Nortel deal separates volatility buyers from those concerned about creditworthiness

By Ronda Fears

Nashville, Tenn., June 4 - Aside from widely varied valuations, Nortel Networks Corp.'s pending mandatory convertible deal, estimated at $700 million to $750 million, seems to have more clearly separated investors into two categories - volatility seekers and credit buyers - than most deals, even though Nortel has kicked in collateralization of the dividend for life.

With the shares getting hit as hedge funds short the stock, closing Tuesday down 28c to $1.80, there were rumblings that the pricing could be advanced but sources close to the deal said it would likely be no sooner than after the close Wednesday. It is currently slated to price after the close Thursday.

In any event, several market watchers say the Nortel deal could set a record for the lowest stock price at the time of issuing a convertible.

"I think it's the difference between volatility trading or if you're a cash flow improving buyer," said Michael Revy, manager of the Froley Revy convertible hedge fund.

"It's a name I hate anyway, but I'm more of a fundamental credit guy. If you are buying this on vol, then I think it's a mistake."

Some of the details of the deal are yet evolving, as the company also plans to sell stock. The convertible and stock issues, however, are not hinged together, so the convert could be accelerated.

Nortel's statement about the deals put total proceeds at $800 million for the deals, but that could be taking into account using some of the proceeds to buy Treasury strips to guarantee the dividend payments.

One source from among the 11 underwriters of the offering even alluded to Nortel pulling the deal if it doesn't appear to be going well. But salesmen seem to be positive about the way the deal is going so far.

"It's going fine," one salesman said. "There are people out there that believe in this story, like with Lucent. Sure, times are rough, but they believe that Nortel will be among those who are still standing when the dust clears in this sector."

Another salesman said some investors have balked at the prospect of the new Nortel issue not having an apparent secondary market venue.

According to the prospectus for the mandatory, the issue will not be listed as there will be no market for the issue or the prepaid forward purchase contracts that are separated from the U.S. Treasury strips that back the dividend payments.

The deal is expected to price with a 7.0% to 7.5% dividend and initial conversion premium of 18% to 22%.

"It just smacks of desperation," said a convertible trader at a hedge fund in New Jersey.

Nortel said, however, last week when it hinted at making convertible and stock offerings last week when it guided revenues lower and announced further cutbacks, that it didn't really need the capital in terms of liquidity. The company reported $3.1 billion of cash and equivalents on hand at March 31.

But analysts are estimating the company will have a cash burn rate of $2 billion to $2.6 billion for the remainder of 2003.

Wachovia Securities convertible analysts are advising caution with regard to the deal.

"It doesn't look like it's pricing very attractively. This is definitely a gamble. There's no way to hedge yourself," said Wachovia convertible analyst Brian Park.

"We also have a little bit of concern in terms of how much longer this will fund the company and the credit facility covenants."

Given that Nortel guided second-quarter revenues to be flat to 5% lower, sequentially, Park said there are no real signs of significant improvement in the near future.

"Although this [the mandatory] delevers the company, if a major turnaround is not seen, we expect Nortel would have to come back to market within the next 5 to 6 quarters," Park said, in a report Tuesday.

He noted that Nortel has full access to its credit facilities - a $1.575 billion loan that matures in December 2002 with a one-year term-out option, a $1.175 billion facility that matures on April 7, 2003, with no term-out option and a $750 million facility that matures in April 2005 - but thinks the company is at risk of violating a covenant requiring cumulative EBITDA of negative $650 million or better for the six months ended June 30.

The first-quarter EBITDA loss was roughly $580 million, he said, which is less by only by a slight margin.

Nortel, which posted a net loss of $27.3 billion last year and has become a fallen angel with its credit ratings now in junk territory, is suffering with its peers as telecom equipment sales melt down. Last August, the company sold $1.8 billion of 4.25% convertible senior notes with a 32% initial conversion premium, which is now busted.

While there is a good deal of concern about the credit, most of the discrepancies with modeling the new issue boils down to the stock - volatility and the borrow cost.

Jocelyn Picl, convertible analyst at Lehman Brothers, puts the deal 8.6% cheap at the midpoint of price talk, using a credit spread of zero due to the collateralized dividend payments and 50% volatility in the stock.

"Cheapness of 8.6% significantly more attractive than recent mandatories. However, with common at $2, fundamental concerns more than warrant cheapness," Picl said in a report Tuesday.

Picl said there is "significant risk, especially given mandatory structure," and estimated upside participation at 97%, but with 75% participation to downside movements in the stock.

The Treasury-backed dividend, she said, is "a positive assuming company remains an ongoing concern."

Alex Robinson, convertible analyst at JPMorgan, puts the deal 4.2% cheap at the midpoint of guidance, using a spread of 25 basis points and 78.3% volatility in the stock, plus a 2.5% cost of carry or borrow cost.

"There is zero risk on payment default because of the Treasury strips," Robinson said.

"I think the best vol to use is the current 90-day vol, which is 78.3%. In this case, you also have to pay attention to borrow cost. The cost of carry for shorting the stock is 2.5% and that makes a difference."

Adrian Miller, convertible analyst at Salomon Smith Barney, puts the deal at 7.0% to 7.5% cheap, using a spread of 0 basis points and 60% volatility.

"In theory, there is zero risk for all of the dividend payments," Miller said.

Not everyone was comfortable with entirely discounting credit risk, however.

"I can't believe that 0 or 25 basis points is appropriate, regardless of the collateralization," Revy said. "That doesn't fly with me."

Park also wasn't comfortable with completely discounting the credit risk, noting that Nortel's 4.25% convertible is trading at a spread of about 1,300 basis points and Nortel's straight debt at a spread of about 1,500 basis points.

"We think it might even be a bit rich," he said, "depending on what credit spread you use."

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