Lehman: Lucent bulls should look at 2.75s due 2025, yield-seekers the 7.75% preferred

By Ronda Fears

Nashville, Oct. 17 - Lehman Brothers convertible analysts said Monday, in light of the firm initiating coverage of Lucent stock with an overweight rating and $4.25 price target, that bullish Lucent fans should look at its 2.75% convertible bond due 2025 over the 2.75% convertible due 2023 and yield-seekers could look at the 7.75% preferred, while holders of the 8% convertible bonds should be aware of high call risk in that issue.

A positive outlook on Lucent's position in the wireline equipment sector was established by Lehman equity analyst Jiong Shao, based primarily on Lucent's leverage to North America wireless infrastructure spending versus that of the leading U.S. players Verizon Wireless and Sprint. Shao noted that Lucent's market share in the code division multiplex access (CDMA) wireless infrastructure space is roughly 40% and its gross margins are also expected to improve as the higher margin wireless business increases as a percentage of overall revenue.

Lucent's near-term liquidity is viewed as adequate with $4.1 billion in cash and marketable securities - largely the convertibles - against maturing debt of roughly $1.5 billion over the next five years. The four convertibles represent roughly $3.3 billion of face value currently outstanding. They consist of a $554 million 8% subordinated note due 2031 (B3/CCC+), a $1.15 billion 7.75% due March 15, 2017 preferred (B3/CCC), a $750 million 2.75% senior note due 2023 (B1/B), and an $881 million 2.75% senior note due 2025 (B1/B).

Lehman convertible analyst Venu Krishna noted in the report Monday that none of the Lucent issues carry dividend or takeover protection features common to more recently issued convertibles. He also noted that the credit benchmarks on Lucent include five-year credit default swaps recently quoted around 260 basis points over Libor and straight debt - a 6.45% bond due 2029 and 6.5% bond due 2028 - quoted around 305 to 315 bps over the comparable U.S. Treasury.

8% issue short paper due to put

Lucent convertibles present a number of investment opportunities as well as compelling alternatives to holding the stock, Krishna said.

For example, he said the 8% bond is a short-maturity instrument - with a 6.1% yield to the August 2007 put at par - with little or no equity sensitivity, and a 775-bps current yield advantage to the stock. There also is solid downside support due to the par put, he said, and a bond floor of 99.81.

The risk to holding the 8s, he said, is that the high coupon and ongoing periodic company buybacks in the context of 0.8 years of remaining call protection and $4.1 billion in cash and marketable securities on Lucent's balance sheet as of June 30 suggests call risk for the security is high.

Lucent has already retired more than 70% of the issue, the analyst pointed out. Also, should the issue be called on August 2006, he added, the yield to call is just 4%, which is relatively unattractive versus nine-month Treasuries yielding 4.1%.

7.75% preferred looks cheap

Yield oriented investors meanwhile should consider the 7.75% preferred, which is estimated 1.7% cheap to theoretical value and has an attractive 9.56% yield to call should the company decide to call it in 1.4 years, Krishna said.

Lehman estimates theoretical value at roughly 1027.5 versus the current market at roughly 1011, and the call price of 1038.8 also is above the current price. Theoretical value is based on a credit spread of Libor plus 450 bps and a 35% stock volatility. In addition, investors should maintain a decent level of equity exposure.

But around 35% of the issue has already been retired via periodic buybacks, the analyst pointed out, making the likelihood of a call fairly high. Another risk, he said, is that the preferred is subordinated in the Lucent capital structure to the other three convertible bonds, and the potential credit deterioration remains the greatest risk to investors in this security.

Of 2.75s, 2025 issue looks better

Of the two tranches of 2.75% convertible bonds, Krishna said the 2025 issue looks more attractive than the 2023 issue.

The 2023 tranche is estimated 2.2% cheap to theoretical value, based on a credit spread of Libor plus 260 bps and a 35% stock volatility, and has better downside support than the 2025 tranche convertible due to shorter dated put feature, though slightly less equity sensitivity as well.

The 2025 tranche is estimated 2.3% cheap to theoretical value, based on the same parameters, but Krishna said that investors who are bullish on the outlook for Lucent stock should consider the 2025 tranche, with good equity participation potential and seniority in the capital structure. Alternatively, investors who prefer slightly more downside protection with a little less equity sensitivity may want to consider the 2023 tranche.

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