By Ronda Fears
Nashville, Tenn., Oct. 14 - Shaw Group Inc.'s convertible is mispriced on the current weakness in the stock, said Merrill Lynch & Co. convertible analyst Robert Dia. He recommends it based on the company's solid balance sheet and cash flow.
"We believe that the Shaw Group 0% convertible bonds represent an attractive opportunity for outright and hedged investors who believe the equity will be range bound over the next 12 months," Dia said in a report Monday.
"We believe that at current trading levels the convertible bonds represent an excellent opportunity for investors to initiate a position in a stable credit profile, given the company's solid balance sheet and free cash flow."
Merrill analysts model the convert with a spread of 1,844 basis points over Treasuries and 45% volatility, putting theoretical value at 50.89, or 1.75% more than where the bonds are currently trading.
"Shaw Group has been experiencing a negative spillover from customer bankruptcies, contract cancellations and power cycle malaise that has pushed the equity down 50% YTD," Dia said.
"While the convertible bonds have been relatively more stable, we still believe the convertibles are mispriced with a 21% YTP."
The spread was arrived at by focusing on comparable spreads for competitors and customers, Dia said.
"While it was difficult to sift through some of the power sector bonds owing to distressed levels, we felt comfortable with looking at names across the spectrum of power names and other BB industrial companies (using Moody's lower rating)," he said.
Given Shaw's capital structure profile with only bank debt and capital leases ahead of the convertibles, and looking at cash on the balance sheet and credit ratios, he said the spread level seems appropriately conservative, with some tightening likely over the short term and into next year.
Shaw's balance sheet is relatively solid with the convertible bonds the only debt except for a $350 million credit facility and capital leases, he pointed out. At the end of fourth quarter, Shaw had $175 million outstanding in letters of credit and about $410 million in cash, or $553 million in cash and cash equivalents. Of total debt of $530 million, the convertible is $520 million.
"Near-term credit catalysts should help tighten the spread levels on the convertible bonds," Dia said.
"We expect the company to renegotiate its bank agreement that expires in July 2003 to fund, along with cash-on-hand, the convertible put due May 2004."
Dia said analysts will be looking for additional language in the new credit agreement to allow for open market bond and stock purchases, noting Shaw's share buyback was completed this year totaling $100 million.
Shaw's financial covenants as disclosed in its second amendment and restated credit agreement dated Feb. 28, 2002 restrict leverage ratio on a last 12-month basis to no greater than 2.5 to 1.0 and a fixed charge coverage ratio to no less than 1.5 to 1.0. Capital expenditure is limited to the greater of 20% of EBITDA or $30 million including capitalized leases.
"There is clearly a risk in the power generation industry that once sported investment-grade credit ratings, but now trade at distressed levels," Dia acknowledged.
"These depressed market valuations generate nervousness and skepticism across the investing community as liquidity is taken out of the market and management creditability is discounted, rightly or wrongly."
Customer problems at National Energy Group and AES Corp. have reduced Shaw's EPS forecast for 2003 to a midpoint estimate of $2.00. However, Shaw reported Monday net income in its fiscal fourth quarter increased 62%.
Shaw Group 0% convertible due 2021
| Price: | 50.00
|
| Stock price: | $10.60
|
| Parity: | 8.80
|
| Current yield: | 0.00%
|
| Yield to maturity: | 3.77%
|
| Call: | May 1, 2006 at 71.49
|
| Yield to next call: | 10.31%
|
| Put: | May 1, 2004 at 68.361
|
| Yield to put: | 21.15%
|
| Premium: | 468.38%
|
| Conversion ratio: | 8.2988
|
| S&P/Moody's: | BBB-/Ba2
|
| Theoretical value: | 50.89
|
| Discount to theoretical: | 1.75%
|
| Investment value: | 50.89%
|
| Investment premium: | -1.75%
|
| Historical volatility: | 45%
|
| Credit spread: | 1844, 1938, 2033 basis points (5, 10, 30 years)
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