Lehman still likes Halliburton, Schlumberger converts, although firm cut underlying stocks

By Ronda Fears

Nashville, Feb. 3 - Halliburton Co. and Schlumberger Ltd. convertibles still look attractive on valuation and income pickup, among other things, said Lehman Brothers head of U.S. convertible research Venu Krishna in a report Tuesday. The report followed a downgrade on both underlying stocks by two Lehman stock analysts.

Krishna noted that the Halliburton 3.125% convertible due 2023 and the Schlumberger 1.5% convertible due 2023 are part of the Lehman recommended convertible portfolio. Schlumberger also has a 2.125% convertible due 2023 in play.

He also pointed out that since the beginning of this year, the Halliburton 3.125% convertible has returned 5.72% versus a 17.3% gain in the common stock, for a 33% participation, and the Schlumberger 1.5% convert has returned 5.2% versus a 12.6% rise in the stock, for a 41% participation.

Following a downgrade of the oilfield services and drilling sector by Lehman analysts James Crandel and Angeline Sedita, including Halliburton and Schlumberger, Krishna said the recommendation on the convertibles was intact. He added, too, that the equity analysts remain positive on Halliburton and Schlumberger overall given their exposure to international markets.

Halliburton offers income

Halliburton's $1.2 billion 3.125% convertible (BBB/Baa2) currently trades at 109.75 with the stock at $30.50, for a 2.85% current yield and 35.5% premium.

Krishna said he still likes the Halliburton 3.125s for its reasonable valuation, balanced risk/reward profile, long call protection, income pickup and attractiveness on an implied volatility and spread basis.

Relative to a marginally rich convertible market, the Halliburton 3.125% models around 1% cheap, based on assumptions of a 27% volatility and 100 basis points spread over Treasuries.

Lehman convertible analysts estimate the issue's risk/reward profile at 51% upside participation and 26% downside participation relative to a 25% move in the common stock over one year.

"With call risk continuing to remain a concern in the convert market, the 4.45 years of call protection on the convert is appealing (the issue is callable in July 2008 at 100), allowing fundamental investors potential room for upside participation," Krishna said.

"In addition, the Halliburton convert is also putable in July 2008, effectively making it a short maturity instrument and inherently defensive."

The Halliburton convertible provides a 121 basis points yield pickup over the common stock, at a 2.85% current yield versus the common dividend yield of 1.64%. The convertible also has a dividend protection feature, which is a positive should common dividends rise in the future.

The Halliburton convertible carries an implied volatility of 26% versus 50-day realized volatility of 29% for the stock. The option-adjusted spread on the convert is 137 basis points versus default swap levels of 60 to 70 basis points.

Schlumberger 1.5s defensive

Schlumberger has $975 million of 1.5% convertibles due 2023 (A+/A1) and $450 million of 2.125% convertibles due 2023 (A+/A1). With the stock at $61.60 the 1.5s were trading at 106 and the 2.125s at 105.

Krishna said he likes the 1.5s over the 2.125s for a better risk/reward profile, relative valuation, enhanced defensive attributes and a lower implied volatility plus higher implied spread. There is long call protection on both issues.

Lehman estimates the 1.5s carry a risk/reward profile of 50% upside participation and 26% downside participation relative to a 25% move in the common over the next year. That compares to an estimated profile on the 2.125s of 47% upside, 35% downside.

The 1.5s appear marginally cheap, 0.65%, versus the 2.125s that appear marginally rich, 0.68%, based on a volatility assumption of 26% for both and a spread of 80 basis points on the 1.5s and 90 basis points on the 2.125s.

Although the 1.5s have 4.35 years of call protection versus 6.35 years on the 2.125s, the long dated nature of call protection on both renders incremental value of additional call protection on the 2.125s of marginal value at this point in time, Krishna said.

With a 4.35-year put on the 1.5s versus 6.35-year put on the 2.125s, the 1.5s are relatively more defensive and attractive, he said. In addition, the estimated bond floor on the 1.5s stands at 90.85 versus 87.38 on the 2.125s.

The 1.5s carry an implied volatility of 25% versus 27% on the 2.125s; the 50-day realized volatility of the stock is 27%. The option-adjusted spread on the 1.5s is 109 basis points versus 70 basis points on the 2.125s. Default protection on Schlumberger is quoted at 30 to 40 basis points.

Krishna noted that while both Schlumberger convertibles carry dividend protection language, they have a trigger at 12.5% of the market value (i.e. capitalization), which limits the practical value of the feature.

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