Description

Summary
Worldcom’s unsecured debt trades currently at 22c. The company is expected to emerge from bankruptcy in early 2004 and this discussion assumes all the debt is converted to equity. I believe creating worldcom equity by purchasing the bonds at these levels is a compelling investment. The current valution multiple at today's prices is 2.8x annualized (11/02) EBITDA and 3.3x annualized pre-tax fcf (albeit capex is unsustainably low).

Capital Structure
In terms of the capital structure, there is $33b of unsecured debt (face value), which is the focus of this discussion. At 22c, the unsecured has a market value of $7.3b. Other obligations include $0.5b of capital leases and $1.6b of pre-petition payables, both of which are senior claims. And $3.3b of MCI debt, also senior to the wcom bonds, although holders may take a haircut (probably 25% at most) during reorg negotiations since their claim isn’t crystal clear. Restructuring costs will probably be around $200m. In terms of cash, they company had $2.3b as of the most recent monthly operating statement (11/02). Therefore, total enterprise value is around $10.5b, made up of senior claims totaling $3.1b (net of cash) and unsecured claims of $7.3b.

Operations
The company’s most recent monthly operating statement (11/02) showed annualized revenue and EBITDA of $26b and $3.8b (14.6% margin), respectively. Annualized capex was $600m, but is unsustainably low (just over 2% of sales). Annualized pre-tax fcf was $3.2b. [note: one could argue it is inappropriate to annualize one month's numbers but this seems conservative based on the other monthly figures that co has reported]

Those are the most recent actual numbers but where do we go from here? Our proprietary research, which was fairly extensive and consisted of surveying corporate customers and competitor salespeople, indicated that telecom price declines have slowed (although still declining). In addition, many WCOM clients are, by and large, staying with them (partially due to hi switching costs, specifically on the data side, partially due to contracts they can’t break, and partially due to service quality continuing to be high). The numbers confirm this as well. As such, I expect revenue declines to continue but not a high rate. Offsetting this, the company has some loss making businesses that should be shed, which will help margins (which are only 14.5% versus 25% for T). One key is for the company to emerge from bankruptcy as soon as possible. It is very hard to win new business while in bankruptcy because of the uncertainty. In contrast, a post-bankruptcy WCOM may in fact be in a strong competitive position because it should be debt free while its two main competitors (FON and T) continue to have a meaningful amount of debt. While it is in everyone’s interest to emerge quickly, this is a key risk to consider.

Valuation
Rather than specifically predict future EBITDA and revenue levels, I use a matrix approach for various EBITDA and multiple scenarios. You get to pick your own inputs :>). It is more art than science but if you assign a 4x multiple to a $3.8b EBITDA figure, it gives you a double in the bonds to 44c. This doesn't seem unreasonable based on the nature of the business and recent trends. You could argue that T is trading at slightly below this but WCOM probably has room for margin expansion (14% mgns vs. 25% for T) and should emerge debt free. Calculating the downside is difficult but if you assume EBITDA goes down to $2.5b (just to pick a number), current valuation is 4.2x. Could the multiple or EBITDA go lower? Sure, but it seems unlikely to go much lower.

Side note: implicit in my discussion is an assumption that capex is 10% of sales (or lower) or roughly $2.5b (i.e. pre-tax fcf is $1.3b). This is the low end of historical telecom provider capex rates but is consistent with my top line expectations. At $1.3b in pre-tax fcf, the current valuation is approximately 10x.

Other consideration
WCOM controls a very large portion of the corporate long-distance and data market (estimated at roughly 1/3 of the market). This is almost certainly an irreplaceable asset and there is really only two of them (WCOM and T). As such, it is also possible that a takeover bid/war emerges for WCOM, probably among the RBOCs. Regulatory approval would be required. I'm not looking at this security from a takeout perspective but it a possibility.

Catalyst

Emergence from bankruptcy in early 04.