HealthSouth heads south on restructuring news; RCN, cablers up on asset-sale

By Paul Deckelman and Paul A. Harris

New York, Aug. 27 - HealthSouth Inc.'s bonds and shares were in sick bay Tuesday after the Birmingham, Ala.-based provider of outpatient surgery and rehabilitative services announced plans to split itself in two, and warned of lower earnings and discontinued guidance due to changes in Medicare reimbursements, prompting concern from the major ratings agencies. On the upside, news that RCN Corp. plans to shed some cable assets boosted that company's bonds and helped push other cable operators up as well.

HealthSouth's bonds swooned more than 10 points and its shares lost nearly half of their value after it said that it would spin off its 209 profitable freestanding outpatient surgery centers into a new, publicly traded company, to be called Surgical Care Affiliates, in a tax-free transaction. Parent HealthSouth, meantime, would continue to operate its own 1,427 outpatient rehabilitation centers, 118 inpatient rehabilitation facilities, four medical centers and 136 outpatient diagnostic centers.

The company said it was taking the radical step at least in part because of "unfavorable developments in outpatient therapy reimbursement" due to changes in the government's Medicare rules, which will require that outpatient therapy services provided to two or more patients in a single time period be paid for under the "group therapy" payment code, regardless of whether such patients were engaged in the same activity - a ruling which will "significantly" lower reimbursement for services previously paid as individual therapy, the company said.

HealthSouth warned that In light of its interpretation of the new rules, its full-year EBITDA will likely be about $175 million lower than previous projections, and it further cautioned that because of the uncertainties surrounding the full impact of these developments, which could render any kind of predictions meaningless, it would discontinue earnings guidance for the remainder of 2002 and for 2003.

Moody's Investors Service, noting that likely impact on the company's finances of the spin-off of the profitable surgery centers, which is aimed at shielding them from the Medicare reimbursement uncertainty, put HealthSouth's ratings, including the Ba1 rating on its senior unsecured debt, on review for a possible downgrade. Standard & Poor's - which currently rates the company's senior unsecured debt at BBB- and its subordinated debt a notch lower, at BB+ - followed by putting HealthSouth's ratings on Credit Watch with negative implications. S&P analyst David Peknay wrote that the CreditWatch listing "reflects the company's announcement [Tuesday] that unforeseen changes in Medicare reimbursement rules may have a significant impact on its EBITDA and cash flow."

Furthermore, the analyst warned, the proposed separation of the surgery center division as a way to isolate that business from the Medicare reimbursement uncertainty "has the potential to reduce the size and diversity of its health care revenue streams and contribute to a more risky business profile."

HealthSouth's split-rated bonds "took a dive," a trader said, "but they bounced at the end of the day" to end slightly better than their lows. He saw the company's bonds first fall anywhere from 10 to 12 points, before firming slightly off those lows to end about nine or 10 points lower on the session. He quoted its 8 3/8% notes at 87.5 bid, while its 8½% notes at 88.5 bid. Another trader saw its 10¾% notes due 2006 as having fallen from bid levels around 105-106 to around 96-98, a swing of anywhere from seven to 10 points.

"I don't know why HealthSouth took such a beating," a market source opined. "Its announcement [which also included the news that chairman/CEO Richard Scrushy would become chairman of the new surgery company, while keeping the HealthSouth chairmanship but relinquishing the daily CEO duties] wasn't that bad. I think it might have been an oversold situation."

On the equity side, the company's shares plummeted $5.26 (43.94%) to $6.71 on busy New York Stock Exchange dealings of 42.4 million shares, about 15 times normal volume.

On the upside, "cable was the big gainer" Tuesday, a trader said, attributing the sector's rise to the news that RCN Corp. plans to sell its Central New Jersey cable systems to Spectrum Equity Investors, a private equity firm, and investor Steve Simmons for $245 million.

RCN, a Princeton, N.J.-based broadband telecommunications and cable operator, said that the systems have about 80,000 subscribers, but don't fit in with RCN's core strategy of building its own systems in metropolitan areas to offer cable, telephone and high-speed data services in competition with the top-tier cable companies.

RCN's Nasdaq-traded shares were up 12 cents (14.12%) to 97 cents, on volume of about three million shares, about 10 times more than usual. Its 10% notes due 2007, which recently had been seen in the 15 bid range, were trading around 21 bid/23 offered on Tuesday.

The trader said that the RCN news also helped to push the bonds of other cablers higher; the sector has already been in a ferment over recent speculation that Charter Communications founder and principal shareholder Paul Allen might decide to take the St. Louis-based cable company private or buy a big chunk of its debt. Also keeping the pot bubbling was last week's announcement that investment-grade cable giants AOL TimeWarner, AT&T Broadband and Comcast had agreed on a huge transaction which will simplify the industry by unwinding AT&T's partnership with TimeWarner, allowing AT&T Broadband to be bought by Comcast. That news, in turn has sparked market buzz that AOL Time Warner might go shopping for more systems, with high yield cablers like Charter or Cablevision Systems as possible acquisition targets.

Charter's benchmark 8 5/8% notes due 2009, which had finished dealings on Monday quoted around 63.5 bid/64.5 offered, pushed up to 67 bid/68 offered, while Cablevision's 7 5/8% notes due 2011 were two points better at 82 bid/83 offered. The trader even saw improvement in the beleaguered bonds of bankrupt Adelphia Communications Corp., whose own 10 7/8% notes got as high as 34 bid/36 offered, a gain of about five points, while Adelphia's Century Communications Corp. unit's 8¾% notes were three points improved, at 22 bid/23 offered.

At another desk, Cablevision's 7 5/8% notes were quoted as high as 85 bid, while another junk cabler Mediacom Broadband LLC's 11% notes due 2013 were up four points, at 91 bid.

Also in the communications field, Qwest Communications International Inc.'s bonds were lower Tuesday after S&P cuts its ratings by two notches, citing the Denver-based regional Bell operating company's deteriorating earnings and high costs. It said that Qwest's weakened operations were the result of lower-than-expected performance for its telephone operations in the second quarter.

S&P also said the lower cash flow expectations for 2002 "are also attributable to Qwest's continued relatively high cost structure, despite cost reduction measures implemented in the first half of 2002." It said this cost structure "was designed for a much higher level of revenue and concomitant operating cash flow than has materialized. Moreover, performance for the data and IP services business was particularly disappointing for the first half of 2002."

While the ratings agency said that Qwest's planned sale of its QwestDex telephone directories unit for $7.05 billion is a positive development, it cautioned that the negative CreditWatch listing "reflects significant concern about future operating performance, as well as the potential for restructuring the public debt. Qwest's inability to obtain amendments or waivers to its bank facility before the end of September 2002 could lead to a further downgrade."

After S&P cut Qwest's corporate credit from B+ to B- and lowered its senior unsecured debt rating from B to CCC+, while at the same time changing its implications to negative from developing, a market source saw Qwest's 11% notes three points lower, at 52 bid/55 offered.

He pointed out that not so very long ago, "those bonds started out as investment grade, so they've gone from investment grade to triple-C."

Qwest had "a small sell-off" on light volume, a trader said, quoting its 7¾% holding company paper due 2006 as having backtracked to 54 bid/56 offered from previous levels as high as 60 bid/62 offered. Qwest's 7¼% notes due 2011 were also seen at 54 bid, down a point or so. However, the company's shares were a dime better (+3.75%) at $2.77, although volume of 8.5 million shares was about half the usual.

Lodging issues were mostly easier Tuesday, a day after consulting firm PriceWaterhouseCoopers scaled back its assessment for a recovery in the industry for the second time since May.

PwC, citing a continued sluggish economy, said that it now expects that the industry will not show robust strength until 2004 at the earliest, later than its earlier expectations. It sees revenues per room - considered a benchmark for hotel industry financial performance - dropping by 2.3% this year from last year's levels. It projected only a modest 3.5% gain in that measure in 2003 and a 5.6% gain in 2004.

Among the factors which PriceWaterhouseCoopers said was shutting the door on greater recovery in the hotels sector were "the negative wealth effect from the sharp decline in stock values in July, the erosion in consumer confidence [and] the increasing frustration with the inconvenience of air travel."

Among high yield hoteliers quoted on the downside on Tuesday were Host Marriott LP, whose 8 7/8% notes due 2008 were down nearly a point at 95, Extended Stay America, whose 9 7/8% notes due 2011 were half a point lower at 97, and John Q. Hammonds, whose 8 7/8% notes due 2012 lost a point to end at 97 bid.

Traders saw no reaction Tuesday among steel issues to a ruling by the U.S. Commerce Department's International Trade Commission denying further tariff relief to the American-based steelers; AK Steel's 7 7/8% notes due 2009 and 7¾% notes due 2012 both continued to hover around par, as did U.S. Steel's 10¾% notes due 2008.

Meanwhile the high yield primary market is not dead, sources assured Prospect News on Tuesday.

It's just asleep.

No news was heard to circulate the market on Tuesday, sources said, adding that there are no deals on the road and no pricings anticipated.

"There won't be anything now until September," one sell-side source counseled.

A couple of sell-siders who had not previously done so seemed willing to chew over the biggest story to hit the primary market during the past five sessions: the QwestDex LBO that is said to be coming with up to $1 billion in bonds, sometime in October.

One source Tuesday said that QuestDex, with considerable leverage, with competition from Internet yellow pages, and with possible capital markets competition from an anticipated fourth quarter deal from Sprint, may have something of a story to tell.

"Still," this source allowed, "the accounts have a preference for liquid deals, so this one has something going for it."

Kathleen Gaffney, vice president and portfolio manager of the Loomis Sayles High Income Funds, told Prospect News on Tuesday that indeed liquidity remained an issue of vital interest to investors. However, she specified, these days there are certainly other issues as well.

"There's such a scarcity in the market today that I think in order to get the participation they want to be assured that the deals will be liquid enough," Gaffney said.

"But I don't know that the size of a deal is going to help. You need to have some breadth and depth in the broker-dealer market. You're not seeing it. And there continues to be uncertainty about the direction of the economy. And equities are certainly weighing on high yield as well."

As with nearly every high-yield investor that has communicated with Prospect News since the Fourth of July, Gaffney said that her fund maintains a closer focus on the secondary market than on the new issuance market.

"That's always the case for us," she specified. "We have never been big players in the primary market. The bulk of what we do has always been in the secondary, mainly because there are greater credit opportunities. There is more uncertainty and we can really leverage our research expertise.

"We tend to be a little bit cynical about the timing when issuers do come to market."

Gaffney said that in her firm's experience new issuance timing is often not in the bondholders' favor.

"There's not as much upside in the new issuance market," she said. "If we're going to be picking our bonds based upon credit fundamentals we prefer to make our money from the compression of the spreads narrowing, as well as the relative value, i.e. the cheapness.

"If you're just buying a coupon, and it's an okay issuer, you're leaving something on the table."

For Gaffney the wealth of fallen angels now nestled into the speculative grade asset class seems to represent more of an opportunity than a hazard.

"I think that's probably where the best bargains are today," she said of the fallen angels.

"It's such a distressed market. There is so much uncertainty on behalf of the investment grade managers who just don't want to get caught holding the next downgrade that the spreads have widened out beyond where a lot of the more defensive, stable double-B credits are.

"The investment grade managers just don't want to take headline risk."

The last time Prospect News had spoken with Gaffney was July 11 - at which point high-yield mutual funds had suffered a mere handful of negative flows. By Tuesday the number of consecutive outflows came to 11, representing approximately $2.5 billion according to some reports.

Breaching the topic Gaffney uttered a gasp akin to one that might escape the patient who has just been told she is in need of a root canal.

"On the mutual fund side you're continuing to see outflows," she said. "On the institutional side it's maybe a little bit better. But primarily what we're seeing is the asset allocators taking money from corporates, from bonds, and adding money to equities."

So, Prospect News followed, when will bleeding stop?

"I think the equity market has to find a floor," Gaffney said. "I think we've got a bit of a bounce going on here. So I think in the short term things will start to get a little bit better until we start to get a read on the economy over the next couple of weeks, in September. But I think equities will remain soft.

"That really doesn't bode well," the Loomis Sayles fund manager continued. "If people keep reallocating to equities as the market goes lower it could be very painful.

"But we've got a couple of corporate accounts that will be making contributions on the pension side. So towards year-end you may start to see more money flow back into fixed income."

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