Category: Issue Comments

S&P has announced:

that the ratings, including the  ‘A-‘ long-term corporate credit rating, on Montreal, Que.-based telecommunications service provider BCE Inc. and its subsidiaries will remain on CreditWatch with negative implications, where they were placed April 17, 2007.
…
The transaction will require about C$38 billion in cash to buyout existing BCE common and preferred shareholders. Details of how the buyout will be financed are not currently available. However, if fully debt financed, the result would be adjusted debt leverage of more than 8.5x–and a rating within the ‘B’ category. Alternatively, if the sponsors’ equity contribution is sufficient to achieve an initial debt leverage of less than 7x, and there was the potential for further reductions in the medium term, the rating would likely remain at the mid-to-low end of the ‘BB’ category.

This opinion – regarding the difference between 8.5x and 7x leverage – is very interesting, as it allows a back-of-the-envelope calculation of the fair value of the preferreds. Please note that back-of-the-envelope is a very generous way of describing the following calculation – NOTHING IS KNOWN, or will be known, until full details are out … and we’re playing with mutually exclusive what-if scenarios anyway (which at least has the advantage of making it very difficult to prove me wrong. Ah, the joys of portfolio management!)

So, let’s look at the leverage ratios. S&P puts the total enterprise value at 51.7-billion. Therefore, to achieve 7x leverage, there will need to be about $6.5-billion equity, while the 8.5x leverage ratio requires only $5.4 billion. THEREFORE, the difference between a “B” and a “BB” rating will require about $1-billion in equity.

The new debt, that will be issued at whatever the new rating is, was estimated by DBRS yesterday to be in the $26-28-billion range. Let’s call it $27-billion for the sake of an argument. And we’ll also make the ballpark assumptions that while “BB” debt could be sold at a spread of 400bp to treasuries, “B” debt will cost them +440bp.

The 40bp difference, applied to debt of $27-billion, implies a difference in financing cost of $108-million per annum, which we will round to $100-million.

Now, here’s where things start to get interesting! It’s going to cost Teachers somewhere around $2.75-billion to buy the preferreds, so let’s look at two scenarios:

i) Preferreds are purchased by Teachers and refinanced with junk at +440, swapped into CAD for an effective refinancing charge of call-it-maybe 9%.

ii) Preferreds are left alone and are presumed to pay 6% (Canada Prime) as dividends, which is grossed up to cost the company a yield-equivalent of 8.4%; payable on $2.75-billion is $231-million, BUT the subordinated nature of the preferreds is enough to convince S&P (and the portfolio managers who actually buy the paper) that the new debt is “BB”, thus saving $100-million in financing charges (and ignore currency conversion, so we can keep the numbers straight). Therefore, the net cost of keeping the preferreds is about $130-million on debt of $2.75-billion, which is a rate of 4.7% which isn’t too much above Canadas!

So … the more I look at it, the less sense it makes to me that the preferreds are being purchased. Note, however, that assiduous reader Drew took the view that the quicker & cleaner plan of arrangement was greatly preferrable to a chancy auction (in the comments to yesterday’s post).

Let’s look at it another way. Teachers has indicated that they are choosing option (i). What happens if another bidder says “Oh, no, we’re gonna go for option (ii)”. How much money is that worth?

The difference on the two financing charges is 430bp, on $2.75-billion, which comes to $118-million p.a. For that $118-million, they could borrow another $1.25-billion at a rate of 9.4% and give all this money to common shareholders, which comes to about $1.50 per share. Note that the phrase “all this money” is a little suspect, as there are knock-on effects, but this exercise has led to a rather interesting answer, hasn’t it?

All readers should be warned that in performing these calculations I am operating way outside my field of expertise. Don’t take any investment action based on any of this! I welcome all comments and critiques of my math – there may be something very obvious that I’ve missed.

BCE has the following preferred shares outstanding: BCE.PR.A, BCE.PR.C, BCE.PR.E, BCE.PR.F, BCE.PR.G, BCE.PR.H, BCE.PR.I, BCE.PR.R, BCE.PR.S, BCE.PR.T, BCE.PR.Y & BCE.PR.Z

Update: With all these numbers flying around, let’s think about the market value of the prefs in the absence of an offer. If new debt is going for +400 to +440, it would seem reasonable that a preferred shareholder would demand at least +500 interest equivalent to hold the paper. That would be call-it-maybe 9.5% swapped to CAD. If we assume that the archetypal BCE prefs pays 6% on $25.00 p.v., and the archetypal investor has an interest-equivalency factor of 1.4, that implies a requirement for 6.8% dividend yield, which implies a price of $22 on the preferred.

Note, however that top-rated perpetual credits are yielding 5% dividend, which is 7% interest equivalent, which is Canadas +250bp, which compares to long bonds at around +100, which implies a spread of +150bp (pref/bond) as opposed to the +60bp (junk pref/junk bond) posited above. If Mr. Archetypal Investor wants 10.5% interest-equivalent for holding a pref, that’s 7.5% dividends, which implies a price of $20.00

DBRS hosted a conference call today shortly after releasing their updated assessment of the credit. The gist of the call was: ‘We don’t know anything much and won’t know anything much until the proxy material arrives in 60-odd days, but we’re being paid to talk about it anyway, so here goes!’.

I find this transaction fascinating, and not just because the plan to acquire the prefs will almost certainly cause MAPF to underperform in July. Why is it being done as a plan of arrangement, which gives the preferred shareholders a right to vote, which I presume is the trigger for the offer?

I have to be careful here, since I am not a securities lawyer – and don’t want to be a securities lawyer – but according to Blakes:

Arrangements are often the preferred acquisition structure in any friendly merger, as the structure allows the acquirer to complete the transaction in one step, unlike a take-over bid which will always require a second step to acquire 100% of the outstanding shares, either through a compulsory squeeze-out of the untendered shares under the applicable corporate statute or by way of a second stage amalgamation transaction. A court-approved plan of arrangement can be completed in a similar time frame as that of a take-over bid and allows companies to merge or combine in a single step, subject to obtaining approval from the target company’s shareholders and meeting any other conditions imposed by the Court.

A very quick reading of the government’s current policy regarding plans of arrangement didn’t ring any bells for me either.

So why isn’t it being done, for instance, the way Xstrata acquired Falconbridge (with the follow-up compulsory acquisition, with a guarantee of the extant prefs? Given that DBRS expects BCE to be a junk credit after the plan of arrangement:

However, DBRS believes BCE’s financial risk profile will be negatively impacted should this transaction close under the terms being recommended by BCE’s board. Teachers’ has indicated that approximately $8 billion of equity will be used to effect this transaction. Therefore, DBRS believes that additional leverage used to accomplish this transaction could add as much as $26 billion of debt to the BCE capital structure assuming a highly leveraged financing of 20% equity contribution is used. Additional debt of this magnitude results in credit metrics deteriorating significantly. For example, the resulting debt-to-EBITDA metric could surpass 6 times. This higher financial risk profile is indicative of bonds rated in the speculative grade range

(“speculative” is the nice way of saying “junk”) it seems rather odd to me that Teachers will voluntarily aquire the prefs. One thing that may make sense is that it simply gives them a lot more flexibility in the future – the company can be chopped up or taken public again without the complicating factor of the preferreds. Seems like a high price to pay, though.

One thing that did come out in the DBRS conference call (which, according to DBRS:

will be available until close of business day Tuesday, July 10, 2007, and can be accessed in North America by dialing 1 800 408 3053, quoting confirmation code 3227900#.

so get your call in now!) is that private equity does not like to have debt come due during the anticipated holding period, which goes a long way towards explaining why a lot of near-term debt is going to be called. Presumably, this relieves the private corporation from the necessity of going cap-in-hand to the market and lifting their skirts for inspection at a possibly inopportune time.

It is clear from all the standard language in the prospectuses for the BCE issues that preferred shareholders are not entitled to notice of shareholder meetings or to vote (the plan of arrangement, being a direct change to their rights, being an exception to this). However, it is not clear to me whether they are entitled to receive financial statements. Could this be the reason?

I’m just a poor dumb fixed-income analyst. This private equity stuff is way too sexy for me. I’m just gonna wait for the proxy materials to be released – should be just before Labour Day – and until then refrain from speculation on the possible twists and turns this story could go through over the next year.

It should be noted that the BCE prefs had a monster day on the TSX, as expected. There’s still lots offered, well below the indicated Teachers acquisition price! Anybody who wants to take a view that the Teachers deal will close as indicated can make oodles of boodle by buying up a lot of these things. Of course, if anything goes wrong with this particular deal – like, f’rinstance, somebody scoops up all the common in a hostile bid – such a buyer will lose his shirt, but some people like that sort of knife-edge existence. Too exciting for me though – it’s just a dice throw, not actual investing as I understand it.

In the mean-time, I’ve got to start reading up on this stuff. In this particular case, the preferred shareholders have better (better! …. better! … BETTER!) credit quality than the bond holders, because they have to be persuaded to approve the plan of arrangement with their vote, while the bondholders have to sit outside in the rain and watch their investment grade portfolios turn to junk. This is – ahem! – rather an interesting thought, particularly if banks are allowed to engage in friendly mergers while their prefs are priced well below par …

BCE has the following preferred shares outstanding: BCE.PR.A, BCE.PR.C, BCE.PR.E, BCE.PR.F, BCE.PR.G, BCE.PR.H, BCE.PR.I, BCE.PR.R, BCE.PR.S, BCE.PR.T, BCE.PR.Y & BCE.PR.Z

Update: It is interesting to consider the language in the prospectuses of the two recent YPG issues.

YPG.PR.A:

On and after March 31, 2012, YPG Holdings may, at its option, upon not less than 30 days and not more than 60 days prior written notice, redeem for cash the Series 1 Shares, in whole at any time or in part from time to time, upon payment of the Redemption Price specified below. In addition, the Series 1 Shares will be redeemable at the option of YPG Holdings on or after March 31, 2007 upon payment of the Redemption Price specified below, provided that any redemption prior to March 31, 2012 shall be done for all of the then outstanding Series 1 Shares and shall be limited to circumstances in which Series 1 Shares are entitled to vote separately as a class or series by law or court order.

and YPG.PR.B:

Subject to the provisions described under “— Restriction on Dividends and Retirement and Issue of Shares”, the Series 2 Shares will be redeemable at the option of YPG Holdings on or after June 30, 2012, at any time, or from time to time, upon not less than 30 days and not more than 60 days prior written notice at the Redemption Price specified below. In addition, the Series 2 Shares will be redeemable at the option of YPG Holdings on or after June 30, 2007 upon payment of the Redemption Price specified below, provided that any redemption prior to June 30, 2012 shall be done for all of the then outstanding Series 2 Shares and shall be limited to circumstances in which Series 2 Shares are entitled to vote separately as a class or series by law or court order.

These are total returns, with dividends presumed to have been reinvested at the bid price on the ex-date. The list has been restricted to issues in the HIMIPref™ indices.

BCE has announced:

that the company has entered into a definitive agreement for BCE to be acquired by an investor group led by Teachers Private Capital, the private investment arm of the Ontario Teachers Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners, LLC. The all-cash transaction is valued at C$51.7 billion (US$48.5 billion), including C$16.9 billion (US$15.9 billion) of debt, preferred equity and minority interests. The BCE Board of Directors unanimously recommends that shareholders vote to accept the offer.

Under the terms of the transaction, the investor group will acquire all of the common shares of BCE not already owned by Teachers for an offer price of C$42.75 per common share and all preferred shares at the prices set forth in the attached schedule.
….
                            SCHEDULE A
                   BCE PREFERRED SHARES – PURCHASE PRICES

    The cash considerations payable to the holders of the preferred shares
    are as follows:

    ————————————————————————-
        First Preferred Shares               Consideration Per Share
    ————————————————————————-
              Series R                             $25.65 (*)
              Series S                             $25.50 (*)
              Series T                             $25.77 (*)
              Series Y                             $25.50 (*)
              Series Z                             $25.25 (*)
              Series AA                            $25.76 (*)
              Series AC                            $25.76 (*)
              Series AE                            $25.50 (*)
              Series AF                            $25.41 (*)
              Series AG                            $25.56 (*)
              Series AH                            $25.50 (*)
              Series AI                            $25.87 (*)
    ————————————————————————-    (*)Together with accrued but unpaid dividends to the Effective Date.

I’m astounded. I don’t understand why they would pay so much for the preferreds … but there is a note in the press release that states:

The transaction will be completed through a plan of arrangement, which will require the approval of two-thirds of outstanding common and preferred shares, voting as a class.

I will be fascinated to learn more of the legal intricacies which make this a viable option for the purchasers! As it is, it looks like all my gloomy prognostications will turn out wrong. Although, mind you, the preferred shareholders don’t actually have cash money in their pockets yet – and there have been tears shed over similar offers.

BCE has the following preferred shares outstanding: BCE.PR.A, BCE.PR.C, BCE.PR.E, BCE.PR.F, BCE.PR.G, BCE.PR.H, BCE.PR.I, BCE.PR.R, BCE.PR.S, BCE.PR.T, BCE.PR.Y & BCE.PR.Z

Telus has announced:

that it has elected not to submit an offer to acquire BCE as part of the strategic review process announced by BCE on April 17, 2007. The inadequacies of BCE’s bid process did not make it possible for TELUS to submit an offer.

… which could be mere posturing in order to get BCE to change their bid process, a reflection of regulatory problems … who knows? Pick your talking head, pick your explanation.

Ten year bonds for both companies widened 20bp on the news, perhaps reflecting the idea that now both will become LBO targets in shareholder-friendly ( = bondholder-hostile) events. But we will see!

I continue to think that BCE prefs are a crapshoot on credit right now and don’t want anything to do with them! There are, as yet, no words of wisdom from the ratings agencies.

BCE has the following preferred shares outstanding: BCE.PR.A, BCE.PR.C, BCE.PR.E, BCE.PR.F, BCE.PR.G, BCE.PR.H, BCE.PR.I, BCE.PR.R, BCE.PR.S, BCE.PR.T, BCE.PR.Y & BCE.PR.Z

As briefly noted yesterday, Telus has thrown its hat in the BCE takeover ring:

“TELUS believes the combination of the two businesses would represent a compelling strategic and financial opportunity for all BCE and TELUS stakeholders. It would be an all Canadian solution for both immediate and long-term value creation, whilst ensuring a vibrant player continues in this increasingly competitive industry,” said Darren Entwistle, President and CEO, TELUS. “TELUS has a unique opportunity to create a truly national Canadian enterprise with the requisite balance sheet strength as well as scale and scope to continue TELUS’ development as a global leader in the deployment of state of the art technology and innovative new services for customers.”

S&P has placed Telus on Credit Watch Negative:

Standard & Poor’s Ratings Services today said it placed its ratings, including the ‘BBB+’ long-term corporate credit rating, on Vancouver, B.C.-based communication services provider Telus Corp. on CreditWatch with negative implications.The action reflects the company’s announcement that it has entered into nonexclusive discussions to acquire BCE Inc. (A-/Watch Neg/A-2). We expect the transaction, if completed, will be funded by a combination of Telus’ shares and new debt, which would lead to pro forma debt leverage (including operating synergies) and corresponding credit metrics that would weaken the current “modest” levels. However, Telus’ management has publicly indicated its desire to maintain investment-grade ratings.

… while DBRS takes a more relaxed view:

DBRS has today placed the A (low)/R-1 (low) ratings of TELUS Corporation (TELUS or the Company) and the A (low) rating of TELUS Communications Inc. Under Review with Developing Implications. This follows the Company’s announcement that it has entered into an agreement with BCE Inc. (BCE) to discuss a possible business combination.DBRS notes that TELUS has put forth some compelling arguments for such a combination. These include significant synergies; a combined entity that would retain investment-grade ratings; a Canadian investment vehicle; and the potential for a tax deferral for BCE shareholders

Oddly, neither agency considered the campaign for par redemption worthy of ink!  

So, let’s think about S&P: the BCE credit rating A-/Watch Neg/A-2, while the Preferred Stock is P-2/Watch Neg/– on the Canadian scale, while the Telus credit rating is BBB+/Watch Neg/NR with no preferred share rating (since it has no preferreds). Therefore, if Telus becomes responsible for the BCE preferreds while at the same time being downgraded, a very major downgrade to the preferred share rating may be expected.

The situation is not quite so clear with DBRS: BCE’s unsecured debentures are A(low) and preferred stock Pfd-2(low), both on Review-Negative, and Telus is now also A(low), Review-Negative, but it still doesn’t look all that rosy for a continued Pfd-2(low) rating on the prefs.

Barring an all-stock transaction (or cash with an equity issue immediately thereafter, netting to the same thing) it would appear that the preferreds are at high risk of being downgraded … the same as current expectations have it given a private equity deal. So … not much comfort here, at least as far as preferred shareholders are concerned!

BCE has the following preferred shares outstanding: BCE.PR.A, BCE.PR.C, BCE.PR.E, BCE.PR.F, BCE.PR.G, BCE.PR.H, BCE.PR.I, BCE.PR.R, BCE.PR.S, BCE.PR.T, BCE.PR.Y & BCE.PR.Z

S&P has announced:

it raised its long-term corporate credit rating on St. John’s, Nfld.-based Fortis Inc. to ‘A-‘ from ‘BBB+’. At the same time, Standard & Poor’s raised the senior unsecured debt rating on Fortis to ‘A-‘ from ‘BBB’, the foreign scale preferred stock rating to ‘BBB’ from ‘BBB-‘, and the Canadian scale preferred stock rating to ‘P-2’ from ‘P-2(Low)’.
…
The stable outlook reflects the underlying operational and financial stability of Fortis’ operating companies. We could lower the ratings if Fortis were to materially elevate its leverage or if one of its larger subsidiaries encountered major financial or operational difficulties. A positive outlook or upgrade remains unlikely in the near term but could occur as a result of further diversification. We expect the company to remain acquisitive in the next few years; further acquisitions should not prompt a downgrade, provided they remain consistent within the company’s regulated focus and expertise and were financed consistent with current financial policies.

The potential for this upgrade has been discussed earlier. It should be noted that DBRS continues to rate the issues as Pfd-3(high), with the last confirmation of this rating on February 26.

Bombardier has announced:

In the case of the Series 3 Preferred Shares, starting as of August 1, 2007, holders will receive a quarterly fixed cash dividend for the following five years, as and when declared by the Board of Directors of Bombardier Inc, based on a fixed rate equal to 115% of the yield on five-year non-callable Government of Canada bonds determined as at July 11, 2007, in accordance with the terms of such shares. The annual dividend rate applicable to the Series 3 Preferred Shares will be published on July 12, 2007 in several newspapers.

At 115% of Five-Year Canadas, the fixed rate may be estimated to be just a hair over 5.25% to be paid on BBD.PR.D following August 1, while the BBD.PR.B will probably continue to pay 100% of Canada Prime. The latter prediction assumes that a Pfd-4 (trend negative) [DBRS] or P-4 (stable) [S&P] issue will not trade above par in the near future, which would start ratcheting down the percentage.

These issues have been discussed in the context of arbitrage. The Bs (ratchet) closed today at 20.63-75, the Ds (fixed) closed at 19.83-11.

Rob Carrick of the Globe & Mail has published an article on BCE Prefs in today’s paper, that has a few interesting snippets in it.

Apparently,

a recent report from Desjardins Securities urged people to write to BCE to request that the company’s preferred shares be redeemed at par value. “Our buyers, both individual and institutional, purchased these shares because of the company’s reputation, the comfort of a regulated utility, the safety of cash flow and suitable dividend coverage, good corporate governance, and recent favourable changes by the Minister of Finance to the dividend tax credit,” the report said.

A bit of a desperation move, but doubtless popular with their clients. I’m certainly not going to alter my views regarding the BCE prefs based on some chance of the company making an enormous goodwill payment to investors.

There was some interview with Douglas Berry, a portfolio manager with Three Macs in Montreal – unfortunately, Mr. Berry’s long term track record was not disclosed. He outlined some arguments favouring an investment in the BCE prefs, although his final judgement regarding the investment was also not disclosed. Arguments in favour are:

• The (potential) new owners may redeem the shares.. Well, I won’t hold my breath! All I can really say is that three issuers with similar issues in the sub-investment-grade category have not found it advantageous to refinance: Quebecor (IQW.PR.D), Nortel (NTL.PR.F, NTL.PR.G) and Bombardier (BBD.PR.B, BBD.PR.D). The price of the financing is steep, to be sure, but the deeply subordinated nature of preferred share debt helps out the credit ratings of senior debt.
• most of the shares are owned by banks, insurance companies and other institutions that are unhappy about how the price has fallen lately. I may be a little slow, but I fail to see how this is relevant. Even if these institutions are disingenuous enough to showboat with calls for redemption at par (as Desjardins is doing), who really cares what a pack of rinky-dink Canadian banks and two-bit Canadian insurance companies think anyway? Financing requirements for the deal are sufficently large and sufficiently junky that funds required will have to be raised in the States anyway.
• the (potential) new owners have lots of money. Again, I fail to understand the relevance of this point. A BCE buy-out may or may not be a good deal. Give me three months, a staff of 20 and a few million dollars, and I’ll come back to you with a more definitive opinion on the value of the firm, but let’s just assume they buy it out. And then … the worst happens. After performing as expected for a few years, there’s a vicious recession, perhaps coupled with extreme technological change requiring huge capital investment just to remain a player … and BCE comes near bankruptcy. The (potential) new owners have no obligation to throw good money after bad. Like Telesat, like BCE Developments, like Air Canada, it will be … ‘So long! Been nice – but not all that nice!’.

The bottom line? I consider these issues to be more in the nature of “equity substitutes” than “fixed income”. Not only that, but there is zero information available on the structure of the firm going forward. How can there be, when there’s three bidders in the ring?

Update, 2007-6-28: In the commentary regarding all the money the (potential) new owners have, I referred to Telesat. Oops! I meant to refer to Teleglobe, a failed investment cut loose by BCE. Telesat actually did reasonably well.