Merrill analysts recommend cable debt, convertibles to equity investors

By Ronda Fears and Peter Heap

Nashville, Dec. 12 - The bonds and convertibles of cable companies are a more appealing investment than their equity, according to a new report by analysts at Merrill Lynch & Co.

They said the fixed-income securities will likely offer similar returns to the stock at lower risk.

The report, a joint effort between Merrill equity analysts Jessica Reif Cohen and Keith Fawcett, high-grade analysts Stuart Rossmiller and Bess Oransky, high-yield analyst Matt Crakes and convertibles analysts Yaw Debrah and Marc Malloy, notes that many investors are now looking at a company's entire capital structure when they make investment decisions.

"They no longer operate in a vacuum of debt or equity. Now it is debt versus equity and where do they get their best risk adjusted return," the analysts wrote. "The focus has revolutionized the market."

In addition, they point out that the fixed-income market is increasingly being seen as a portent of potential problems in a company since bond investors are more focused on avoiding company blow-ups.

As far as favoring the debt of cable companies, the analysts wrote: "If Richard Bernstein, Merrill Lynch equity strategist, is correct in his assessment of single digit returns on average for the foreseeable future, then equity investors should also be looking into the potential of an investment in a company's debt, where similar returns may be achieved at lower risk."

The report also points out that a bond investment puts the investor higher in the capital structure in the event of bankruptcy.

Given that most cable convertibles are busted, investing in one of these securities is generally buying a fixed income instrument with a free out-of-the-money option.

"If an investor is comfortable with the general subordination of cable convertibles to their straight debt, an investor can pick up significant yield by being in the convertible as opposed to the straight bond," the analysts noted. Compared to stocks, "in a volatile market, convertibles offer a significant current yield advantage over stocks, with downside protection in the case of continuing market declines."

Overall as far as convertibles are concerned: "For the investor who is bullish on the cable sector in general, but is looking for enhanced yield coupled with greater equity sensitivity, we would suggest the mandatory convertible structures."

For the junk bonds of cable companies, the analysts said they believe most are now fairly valued following the rally since the middle of the third quarter. Their view is based on a liquidation analysis of unlevered free cash flow and asset values.

But the analysts cautioned that they expect continued bond price volatility as the investment community remains focused on operational issues such as: basic subscriber erosion; slowing advance services (i.e. digital) growth; strength of EBITDA growth; and high leverage.

Overall they recommend a market weight investment.

By individual company, the analysts have an overweight on Cablevision bonds and a speculative buy rating on its preferred stock based on "very strong" asset coverage for bondholders and the 15.82% yield on the PIKs. They raised their recommendation on Mediacom LLC bonds to neutral from underweight, saying they consider the company to have one of the better balance sheets and liquidity positions in the sector, noting that it was the only high-yield MSO to post positive sequential growth in basic subscribers and citing the relative value of the bonds.

From a convertibles perspective, the analysts said:

* AOL Time Warner's 0% convertible due 2009 (at a price of 55.25, yields 3.52% to maturity, 7.49% to Dec. 1, 2004 put, with a 566.5% premium) is a better play than the straight debt for investors who believe the issuer's credit spreads will narrow further because of the short time to the Dec. 12, 2004 put date, its additional 100-200 basis points of yield for a maturity well before any straight debt and the free out-of-the-money equity option.

* Comcast Corp.'s 0% convertibles due 2020 (at a price of 79.88, yields 1.25% to maturity, 0.72% to Dec. 19, 2002 put, with a 145.75% premium) has been helped by its short put at 79.9 on Dec. 19, 2002 and investors may be offered an incentive not to exercise the put.

* Comcast's 0% Zones exchangeable for PCS due October 2029 (at a price of 24.12 yields 8.08% with a 117.0% premium) and 0% Zones exchangeable for PCS due November 2029 (at a price of 24.57 yields 8.85% with a 121.05% premium) offer a higher yield to investors who view the company's credit as improving and are comfortable with its subordinated debt. The November 2029 Zones offer a higher yield.

* AT&T Corp.'s 6. 5% preferred mandatorily exchangeable for Cablevision (at a price of 19.51 has a 12.01% current yield with a 45.4% premium) offers 1,200 basis points of yield more than the common stock and will return 22% on a 25% gain in the stock or lose 16% on a 25% loss.

* AT&T's 6.25% Strypes preferred mandatorily exchangeable for Cablevision (at a price of 19.72 has a 7.13% current yield and a 23.4% premium) would return 21% for a 25% gain in the stock and lose 17% on a 25% loss.

* Cox Communications, Inc.'s 0.348% convertible due 2021 (at a price of 71.38 yields 2.28% to maturity or 4.18% to the Feb. 23, 2003 put at 71.976, with a premium of 102.8%) is likely to be put back in February, the analysts say, because the equity option is out of the money. They do not consider the yield attractive and note that Cox's credit spreads have held up best among cable companies and that the convertible has never traded cheap to its theoretical value.

* Cox Communications' 0.4259% convertible bonds due 2020 exchangeable into Sprint PCS (at a price of 45.25 yields 5.28% or 6.51% to the put on April 19, 2005, with a 918.91% premium) and 3% Phones due 2030 exchangeable for PCS (at a price of 40.94 yields 8.69% with a 329.9% premium) offer a higher yield for investors who are comfortable with Cox's credit situation and are happy holding a subordinated instrument.

* Cox Communications' 2% Prizes due 2029 exchangeable for PCS (at a price of 29.56 yields 8.13% with a 152.65% premium) offers a 5.99% current yield and a free but out-of-the-money equity option to fixed income investors who feel that they are being properly compensated for the subordination of the convertible debt.

* Charter Communications' 4.75% convertible due 2006 (at a price of 25.88 yields 54.12% with a 314.2% conversion premium) and 5.75% convertibles due 2005 (at a price of 31.00 yields 57.61% with a 307.52% conversion premium) are both ranked behind a "substantial amount" of debt, hence the "extreme levels of yield." Charter has 9.3 times leverage, the highest of all high yield cable operators, and can add more, which would not only increased absolute debt but also put it senior to bondholders. The analysts also said that Charter might not be growing fast enough to grow into its capital structure and meet cash interest expense requirements under its bank covenants. If Paul Allen takes the company private, the transaction could be structured so that the change-of-control put in the convertibles is not triggered - which would avoid the forced purchase of close to $1.4 billion of convertibles.

* Mediacom 5.25% convertible due 2006 (at a price of 85.13 yields 10.32% with a 78.07% conversion premium) offers higher yield to fixed-income investors who view the credit situation as improving and are comfortable with a holding company instrument. Versus the stock, the convertible offers a 617 basis points yield advantage and better downside protection. At a 785 basis points spread to Treasuries, the analysts see substantial upside potential to the bonds as credit spreads decrease in the market place.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.