Description

Summary

United Pan-Europe Communications, ticker UPCOY, (1) is the largest cable company in Europe; (2) controlled by United Globalcom, ticker UCOMA, which itself is 75% owned, though not controlled, by Liberty Media; (3) has filed a pre-packaged plan of bankruptcy in both US & Dutch court, where all voting classes of impaired claims have committed to support or are very likely to support a pre-negotiated restructuring; and (4) has bonds that trade at an implied equity valuation of 600 million Euros while UCOMA's stock price implies an equity valuation of UPCOY of at least twice that 600mm amount.

There is just a disconnect in the markets for the UPCOY debt (which is close to being UPCOY equity) and the UCOMA stock (whose value is largely determined by UPCOY equity's value); the long term sustainability of this disconnect is extremely improbable; this disconnect offers as much as triple digit returns to the capital structure arbitrager; and the recapitalization of UPCOY is a good catalyst.

Oh, the trade is long the UPCOY bonds, short UCOMA stock.

UPCOY Recapitalization

The story of how UPCOY got into financial trouble is familiar, especially to cable investors: A lot of acquisitions, mostly financed with debt; a lot of capital spending to upgrade narrowband cable plant; new service rollouts (primarily data & telephony) with upfront costs; and a general lack of disciplined capital allocation driven by hockey stick projections and bull market equity prices. (Aside: The great thing about my investment is I am insensitive to the value of UPCOY--whether UPCOY is worth more than or less than 600mm, I should, over time, earn a very good return.) UCOMA controlled the equity of UPCOY, and has seen its share price suffer with UPCOYs since mid 2000. Libery Media, seeing the potential to use UCOMA as their platform for European cable investment, bought UCOMA stock, and then senior and subordinated UPCOY debt, and exchanged the UPCOY debt for UCOMA stock. Liberty now owns 75% of UCOMA stock, but control resides with Gene Schneider, UCOMA's long time CEO, who maintains a close relationship with Liberty. UCOMA also bought UPCOY debt as it fell into distress. With Liberty's "help," UCOMA then negotiated a deal with the independent UPCOY bondholders, and the UPC bank lenders, to restructure UPCOY. This negotiation took more than 9 months. The risk of the banks or independent bond holders falling out at this point are low. The terms of the recap, which are summarized below, are laid out in a disclosure statement filed in an 8-K by UPCOY in early December.

Old UPCOY
Bank Facility: 3.2B Euros drawn.
Senior, $1B Belmarken UPCOY Note: Owned by UCOMA.
4.3B UPCOY debt: 2.8B owned by independent bondholders, 1.5B owned by UCOMA.
2002E EBITDA--325-350mm.
Leverage: 24x.

New UPCOY
Bank Facility: Remains at UPCOY.
New UPCOY Equity: 50mm shares, 65.5% owned by UCOMA, 34.5% owned by bondholders.
Leverage: 9x on 02, 6.4x on 2003E EBITDA.

New UPCOY Valuation
Bonds for sale at 7.5 cents, up from 3 cents, down from 22 cents in the mid summer, and each bond brings roughly 6.00 new UPCOY shares. We own the 11.25% of 2010, which carry 6.21 shares of new UPCOY for $1,000 face. We own them creating 1 new share of new UPCOY at $12.08 ((0.075 times 1000 face) divided by 6.21 shares is 12.08). Implied valuation for new UCOY equity is $603mm. There is 3.2B of debt (all bank, in euros) left at UPCOY. For what it's worth, there should be around E500mm of EBITDA at UPCOY in 03, from 7.2mm basic subs, with capex of E325mm. I take the projections with a grain of salt, and again, the investment case is not sensitive to the value of UPCOY.

(Another aside: Are the bonds outright long cheap? The recap plan priced the bonds at 21 cents (or the equity at 1.9B, both the bondholders and UCOMA signed off on these prices). The 3.7B EV is 7.4x 03E EBITDA for 50% EBITDA growth, 510 per sub (although reference to US cable sub valuations is silly, as cash flow per sub of 69-70 is a LOT lower than
US sub cash flows), and my rough sense of 04E is 100mm FCF is not impossible (700mm EBITDA is likely guidance out by year end, capex growth off 03 will be minimal, and interest costs of 225-250mm--forget about tax benefits for a while). A lot depends on the EBITDA growth, which is driven by continued data & telephony penetration on the 65% of the plant that is 750 MHz 2 way upgraded. Not crazy, and Liberty is not dumb. But not central to the investment case being made here).

UCOMA Valuation.
UCOMA has 420mm shares, and essentially no debt. (The small amount of cash on the balance sheet is offset by (a) an obligation to put 100mm Euros into new UPCOY, which is part of the UPCOY recap, and factored into the 65.5% of UPCOY that UCOMA will own after the recap; (b) 20mm in non recourse loans to UCOMA executives.) The market cap is 1.2B.

UCOMA owns 3 main assets: Its interest in UPCOY, a Chilean cable company (VTR), and a few other, assorted assets. On the positive side, VTR will do 44mm in 02 EBITDA, is planning 55mm in 03, has made its numbers 3 years running, and whoe equity is valued by UCOMA management in their investor presentations at $1.00 per share. On the other hand, VTR has 150mm in debt, the debt is dollar denominated (while the cash flows are Chilean pesos obviously), US cable companies trade at 9x 03E EBITDA, and Latin America is, um, volatile. I think it makes sense to lay out an aggressive case and base case valuation for VTR, which in my trade, I am essentially short. I think a great if not best case for VTR's equity valuation is 400mm, or 10x 03E EBITDA, a premium to a company like ICCI, which has 45% EBITDA margins in a well clustered section of the US, is 99% 750Mhz 2 way upgraded, which buys its programming through Comcast and sells telephony in a manner that generates FCF behind the AT&T brand. I think a 200mm is a fair base case value for VTR equity, which is 6.4x 03E EBITDA, a fair discount for the currency & country risk. The recent VIC discussion of NII is relevant to this analysis.

The other assets at UCOMA are small, the largest non-UPCOY asset being a Mexican cable system that did 9mm in EBITDA with no debt in 2002. There are a number of pieces, but summing them to more than 100mm is pretty difficult. In my aggressive case, then, UPC represents 700mm of the 1.2B UCOMA market cap (and this is almost certainly conservative). The market is paying $700mm, then, for UCOMA's interest in UPCOY, which is 65% of the equity, or 32.75mm shares, or $19.84 per UPC share. I am buying UPC shares through the 11.25% 2010 bonds at $12.08, or a 39% discount. In my base case, UPC represents 900mm of the 1.2B market cap of UCOMA, and the market is paying $27.48 per share for the new UPCOY shares inside UCOMA. My bonds create the same equity at a 56% discount to this price.

What Is Wrong With This Trade

I see 3 main risks:
(1) The UPCOY shares I am long are minority shares, and UCOMA owns a controlling interest in UPCOY. Fair point, especially where being a minority shareholder in a Liberty controlled entity is concerned. But the discount is just too large to be justified by a minority shareholding dynamic. Indeed, for many years, UPCPY and UCOMA traded in relation to each other--back when both were solvent--and there were times when UPCOY actually traded at a premium to the price implied in UCOMA stock, for liquidity reasons, or because people wanted to directly invest in the most interesting asset inside UCOMA, or for whatever reason you wanted to point to at that time. The discount, despite the fact that UPCOY shares have always represented a minority position in UPC, was never 40-50%.

(2) The technical dynamics of the trade are poor. New UPCOY shares, when they trade following the recap, are likely to trade poorly, as bondholders seeking liquidity and unaccostomed to holding equity dump their stock, while investors in UCOMA are likely to pay more for their UPC interest once the recap plan is completed. Maybe, for a time true. However, I am willing to bet that once there are 2 liquid equities trading, essentially representing interests in the same venture, the gap converges. Keep in mind, if the fair price for new UPCOY stock is $20.00, the potential return to the trade is greater than 100%. The disconnect in the market here is just huge.

(3) The recap plan fails. I discuss below what has to happen for new UPCOY to emerge as intended. If the recap fails, my bonds are likely worthless. Indeed, under Dutch law, if no recap plan is approved, UPC is liquidated, and a great deal of discretion as to how lies with a judge whose opinions are very tough to appeal. (All the more reason why the classes cut this deal and vote for the plan and do what it takes to get it through). Even under this scenario, however, UCOMA stock should fall more in value than the UPC bonds do. Walk through the math of the trade. I am long, let's say, 1mm face of the 11.25% of 2010s. That is a $75,000 investment. I am thus, through the recap, long 6210 new UPCOY shares. What am I short? UCOMA owns 32.75 new UPCoY shares, and there are 420mm UCOMA f/d shares. Each 1.00 UCOMA has 0.078 new UPCOY inside. I thus am short 79,600 UCOMA shares (6210/0.078), or $230,000. If new UPCOY equity is worth zero, I lose $75,000 on my long investment. To make that back on the short, I need UCOMA to fall by 32% (75/230), or $390mm (.32*1.2B current market cap). The market is currently valuing UPCOY equity inside UCOMA at $700-900mm, with 3.2B of senior UPC debt. Wouldn't that equity value fall by 50% if UPC were liquidating?

The Recap Process
The plan needs 2/3 votes from each class in the US, and 3/4 in the Netherlands. All of the classes other than the preference shares of UPC are contractually locked up. The preference shares are owned by UCOMA, L, Motorola (UPC's largest supplier), and friendly investors, all of who stand to walk away with zero for their preference shares if UPC liquidates. The disclosure statement draft is out, and needs to be approved. Both courts need to sign off on the plan, a plan that has been negotiated for close to a year, and has broad class holder support. It ain't over til it's over, but it's close. And there are no obvious impediments to the approval.

Catalyst

The UPC bankruptcy recapitalization; or Liberty or UCOMA buying UPCOY bonds in the open market