I'll Take the Bengals and the Under on Cincy Bell

So here is the question – what organization in Cincinnati has the bleakest future. Well, let’s consider that for a moment. What about the Bengals? The situation with the Cats isn’t too bad since quarterback Carson Palmer has tons of upside, there is a great receiving corps and Coach Marvin Lewis seems to have his guys headed in the right direction. With that said, I wouldn’t pick the Bengals - but what about the Reds? That situation isn’t too rosy as the Reds are teetering on the edge of the Abyss and there is little hope with that pitching staff and the team’s restricted payroll. So the Reds are definitely a candidate. But if I had to choose the absolutely bleakest situation in town, I would have to say the honor goes to Cincinnati Bell, the city’s local telephone provider.

Here is the Thumbnail on Cincy Bell, listed on the NYSE under CBB. It is a highly levered telco whose business is slowly evaporating as technological changes overwhelm the traditional phone business. CBB’s big problem is its bread and butter is providing basic telephony services to people in Cincy, and that business is under attack from Time Warner - the incumbent cable provider. CBB also provides telecom services to businesses in Cincy and there is a small wireless business that they share with Cingular. In a nutshell, that is the business. When it is all said and done, the company will generate about $1.15 Billion in revenue this year and about $475 million in EBITDA.

So what is the problem? Well, the problem begins with the fact that revenue will be down about five percent this year. That wouldn’t be too problematic if it weren’t for the fact that the company has roughly $2.1 Billion of debt on its balance sheet. With debt four times greater then EBITDA and revenue declining, CBB could face a real liquidity crunch down the road. Now the company will tell you that it will generate $150 million of free cash flow this year, which can be used to pay down debt, but with the business in decline, how long will this pig keep spitting off this kind of cash?

The real key here is how long can that local telephone business stay vibrant? If you listen to Time Warner, the answer is “not too much longer.” Time Warner is expanding their telephony business at a rapid pace since it sees this business as a significant business opportunity. As such, they are spending considerable marketing resources on telephony and nationally, they are adding more then 10,000 customers per week. Such success is having a toll on CBB which has seen its numbers of residential lines fall from 611,000 to 584,000 over the past year. Now that isn’t a disaster, but what happens if the pace of loss accelerates as Time Warrner is predicting? What happens if Time Warner achieves just ten percent penetration over the next year? That equates to a loss of roughly 50,000 lines and $30 million in annual revenue. And what happens down the road when Time Warner really gets its hands on that business? It is not inconceivable that CBB’s line count will be slashed by a quarter, if not more, over the next few years.

This all adds up to big trouble for CBB since it is dogged by that huge balance sheet which requires the company to cough up $200 million in annual interest payments (this amount may be shaved as one particularly onerous loan is refinanced). On top of this, CBB is required to spend about $130-140 million a year to keep its networks running and there is not much more that can be cut from this figure. Thus, CBB has about $330 million in fixed costs that will continue to eat away at the company’s cash flow. Currently, CBB’s cash flow can easily accommodate these payments, but with the business in decline, can this continue forever? I believe the answer is no.

CBB is basically in a race to beat the clock. The bet is it can use its free cash flow to get its balance sheet under control faster then its business declines. This is a race that CBB cannot hope to win. It is delevering at a pace of $100-150 million a year, but at this rate, it would need at least a half dozen years to get its house in order. This is entirely too long for a business that is currently under fire and may be ready to break. It won’t be this year or next, but the time is coming when CBB’s cash flow will not be able to cover its fixed obligations and that means one thing – restructuring.

If the business outlook weren’t bleak enough, there is also a valuation component to this story that befuddles me. Currently, CBB has an enterprise value that approaches $3B. That is made up of about $2B of debt and $1B of equity. At this sum, CBB is trading for a bit more then six times its EBITDA. This is peculiar since CBB has only a very small wireless business and the market basically affords much lower multiples to the wireline businesses of the nation's regional bell operating companies. While it is hard to perfectly ascribe a market value to those businesses, it seems to this scribe that based on some recent acquisitions in telecom, basic non-rural telephony services are trading for about 3x EBITDA. If you throw that multiple on CBB, you get no equity value whatsoever. And, CBB is probably deserving of even a lower multiple since it doesn’t pay the fat dividends that its big brothers cough up every quarter. Another interesting facet to note is that CBB’s PP&E is only valued at $800 million while its debt is more then $2B. In other words, if the network were sold off at depreciated cost, it would fetch only 40 percent of the debt on the balance sheet. As a point of reference, Verizon’s depreciated plant is still twice that of its debt.

It all boils down a very ugly story in Cincinnati. The Reds may be bad right now, but you can count on them being around in a few years. The same cannot be said for CBB. They aren’t going anywhere this year, or even the year after. But come 2007, the bet here is the CBB situation will turn dire and calls for Cincy will be placed to the region’s top bankruptcy attorneys. It will take the stock a while to anticipate this eventuality since most still consider it an option on a turnaround at this point, but rest assured, no turnaround is coming. This story will end and it will end poorly for the city’s bleakest franchise.

Duke Swallows up Cinergy

So we had a little merger in the wonderful world of electricity today as Duke Energy moved north of the Mason-Dixon line to snag Ohio-based Cinergy for a mere nine billion dollars. The deal really makes perfect sense for Duke which was sitting on a bloated currency that was just screaming to be used for an acquisition. After all, if you have a currency that is trading at almost 19x earnings, it is a no brainer to buy similar assets that are trading at only 15x 2005 estimates. And lets be frank here – there are no huge differences in the underlying assets of these two companies. Sure Cinergy has some environmental costs coming down the pike (more coal fired plants then Duke) and they operate in a state (Ohio) with a less favorable regulatory and economic environment then North Carolina, but at the end of the day, we are talking about two basic power producers. Now the one aspect of the deal that is appealing is Duke has a bunch of natural gas units in the Midwest that are currently underutilized because their fuel costs are too high to be competitive. It is possible that some of this excess capacity could be soaked up and perhaps used to offset some of the capacity constraints that Cinergy will soon face under both existing and new pollution control requirements. I am not sure Ohio regulators will bless this plan, but it is possible that the Newco will be able to fold those gas plants into the company’s rate base and have Ohio consumers pick up the tab for higher electricity costs. We’ll have to see if that flies. Regardless, of whether it does or not, you can’t fault Duke for pursuing this move. They had a valuable currency and they used it as a weapon to secure valuable assets. However, as with all utility merges, this one may have trouble getting approved. I am sure Duke is touting it as a done deal, but FPL-ETR fell apart and EXC-PEG doesn’t exactly look clean at this point. As such, I don’t think you can take this one to the bank.

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.