Qwest Reaches its Breaking Point

Well, it looks as if Qwest has finally reached its breaking point and I say this becasue of the following. Certain big shareholders of MCI are now ready to loan Qwest some money so the company can increase its bid for MCI. As far as I can tell, Qwest can only afford to pay $27-28 for MCI, but investors like Omega’s Lee Cooperman are now ready to fork over hundreds of millions so Qwest can take out MCI at $30. In effect, Cooperman and his buddies seem willing to pour some of their MCI profits back into Qwest on terms that I suspect are probably pretty favorable. Who can blame them? Many own MCI from the mid-teens, so pouring some of those profits back into the company is probably digestable, especially if it means the bulk of their shares get taken out at a higher price then Verizon is willing to offer. This has become a very odd situation that doesn’t exactly comport with what I learned in risk arb 101. In a perfect risk arb world, these investors would be shorting Qwest and not moving in to be the company’s lender of last resort. But this is not a perfect world and this is certainly not your mother’s typical bidding war. This one has been usual from the start and it just keeps getting creepier.

I am now curious what the folks at Verizon think of all this. If I had to guess, I would say Verizon CEO Ivan Seidenberg is probably tiring of all this chirping he is hearing from his much smaller brother out in Denver. But at least at this point, he knows Qwest has hit its breaking point. Clearly, if Qwest is borrowing from Peter to pay Paul, they have no more ability to sweeten their offer. So this is what I do if I am Ivan. I take my bid to $26-27 (they paid 25.72 for a big block the other day) and give MCI one business day to either crap or get off the pot. So long as he can put an offer together that is within 10 percent of Qwest, I think he stands a good shot of getting MCI. If that happens, Qwest is a goner. First stop is $2.50 and the train won’t stop until it breaks two bucks. But what if VZ fails? Qwest should pop, but how much? I am sure the hedgies will step in to pound a rally, but where will this fight be waged. Four bucks seems like a good place to hold the fight.

Will Adelphia Purchase Spark CVC To Sell The Knicks?

If I were a New York Knicks fan, which I’m not, I would be paying close attention to what is going on with Cablevision’s bid to acquire Adelphia and its five million cable customers. I say this because if Cablevision is successful, it just may spark the company to sell the Knicks and Madison Square Garden, thus freeing thousands of Knicks fans who have long felt Cablevision's James Dolan is an idiot who cannot competently run the franchise. Well, it is being reported in today’s WSJ that Cablevision has upped its offer for Adelphia from $16.5 Billion to $17.1 Billion. A healthy slug of this offer would be conveyed in cash, meaning Cablevision would have to issue a lot of debt to finance the deal.

So that brings me to the Knicks. If Cablevision were to acquire Adelphia, the company would lose some of its New York-centric focus since Adelphia’s systems are spread out throughout the country. As such, there would not be as much need to own New York properties such as MSG. Further, the Knicks and MSG could probably fetch a big number on the open market and such a windfall could help Cablevision finance its Adelphia acquisition. I say probably because it is not the best time to be selling MSG with the Rangers stuck in a lockout and the Knicks being jailed in salary cap hell. It is clear to me that post acquisition, MSG has much less strategic value for Cablevision and it begs the question of why the company would want to keep the team. The only answer I can provide is Jimmy Dolan is an egomaniac who has an unquenchable thirst for the spotlight. Without the Knicks and MSG, he is just a typical corporate executive and I am not sure that excites him much. So Jimmy’s ego remains the greatest impediment standing in the way of a sale, but the times are a changing and the financial implications of a deal for Adelphia could upend the landscape. So for all you Knicks fans that been in exile under the Dolan regime, this may be your shot at a pardon. The odds may not be great, but at least there is now a reason to pick up the WSJ once in a while.

April 18 - Is TXU Risking a Backlash?

Over the past year and half, Texas Utilities (TXU) has seen its stock fly off the map as new management, a massive restructuring, a surge in earnings and some healthy financial engineering have sparked a quadrupling of the company’s stock price. All is well in Dallas, where TXU officials and patient investors have been enriched beyond their wildest expectations. This company has been the poster child of a group that has had some run. But while the TXU story still seems pretty attractive, it seems to me like there is an issue on the horizon that bears watching.

I say this because last Friday, TXU filed a request with the Texas Public Utilities Commission to significantly boost its electricity rates on account of high natural gas prices. This is permitted under the state’s retail competition law, which, if memory serves, works as follows. Under deregulation, utilities must sell power at a regulated rate until 2007 or until 40 percent of its customers change to different suppliers. The initial rates, set in 2001, carved about ten percent off the top of those rates that existed prior to deregulation. Subsequent to that action, TXU was able to pass through two price increases in 2002 when the price of Natural Gas rose and hence their fuel costs rose. These rates increase, for all intents and purposes, wiped out most of the price cuts that came from deregulation.

Well, TXU is now back in Austin asking for a ten percent rate hike, and Wall Street loves the move, arguing that it will be a significant earnings driver for the company. As such, some think this company can do about $6.50 in earnings this year and perhaps $8 next year. That 2006 number is probably triple where it was eighteen months ago. With the stock trading at 84, TXU is a relative bargain if these estimates come to fruition. But here is the catch. How long can the company keep getting away with these rate increases? How long will the PUC stand idly by and let TXU sock it to the ratepayers of Texas. After all, the stock has quadrupled and don’t think for a second this fact is lost on regulators. They know how rich people have gotten off this story and at some point it seems likely that they will force shareholders to absorb some of the pain that TXU wants to inflict on its customers. And if the law and the courts deny the PUC any discretion on this front, then how long will it take for some populists in the state legislature to take a look at this issue and the state of deregulation?

My point here is TXU is taking a risk that it will incur some sort of regulatory or legislative backlash. I know they operate in Texas where making money off energy is a way of life, but this is power and not gas. The last time I checked, Texas was still part of the Confederacy and, as such, economic populism still carries the day in the area of regulatory rates. I am not going to sit here and say TXU doesn’t have every right to push for these increases, but buyer be warned, regulators and lawmakers have no obligation to oblige. At some point, critics of TXU may say enough is enough and ratepayers are not going to incur additional costs for the benefit of TXU stockholders. It may be nice that Wall Streets analysts think this company will earn eight bucks next year, but what if the Texas legislature thinks five is enough in 2006 or 2007 or 2008? That would probably be unlikely in a low rate environment, but with rates surging, who is to say that regulatory changes are not coming? With that in mind, keep an eye on TXU’s dividend, because if it doesn’t start rising to keep pace with all these EPS surges, it says the company may not feel too comfortable that this rate climate has legs.

April 14 - Desperately Seeking MCI

Has there been a more desperate large-cap acquirer in recent M&A history then Qwest Communications? To this observer, the answer is a resounding no and that is why Qwest will do just about anything permissible to get its hands on MCI. This is no longer about friendly courtship. That game ended weeks ago. Instead,. Qwest CEO Dick Notebart has turned into a stalker who is well aware that his company's immediate future is riding on this deal. And because he is desperate, Notebart keeps sweetening his takeout offer even though the price has reached prohibitive heights.

For Qwest this deal has always been about one thing: the company needs to get its hands on MCI’s pristine balance sheet. This is because Qwest’s own balance sheet is in total disrepair, weighed down by more debt than most Central American countries. With its opening bid, Qwest could have secured MCI’s balance and used it to help solidify its own horrific credit metrics. But that was several billion dollars ago and a deal at current levels makes it much more difficult for Qwest to achieve its original purpose.

Qwest knows this but it hasn’t stopped the company from pursuing MCI with reckless abandon. Qwest executives are probably getting a bit gun shy at this point, but a quick glance at the company’s financials is all that is needed to restore their fighting spirit. I say this because those financials are about as bleak as typical day at the Battle of Verdun. Here is a company that has approximately $16 Billion in debt and other obligations supported by roughly $3 Billion in EBITDA. That is not a pretty equation and the interest coverage metric is perhaps worse since Qwest’s pre-CAP EX EBITDA is only twice its annual interest payments. This is a company that has $16 Billion of debt on the sheets, yet doesn’t generate any meaningful free cash flow. And just to make matters worse, revenue declined three percent in 2004. This patient isn’t just sick – it is terminal and for equity holders, it will be a long slow death.

It has gotten to the point where a deal for MCI at these prices is just a band-aid for Qwest. It buys the company some time, but it is not a cure all. The reason is Qwest’s balance sheet, barring an emergency appropriation from Congress, is perhaps beyond repair. A creative deal and some massive cost cutting could probably help Qwest stabilize its metrics for the moment, but MCI is not a long-term solution. This is because there is simply very little Qwest can do to deleverage this monster. The business is in decline and all valuable assets have already been sold off. In fact, if the business keeps declining, there is no telling how long this company will have sufficient liquidity to operate. That is a recipe for disaster that the acquisition of MCI cannot fix, especially at current deal prices. Qwest executives know this but are desperate to stay in the game and see another card, even though they know deep down that it will take a miracle to keep this company out of bankruptcy. Many MCI holders know full well what it feels like to restructure and that begs the question of why they would want to do it again, this time under that big Q umbrella.

April 14 - The Electric Utility 400

Is there any limit on the public’s appetite for dividend-bearing electric utility stocks? If recent history is any indication, I would have to say the answer is no. Two years ago, when President Bush first proposed altering the tax treatment of dividend income, the Philadelphia Utility Index hovered around 250. The other day it broke 400. That is quite a ride for a stodgy old group like electric utilities. The catalyst for the early part of the move was clearly the tax issue since reforms made it much more attractive to derive income from dividends than treasuries. And with treasuries spitting off historically low yields, utilities offered investors with an attractive investment alternative.

So tax reform can probably be used to explain the first leg up and perhaps even the second and third legs as well, but it strikes me as a ludicrous to suggest that reform alone catapulted this group up to this stratospheric level. In defense of the group, many utilities are much healthier than they were two years ago, having done much repair to their disgusting balance sheets. Debt has been pared, unprofitable assets have been shed and poor management teams have been evicted. These are all positives and as a result, many companies have been able to restore their earnings up to optimal levels. But at what point, is all this priced into the stocks? After all, many companies in the group are now trading at twenty times 2005 estimates, although the lion’s share trade closer to 16 times. Moreover, yields have now fallen to levels that make them no more attractive then treasuries. You can still find some utes that spin off yields greater then four percent, but most are now planted with three handles.

So basically you have well regulated companies with low growth profiles trading at sixteen times earnings and three percent yields. That is pretty damn steep when compared to historical levels even after you consider the new tax treatment of dividend income. So who keeps buying this stuff? That is a good question and my only guess is that retiring baby boomers just cannot get enough of this stuff. This group is desperately searching for income streams and with treasury yields still fairly tame, Utes still look fairly attractive. But how long can this continue? Well, if you believe the Fed will continue to move and long-term rates will continue to rise, you probably would be wise to steer clear of electrics. As those rates rise, investors searching for income will turn their attention to fixed income instruments and there is likely to be some selling pressure on over-bought utes. I am not saying this going to happen tomorrow, but the day doesn’t seem too far off. But heck, I said that four months ago and look what has happened since.

April 13 - Delayed Reaction?

Why are they killing the market this afternoon? I am not sure that is the relevant question. The more important question is why they rallied the market yesterday on what was basically bearish news from the Fed. I may not be a macro specialist, but since when is it good news for equities when members of the Federal Reserve come out and say inflationary pressures are growing ahead of previous expectations. Doesn't that suggest a score of rate hikes loom ahead? It would seem so but for some peculiar reason, this news was embraced yesterday afternoon. CNBC gets an assist on this front for completely mangling and torturing the analysis of the notes released by the Fed. Nice one guys. If I had to guess, I would say today's action merely reflects the proper digestion of yesterday's news.