S&P Leaves BCE on Credit Watch Negative

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

3 Responses to “S&P Leaves BCE on Credit Watch Negative”

  1. […] The BCE issues settled back a little after their enormous gains of yesterday – I suspect that they’ll be volatile for a little while longer, as greed wars with fear. I wrote yet another post on the BCE/Teachers Plan of Arrangement today and estimated that taking out the preferreds is costing the common shareholders $1.50 per share. […]

  2. Drew says:

    To clarify, all else being equal (which it never is), a plan of arrangement is generally a preferable route to doing a friendly deal. Keep in mind, however, that it does not preclude an auction process developing. Notwithstanding the Arrangement Agreement is binding on Teacher’s and BCE, these sorts of agreements typically contain an escape clause whereby if a better offer is made by another party, such that the Board of BCE cannot in good faith recommend the Teacher’s deal to its shareholders, BCE could terminate the Arrangement Agreement by paying the break fee. So an auction process can still develop, if it can get over the break fee.

    One other item of clarification. As a matter of statute, federal corporate laws (unlike some of the provinces) do not require shareholder or any other stakeholder approval of an arrangement, though it does require court approval. Generally, a necessary, though not sufficient, condition of court approval is the approval of those stakeholders who are directly affected, typically the equity holders and those holding securities convertible into equity. It does not include those holding debt or quasi debt, such as preferred shares, as they would not be entitled to a say if the bid proceeded by way of takeover bid.

    What makes the Teacher’s bid puzzling is why have they offered to take out the preferred shares at all, let alone at above market rates. Economics aside, it eliminates the flexibility they would otherwise have to respond to a competing bid. But I’m sure they have thought this through and have a rationale that presently escapes me.

  3. jiHymas says:

    What makes the Teacher’s bid puzzling is why have they offered to take out the preferred shares at all, let alone at above market rates. Economics aside, it eliminates the flexibility they would otherwise have to respond to a competing bid. But I’m sure they have thought this through and have a rationale that presently escapes me.

    You and me both, brother, you and me both!

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