By Ronda Fears
Nashville, Nov. 14 - If EDO Corp.'s stock pops upwards the convertible should participate nicely, according to Wachovia Securities, Inc. convertible analysts. And the convertible is defensive against a drop in the stock, the analysts note.
On Tuesday, EDO reported solid third-quarter results and Wachovia defense stock analyst Sam Pearlstein raised his rating on EDO shares to a strong buy with a $26 price.
"Should the stock reach $26 as Pearlstein asserts, we believe the bonds could trade to 111 [from current level of 104], providing a 12.1% total return, or 40% of the upside in the common," said convertible analysts Jeanine Oburchay and Brian Park in a report Thursday.
"Our primary concern is that the company will make significant acquisitions, which would require it to face integration risk and draw down its revolver to pay for those acquisitions. EDO has been vocal about its plans to continue to be an acquirer of defense companies."
The stock is trading at a discount to its peers, though.
The defense group tends to trade at an average of 8x-9x estimated 2003 EBITDAP. EDO, on the other hand, is currently trading at just under 7x.
Pearlstein said in a report earlier this week that if EDO traded at $26, it would reach 9x EBITDAP, at the high end of the new defense multiples. Pearlstein also believes U.S. military spending could grow 7%-8% per year on average for the next several years, which should help drive organic growth at the defense contractors.
EDO's only debt is the 5.25% convertible bonds due 2007, totaling $138 million.
Using the implied credit spread of 620 basis points and a volatility of 48% (where April 2003 $30 calls are bid), the convertible analysts estimate the bond is fairly valued.
"Given that the average defense/aerospace straight debt is quoted around the Treasury plus 800 bps level, the converts may be implying too tight of a spread. If we conservatively model the bond using an 800 bps spread, we arrive at a valuation of 4.1% rich," the analysts said.
But if the stock pops, so will the convert.
"On the downside, we believe the stock will likely not trade below $15, unless there is significant continued multiple contraction. In October, as multiples in the group bottomed at 17x forward earnings, the stock bottomed at $15.50," the analysts said.
The company ended the latest quarter with cash and equivalents of $122.1 million, with another $28.2 million in restricted cash for collateral backing 105% of letters of credit assumed when EDO acquired Condor. On Monday, EDO signed a credit facility for $140 million, which can be increased to $200 million if it is syndicated.
Management referred to this as its "acquisition war chest" of more than $300 million, the analysts noted, and indicated it would not have trouble integrating a $100 million acquisition, even though it closed Condor in July.
"As a result, we would expect any new debt used for acquisitions to be senior to the existing converts," the analysts said.
Currently, EDO's debt/EBITDAP run rate is 2.6x. The analysts expect 2003 EBITDAP of $73 million, which would translate to a debt/EBITDAP (assuming no acquisitions) of 2.5x.
Interest coverage next year should be 7.6x, the analysts said, but should the company have to draw down its $200 million credit facility it could increase the debt/EBITDAP ratio to 3.6x and interest coverage would decline to 5.5x.
EDO 5.25% convertible due 2007
Price: 104
| Stock price: | $20
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| Current yield: | 5.4%
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| Yield to maturity: | 6.1%
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| Premium: | 40%
|
| Call: | April 20, 2005 at 102
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