Description
Short LVLT common against Level 3 6% Subordinated Convertible Notes
LVLT is the only independent bubble-era fiber optic company to avoid Chapter 11, and they'll continue to dodge bankruptcy for at least another 4-5 years. This investment idea is based more on that fact than LVLT business fundamentals. LVLT hit $132/share at the peak of the mania (for comic relief I suggest the 8/29/00 writeup at $81/share, which starts out "LVLT is not a value company in the true Buffett methodology..."). Unfortunately LVLT collapsed to $5 by July 2001 and has traded between $2-8 ever since.
LVLT has a steady 1.6-1.8b/year business selling bandwidth on their wonderful fiber optic network (it should be wonderful, they spent $15b on it!). Operating cash flow after sustaining capex is a lumpy 150-250m/year. LVLT financials are difficult to parse, filled with terms like "Consolidated Adjusted OIBDA, excluding termination and settlement revenue". Continuity is marred by a continual flood of "one-time" events. LVLT also has a $2b-ish software reselling subsidiary and, believe or not, some coal mines. Both are basically worthless but serve to further muddy the numbers. Fortunately a simple understanding that the core business and network is worth $2-3b is sufficient to execute this idea.
Capital Structure:
875 Secured debt, mortgages, cap leases
3400 Senior unsecured notes (maturing 2008-2013)
875 Subordinated 6% converts ($65-135/sh strike, 2009-10 maturity)
-----
5150 Total Debt
850 Cash & marketable securities
-----
4300 Net Debt
2350 Common Market cap
----
6650 TEV
Thus the subdebt is a little out of the money and the common is WAY out of the money. The subdebt trades just below 60 and pays 6% of par for a 10%+ current yield. I recommend shorting 100 common for every bond. I also recommend cheap out of the money calls (e.g. Jan 06 7.50 for 0.05) to protect against a return to $132/share. Here are some scenarios:
Scenario 1 - YE08 Chap11 w/zero subdebt recovery:
-585 loss on bond
+240 bond interest
+345 common short profit
-----
breakeven
Scenario 2 - Bonds mature, LVLT muddles
+415 bond profit
+300 bond interest
0 breakeven on common short
-----
+715 profit
Scenario 3 - Bonds mature, LVLT skyrockets
+415 bond profit
+300 bond interest
-405 loss on common short (limited by 7.50 call)
-----
+310 profit
These numbers exclude call option cost for simplicity, one should subtract 25-50 to compensate. Still, it's clear the common's overvaluation presents an asymmetric situation. Remarkably, scenario 2 is both the most profitable and the most likely. LVLT has continually swapped debt for debt, debt for equity, debt for cash, debt for housepets and so on with seemingly boundless creativity. One could argue that balance sheet restructuring is their real business, with bandwidth sales a mere sideline. I'm reluctant to predict what new manuvers LVLT will conjure up over the next 4-5 years to push these maturities out, but watching it should prove both fun and educational.
Fully diluted shares outstanding is a bit over 700m vs. 360m five years ago. A 2:1 split? Well, no, LVLT issued those new shares to debtholders and employees. This actually presents a Scenario 2++, where you profit on both sides as LVLT continues to dilute the common you've shorted to refi the bonds you own. You can also enhance ROI by trading off LVLT's volatility, varying your short position with LVLT's common price. Rough example:
LVLT ShortPos
$0.00 - 0
$2.25 - 50
$3.50 - 100
$4.75 - 150
$7.00 - 200
Each excursion from 4.75-2.25 adds 250 to your return. If you plan to do this you'll obviously want to overload your call options 2:1 when you initiate the position. And this trading isn't entirely risk-free, in the unlikely event LVLT falls to a buck and stays there your gains on the short will be reduced, setting yourself up for a net loss in Scenario 1.
There are too many variations on the general theme of playing the expensive common against the relatively cheap debt to list here, but I'm happy to discuss them in followup messages. There only real risk I see is an early Chapter 11 in which the senior bonds and common team up to try and screw the subdebt. The subdebt position is large enough at 875m to hire representation and counter such an attack, but I don't know for sure this would happen. On the other hand, management has fought tooth and nail to avoid bankruptcy despite the obvious incentives to wipe out the debt. With no maturites befoe 2008 it doesn't make sense that they'd throw in the towel now.
Catalyst
-Ongoing debt swaps and tenders
-Ongoing common dilution