Merrill updates portfolio recommendations to address premium bleed

Nashville, Tenn., Jan. 10 - Merrill Lynch & Co. convertible analysts have tweaked their recommended portfolio - and to address what's referred to as premium bleed they have added a barbell of stock-sensitive new issues and credit-oriented names with high static returns.

Added to the portfolio were Shaw Group Inc.'s 0% due 2021 as a yield alternative and Veeco Instruments Inc.'s 4.125% due 2008 as a total return alternative. Merrill analysts Anne Cox and Shawn Foley also recommended a relative value exchange out of the Solectron Corp. 0% due May 2020 into the Solectron 0% due November 2020. They removed Hilton Hotels 5% 2006

The Shaw Group issue is inefficiently priced relative to fundamentals and offers considerable value in form of a short-term, fixed-income instrument, the analysts said, noting also that increases in free cash flow will improve Solectron's credit profile and should drive the yield on the convertible lower.

"We view the SGR 0% as principally an outright credit bet, considering the issue's 186% premium and modest 0.21 parity delta. At 52.13 versus the common at $22.00, the SGR 0% due 5/1/21 offers a 12.2% yield (910 bps over two year Treasuries) to its May 2004 put. Theoretically, the issue's BBB-/Ba2 rating should imply a fair value spread of somewhere closer to 375 bps over two-year Treasuries," the analysts said in the report.

"However, considering the "soft" (i.e. cash, stock or combo settlement) nature of the put and the issue's zero-coupon status (albeit for only a 28 month horizon), we conservatively employ a 600 bps credit spread. Even assuming our credit spread, we estimate the issue 6.5% below its bond floor. With a solid balance sheet, improving cash flow generation and a relatively conservative target yield of roughly 9%, we believe the issue is capable of producing mid-teen returns over a 12-month horizon."

Veeco Instruments' 4.125% convertible bond was added as a total return alternative based on the issue's attractive valuation and compelling equity fundamentals, the analysts said. At 119.38 vs. $38.51 for the common, the bond has a modest 19.4% conversion premium and a sizable 7.6% theoretical value discount. In contrast, the analysts estimate the market valuation discount for speculative-grade cash-pay bonds is just 2% while the average conversion premium exceeds 100%. Conservatively holding the 5%'s theoretical value discount constant, the analysts anticipate the issue will return +15% and -16% for a +/-25% change in the common. More aggressively assuming compression of the discount to 5%, total return horizons improve to +18% and -13% for a +/-25% change in the stock. The valuation assumptions include a 662 bps credit spread over five-year Treasuries and 60% volatility.

A relative value swap out of the Solectron 0% due May 2020 (IIs) into the Solectron 0% due November 2020 (IIIs) is recommended, the analysts said, noting that Solectron's significant balance sheet restructuring efforts has caused a marked shift in the relative value offered by the IIIs versus the IIs. The IIIs offer substantially more total return potential for little increase in risk, the analysts said, noting also that while the IIs are attractively priced they favor the IIIs given a higher yield to maturity.

"At current valuations the IIIs offer roughly a 240 bps yield advantage over IIs for only 12 months of additional exposure. We believe this spread is too wide considering the similar risk of the IIs and IIIs and represents an opportunity," the analysts said in the report. "At 43.31 versus a $12.20 stock price, the IIIs are at a 13.4% yield or 1030 bps over two-year Treasuries to their May 2004 put date. The yield on the IIIs has actually widened by roughly 70 bps since the company announcement. By comparison, the IIs are at an 11% yield to put or 800 bps over two-year Treasuries. We estimate the IIS have tightened by 60 bps since the company's December announcement."

Hilton Hotels Corp.'s 5% convertible bond due 2006 was removed from the model portfolio as a yield oriented holding based on valuation considerations, the analysts said, noting that since the bond is fairly valued there are more compelling yield opportunities exist. At 91.50 versus a stock price of $11.50, the issue's 2% valuation discount is in-line with the market for speculative grade cash pay issues, the analysts said. While the 5%'s risk/reward profile is attractive, its unleveraged total return potential is modest, the analysts said. At 91.50, the bond offers a 7.3% yield to maturity (294 bps over 5 year Treasuries) and is roughly 6% above bond value.

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