Deutsche Banc analysts say Tyco 2020 convert undervalued

By Ronda Fears

Nashville, Tenn., Jan. 23 - Tyco International's 0% convertibles due 2020 are still undervalued and a better way to play the unfolding situation of Tyco's breakup than the 0% convertibles due 2021, according to Deutsche Banc Alex. Brown convertible analysts Jeremy Howard and Jonathan Cohen. But both converts are appealing, and to both outright and arbitrage investors, the analysts said, because they estimate there is nice continuation value as well as plain upside potential in the underlying stock.

"We feel that the holders of the 2021 should consider switching into the 2020 bond. For investors who hold neither security, we would recommend a position in the 2020 bond as the most attractive way to play the unfolding situation. Given our strong buy recommendation on the stock and potential 'sum of the parts' valuation of $73.40 on the stock, we believe that the bonds should be of interest to outright convertible investors as well," the analysts said in a report Wednesday.

"The newer Tyco 0% 2021 is also interesting, but we find it slightly less attractive than the 2020 bonds," the analysts said, because the yield to accreted value is lower, the inflection price for the stock is higher and it is more expensive on a simple premium basis.

The 2020 bond's discount to the 2021 issue may be because the put on the 2021 in February 2003 is nine months before the November 2003 put on the 2020 bond, the analysts speculated. But they asserted the huge deleveraging that is planned by Tyco does not justify the discount, given the probability of the bonds being tendered long before either put.

"We believe that there is a strong case for Tyco to bid at least accreted value in the tender offer for the convertibles. In response to investor enquiries at the analysts' meeting, Tyco management stated that all bondholders would be treated 'fairly'," the analysts said. "Given that the entire yield on the bond is made up of its accretion rate of 1.5%, it is difficult to see how a fair bid could be less than accreted value. Holders who tender bonds give up hard call protection to Nov. 17, 2007, and therefore should be compensated to the tune of at least the bond's 'present value' based on the issue YTM."

The timetable for the tender is uncertain, but Tyco management indicated that it would be completed in line with the IPO of the separate divisions, which are scheduled over a three to four month time frame. Overall, Tyco is targeting completion of the breakup by year-end.

At May 22, the analysts calculate the yield to the likely tender price on the 2020 issue to be 8.8%, based on an accreted value of 75.49 and the current offer price of 73.75. At April 22, an accreted value of 75.77 would put the yield at 11.3%. At March 22, the accreted value would be 75.67, with a 16.6% yield. At Feb. 22, the accreted value would be 75.58, putting the yield at 31%.

At May 22, the analysts calculate the yield to the likely tender price on the 2021 issue to be 7.1%, based on an accreted value of 75.22 and the current offer price of 73.875. At April 22, an accreted value of 75.77 would put the yield at 9.0%. At March 22, the accreted value would be 75.41, with a 13.1% yield. At Feb. 22, the accreted value would be 75.31, putting the yield at 23.9%.

"For the arbitrageurs, the Tyco 0% 2020 may be more attractive than the 2021 bond because the potential for gamma trading is greater. We calculate the inflection point above which a holder would not accept an accreted price tender offer of 75.87 on May 22 would be around $58.50," the analysts said in the report.

"This assumes that the 'basket' convertible that would result from the bond not being put would trade on a 22% implied volatility. What is especially interesting for the arbitrage community is the high gamma in the 2020 bond, which causes delta to change rapidly as the stock price increases. We believe that this high gamma potential is undervalued by the market at current levels."

The analysts also note that, assuming a tender at accreted value at the end of May, investors buying the 2020 issue now pay no implied volatility at all to own the security. And, they added that the 2020 issue is more attractive than the 2021 bond on a simple premium basis - 28.2 points less. The analysts added that the inflection point of Tyco stock for the holders keeping the bonds is also higher on the 2021 bonds at $66.25, versus $59.00 on the 2020 issue. This results in lower gamma, or trading potential, for arbitrage funds and also lower delta, or equity sensitivity, for outright funds, the analysts said.

If convertible holders opted not to tender their bonds, the analysts said the resulting basket convertible that would convert into the four new stocks is not unattractive, and the estimated outright upside potential for the new Tyco stock to $73.40. If the contribution value is realized, the analysts said Tyco should trade in the $70 to $75 range before the IPOs.

"If the stock achieves anything like our theoretical 'sum of the parts' analysis the company will have to tender a good deal more that accreted value to retire either of the convertibles," the analysts added. "Any holder on an outright or hedged basis would do very well in this scenario."

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