Northrop, L-3 pounded lower as Citi cuts defense stocks; CKE soars 4.5 points in gray market

By Ronda Fears

Nashville, Sept. 23 - Defense issues were pummeled Tuesday, with the biggest sell-offs in the Northrop Grumman Corp. and L-3 Communications Holdings Inc. convertibles, after Citigroup cut several defense stocks to sell from hold.

Northrop's mandatory and L-3's notes each fell 3 points.

Lockhead Martin Corp.'s new convertible floater and Raytheon Co.'s mandatory were also hit to a lesser degree, each dropping 1 point.

Heading higher, however, were the three pending deals on strong enthusiasm for new paper.

"There just hasn't been any new deals, so all these were active, and bid up considerably," said a buyside convert trader on the West Coast.

"They are pretty cheap, but they needed to be. In a more normal new issue market, these probably wouldn't get any lookers at all."

CKE Restaurants Inc., which priced after the close at the tight end and was upsized, was the big mover in the gray market. It steadily moved up during the session, with bids moving from 1.5 points over issue price at the open to 4.5 points over at the close. The stock ended down 69c, or 8.97%, to $7.00.

At the closing bell, the operator of Hardee's and Carl's Jr. fast-food chains announced the Rule 144A deal had been upsized to $90 million from $75 million and the deal priced aggressively.

CKE sold the 20-year convertible subordinated notes at par to yield 4% with a 27% initial conversion premium - versus talk that put it at 4.0% to 4.5%, up 23% to 27%. The company is using all those proceeds, plus a drawdown from a new bank facility, to retire its 4.25% convertible due 2004.

Being such a small deal, interest in the CKE deal was fairly limited and mostly based on the cheapness of the deal, one fund manager in New York said.

Merrill Lynch & Co. analysts put the new CKE convert 5.75% cheap, at the midpoint of guidance, using a credit spread of 1,000 basis points over Treasuries and a 40% stock volatility.

Lehman Brothers analysts put it 6.31% cheap, at the middle of price talk, noting new deals in August averaged about 4% cheap. Lehman used a stock volatility of 38% and credit spread of 850 bps over Treasuries, citing subordination of the notes and lower 2004 earnings estimates as cause for the conservatism.

While the CKE deal was cheap, another fund manager noted that "anyone who got burned with Triarc" likely steered clear of the deal.

Triarc Cos. Inc. - which operates the Arby's fast-food chain - stunned, and angered, convertible players earlier this month when it created Class B common shares and made a special dividend of Class B stock to Class A stockholders. It particularly stung hedge fund players.

On Tuesday, Triarc said in a statement that the situation would require special tax allocating methods for the two classes of common stock. The company said its tax consultant advised that one method, in general, would be to value shares of each class on the basis of mean prices, resulting in a tax basis allocation of 30.69% to Class A shares and 69.31% to Class B shares. Also, the company noted that an additional allocation would be required for the special dividend of Class B shares to Class A shareholders.

"I got enough indigestion with Triarc," said a convert trader at a hedge fund in New Jersey.

"I didn't even look at CKE."

Next up are Doral Financial Corp. and MemberWorks Inc., both after Wednesday's close.

A fund manager in New York, who is launching a multi-strategy fund sometime over the next couple of weeks, said CKE and MemberWorks were of no interest, and "as for Doral, [it's] worth a

look, but not a good long-term investment as far as I can tell."

Doral is pitching $300 million of perpetual convertible preferreds talked to yield 4.25% to 4.75% with a 30% to 35% initial conversion premium. The mortgage company's stock fell $2.18 on Tuesday, or 4.54%, to $45.89.

The new Doral issue was bid 7 points over issue price - par is $250 - early in the day, but that dropped back to 3 points near the close, according to buyside traders.

Lehman analysts put the Doral deal 4.54% cheap at the midpoint of guidance, using a credit spread of 350 bps over Treasuries and a 28% stock volatility, plus accounting for the 1.16% common dividend yield. The credit assumption was based on a discount to Doral's straight 7.65% due 2016 estimated at 125-150 bps over Treasuries, reflecting the perpetual maturity on the convert, subordinated ranking and operating region risk.

Merrill put the Doral issue 3.56% cheap, at the middle of price talk, using a credit spread of 350 over Treasuries and a 25% stock volatility, plus accounting for the 1.16% common dividend yield.

Another sellside shop put the Doral convert 2% cheap, using a credit spread of 350 bps over Treasuries and a 30% stock volatility.

Tatyana Hube, a convertible analyst at Merrill, said the Doral valuation seemed in line with the convertible preferred market, which as a whole is trading about 3.9% cheap.

MemberWorks was a tougher cookie to crack, especially on the credit end.

"There weren't really any comps for the credit," said one market source, adding that he had some reservations about the MemberWorks business model, which appeared to be enrollment based coupon sales or a similar discount pricing service. He also noted that it appeared 25% the company's revenue stream came from telemarketing, which he considered at risk.

MemberWorks is marketing $75 million of seven-year convertible notes talked to yield 5.25% to 5.75% with a 30% to 35% initial conversion premium. The stock on Tuesday dropped $1.48, or 6.9%, to $30.11.

Traders said the MemberWorks issue was higher in the gray market, but no specifics were mentioned.

One market source, not associated with the MemberWorks deal, pegged it roughly 2% cheap, "guesstimating" the credit spread at 1,000 bps over Treasuries and using a stock volatility of 35% to 40%.

Back in the regular aftermarket, traders said activity was not overwhelming still, although converts were generally firmer.

"It's been fairly quiet today," said Pat Prendergraft, head of convertible research at Thomas Weisel Partners.

One buyside trader said biotech issues were mostly marked higher on stock advances, a day after getting "crippled."

Dealers noted live markets for several 0% convertibles, though no names stuck out.

Defense issues were mentioned by several traders, though, as they got sideswiped by the Citigroup downgrade of several stocks in the group to sell from hold.

Northrop's 7.25% mandatory due 2004 plunged 3 points to 99.125 bid, 99.5 offered while the underlying stock lost $3.53, or 3.86%, to $87.96.

L-3 Communications' 4% convertible notes due 2011 also dropped 3 points to 103 bid, 103.5 offered. The common fell $2.47, or 5.24%, to $44.66.

Lockhead Martin's new convertible floater lost 1 point to 99.875 bid, 100 offered. The stock closed down $1.85, or 3.87%, to $45.97.

Raytheon's 8.25% mandatory due 2004 fell 1 point to 52.75 bid, 52.875 offered, according to a dealer. On the New York Stock Exchange, the Raytheon mandatory dropped 1.6 points to 54.15. The stock lost 88c, or 2.93%, to $29.16.

Elsewhere, a couple of traders noted some high-yield interest in Level 3 Communications Inc.'s new 2.875% convert due 2010, as the company prepares to sell $500 million of new eight-year notes later this week. The issue was quoted up 0.5 point to 88 bid, 89 offered. Level 3 shares closed up 3c, or 0.63%, to $4.79.

Also, the HealthSouth Corp. 3.25% converts were seen down 2 points at 88.5.

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