HealthSouth set to trade at midnight, pegged in the 20s; El Paso gains on settlement

By Ronda Fears

Nashville, March 20 - After a slow, rather downcast session underscored by the continuing fallout from the alleged fraud at HealthSouth Corp. and the war beginning in Iraq, Liberty Media Corp. launched a drive-by $1.5 billion exchangeable into AOL Time Warner Inc.

Convertible traders were preparing to trade HealthSouth bonds as soon as the Securities and Exchange Commission's trading moratorium is lifted at midnight - pegging the convert, which was roughly at par on Tuesday before the allegations of massive criminal fraud emerged, in the 20s.

Negative influences also cast a shadow at Fleming Cos. Inc. as the food distributor - financially strapped by the Kmart Corp. bankruptcy - was said to have hired Gleacher & Co. to help negotiate with creditors in order to avert its own bankruptcy. Also S&P cut the senior paper to CCC-.

El Paso Corp. was the bright spot of a market otherwise in a gloomy mood as the war in Iraq started on the heels of the HealthSouth news.

Reports put El Paso near a preliminary $1.7 billion settlement with California regulators to put the issue of alleged price-gouging in the 2000-2001 power crisis behind it.

Trading actually was described as thin, however, with many market participants turning their attention to the early war efforts.

"There are traders lining up trades [in HealthSouth bonds] at midnight," said a convertible dealer, noting the moratorium to trade HealthSouth bonds expires at 11:59 p.m. ET Thursday.

"I don't think there's much doubt that this company is in bankruptcy pretty soon."

Holders abandoned hope of the 3.25% converts getting paid off at the April 1 maturity and began trying to estimate recovery value as the latest volley of news in the scandal had HealthSouth's banks freezing the balance of its $1.25 billion revolver.

A bank source confirmed with Prospect News that the revolver had been frozen.

The trader pegged the early trades in the convertibles in the 20s, and said he expects most of the trades to be short-covering as opposed to distressed buyers stepping in. Trades made early Wednesday before activity was halted, said to be in the 30s and 40s, were unwound.

"Oh, you wish you could make those exact trades again, but that's not going to be the case," said another convertible dealer.

"You'd be happy to get 30 or 40 tomorrow. You'd feel like you got out nicely, under these circumstances."

Michael Vaughn, head convertible trader at Credit Research & Trading, said he expects a fair amount of HealthSouth paper to trade initially, and agreed that distressed funds will not be among the first wave of buyers.

"The senior paper looks to be in the low to mid-40s, so why would you be looking at the subordinated paper in the 20s?" Vaughn said.

"The 20s would actually be generous [for the converts], with the senior paper at those levels. WorldCom, it seems, went into the teens."

Indeed, the value of the HealthSouth converts, with about $350 million outstanding, was the focus of holders and many credit analysts.

"You just want to go puke," said a fund manager holding "a good chunk" of the HealthSouth bonds.

"Based on what we heard in the market yesterday before trading was halted, you could get about 55 cents on the dollar. If you figure HealthSouth files [bankruptcy], and I do, then that would be a great price. But that's wishful thinking now, I'm afraid."

The bank revolver getting frozen was no great surprise, though.

"One of the only things that is clear at this point is that HealthSouth cannot draw on its revolver now to repay the converts," said CreditSights analyst Pearl Chang, as the criminal charges clearly qualify as a material adverse change.

Similarly, she added that the status of HealthSouth's current cash balance is unknown and likely moot as well.

"We have been asked whether HealthSouth could potentially use any of its existing cash balance, that is, assuming there is a cash balance ... to make the convert payment," Chang said.

"Based on our reading of the bank agreement, it doesn't look like HealthSouth is technically prevented from doing this. However, if HealthSouth has any intention of trying to remain a going concern, it needs to work with its bank group in order to have liquidity.

"Whether any bank would agree to lend to HealthSouth now is a huge question in and of itself and remains to be seen over the next two weeks, but we find it difficult to imagine that any bank, in negotiating amendments or a new facility, would find it acceptable for HealthSouth to use cash to repay the converts."

Moreover, she said the bank negotiations are clouded by the upset in HealthSouth leadership.

"Who will the banks negotiate with?" she asked.

"It looks like numerous senior managers at HealthSouth could be indicted."

There's also the consideration is that if HealthSouth were to repay the converts now, it could be opening itself up to additional legal liability if it later files bankruptcy, she added.

"Clearly, the next step in looking at HealthSouth is estimating recovery values," Change said.

"This will be difficult, to say the least, in that we don't know what the real earnings of HealthSouth are, and whatever those real earnings are, they are certainly likely to go lower now."

The company did not return calls asking about its plans by press time.

S&P cut HealthSouth ratings again on Thursday, putting the senior paper at CCC-, saying it appeared a default was imminent on the convertible. Immediately after the HealthSouth news on Wednesday, S&P slashed the HealthSouth senior ratings to B- from BB-.

Moody's cut HealthSouth senior debt to Caa1 from Ba3 on Wednesday.

Beyond the HealthSouth shocker, the market was pleasantly surprised that El Paso may be putting the California power crisis behind it, and in a fairly painless manner.

One trader said the reported $1.7 billion settlement cost, while perhaps staggering would only require a small initial cash outlay with the balance paid in increments.

Dow Jones reported, on information from sources close to the negotiations, that El Paso will only be required to pay up front $100 million in cash and $125 million in stock, following by $440 million in cash over 20 years.

El Paso's 0% convertible was quoted at 37.5 bid, 38 offered, up about 3-4 points on the day.

"I was really surprised. The junk put in a much better day and these [El Paso convertibles] are senior, unlike a lot of convertibles," said CRT's Vaughn.

The senior junk bonds were at about a 11% yield to something like 13% to 14% for the converts.

"That seems too wide a yield gap to me," Vaughn said.

"It seems like the settlement with California takes El Paso out of the woods. They are maybe not investment-grade, but certainly not distressed."

Buyside traders in general were a downcast lot on Thursday, particularly among the hedge funds as they are feeling some pressure due to the convertible market softening.

"There were better sellers for convertibles. The tone has changed dramatically, but it's been heading this way for the past week," said a convertible trader at a large hedge fund in New York.

"In general, bonds are down and stocks are up. Premiums are contracting. Add it up. It's just not good for convertible arbitrage."

While the market was described as weaker, trading was said to still be thin.

"A lot of people are just glued to the TV, we've not done a lot today," said a dealer at one of the major investment banks.

"The market is definitely softer but I'm not hearing really any specific bonds moving to a great degree. Earlier this week it was concentrated in the zeroes, issues that are sensitive to Treasuries. Now, it's more broad-based."

In addition to the pain from premium contraction, hedge funds are hurting as volatility comes in, too.

"On big moves up, volatility usually comes in. A reminder that there is fraud [like at HealthSouth] should also bring in premium. At least it makes me less of an enthusiast," said Michael Revy, who co-manages a hedge fund for Froley Revy.

"HealthSouth and Tyco are making the convertible 'buyers of last resort' want to reprice these risk premiums."

Thus, a hedge fund manager in Bermuda said the market's obsession is focused on new issues, with some trepidation.

"It seems we are nearing a critical point in the convertible market and I don't think many people want to call it either way," the manager said.

"I think it is critical due to the fact that new supply could go away completely. What then, especially matched against high demand?"

There were optimists, though.

"Despite the turmoil in the markets, the convertible market continues to see new issues coming to market," said Jim Barry, senior portfolio manager at Froley Revy.

"People have not closed the doors. There was the Interpublic deal recently and hopefully we'll see more this type of activity.

"I think the real issue is the economy. It's always the most important factor in the long run," rather than the war, he said.

"The war is an overhang right now but once that gets cleared up, people will focus on the economy. Some say we're in store for a double recession, others say once the war is over the markets will come back. Time will tell.

"Some of the recent numbers, like auto sales, were discouraging," Barry said, but it appears that fiscal and monetary policymakers appear willing to take measures in an effort to prop up the U.S. economy.

CAE Inc. withdrew its small $100 million deal late Wednesday just before pricing, but Liberty's deal more than made up for that.

After Thursday's close, Liberty launched a $1.5 billion exchangeable, which it will pay in either AOL shares, Liberty Class A common stock, cash or a combination.

Pricing is slated before Friday's open.

The deal is talked to yield 0.25% to 0.75% with a 52% to 57% initial conversion premium.

Analysts put it from 0.55% rich to 4.2% cheap.

AOL shares closed unchanged at $11.46 but were down 5.5% to $10.83 in after-hours trading.

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