Deutsche analysts recommend L-3's 4% of 2011, or switch from 5.25% of 2009

By Ronda Fears

Nashville, Tenn., Feb. 15 - For investors who do not hold L-3 Communications Holding Inc., Deutsche Banc Alex. Brown convertible analysts recommend the 4% due 2011 as an outright or an arbitrage idea. For those holding the 5.25% due 2009, they suggest switching into the 4% issue. The 4% issue is undervalued chiefly because the value of the contingent features is misunderstood, the analysts said, and the credit has improved as well.

"We feel that the 4% due 2011bonds are mispriced in the market versus the 5.25% due 2009 for two main reasons - the contingent conversion feature is not properly modeled and contingent interest is not properly accounted for," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Friday.

"We feel that there may be some confusion on the CoCo feature in the market and that some participants may be undervaluing the bond by overstating the negative value of the CoCo feature. Although the bond is a CoCo, it does not have the usual negative of a discount to parity possibility at maturity."

The 4% issue is theoretically cheaper, even allowing for the CoCo features and a volatility skew, the analysts said, acknowledging that the fact that the security matures in 2011 with no puts and has a contingent conversion feature at 120% complicates its valuation.

There are two extremes - modeled without the 120% CoCo feature the bond trades on implied volatility of 40.2%, or using a full CoCo model the implied volatility rises to 45.4%.

"We believe that the full CoCo model, which effectively subtracts the value of a 100/120 parity call spread at maturity, significantly undervalues the bond," the analysts said in the report.

"The reason is the second 'conversion' bullet in the prospectus, which states that the issue would be convertible in any five-day window following 10 consecutive days during which the premium was less than 5%."

Consider the situation three weeks before maturity if parity was 110. In its standard form a CoCo bond with this profile would trade at 100 plus the value of a three-week call option on parity at 120, or just above par and at a significant discount to parity, the analysts said.

But in the case of the L-3 4% due 2011, as soon as the bond had traded at a discount for 10 days it would then be convertible. So it wouldn't trade at a discount. It would actually trade at parity as it approached maturity and would be convertible exactly as a standard convertible bond, the analysts explained.

In addition, the analysts said, the contingent payment feature on the 4% issue may add 0.8 point to theoretical value. The 5.25% bond does not have that feature.

The analysts also said the volatility curve for L-3 shares implies a small discount for the 4% issue over the 5.25%. But the bottom line, the analysts said, is that on an implied volatility of 40.2% versus OTC/Listed at around 41%, the 4% issue is slightly undervalued compared to the option markets and is significantly cheaper than the 5.25% issue, which trades on an implied volatility of 49.6%.

Other reasons to switch out of the 5.25% issue into the 4%, the analysts said, are that it offers a superior risk/return profile, longer hard call protection, has pari passu ranking, is larger in size and has excellent change of control language like the 5.25%.

The more balanced profile of the 4% issue leads to significantly better upside/downside participation. With a 25% movement in the stock, the 4% issue would participate with 76.1% of the upside and 64.4% of the downside, the analysts said, whereas the 5.25% issue have 75% upside participation and 74.8% downside.

"One might wonder how the 4% can outperform on the upside given a lower delta and a lower coupon. This highlights the importance of call protection," the analysts said in the report.

"In one year the 4% still has almost 1.5 years of hard call protection remaining. This means that it would trade at a 7.2% premium even with parity at 130.60 (+ 25%). However, in one year the 5.25% is absolutely callable and therefore trades at almost no premium."

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