Deutsche: IOS/Ikon convertible suffers from credit, structure confusion

By Ronda Fears

Nashville, Tenn., July 17 - The IOS Capital/Ikon convertible is at a depressed valuation due to market confusion on the credit and structure, said Deutsche Bank Securities Inc. convertible analysts in a report Wednesday.

"Since [the convertible was issued in May], weakness in the underlying equity has been accompanied by a deterioration in the valuation of the convertible. We believe that the implied credit spread of Libor plus 800 basis points is at least partially attributable to the convertible market's lack of understanding of the nature and credit quality of the issuer, IOS Capital," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron.

"This bond is likely suffering from the inverted yield curve that so many borderline investment grade credits are suffering from on the short end. Thus, the 2007 maturity of the convertible should, theoretically lessen the negative impact of the inversion," the analysts added.

IOS Capital is a leasing company showing reasonably healthy operating statistics with cash from operations in excess of $137 million for the past six months and pretax income of $85 million for a 43% margin.

The balance sheet remains highly levered, the analysts noted, but both it and IKON continue to demonstrate access to the capital markets at multiple entry points.

The IOS Capital 5% convertible due 2007 is subordinated and trades at an implied spread of Libor plus 800 basis points. The Ikon 9.75% 2004, a senior unsecured obligation, also issued by IOS Capital, has recently tightened to a yield to maturity of 8.94% or Libor plus 615 basis points.

"Although the convertible has a different issuer and underlying equity, it is not an exchangeable bond for U.S. tax purposes," the analysts said.

"This means that there is no 'phantom income' for on-shore U.S. funds. Because IOS Capital is 100% owned by Ikon, there is no concern about 'ring-fencing' of the Ikon shares to be delivered on conversion. There is no look back, no cash settlement, no averaging period, good special dividend protection and a change of control put."

Deutsche Bank's equity analyst Peter Ausnit has a strong buy rating on Ikon shares with a $14.25 target price.

The overall Ikon story is a consolidation, roll-up model.

By the end of 1998, Ikon had completed more than 450 acquisitions of small independent distributors. This resulted in goodwill of $1.225 billion as of March 31.

In 2002 or 2003 Ikon stands to reap the benefits of improved operational performance as operating margins are forecast by Deutsche Bank to grow 8% to 10% from the current level of 5.7%.

As part of their negative outlook, the analysts noted the rating agencies have pointed out that while management has made good operating progress intense competition and a weak economic environment may continue to pressure profitability in the intermediate term.

Also, the analysts said there is a small amount of ratings risk in the business model, in that if IOS Capital falls to below Ba2 or BB, the insurer of its loans can replace IOS Capital as 'servicer' of the lease pool.

Of greater severity would be the effect of a downgrade below Ba1 or BB+, the analysts said, in which case the banks that currently finance the leases through conduit arrangements before they are sold in the asset backed market could refuse to accept new leases.

The analysts noted that Ikon's $300 million unsecured revolver priced at Libor plus175 basis points and IOS Capital issued a small $250 million 9.75% bond due 2004 on a senior unsecured basis in 2001.

"Although illiquid, we believe this bond is currently trading in the 101.375 range for a spread over Libor of +615 bps," the analysts said.

IOS Capital/Ikon 5% due 2007

Ask Price: 83.394

Parity: 52.029

Premium: 60.283%

Yield to Maturity: 9.385%

Equity Price: $7.82

Current Yield: 5.996%

Implied Volatility: 28.87%

Bond Floor: 77.801

Risk Premium: 7.189%

Delta: 45.49%

Theoretical Value: 86.933

Stock Volatility: 40%

Credit Spread: Libor + 650 bps

Dividend Yield: 1.98%

Stock Borrow: 50 bps

Call: May 9, 2005

Call Price: 102

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