Investing

Well AES and OCA have been doing pretty well over the last few weeks. My largest position by far is in Allegiance Telecom (ALGX), or at least largest position in terms of investment rather than current price. I first came across ALGX at the end of 2000. I was looking for shares in companies that had options traded on them. Specifically deeply in the money call options that had quite a high premium such that the shares could drop in price by a large percentage and I would still make money having sold covered calls. Well the activity was utter folly and I lost a lot of money. I now realize that I had absolutely no idea what I was doing. Once of the companies I came across was ALGX. The others were Northfield Labs NFLD and Emcore EMKR. All three companies have no earnings but EMKR and NFLD have no plan to eventually start making money. As I became a little more knowledgeable I realized that NFLD and EMKR were an absolute waste of time with no hope of a fundamentally improving share price any time soon and I cut my losses.

ALGX however, was a different story. This was a company with a utility like business with simple financials that could be modeled into the future. It appeared that they had a sound business plan, had been executing to it for a long time and only had 18 months or so to go before they became EBITDA positive on their way to being free cash flow positive according to my model. They could continue to make interest payments and transition from their start up like negative cash flow to become a money making utility.

The stock price kept falling and compared to intrinsic value it became a better and better buy so I kept on buying. There was a lot of concern in 2002 about their ability to hit certain senior bank covenants. Specifically they had to raise revenues each quarter by a significant amount or the banks would demand their loans back. The accepted wisdom at the time was that the company could not grow sufficiently fast. Well this seasoned management team kept hitting all of their commitments and I kept buying more.

The company kept making assurances that they were on target and had met pretty much all of their milestones even in this terrible environment for Competitive Local Exchange Carriers (CLECs). As we approached the end of '02 they announced that they had re-negotiated covenants with their banks to relax the revenue covenants and instead provide them with time to transition from strictly revenue to EBITDA (profit like covenants rather than just total sales) covenants. In exchange the banks wanted the company to de-lever their balance sheet (reduce the amount of debt). ALGX had over 1bn in debt, of which around 650MM was high yield; the banks required ALGX to retire the HY using only 25MM in cash. With the HY then at $15 or so (from $100 face value) this didn't look so simple. Initially the markets loved the news and the stock traded up to $1.50. Since then it has traded down to the low .20's. The company had until May 1, 03 to retire the HY debt. They had not done so in time and on April 1st they announced that they had defaulted under their secured covenants but that the banks had agreed to not take any action until May 15th.

The point here is that I am going to state my current thinking on the likely outcome before May 15th so that no one can accuse me of being a revisionist.

1. I am confident that the issues will be resolved one way or the other by May 15th and there will not be another extension. As part of the bank's "forbearance" agreement ALGX has to supply certain plans to them by May 15th. I also heard form a sales rep that by May 15th the issues will be resolved and either the company will go into Chapter 11 and will have all debt wiped out or there will be some other resolution. I don’t think this is particularly reliable but it did look like a standard email approved by someone corporate and it supports all the other evidence. May 15th resolution - 80% chance.

2. Chance of chapter 11 pre-pack is low - 30%. In the end if the High Yield debt holders agree today to take 4c on the dollar then there would be no problem. Expecting them to take that is unreasonable but it highlights that the HY debt holders are in control of the events that would lead to a pre-pack. Now if they go down that road the whole company would become worth less in its entirety and even if they get more of the company, they would be getting more of a much "smaller pie". It would not be rational for the HY to force a Chapter 11 bankruptcy if they were being made a reasonable offer outside of that remedy (such as cash + warrants (lock term stock options) + stock). The company also settled a series of claims and counter claims with WorldCom. This settlement would not be enforceable if ALGX declared bankruptcy within 90 days (I am relatively sure but not 100% sure about the bankruptcy law in this case), therefore ALGX must have given the WorldCom deal makers some reasonable assurances about the likely outcome of the recapitalization (the de-levering activities to reduce debt) negotiations.

3. Dilution to current shareholders will likely be around 30% - well I thought this originally but with the decimation of the equity this may now be too optimistic. Still less than 50% dilution is the most probably case - 50% chance. There is then a sliding scale of probabilities leading me to believe that the worst case situation would be similar to the MCLD recapitalization where equity holders were left with 17% of the new company. Chance that Equity holders retain at least 17% - 95% chance.

4. The banks may relax the requirement that HY debt has to be retired and may in fact be satisfied with the current performance and therefore will agree to new permanent covenants. If the company saw retiring the HY with equity as a good idea back in late '02, but the plan got scuttled by capital arbitrageurs (see below) then they may just decide to work with the banks to keep the HY and secure debt. The banks may agree because operationally the company is showing great progress. Chance - 50%.

The behavior of management right now has been called strange and the many investors have an issue with the lack of communication. Up until the extension I was confident that management was playing this exactly as they should be. They were turning up the pressure and starting to assert that bankruptcy was a possibility if the HY didn't come to the table. The extension could be the final move required to take the negotiations to the brink and to allow an agreement to be reached. May 15th approaches!

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Capital Arbitrage (CA) is buying the debt of a company and selling its shares (or at least one type of CA is). Once you know that a company has to retire debt and only has equity as currency then you can create an almost no risk situation by buying the debt and selling short the equity (selling shares that you don't own). Once a deal is announced you get new shares from the recapitalization and use those to close out the short. If the equity price rises then the debt prices should rise by even more and in the end there is no problem because you will get shares to cover with. If the equity price falls you can always close out your short at a profit. The remaining risk is that debt decreases in price and equity increases, this is very unlikely as the debt has the first right to the companies cash flows and as equity is fundamentally valued on cash flows once they have paid off debt, it would be improper for equity to rise and debt prices to fall.

Whitney Tilson is one of the links on my sidebar. I like a lot of the material that he publishes. His unabridged notes from the Berkshire Hathaway annual meeting are a must read. When Warren and Charlie speak, I listen. I haven't quite managed to reconcile my investment philosophy and there's. There is no doubt that he is a six sigma event in the investing world (a great argument against the strong form of efficient markets) and everyone could learn so much from him. I currently take small positions in much undervalued companies, I guess he can't go after the small opportunities that I do because to take a meaningful position in OCA for example would be buying the company and then the affects would still be minimal on Berkshire. I also don't plan on finding good business and holding on for the long term. I intend on finding cheap business and holding on until they become fairly valued businesses.

Buffett talks about the massive inflows into Junk Bonds, something like 1bn a week. With that he says that he no longer thinks they are a good buy (he apparently made about 1bn on 8bn of junk last year). With my AES preferred success I am going to start reducing my position once I have had lots for a year I am going to prepare to sell them.