plunging. Most of the brave few who did got trampled as investors drove up values to insane heights.
About a year ago, though, the tide turned when the tech bubble burst. Short sellers have made fortunes on, among others, Nortel ($124.10 to a low of $19.90) and Celestica ($128.25 to $37.55), although playing the latter took impeccable timing because the selloffs were routinely followed by rallies.
In the U.S. markets, the short-selling opportunities were -- and still are -- endless. One of the more famous recent cases was Winstar Communications, a wireless network company whose stock went from $45.50 (U.S.) to nothing when it filed for bankruptcy this month. Winstar was a short seller's dream because it was overvalued and saddled with debt that it had no hope of paying off. Companies that are overvalued but still financially secure, such as Nortel, are much riskier short-selling targets.
Canadian short sellers think they may have found an ideal target in 360networks, a Vancouver company that builds and operates fibre-optic communications networks in North America and Europe. The stock, like all optical network stocks, was obviously overvalued and had to come down, which it did with a loud thud. At its peak last autumn, the shares were worth $24.19, giving the company a stock market value of, incredibly, $17.7-billion. That made it more valuable than most of the Big Five banks and every telecommunications company save BCE. The shares traded on Nasdaq yesterday at $2.57, down about 90 per cent from their high.
At that level, you would think the worst is over. That may be the case, but the sorry debt structure suggests another beating could be in store. An April 18 BMO Nesbitt Burns research report cites "funding concerns" for its inability to recommend 360networks' stock.
The company has about $1.9-billion of debt, of which $1.45-billion is in the form of high-yield notes issued in 1999, a year before the initial public offering; the rest is bank debt, which is trading at about 50 cents on the dollar. The high-yield debt trades at about 17 cents. Corporate debt that trades below 20 cents on the dollar generally suggests the company is in serious trouble and may not have enough money to fund its business plan. Investor who buy the bonds in the teens are gambling that a restructuring will pay them something more.
Here's the mystery: Why is the equity, valued at about $2.1-billion at current prices, worth so much more than the $500-million trading value of the company's entire debt? When troubled companies are restructured, equity holders typically get wiped out so that debt holders, who rank ahead in the feeding chain, can recover all or some of their money. If the debt holders are right, the equity will take another beating. This is why, despite the shares' plunge, short sellers are still circling 360networks like vultures.
But the shorts are not necessarily in the clear because the index funds are circling too, which makes 360networks one of the more complicated, and intriguing, short-selling plays.
A few days ago, a post-IPO share lockup expired that will increase the float by a massive 281 million shares. Since the float is larger, the company's weighting on various indexes, including the TSE 300, also increases (from 0.07 per cent to 0.26 per cent in that case). As a result, index funds will have to buy more 360networks shares simply to reflect the company's greater index role; the value of the shares, or lack thereof, is irrelevant. Nesbitt Burns expects the funds to acquire 17 million more shares and if they do, upward pressure will be put on the stock.
Now it gets interesting. Rarely does the market see a situation in which short sellers are battling the index funds as well as investors who remain bullish on the stock. Welcome to the dangerous world of short selling.
This should be one of the market's more entertaining shows in the next few weeks.
Copyright © 2001 The Globe and Mail
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