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A scant two months ago, the junk-bond market was pretty much left for dead -- the victim of deteriorating credit quality. Nobody could bring a new issue to market. What's more, the public equity markets were squeezing stocks, and the spreads junk-bond issuers had to pay over Treasuries were prohibitive. No sector was hit harder than telecommunications -- where a host of fledgling companies had been using the junk-bond market almost like venture capital.
But in January, Federal Reserve Board Chairman Alan Greenspan jolted the junk-bond industry by lowering interest rates a full percentage point in two half-point doses. Junk bonds were revived! Issuers who could not have afforded the soaring rates of the previous two months flooded into the market. Time to celebrate? Not really.
While junk bonds in general have resurged, it may be a little early to pronounce this patient alive and well. Defenders of the hot young telecoms called "competitive local exchange carriers" (CLECs) say the infusion of liquidity into the market since January will help carry most through to positive cash flow. But the bears claim the problem that plagued the sector is just as evident today as it was three months ago: more debt than the issuers' negative cash flows can handle. As for the new debt issues, skeptics see them as no better than the grandiose equivalent of taking out a new credit card to pay off the five you've already maxed out.
PROFITS ON HOLD. Investors should think hard before buying telecom junk bonds, even among the darlings of the sector -- CLECs like XO Communications (XOXO
). These companies may have good telecom assets, but they're still struggling to make positive cash flow -- and it will be years, not months, before they attain it. Investors should be aware that given these companies' current debt loads, lower interest rates will not make a huge difference in their ability to service their debt. So investing in these bonds should be looked at more like investing in equity, and highly speculative equity at that.
"The telecom end of the junk-bond market moves like venture capital," agrees Aryeh Bourkoff, executive director of high-yield media and telecommunications research at UBS Warburg. Like companies that raise venture capital, access to ongoing funding can be the key to survival for junk-bond issuers.
The market has stratified into three layers, according to David Solomon, a managing director and global head of leveraged financing at Goldman Sachs. The junk A-list (not to be confused with debt issuers with an A-rating from Standard & Poor's or Moody's) is high-yield issuers everybody knew would be around for the long haul, like Time Warner Telecom (TWTC
), Level 3 (LVLT
), and Global Crossing (GX
).
"NOT REBOUNDING." Then there's the B-list, which includes names like XO Communications. "These were real companies, but funding could affect their survival," says Solomon. "A lot of the B-list stabilized at the beginning of this year when the markets opened up again."
The C-list comprises small companies that better be thinking about selling their assets to bigger fish, analysts say. These included companies like GST, which Time Warner bought for 50 cents or 60 cents per dollar of debt. In Solomon's opinion, more of these companies are still in danger. "Bonds of companies like Teligent (TGNT
) are not rebounding," agrees UBS Warburg's Bourkoff.
But among the B-list names, Bourkoff believes, like Solomon, that a lot of the problems have been solved. "The issuers have filled their coffers in case they have a dry period, and they don't necessarily need to raise more capital," he points out. Fears about access to necessary capital caused even the higher-quality credits to be "unduly punished" at the end of last year, according to Bourkoff.
Perhaps. But take a look at XO. The company provides bundled local and long-distance service as well as dedicated voice telephony to small and midsize businesses. "They have $2.7 billion in cash on hand plus some available under their bank loan, which we estimate is funding enough to support their business plan through the first quarter of 2002," says Rosemarie Kalinowski, analyst at Standard & Poor's (a subsidiary of The McGraw-Hill Companies, as is BusinessWeek Online).
MORE DOUGH NEEDED. XO has strong management, with a proven history of running capital-intensive businesses that require enormous amounts of cash up front, Kalinowski points out. Noelle Beams, treasurer of XO, adds that most of the company's debt isn't due for 10 years and that it will have positive operating cash flow in the second quarter of 2002, and positive free cash flow -- cash flow including capital expenditures -- by the end of 2004. That leaves XO plenty of time to amass cash to pay off its debt when it comes due, Beams says.
But XO had $4.4 billion of debt at the end of September, 2000. And even company spokesman Todd Wolfenbarger says XO "will definitely have to go after more capital" before it reaches positive cash flow. That money is needed to fund an ambitious buildout of its network that will add roughly $2 billion of additional spending in 2001 alone -- when the company's guidance says it will post an operating loss of between $210 million and $240 million.
With the current economic slowdown putting a damper on small businesses, XO's success hangs in the balance. That $2.7 billion cash in hand may sound like plenty of cushion, but XO hasn't finished its capital expansion yet, according to a fixed-income research report on the telecommunications industry published by Lehman Brothers in December.
DAUNTING CHALLENGE. The company's debt and preferred stock of $6.4 billion is more than three times the net plant -- assets the company could sell to pay its debt -- that it shows on its balance sheet. It lost $88.9 million in third-quarter 2000 and $88.7 million in the fourth quarter. "XO is likely to feel the financial burden of a highly leveraged balance sheet in the near term, which may inhibit operational flexibility," writes Ravi Suria, the Lehman analyst bond investors generally give credit for being the first to raise the red flag above the telecoms sector last fall.
Even UBS Warburg's Bourkoff, who has a buy rating on XO's bonds, acknowledges in the report he published on Feb. 8: "After an expected slow start in the first half of 2001, the company will be challenged in ramping up its growth rates in order to achieve the lower end of its targets."
As attractive as the 12.25%-plus yields on its 10.75% senior notes due 2008 and trading in the low 90s may appear right now, the company has a huge debt burden to bear even as it faces a worsening economic environment. Hardly an invitation for investors to rush in.
Popper covers the markets for BW Online in our daily Street Wise column Edited by Douglas Harbrecht
Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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