High yield secondary - a tough year past, an uncertain one ahead

By Paul Deckelman

New York, Dec. 31 - Two thousand and two could be described as the "year of the blow-up" - and 2003 is expected to be pretty tough, junk bond market participants said, as secondary sphere investors try to maneuver around the wreckage of companies and sectors that crashed and burned in the year just passed - many of them laid low by jolting revelations of fishy accounting that shook investor confidence in their bonds and sometimes even triggered regulatory scrutiny and prosecutorial action.

Some names merely suffered the indignity of having fallen from their previous lofty status as investment-grade credits and tumbled into junkbond land. Bank of America Securities estimated in mid-December that a whopping $134.3 billion of debt had assumed the status of "fallen angels" in 2002, with fully 42% of that in the still-deteriorating telecommunications sector, paced by such disasters as WorldCom Inc., and another 40% in the utility sector, much of which seemed to have migrated en masse into the high yield market, as companies such as Dynegy Inc., Mirant Corp. and Williams Cos. ran into trouble as they attempted to dodge the flaming wreckage of Enron Corp.

It should be noted that even though some fallen angels (but by no means all) actually fell no farther than the not-so-terrible double-B tier, such a loss of status is still nothing to take lightly, since it can have both a psychological impact, in terms of investor perception of a credit's financial stability and may even have real dollar costs, in terms of the ratings downgrade triggering higher interest payments and collateral calls on existing debt, as well as making it more expensive for a borrower to float any new bonds or hit up its bank lenders for additional funding.

But fallen former investment-grade angels were only the tip of the iceberg. Some seemingly solid junk credits found themselves thrown into a downward skid, brought lower by a combination of weakness in their fundamental operations - slowing subscriber growth for telecom and cable companies, for instance - coupled in many cases with troublesome accounting issues. Massive loads of debt, borrowed during the heady days of the late 90s when future prospects seemed limitless and due diligence almost non-existent, ate up increasingly slim liquidity resources in interest costs and forced already weakened companies into often difficult restructurings.

And a parade of once-powerful corporate names, including Kmart Corp., WorldCom Inc., UAL Corp., Conseco Inc. and Adelphia Communications Corp., were closing out 2002 mired in Chapter 11, hoping to be able to turn their situations around and emerge as leaner, stronger, less debt-laden entities - but with no outcome guaranteed.

Cable industry encounters static

"The biggest surprise to me was how the cable-TV industry fell apart this year," said a buyside source. "Companies that people thought were pretty rock solid, like Adelphia and Charter Communications Holdings LLC, experienced significant volatility in their bond prices this year - Adelphia because of their accounting issues and Charter to a certain degree in sympathy with that, but also due to certain issues specific to that company. But if you had asked someone on Jan. 1, 2002, whether they thought Adelphia and Charter would be trading higher or lower by the end of 2002 where they were, most people would have thought they would be higher, or at least unchanged. I don't think anyone would have predicted the bonds would go down 50 or 60 points."

He pointed out that Charter's 10% notes, which finished 2001 trading at 102 bid, were most recently quoted as having fallen to 44.

"By this time [end of 2001/beginning of 2002] people already knew the telecoms were in trouble - but they didn't perceive the cable operators to be in trouble. They thought Charter was doing very well, and that cable was a predictable business, and it was okay for them to have leverage."

But during the course of the year, as the Adelphia debacle unfolded - triggered by revelations of massive off-balance sheet borrowing from the Coudersport, Pa.-based cable operator by members of the founding Rigas family - "so did people's confidence in the cable-TV sector," the buysider said.

Aryeh Bourkoff, high yield cable analyst for UBS Warburg, said that as a whole the cable and satellite sector "continues to be highly competitive, where subscriber growth comes out at increasingly high cost of acquisition, and free cash flow and financial flexibility will be critical to ensuring a healthy competitive environment for certain operators. "

He saw Cox Communications Inc. and EchoStar Communications Corp. as "best-positioned, given their free cash-flow build-up expectations for 2003, to compete." Other companies which he said have started to position themselves well for the competitive environment include Cablevision Systems Corp.

But the UBS analyst believes that the eyes of sector players will certainly be on Charter's efforts to pull itself out of its current straits, which he called one of the three significant events that cable-watchers would be looking for in 2003 (the other two being the outcome of TimeWarner cable's scheduled initial public stock offering, which Bourkoff sees as a key test of investor sentiment toward the somewhat tarnished sector, and earnings guidance to be released by the industry's dominant player, Comcast Corp.)

He said the St. Louis-based cabler "is likely to hire a new CFO in the first quarter," to replace ousted chief financial officer Kent Kalkwarf, whose firing was announced in mid-December, with the company linking that corporate beheading to the ongoing federal probe of how Charter calculates its subscriber numbers.

Also, with approximately $20 billion of debt to get rid of, "Charter is likely to begin the pursuit of a restructuring alternative in the first quarter."

While Bourkoff did not see a Chapter 11 filing in that quarter, "our analysis is that Charter will have to pursue a pre-packaged bankruptcy in the middle-to-late 2003 timeframe" in order to accomplish its restructuring. "The company has started to acknowledge its need to restructure, for the first time."

He also believes that the recent firing of Kalkwarf and of chief operating officer David Barford, "was intended partially to appease the [federal] investigators into taking a fresh look at the company as the company restructures its management team and its operating profile."

Bourkoff noted that the recent debt restructuring by Qwest Communications International Inc. was an example of how a company with big pending accounting and regulatory issues could still shave down its debt, by in that case limiting the restructuring transactions to qualified institutional buyers, where disclosure requirements are considered less stringent than when a company makes a tender or exchange offer to all holders of its debt.

But while he saw Charter examining many different possible restructuring tactics, "the Qwest structure would be more difficult for Charter to pursue, given that Charter's high yield covenants are tighter and more restrictive than the covenants at Qwest. And the organizational structure of Charter is complex enough that it makes a Qwest-like restructuring more problematic."

"Restructure this debt - or else!"

While Bourkoff therefore doesn't expect Charter to pursue a Qwest-like debt exchange - which essentially involved the Denver-based telecommunications operator forcing its balky bondholders to accept a substantially smaller principal amount of new debt with much higher coupons and, in most cases, longer maturities - other companies are likely to see that Qwest was able to get away with it, even getting the backing of the federal courts, and try similar tactics, believes Ron Gies, a high yield analyst with Stone & Youngberg LLC in San Francisco.

"This [2002] was the year of trying to find a new way to refinance your debt, because there's no capital market access. So we saw an awful lot of companies doing a variety of voluntary and what I would call extortionistic type exchanges of debt, forcing bondholders to cooperate with refinancing programs," he declared.

Among those doing things pretty much voluntarily, he said, was Level 3 Communications Inc., which took out a sizable amount of debt early in the year, "but we've had an awful lot of stuff, a lot of exchanges, where bondholders essentially had a gun put to their heads" - and he named Qwest as an example.

"As businesses over the last year have come to realize that they have no access to the capital markets, they have become more and more slimy in terms of their survival." Qwest bondholders "clearly thought they were getting shafted in this," he said, noting the unsuccessful legal challenge mounted by some bondholders against the company, and the relatively low level of participation, with the company having only received tenders of about $5 billion or bonds out of the $12.9 billion it was originally hoping to receive and actually only taking out a net of about $1.9 billion face value of existing debt, a relatively small portion of its overall debt load. "I don't know why [the company] is calling this a success," he said.

Even with such mixed results, he warned, "that sort of disregard for investors has been a hallmark of this year . . . There's definitely been an acceleration of that kind of strategy, and I would expect that to continue."

Investors betting on gaming

On a brighter note, while Gies said that he takes a "generally pretty conservative" approach to the junk market's prospects and "doesn't see a whole lot to be really excited about," still, he likes "the cash-flow stuff. I like gaming and hotels and consumer-type products, anything I can look at with really predictable cash flow."

He cautioned, however, that "there are fewer and fewer of those because we've really been through a stress test the last year or so, but anything that can show me a stable cash flow over the last 12 months, I'm generally pretty comfortable with."

He noted that a lot of those kind of names have already run up substantially and are trading at or above par, such as most gaming credits.

"The casinos all trade at big premiums. That was a great idea six months ago, when you could buy them at par or just below. But still, if you have high-yield money and you have to be in the high-yield rating categories, I would still rather be in those than reaching for yield right now" by buying other bonds at substantial discounts from par - but having to worry about where those bonds might be six months from now, or even where they might be next week.

"My primary concern is still preservation of capital. I still see risk to capital with most names that you have to stretch for yield for," Gies concluded.

Another analyst who likes the gamers is Jacques Cornet, the recently appointed high yield research chief at CIBC World Markets Corp., who watches gaming and lodging as his primary beat.

"Gaming and lodging, both sides have done very well this year. From a credit perspective, I believe that this will be the sixth consecutive year in which [gaming] has outperformed the various indices within high yield. Especially over the last two and a half or three years, the sector has clearly outperformed. It continues to have free cash flow and tangible assets, and earnings visibility on a relative basis is exceptional."

In this "year of the blow-up", when it seemed that not a week went by without some major company or other unpleasantly surprising its investors with the unwelcome news that it would have to restate revenues or earnings, or even worse, be the subject of accounting-related probes by the Securities and Exchange Commission or other regulatory or law enforcement authorities, Cornet said the fact that the gaming industry is so heavily regulated by the individual states in which casinos operate proved to be a blessing for the sector investors.

"You would never have imagined this three years ago, but the fact that this is a highly regulated business has been a tremendous positive. Because here is an industry that has strict adherence to a set of rules, whether they are political, regulatory or financial, they have lots of folks watching them. From a license and a regulatory standpoint, that is the greatest asset they have, and they would not risk losing [their licenses]. "

Cornet noted, for instance, that since the states all tax casino revenues, they have a keen vested interest in the monthly numbers coming out of Las Vegas, Atlantic City, Tunica, Miss. or other gaming venues. "Not to say 'never' - you can never say 'never' - but the regulatory barriers make [fishy accounting] much less likely in this industry," the CIBC analyst asserted.

He said it's "much more difficult" for the casinos' corporate book-keepers to cook the books, as was done at so many other companies in other industries "because you have to report your revenues every single month, and you have regulators that work on-site. I think that has helped a tremendous amount in terms of investor perception" about the gaming companies.

Not that the gamers are necessarily an ironclad guaranteed money machine. Cornet noted, for instance, that with the expected opening this coming summer of the billion-dollar Borgata gaming resort in Atlantic City by joint-venture operators MGM Mirage and Boyd Gaming Corp.-an event that Cornet called "the most anticipated gaming industry event of 2003 - some doomsayers are warning that the new entrant, with its more than 2,000 rooms and 3,600 slot machines, will overwhelm the existing operators, cannibalize the current revenue base and spark a destructive and expensive promotional war among the dozen incumbent gambling halls that will drive margins down.

On the other hand, he said, some optimists expect the Borgata to create enough excitement to attract many new visitors to the seaside resort city and grow the entire market, benefiting everyone. Cornet said that's what happened in Las Vegas in 1989 when the glossy new Mirage opened on the Vegas Strip. But in New Jersey, while he predicted the Borgata itself would be a big success, he cautioned that it will put some pressure on the incumbent operators until all of the room product is absorbed, although he said revenues at the existing properties would be off, on average, a maximum of about 10%.

Another potential weak spot for the gaming industry could be another terrorist assault like 9/11, which threw the whole gaming and lodging industry, which depends heavily on air travel, for a loop.

But Cornet said that while such a calamity could "absolutely" happen again - "that's clearly a risk within this group," he agreed - "the point is that at least from a credit standpoint, folks went through this exercise after 9/11. If you made assumptions about sustained earnings losses because of all these reasons, folks found that in many cases, there was still excess free cash. The credits were capitalized so that they could survive difficult times. I think that in terms of investor perception, this helped these bonds."

Gaming investors "were forced to go through the exercise, 'what if EBITDA is down 30% for the year?' "While a company's credit profile might, in relative terms, get worse "it wasn't 'we're gonna miss our coupon worse,' " he said. "They're well capitalized as a group."

Airlines continue to hit turbulence

While the gaming industry might be able to weather another negative event of the magnitude of 9/11 - Cornet said "the destinations you had to fly to took a hit that was noticeable and it was quick," but have since recovered - the airline industry still hasn't pulled out of its tailspin, which was actually going on before 9/11 and which was aggravated by the airborne terrorist assault and resulting counter-measures which have since made air travel more expensive and more inconvenient.

"It's been a tough year for everybody, equity investors and high-yield investors alike," said Ray Neidl, airline analyst at Blaylock & Partners. He noted that "30% of the industry is in bankruptcy proceedings," between the filing of Number-Two U.S. carrier United Airlines and its corporate parent, UAL Corp., US Air Group, and some smaller industry players. "Equity investors are being wiped out or probably will be wiped out, while unsecured bondholders will be taking a huge haircut, as you can see in the recent US Air filings - they're getting about two cents on the dollar for the reorganization with some stock in the new company." UAL bondholders, he said, probably "are not going to do much better." However, he added "secured investors seem to be making out OK."

United, he estimated, has about a 25% chance of emerging from bankruptcy stripped of its debt burden and other liabilities and in a stronger position to compete, about a 15% chance of having to liquidate altogether and a 60% likelihood of emerging intact but weaker and continuing to limp along. "The key is whether they can come up with a good business plan and get their cost structure down to be competitive. If they can't, then they will either liquidate or struggle along for a few years and go the Pan Am route," flying off into oblivion as that historic pioneer carrier did in the early 1990s.

Even as UAL bonds continue to languish down around 20 bid or below, bonds of other carriers not in bankruptcy are mostly trading in a range straddling 50 cents on the dollar, continuing to reflect the risk that some of those other carriers may end up following the UAL/US Air example and crash land in the bankruptcy court, as well as the more likely risk that they will manage to stay solvent - though barely - limping along, trying to cut their costs down to a manageable level, conserve their cash and keep their debt obligations paid.

But Neidl was skeptical of the theory floated in some quarters that other relatively more well-off carriers might choose bankruptcy, even if they have adequate cash, in order to quickly get out from under burdensome labor contracts, bond payments, aircraft leases and the like.

"Bankruptcy is not an easy answer," he argued. "There's a lot of sacrifice, a lot of expenses, a lot of time that has to be spent in reorganization, and there's no guarantee that an airline's current management will get any compensation out of it, or even retain control. Bankruptcy is always a dangerous route. "

He noted that the track record for airline bankruptcies "is pretty poor," with only Continental Airlines and America West managing to survive intact. "You're not going to go into bankruptcy unless you really don't see any other alternative and you're in that downward spiral. The other [major] airlines aren't at that point yet."

Neidl didn't see the others necessarily heading for immediate bankruptcy, but said he "wouldn't be surprised to see a couple of the big network carriers disappear over the next few years," possibly by being combined into a rival, as the airline industry continues to contract. Big carriers like American Airlines, UAL, Delta Airlines, Northwest Airlines and Continental, with their far-flung routes, continue to lose market share to lower-cost carriers like Southwest Airlines and more compact upstarts like Jet Blue.

"There will be a place for some of the big network carriers," he predicted, "but the ones that get their cost structures down are the ones that will be around, while the ones that don't get their cost structures down will be gone."

That having been said, however, Neidl said he expects a better showing in 2003 for the bonds of airlines other than bankrupt UAL and US Air. With the airline industry recovering as the economy does better, he said "the bonds will come back" in 2003. "The prices right now reflect the possibility of another bankruptcy. But I don't think we'll see further bankruptcies" in the near term.

High prices fuel energy sector strength

While airline industry investors are nervously scanning the headlines for news on whether America will got to war with Iraq in 2003 - an event which would raise fears of more terrorism and stymie any recovery by the sector's bonds - energy investors are not nearly so nervous.

With world crude oil prices hovering above $30 per barrel and natural gas prices around $4.80 per thousand cubic feet, "it looks like this sector is going to be pretty strong, as long as you have crude prices and natural gas prices where they are, or even if they go [somewhat] lower than recent levels, said John White, a Houston-based high yield energy analyst for BMO Nesbitt Burns.

"I think a lot of people look at this as a sector where there are real assets, and even though you have a lot of volatility in commodity prices, people still have a good idea of what oil and gas production is going to be, so they can apply whatever price they feel comfortable using, so they have a pretty good idea of what the cash flow is going to look like."

White noted, for instance, that natural gas futures prices - currently at seasonally high levels because of the cold weather gripping most of the U.S. - are projected to most likely average at least $4.55 mcf on a 12-month basis.

Any kind of conflict in the Middle East is likely to drive both oil and gas prices higher, which White said would benefit high yield energy exploration and production companies as well as the oil service sector, although he cautioned that it could negatively impact upon refiners who would have to buy crude at inflated prices.

Some oil-industry watchers have predicted a crash in oil prices - or at least a sizable downward retrenchment - in the aftermath of any Mideast war, especially a quick one that ends in a U.S. victory, on the assumption that a regime change in Iraq could lead to more oil being put on the world market. They note that after having spiked upward during the Gulf War, oil prices headed back downward throughout the 1990s, even reaching lows of around $10 per barrel in the late 90s, which drove down the shares and bonds of high-yield energy producers and actually forced a number into restructuring.

On the other hand, some in the industry don't see the past repeating, citing the possibility that even with a U.S. victory in Iraq, terrorism will continue to keep the Mideast pot bubbling and could actually target energy facilities there, potentially reducing supply. They also note that unlike the 1990s, Venezuela, a major oil producer with a government not considered overly friendly to Washington, is in a state of political and economic turmoil that could interrupt its oil supplies, which would also keep prices high.

The not-so-powerful power operators

Besides oil, White also watches companies such as Williams Cos. and others in that energy pipeline/trading/electric production sphere, which fell out of bed in 2002 in the wake of the troubles at Enron, which resulted in the latter's eventual bankruptcy, fallout from the California energy crisis of late 2000 and early 2001 (which saw the state accuse many merchant energy operators of price gouging), as well as allegations that some players may have engaged in bogus "round-trip" trades that inflated their volume statistics but did not add any economic value.

Besides Williams, such players as Mirant Corp., Dynegy and El Paso Corp. saw their ratings dropped to junk, their stocks (with the exception of El Paso) fall to virtually penny stock levels, and their bonds, for the most part, on the slide.

White noted that all of these companies, as well as other traditionally junk-rated merchant energy operators like AES Corp., CMS Energy Corp., Calpine Corp., have varying mixes of pipeline, energy trading, utility generating, domestic, foreign, regulated and unregulated assets.

Investors in the utility sector are faced with all kinds of tough questions about electric generating capacity, with some parts of the country not having enough, others having too much, or having to rely too heavily on aging plants due to be taken out of service soon. Power prices - and hence the amount of revenues that utilities can generate - are another question mark, given the state-to-state differences in the crazy-quilt patchwork of regulatory oversight - witness the problems that grew out of California's hybrid half-regulated/half-deregulated approach to electric power in 2000 and early 2001.

Against that kind of backdrop, White believes that investors should carefully weigh the mix of assets in the companies they expect to buy the bonds of. "Companies that are more weighted toward pipeline operations are the better credits," he counseled.

"As you move away from the pipelines and get more electric generating assets, that's where you get more uncertainty - a lot of uncertainty."

A trader said some of the companies in that sector "were products of the time, and built their business plans in the mid-90s, when there was free money to put to work, and a lot of people built a house of cards." On the other hand, he said, there are some companies with valuable hard assets and some "that didn't leverage themselves up to the hilt, that will probably survive. But I wouldn't be surprised to see a lot of them go away."

Another trader said that "I don't see any major improvement" in the merchant energy sphere. "Oil prices are likely to go up [most generating plants burn either oil or natural gas] and rates are regulated. I don't see how you can have any improvement there."

In general, he said, noting the merchant energy sectors problems and the continued weakness in telecom, which still has not finished completely shaking out, he lamented that "the first half of [2003] is gonna be difficult. I don't see how high yield can have an easy first half."

The first trader was a touch more sanguine about the overall picture - but just a touch - noting the strong upturn that the junk market took toward the tail end of 2002 as liquidity rushed in.

"Was there a lot of value in the market? Not really, but there was cash coming in, that had to be put to work, so you picked the names that are cash flow positive or have a really good inkling that they're going to make it. Everyone bid those names up and the rest of it just sat there."

Looking ahead, he said that he didn't "see any big catalyst" for the market - but predicted that in the first quarter and the first half, "you're still going to have a pretty strong market, absent any new disasters in the global economy. I think you're going to continue to have a pretty hopping new-issue market. You may see an upturn in LBO activity and that will drive some of it as well. I think you'll continue to see positive inflows as well - but it'll be tougher and tougher to spot value, at least until we start to see earnings really turn around."

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