From barrons (the reference to fun made me think of posting here):
Double or Nothing
By ANDREW BARY
BLACKSTONE GROUP, APOLLO MANAGEMENT and the rest of the private-equity crowd may be sidelined by the mess in the credit markets, but investors still can play at their game by purchasing shares of debt-laden companies in the public markets.
Buying shares in financially leveraged companies isn't the standard investment advice that's being tossed out these days -- and for good reason. Given the tough economic and financial environment, investors generally are being told to stick with blue-chip stocks. Why mess with dicey investments when quality companies ranging from General Electric to Merck, Cisco Systems and Procter & Gamble carry reasonable valuations?
It's hard to argue with a prudent approach, but some investors see opportunity in debt-heavy companies whose shares have been pummeled in recent months. This depressed group includes stocks like Bon-Ton Stores (ticker: BONT), Idearc (IAR), Libbey (LBY), McClatchy (MNI), Carmike Cinemas (CKEC), FelCor Lodging Trust (FCH) and Gray Television (GTN).
Bon-Ton: A badly fitting purchase raises doubts, but cash flow is good.
If the economy stabilizes and the credit markets start returning to normal by midyear, these stocks could shine because of the very financial leverage that has hurt them lately. Given the modest market capitalizations of these "levered" equities, it doesn't take much change in sentiment or valuations to produce a big move in their prices. The success of the private-equity business has been based on this premise. A little bit of equity and a lot of debt can produce huge returns in a favorable market. It's like buying a house with a down payment of 5% or less. Expect volatility with these stocks.
Given the risks, levered equities aren't for the timid and diversification probably is a good idea. The ultimate danger is bankruptcy, which typically is death for common shareholders. The bankruptcies in the airline and auto-parts industries are testament to the risks in leveraged companies.
"The best time to buy these is when credit spreads peak," says Carney Hawks, a partner at Brigade Capital Management, a New York fixed-income firm that also invests in levered equities. "A basket of levered equities will dramatically outperform the market once spreads peak. Since you don't know when that will happen, you may want to start buying them now. Many stocks are pricing in very negative outlooks."
Yields on junk bonds have risen sharply since last summer with the average issue now carrying a 10% yield, versus 7% a year ago. The spread of junk debt above risk-free Treasuries has widened to about seven percentage points from three points. When looking at levered equities, it helps to understand something about credit. That's why this game is easier played by professionals than retail investors. If a company has debt yielding 15% or more, it pays to be careful about the equity because bond investors are signaling concern.
Hawks is partial to FelCor, a hotel owner, and Libbey, a maker of glass tableware, which he says are well run with manageable debt loads. Carmike Cinemas, a movie-theater operator, and Bon-Ton Stores, a regional department-store chain, are riskier given their high debt and tough industry trends.
McClatchey: An ill-advised acquisition has made it a cheap play on an economic and advertising recovery.
WHAT ARE LEVERED EQUITIES? There is no established definition, but we'll call them shares of companies whose debt exceeds their equity market values. Most public companies don't intentionally create debt-heavy balance sheets. Debt usually gets large relative to equity market value because of a declining stock price. Many levered equities are in out-of-favor industries.
This highlights a difference between public levered equities and leveraged buyouts. Private-equity shops usually operate by putting lots of debt on solid companies in what they believe are stable industries like casinos and media, while levered equities often are fallen angels.
One plus with levered equities is that investors can potentially earn similar returns to those of LBO specialists and avoid paying the steep fees levied by private equity on their funds. With limited ability to finance LBOs, private-equity shops may consider putting money into levered equities because they amount to public LBOs. The valuations on FelCor, McClatchy and Gray Television are below what private-equity firms paid for similar companies last year. Skeptics may say this simply reflects the outrageous prices paid by private equity in 2007.
We're not going to ignore the risks. If the newspaper industry continues its decline, the shares of McClatchy could go toward zero from the current 10, which is down from 50 when McClatchy took on $3 billion of debt for its ill-fated purchase of Knight Ridder in 2006. One leveraged newspaper operator, Journal Register (JRC), has already seen its shares drop to $1 from $7 a year ago. AbitibiBowater (ABH), a leveraged newsprint producer favorably profiled1 by Barron's last year, has been a disaster, with its shares down 70% since then.
When investors sour on an industry, levered equities get punished. Look at Charter Communications (CHTR), whose shares are down 80% to $1 from their June 2007 high of $4.80 as Wall Street cooled on cable TV. Charter has fallen much more than Comcast (CMCSA), whose stock is down 30% to 20. Why? Charter has a sliver of equity that's now worth under $1 billion and debt of $20 billion, while Comcast has an equity market value of $62 billion and debt of $30 billion. Small changes in cable TV valuations have a big impact on Charter's share price.
Gray Television: This year's surge in political advertising on TV will help pay down its debt.
Not all levered equities look attractive. Charter still appears richly priced based on its high debt and onerous interest expense. Revlon (REV) and Six Flags (SIX), the amusement-park operator, also seem pricey.
An alternative -- and lower-risk -- way to play levered equities is to buy corporate bonds issued by these companies. They often yield 10% or more. Yellow-pages publisher Idearc has bonds now yielding more than 15% while McClatchy debt yields 11%. Reflecting its precarious situation, Bon-Ton has bonds yielding 20%.
There aren't many mutual funds that specialize in debt-heavy companies. One of the few is the Fidelity Leveraged Company Stock2 fund (FLVCX) that has handily beaten the S&P 500 over the past one, three and five years. Its success shows the benefits of levered equities. It was up 17.9% last year, ahead of the 5.5% gain in the S&P 500 index. Some of its strong performance reflects a heavy weighting in energy and commodity stocks like Freeport McMoRan Copper & Gold (FCX), Forest Oil (FST) and Celanese (CE). Freeport took on debt in its 2007 purchase of Phelps Dodge, but it's not heavily indebted any more. It has a market value of $39 billion and debt of $7 billion.
Table: Taking a Calculated Risk3We've shown a sampling of levered equities but there are many more out there. Those with market values of more than $5 billion are scarce. Some larger outfits include Hertz Global Holdings (HTZ), Virgin Media (VMED), Rite Aid (RAD), Dean Foods (DF) and Level 3 Communications (LVLT). Virtually every major airline besides Southwest Airlines amounts to a levered equity, thanks to high and widespread levels of debt and airplane leases in the industry. The same is true for most public operators of radio and TV stations, including Emmis Communications (EMMS), Entercom Communications (ETM) in radio, and Gray Television and Lin TV (TVL). General Motors (GM) and Ford Motor (F) probably are the most prominent levered equities because their market values are dwarfed by their debt and health-care obligations.
If the $26 billion buyout of Clear Channel Communication (CCU) is completed, investors will have an opportunity to invest alongside the private-equity buyers Bain Capital and Thomas H. Lee Partners. Some 30 million Clear Channel shares will remain outstanding, representing a super-levered bet on the radio and billboard company.
When evaluating levered equities, investors use a vocabulary that goes beyond price/earnings ratios and market capitalizations. Among terms thrown around are "option" values, enterprise value and a cash-flow measure known as Ebitda, or earnings before interest, taxes, depreciation and amortization. Option value doesn't refer to a standard call or put option, but to the idea that even troubled companies can retain equity value because of the chance they will survive. Investors often will say a depressed stock represents an "option" on the company. The better a company's balance sheet and the longer a firm's staying power, the more valuable its equity becomes.
Enterprise value refers to the combined value of a company's equity and net debt. With the ability to shoulder interest payments critical for a leveraged company, investors often focus on pretax earnings, and one key measure of that is Ebitda.
Here's a closer look at some potential winners and losers among levered equities. We've also included a safer choice in the same industry when there is one:
Winners
FelCor: Its portfolio of mostly upscale hotels includes Embassy Suites and Doubletree properties. The stock, now below 13, is down from a July peak of 29 and carries a dividend yield of 11%. Despite the company's good financial results, FelCor stock is depressed because of concerns about the impact of a weaker economy on the lodging business. FelCor, however, should benefit this year from extensive renovations of its hotels in 2007. An optimistic management increased the company's dividend by 16% in December. FelCor is valued at a modest five times estimated 2008 funds from operations, a cash-flow measure used to value real-estate investment trusts. FelCor's enterprise value is equal to nine times projected 2008 cash flow of $300 million. That's a big discount to the price paid by Blackstone Group for Hilton Hotels last year. One reason that Hawks of Brigade Capital is bullish on FelCor is that growth in the supply of hotels is very limited. "FelCor's dividend is being paid out of free cash flow. Where else can you find a sustainable 11% dividend yield." Safer choice: Starwood Hotels & Resorts Worldwide (HOT).
FelCor: An attractive dividend yield and renovated hotels enhance its value.
Bon-Ton: With Bon-Ton's share price down to under $6 from $57 last spring, Wall Street is worried whether the York, Pa., retail chain will make it. Bon-Ton now has a market value of just $100 million, versus estimated debt of $1.2 billion at the end of January -- fourth-quarter financial results haven't been released yet. Bon-Ton bet the company on a $1 billion debt-financed purchase in 2006 of Carson Pirie Scott and other chains from Saks, and that deal looks like a loser. The bad news is that Bon-Ton's same-store sales have been weak, including an 11% drop in December. Bon-Ton earned nearly $3 a share in 2006, but it may have operated close to breakeven last year. The good news is that cash flow is comfortably above interest payments and Bon-Ton isn't burning cash. Assuming vendors continue to allow Bon-Ton to finance its inventories, there appear to be no near-term risks to its survival. Given a sizable base of short sellers, Bon-Ton stock could rally on any hint of good news. Safer choice: J.C. Penney.
Libbey: As the leading manufacturer of glass tableware in the Western Hemisphere, Libbey has exposure to the faltering U.S. restaurant industry, which has depressed its shares. The stock, around 16, trades for about 27 times projected 2008 profits, a rich-looking valuation. The high P/E, however, reflects a steep 13% interest rate on its debt that eats into earnings. Once the credit markets thaw, Libbey may be able to refinance debt, cutting interest expense by perhaps three percentage points and boosting earnings. Libbey is valued at a modest six times estimated 2008 pretax cash flow and has few direct competitors. Profits this year are expected to rise despite the economic slowdown. "There's a cost-reduction and interest-reduction story, as well as a significant moat around Libbey's business," says Hawks. If Libbey can hit its 2008 financial projections, the stock could be up 50%. Safer Choice: None.
Idearc: Any stock trading with a P/E ratio of two and a dividend yield of 25% is worth a closer look. Verizon Communications spun off its yellow-pages business as Idearc to its shareholders in 2006 rather than sell to private-equity buyers. Because it viewed the yellow pages as a stable business, Verizon put $9 billion of debt on Idearc, effectively creating a public LBO. That debt is proving a millstone amid a sudden weakening in phone-directory industry trends. The company's CEO resigned for health reasons last week, just a week into the job. Idearc's shares, which hit $38 last spring, now fetch under $5, valuing the company at less than $1 billion. At issue is whether recent troubles merely reflect a weak economy or a permanent shift by advertisers away from print directories. Despite its heavy debt, Idearc isn't going away anytime soon. This year's cash flow is expected to cover interest payments by a factor of two to one. Even with revenue declines in 2008, Idearc should have ample earnings to pay the annual $1.37 dividend. If revenue declines persist, Idearc could cut the dividend in order to focus on debt repayment. With its stock down 75% this year, Idearc could surge on any signs its business is stabilizing. No Safer Choice: Rival R.H. Donnelley (RHD) also has a lot of debt and similar business problems.
Carmike: More popcorn sales and a few more Hollywood blockbusters in 2008 would brighten its books -- and lighten its debt.
McClatchy: The California newspaper publisher's 2006 purchase of Knight Ridder -- largely financed with debt -- has been a killer because it came just before industry advertising trends took a sharp turn for the worse. Compounding the problem is McClatchy's exposure to tough California and Florida markets. Wall Street has punished McClatchy, whose shares are down to 10 from 50 when the Knight Ridder deal was announced. Investor Thomas Russo, a partner at Gardner, Russo & Gardner, a Pennsylvania money manager, has been on board McClatchy all the way down and isn't giving up. He calls McClatchy "a cheap option on an economic and advertising recovery, its Yahoo! alliance and its Internet assets." McClatchy now is valued at just eight times projected 2008 earnings per share. Equity market value is just $800 million, versus debt of $2.4 billion. The dividend yield is 7%. Management is focused on debt repayment, but Russo argues that with the stock so depressed, the company should consider a buyback. McClatchy is valued at less than six times estimated 2008 cash flow, versus more than 10 times cash flow for the private Tribune. Safer Choice: Gannett (GCI).
Gray Television: The well-run TV operator owns a slew of top-rated CBS and NBC stations in small to mid-sized markets around the country. It focuses on state capitals and college towns, including Lexington, Ky.; Madison, Wis.; and Tallahassee, Fla. Gray shares ran up as high as 11 last year on LBO hopes, but they've fallen back to 6 as private equity has faded. Gray is highly leveraged with a market cap of $300 million, against debt of $900 million. "Our stock is extremely undervalued," says Gray President Bob Prather, who lately bought 11,500 shares in the open market. "Wall Street is down on Old Media and we've been dragged down by newspapers and radio. TV has some issues, but they're nothing like those industries." Thanks to political ads, Gray should enjoy a strong 2008 and it plans to use that windfall to pay down debt. If TV can hold its own in the face of the Internet advertising threat, Gray should do well. Safer Choice: Hearst-Argyle Television (HTV).
Carmike: Movie-theater operators have had to contend with fickle audiences, and Carmike, the country's No. 3 exhibitor, has done worse than its peers. Attendance per screen was down 0.7% in the third quarter while the industry showed an 8% gain, as Carmike's small-town audiences didn't cotton to what Hollywood churned out. With its shares down to 7 from 27, Carmike has seen its equity value shrink to $100 million. There's over $400 million of debt. Unless Americans stop going to the movies, Carmike looks like a survivor, and its stock offers a good bet on rising attendance or higher theater valuations. The company may seek to cut debt by selling $175 million of real estate. The theater business is still pretty good, especially pop corn and other concessions, which produce 90% margins. If Hollywood has a good 2008, Carmike shares could double. Safer Choice: Regal Entertainment (RGC).
Losers
Charter Communications: When looking at levered equities, it's important to compare them with financially stronger peers. If cash-flow valuations are out of whack, it probably pays to avoid the levered equity. Charter, the country's No. 3 cable operator, looks unappealing relative to rival cable companies. Its shares may seem tempting at just $1, but Charter is valued at nearly 10 times projected 2008 pre-tax cash flow, versus six to seven for Comcast and Time Warner Cable (TWC), which have far stronger balance sheets. Charter has $20 billion of debt. Lehman Brothers analyst James Ratcliffe, who carries an Underweight rating on the stock, last week cut his price target to $1 from $2, saying the stock is "still too expensive." Charter continues to bleed cash after capital expenditures and some of its debt yields more than 20%. Safer Choice: Cablevision Systems (CVC).
Libbey: Pricey debt should get refinanced as markets improve.
Revlon: The cosmetics company remains Ron Perelman's baby. The billionaire, who owns more than half the stock, continues to prop up Revlon, recently agreeing to refinance $167 million of maturing bonds. Revlon shares, at around $1, appear to be no bargain. Financial results did improve in 2007, but the company is still losing market share to financially stronger rivals L'Oreal and Procter & Gamble, maker of Cover Girl. Interest costs, capital expenditures and outlays for displays in drugstores and other retailers continue to chew up the bulk of Revlon's cash flow, making it tough for it to reduce debt. The company has lost money for 10 straight years. Valued at about nine times annual cash flow, the stock doesn't look cheap. Safer Choice: L'Oreal (OR.France).
Six Flags: The amusement-park operator is in an even bigger bind than Revlon after a tough 2007, when attendance was weak and estimated pretax cash flow of $190 million wasn't enough to cover its interest costs of $200 million. That's a bad situation for equity holders, considering the company spends $100 million annually on capital expenditures to maintain existing rides and build new ones to keep patrons coming back. New roller coasters are expensive. Six Flags also is hostage to the weather during the critical summer season. Even assuming a better 2008, the company probably will still burn cash, while debt and preferred stock is equal to a stiff 10 times annual cash flow. Six Flags stock, now trading around 2, looks like an out-of-the-money option on the company's revival. Reflecting the risks, Six Flags debt yields over 20%. Safer Choice: Cedar Fair (FUN).
Levered equities aren't for everyone. But investors who choose carefully and do their credit homework could earn high returns if the economy and markets revive later this year.
