Levi likely to take out 7% notes first with Dockers proceeds, analyst says; 12¼% buyback seen unlikely

By Paul Deckelman

New York, Sept, 28 - Debt investors will be trying to handicap how Levi Strauss & Co. will go about paying down its roughly $2.25 billion debt load with the proceeds from the sale of its Dockers casual clothing unit now the financial community has pretty much accepted as official the news that Levi has agreed to sell Dockers to Vestar Capital Partners and clothing industry veteran Eric Rothfield. Although there has been no specific confirmation from Levi, Monday's story in The Wall Street Journal carries considerably more weight than Friday's speculative report in the New York Post.

According to high-yield analyst Alexis Gold of CIBC World Markets, look for the venerable San Francisco-based blue jeans maker to use the proceeds from the reported $800 million deal to mostly take out bond debt rather than repay its bank loans, with Levi's outstanding 7% notes due 2006 likely to be the first piece of debt redeemed, followed by its 11 5/8% notes due 2008. Least likely, for a variety of reasons, she says, is its highest cost piece of debt - the 12¼% notes due 2012.

Gold said that while the first thing Levi will do will be to make an offer to the banks to repurchase its roughly $580 million of bank debt: "I think that the bank debt will stay in place."

The main reason, she said is that "the bank debt is currently not callable. The thought process is that the banks will actually refuse that offer, because the offer would come to the banks at par plus accrued [interest] - and the bank debt is trading substantially better than that."

Gold noted that when Levi negotiated with its lenders on a new credit facility a year ago, "the banks did receive additional call protection, because the old credit agreement had allowed them to call the bank debt in 2006 at par. The new agreement has a call premium of 108 - so the banks have no incentive to come out now."

The analyst said her company believes that Levi probably will call the bank debt in 2006 when it is callable, "but for now, the assumption is that the bank debt will actually stay in place and that really the majority of the proceeds will be used to call the bonds."

But which bonds?

Gold estimated that Levi currently has about $1.67 billion of outstanding bond debt, most of it in the well-traded three issues the junk bond market is most familiar with - its $448.2 million of the 7% notes, $376.7 million of dollar-denominated 11 5/8% notes due 2008 and $575 million of 12¼% notes due 2012 (the company also has approximately $110 million of 11 5/8% euro-denominated 2008 notes and $166.7 million of 4¼% yen-denominated securities outstanding).

Bonds at par plus

The bonds firmed smartly Friday, in response to the initial New York Post report on the Vestar deal and added to their gains Monday on the Journal story, even though Levi itself has neither confirmed nor denied the stories. As of Tuesday afternoon, the 7% notes were quoted at par bid, the 11 5/8s were seen at 103.5 and the 121/4s hovered at 106.

That's a far cry from the depressed levels those bonds held at the start of the year, when, according to information supplied to Prospect News by Advantage Data, the 7% notes, the 11 5/8% notes and the 12 ¼% notes were all trading in a bid range between 64 and 67.

The three series of bonds began consistently pushing up to bid levels in the 70s in early March and had broken into the 80s by early April - coinciding with the start of speculation that Levi might put Dockers up for sale and use the proceeds for debt reduction - particularly after the turnaround specialist firm of Alvarez & Marsal LLC presented Levi's board with a laundry list of suggestions for improving the company's finances, including asset divestitures.

That speculation continued over the next month, with the bonds having attained the upper 80s by May 11, Advantage Data said, when Levi made official what everyone in the market had already surmised - that it was shopping Dockers around, with the help of Citigroup Inc. After that, the bonds firmed into the 90s, and continued their upward rise to their present levels.

7s easiest to redeem

Conventional wisdom says take out the highest-coupon debt first and save money in the long run - but things aren't quite so simple in this case.

The 7% notes would be the easiest to take out, according to Gold's reasoning, and probably will be the first.

"The 7% notes are an old investment-grade indenture," she said, "so there's no limitation on asset sales tests - which means that they don't need to make an offer to repurchase the 7% paper."

She noted, however, that "there's been a carve-out in the bank debt that allows for the repurchase of the 7% notes if the company is in compliance" with certain tests - a leverage covenant specifying a pro-forma debt-to-EBITDA ratio of no greater than 4.75 times, and a $150 million liquidity requirement. "So it's obvious the banks have always wanted that 7% paper to come out because it's the first maturity in the capital structure."

With the credit facility carve-out, she said, "if they wanted to, all they would need to do is draw on their credit facility, repurchase the notes, and then they would repay the credit facility out of the [Dockers] proceeds - so it's sort of one pocket to another."

Gold said that the company is required to make an offer to take out the other two series of bonds at par plus accrued interest using asset-sale proceeds - but with both of those notes trading well above par, such an offer would essentially be a formality.

The 11 5/8% notes, meanwhile, "are actually callable starting in January 2005," and she expects Levi to refinance them at that time, "substantially less expensively," since the anticipated $800 million Dockers proceeds - assuming the amount is not reduced by cash taxes on the sale or other items - will not be enough to fully take out both the 7% notes and the 11 5/8% bonds.

121/4s for long-term investors

On the other hand, said the analyst, "the 12¼% paper is not callable until 2007.

"Most of those [12¼%] investors have made longer-term bets at this point, and I think that the trading levels reflect that. With the notes trading in the 106 area, and if they're going to get an offer of par plus accrued, those investors are saying 'we want to stay in and be involved in this name longer term, because we think this double-digit coupon is attractive on a longer-term basis.'"

Since the 12¼% notes "can't come out till 2007, they are somewhat call-constrained - but for some period of time, you could conceivably see them trading above that call price."

Mounting a tender offer for the 12¼% notes just to get rid of the big-coupon issue is always an option, but Gold believes it's a long shot. "I think that would be a pretty expensive process. I think it is more likely that they would take out that other paper."

Gold pointed out that Levi's options on debt takeout will be constrained somewhat by the possibility that it might not get the full $800 million in cash.

"The one caveat in all of this is we don't have a real sense of what the cost-basis in Dockers is. The company hasn't disclosed that. We think they'll have benefits - they'll recognize deficiencies from their deferred tax assets. It's hard to say what the cash taxes associated with this sort of divestiture could be. If the purchase price is $800 million we don't know that the company is going to see $800 million in cash." Even with its deferred-tax assets, "it's unlikely that they will pay zero in cash taxes with the sale."

Levi still faces challenges

Gold says the Dockers deal is surely a positive for Levi - but once it goes through and Levi uses the available proceeds to take out whatever debt it will take out, that still won't be an automatic magic wand to financial stability and assured prosperity.

In predicting that 2005 will be "a pretty tough year" for the company, the analyst noted that first and foremost, "they're not going to have Dockers anymore, and although Dockers sales have been declining [in recent months], it was something that lent some stability to their top line in general. I think if you look over the last year or two, you've definitely seen this, especially in the U.S. - even with their Signature sales [Levi's new line of premium-priced jeans], you've started to see those sales decline."

In the post-Dockers era, she said, "for the first time people will focus on the top line. They're going to be up against tougher comps [comparable statistics from a year earlier] and I think it's going to take time for them to re-focus on [their blue jeans] business - especially because this year [management] has really been tied up on cost-saving initiatives, corporate finance events, the sale of Dockers and refinancing their capital structure, and they're really going to need time to focus on that top line. I think it's going to take time for them to work that out."

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