Deutsche analysts identify six "fallen angel" convertibles poised to benefit from a turnaround

By Ronda Fears

Nashville, Tenn., Jan. 8 - As restructuring demand prompted several issuers to sell convertibles during the last half of 2001, Deutsche Banc Alex. Brown convertible analysts Jeremy Howard and Jonathan Cohen said in a report Tuesday that a few of those were issued when the underlying stock was at a low point and the so-called "fallen angel convertibles" are now positioned to benefit nicely from a turnaround.

"In the second half of 2001 the U.S. convertible bond market became a haven for a certain type of issuer - one that was driven to the market by restructuring demands, a liquidity crunch, confidence crisis, or both," Howard and Cohen said in the report.

"In contrast to the zero coupon bond feeding frenzy in the first half of 2001, all of these transactions have cash paying coupons and generally came to the market with reasonable premiums. Because of the difficult circumstances surrounding the companies at the time of issuance, the stocks were almost all at, or near, record lows - in the single to low double-digit price range.

"This makes the bonds highly interesting in any scenario under which confidence returns to the underlying stock story. All of these convertibles were issued to help the company over or through a restructuring or liquidity crunch or some kind of confidence crisis. These convertibles should be attractive to outright investors who have a positive directional view on the underlying stock. Furthermore, all of these securities should benefit from any economic recovery in 2002."

The analysts found six so-called fallen angel convertibles that they are recommending - the Lucent 8% convertible preferred due 2031 (B3/B-), Nortel Networks 4.25% convertible note due 2008 (Baa2/BBB-), the Corning 3.5% convertible note due 2008 (Baa1/BBB), Xerox 7.5% convertible preferred due 2008 (Ba2/B), Calpine 4% convertible note due 2006 (Ba1/BB+) and Solectron 7.25% mandatory convertible due 2004 (Ba2/BB-). The analysts also noted that Calpine and Xerox are furthest along in their turnaround efforts, and that the outlooks for the telecom equipment and EMS sectors remain uncertain.

Lucent's $1.88 billion deal, with a conversion price of $7.48 52, was brought to market with the stock at $6.13. Lucent shares ended Tuesday up 24c to $7.19.

"Execution of (Lucent's) turnaround plan in the first half of 2002 will be critical to the survival of Lucent. This is the weakest credit that we are commenting on in this research note. In the past, we have been skeptical on the ability of management to effect the turnaround in a timely manner," the Deutsche analysts said. "While the premium on this bond widened in December, the analysts the implied volatility of 34%, assuming a Libor plus 1,200 basis points spread, is still undervalued when compared to listed volatility in the mid to low 70% range. However, we would caution against implied volatility analysis for such a weak credit, and would adopt a cautious stance to this preferred."

Nortel's $1.8 billion convert sold when the stock was at $7.56. The conversion price is $10.0. Nortel shares closed Tuesday off 29c to $8.30.

"We are encouraged by Nortel's progress in reducing its cost structure, which will be critical to the ongoing health of the business. This bond appears inexpensive to us. Premium has tightened as the equity had a strong fourth quarter and using a credit spread of Libor plus 700 bps, we calculate an implied volatility in the high 50% range," the analysts said.

Corning's $665 million issue was priced with the stock at $7.74. The conversion price is $9.68. Corning shares ended Tuesday off 3c to $10.48.

"In fourth quarter, (Corning) management forecast that the restructuring will cut the cash burn rate and provide $300 million to $350 million in cost benefit in 2002. Management expects both the fiber and photonics businesses to recover in the second half of 2002. With the jump in Corning common in January 2002, this bond now trades on a delta of almost 90%. This makes the security highly attractive as an alternative to the underlying shares, enhanced by a 3.50% coupon versus a 0% yielding underlier," the analysts said in the report.

Xerox's $900 million issue was brought with the stock $7.30 and has a conversion price of $9.13. The 7.50% dividend is backed by U.S. Treasuries for the first three years. Xerox shares closed up 7c to $9.95 on Tuesday.

"With over $2 billion in cash from previously completed convertible and receivables financings, the liquidity crunch of 2001 is behind Xerox, allowing management and investors to focus on the long term. We believe that the long term means a return to industry average profitability and revenue growth for Xerox. Thus far, the turnaround strategy and execution have been good, raising needed capital and cutting costs. Despite a significant richening since issue, the preferred still represents reasonable value," Howard and Cohen said.

Calpine's new $1.2 billion convertible, with a conversion price of $18.07, sold with the stock at $14.69. The stock ended Tuesday down 26c to $16.60.

"The bond has run up with the equity as confidence has returned following the successful capital markets offering of the bond," the analysts said. "We believe that this convertible represents inexpensive volatility. Assuming a credit spread of Libor plus 650 bps, down from 900 bps at issue the implied volatility for the bond is around 38%. The 6M and 18M listed volatility has been trading in the low 70% - high 60% range. Although this is likely to decline as the Enron fallout continues to recede, the convertible still looks relatively undervalued."

Solectron's $1 billion mandatory sold with the stock at $9.81. The conversion price is $11.58. Solectron shares closed Tuesday down 20c to $12.

"Solectron, along with the entire EMS sector, has been suffering from the capex pull back in the telecom equipment and IT sectors, for whom they manufacture equipment. However, Solectron's financials have deteriorated more noticeably than the rest of the majors in the EMS sector. Highly levered Solectron issued the 7.25% mandatory to cover the $845 million liability on the 0% 2019, which is anticipated to be put on Jan. 27," the analysts said in the report.

"The mandatory structure effectively wipes out the refinancing risk in 2004, helping to de-lever the balance sheet. But this is still a credit on which we advise caution. The price of this mandatory preferred has run up with the equity. The maximum conversion price is $11.58 compared with the current stock price of $12.25 at the close Jan. 4. This implies that the preferred will exhibit excellent participation on the upside from here."

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