Want to reduce debt? Try buying it back

Your company's high-yield bonds are trading at a few nickels to the dollar, debt-rating firms have just downgraded your credit again and Wall Street analysts are calling for your chief financial officer to resign because your debt-to-equity ratio is alarmingly high.

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One way to release some of the pressure is to execute a debt buyback, a balance sheet tactic that more telecom companies are using as their high-yield notes trade at extreme discounts to face value.

In a debt buyback, a company purchases back its bonds with cash, either in a tender offer or auction. Although the price is usually slightly higher than the secondary market price, companies can usually get discounts of 50% on high-yield debt. That means the company not only reduces its annual interest expenses but also retires debt at a fraction of the principal (see table).

Reaping the rewards
Company	Debt repurchased/ converted	Cost  outlay	Estimated  savings
Level 3 Communications	$1.8 billion	$814 million	$1 billion plus $165.2 million annual interest
Nextel	$857 million	$207 million*	$650 million plus $100 million annual interest
Critical Path	$187 million	$47 million	$132 million
*Based on an exchange of 21.6 million shares of stock at a recent trading price of $9.60 Source: Companies

Debt buybacks are a no-brainer if the cash is available, said Kenneth Taubes, senior vice president and head of fixed income for Pioneer Investment Management. “They can be a big gain to the company in an accounting sense, and [companies] reduce their interest expense dramatically going forward.” On the balance sheet, corporate cash is probably earning 2% to 3% and maybe less. Meanwhile, telecom coupons currently trade in the 11% range. “That's a large, negative carry on a lot of money,” Taubes said.

Debt buybacks are also becoming popular because they can be executed relatively quickly because the company doesn't need the approval of all bondholders and is subject to few regulations.

Debt buybacks are also superior to debt-to-equity exchanges, Taubes said. Such exchanges can result in massive dilution, causing equity investors to sell and drive down the company's share price. In addition, not all bondholders are anxious to own stock, Taubes said.

The steep slide in telecom shares can make equity-for-debt swaps a bargain, however. Nextel is exchanging 21.6 million shares of its common stock for $857 million in bonds. Not only will Nextel save $25 million in interest quarterly, but it will retire the debt for about 25% of its face value because of the low price of its shares. Nextel expects to record a one-time gain in the third quarter because of the large discount. The number of Nextel shares outstanding will increase less than 3%. “We were able to get a very good deal because of the way the market was trading,” a Nextel spokesman said. “We wanted to preserve liquidity.”

In early September, Level 3 Communications announced it would buy back up to $1.8 billion of its $8 billion in debt, offering cash for portions of notes maturing in 2008, 2009 and 2010. Level 3 will pay between 27¢ and 57¢ on the dollar for each tender.

Level 3's tactic is a good use of cash, assuming it has good visibility into cash flows, said Vik Grover, senior analyst for Kaufman Bros. “If they did not believe the economy was going to recover, they would keep that cash and weather the storm. They're betting that the capital markets will reopen to the bigger and better companies.”

“It doesn't have to be a bet that the economy is getting better,” Taubes said. “There has to be confidence from senior management that operations will improve and that [the company] will become cash flow-positive or break even.”

For bondholders, the decision to tender their notes can be complicated. If the notes were bought in the secondary market at “distressed” price levels and the company is buying them back at higher than market price, a bondholder would likely sell. Likewise, institutional buyers that trade in bonds in large lots may not find liquidity other than through a buyback.

But for investors that have held the bonds since issuance, it's a tough call, Taubes said. By repurchasing bonds, a company is in effect saying its business prospects are bright enough that it can spend surplus cash. “But are they right?” he said. “The company could be wrong.”

Taubes doubts that all the bonds will get tendered, but with a possible “flight to quality” in the bond markets in the wake of the recent terrorist attacks, more investors may be looking to exit high-risk investments. “The high-yield market has been quoted lower since the tragedy — those prices may look more attractive,” Taubes said.

The big drawback to debt buybacks, of course, is that a company sacrifices liquidity to reduce its leverage, and some companies may be better off holding onto cash or using it in other ways.

For example, according to SEC filings, XO Communications purchased an undisclosed amount of unsecured debt in the third quarter. The move drew criticism from Glenn Waldorf, an analyst at UBS Warburg who covers emerging carriers.

“Given that XO's high-yield bonds trade in the mid-30s, the company could realistically spend nearly $800 million to reduce the face value of its debt by $2.2 billion. If we assume an average interest rate of 10%, this would immediately reduce its annual interest payments by approximately $220 million. But is it worth spending $4 of capital today to save $1 of interest payments tomorrow?”

‘The balance sheet isn't the big issue — it's the economics. The company has to generate cash flow — that's the bottom line.’ — Kenneth Taubes, Pioneer Investment Management

According to XO, it purchased between $500 million and $1 billion of debt back in the third quarter. “We saw a price opportunity to improve the balance sheet,” a spokesman said. “We're managing this like a company that is going to be around in 10 years. It's ironic because one of the first complaints UBS Warburg has about [service providers] is that they're carrying too much debt.”

According to Waldorf, it is more important for XO to conserve cash or use it to fund core operations. “A healthier balance sheet does not guarantee that the capital markets will reopen for the company if and when its funding runs dry,” he said. At the end of the second quarter, XO's balance sheet showed $1.4 billion in cash and $5.3 billion of total debt. Although XO closed a $250 million investment from Forstmann Little in June, it is funded only to the middle of 2003 and has a funding shortfall of about $750 million, Waldorf said.

Offloading debt is an excellent idea, particularly for an overleveraged company whose bonds are trading at substantial discount to par value, Waldorf said, but CLECs do not have an unlimited amount of cash. “Most CLECs are either fully funded with a narrow cushion or not fully funded at all,” Waldorf said.

Not all companies have a choice in repurchasing debt, however. For example, Critical Path, an Internet messaging infrastructure vendor, was forced to repurchase about $187 million of subordinated notes recently to comply with Nasdaq requirements, a Critical Path spokesman said.

Indeed, for the majority of companies, the balance sheet is the least of their problems. “The balance sheet issue isn't the big issue — it's the economics,” Taubes said. “The company has to generate cash flow — that's the bottom line.”

VC watch
Acquirer	Acquired	Value	Closing date	Description
Cogent Communications	Assets of NetRail	$11.7 million	Sept 13	Metro ISP acquires assets of bankrupt IP backbone provider
Crisp Partners	LogicChain	Undisclosed	Sept. 6	Merger creates Java-based mobile content provider
Indiginet	SBSI/Cyberspeedway	Undisclosed	End of October	Business ICP acquires Arizona-based business ISP
AxTechnology	Infinite Technology	Undisclosed	Sept. 4	IP Network management buys software and systems engineering firm
AM Communications	SRS Communications/ EDJ Communications	$6.9 million	Early October	Broadband and HFC network-monitoring firm acquires two providers of CATV and last-mile fulfillment services
ActivCard	Authentic8 International	$15 million	Mid-September	Smart Card developer buys managed digital identity authentication provider
Compiled by Toby Weber return to top