Qwest Q W
January 31, 2003 - 4:00pm EST by
2003 2004
Price: 73.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 7,500 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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This is not your typical Value Investors Club trade idea but I think it falls within the boundaries if you think of value investing as looking for the highest probability of capital appreciation with the smallest probability of permanent capital loss. This trade is really not too accessable to the individual investor, so I apologize in advance. The good news is that this is a trade you can allocate as much money as you want to. My prime broker has over 100mm bonds available to short.

The trade is to buy the Qwest 7.00% notes due August 3, 2009 at 73.5 which is a Yield to Maturity of 13.20% and +985 basis points to the 2009 treasury and short the Qwest 6.875% of 2028 at 67.5 which is a YTM of 10.41% or +552 basis points above the corresponding 2033 US treasury.

A (very) brief history of the company: Qwest, not long ago, used its inflated stock to buy US West, an RBOC. The rest of Qwest went the way of all the other long haul fiber companies and now Qwest bond/stock holders are left with more or less just the assets of US West and the Qwest Directories business. With $26 billion in debt, as recently as July it looked as if Qwest might have to file for bankruptcy. But instead they exchanged much of their short dated obligations for higher yielding bonds that mature in 2007, 2010 and 2014. They also agreed to sell their Directories business for $7 billion. So now they have a much more manageable capital structure and ample liquidity for the forseable future. It is not surprising that after these issues were resolved the stock responded and traded from a low of around 1 to its current price of 4.53 which equates to a $7.7 billion dollar market cap.

But lets get back to our trade...

Qwest has a very complicated capital structure and there are various holding companies and operating companies which make looking at the bonds in relation to one and other somewhat confusing. The important thing to note is that both of these bonds we are discussing sit at the same entity- Qwest Capital Funding, and they are parri passu.

First and most important: how do you lose?

1) If Qwest were to file for bankruptcy and equitize the debt tomorrow then you are long the same claim that you are short and so you would lose the 6 points that you paid up to own the shorter maturity security. In reality, even when the bonds were 30 points lower in the mid 30s and it looked like Bankruptcy had a 50%+ chance of happening - the spread between these two bonds was still 3.5 points wide - implying that there was still a chance that either Qwest stayed out of bankruptcy or died sometime between '09 and '33 instead of immediately. With the completion of the exchange and sale of the directories business, Bankruptcy is still a possibility longer term, but if you do lose the 6 points... it will be at a much later date.

2) You would also lose if someone who could pay 33 billion dollars cash for the entire enterprise value chose to do it and tender for the bonds at Treasuries +50bps. In this case you would lose 6.5 points if the long bonds were taken out at $120.90 and the shorter Bonds are taken out at 114.13 (T+50 for both). There is basically a zero probability that this happens.

So how do you win? and how much do you win?

If the company remains a going concern in any normalized environment than you will make money. I will take a step back..

The debt of most companies trade with a positive credit curve meaning that a credit investor demands to be paid more (defined as spread over treasuries) for a longer term loan than for a short dated loan. This makes sense-- we can be very confident that a company will be around in a year or two but who knows what will happen in 30 years?

Taking a look at some similar companies to Qwest you can see that investors want to be paid more for a long dated loan than a shorter dated loan.

BLS 2011 +80 Dif
BLS 2031 +116 +36

VZ 2012 +90 Dif
VZ 2032 +170 +80

VOD 2010 +87 Dif
VOD 2032 +153 +66

BT 2010 +137 Dif
BT 2030 +192 +55

Avg +59.25

When do bonds trade with a negative credit curve? When the probability of bankruptcy and reorganization becomes very real investors instead look at what their future recovery will be. In Bankruptcy a 10 year note holder gets treated the same as a 30 year noteholder so when the probability of bankruptcy increases, the bonds prices NOT YIELDS or SPREADS will tend to converge. We saw this when our two bonds traded to a 3.5 point spread in July when everyone thought qwest might file.

But it is important to note that this business is not going to file anytime soon.

The thesis of this trade is that company has taken steps to avoid bankruptcy, everyone has recognized this (bonds and stock have already rallied) yet this relationship which can be viewed as the probability of near term default- has not reflected the companies change in prospects**

I think it is very possible that Qwest lives for the next 6 years and then eventually collapses under its debt load at a later date. Which would be a home run for us if it looked like that was going to happen because the spread would widen incredibly.

If these bonds trade to even spread - lets say +500 than our long will trade to a price of 90.46 while our short will trade to 72.33 - an 18 point spread or 12 point profit.

If the short bond trades to +500 and the long to +559, (a 59 bps difference like better capitalized peers) than our long will trade at 90.46 and our short will trade 68.34 - a 22 point spread or 16 point profit.

What is the catalyst? Right now most of the bonds are in the hands of distressed holders, as these bonds begin to migrate into the hands of general high yield funds the shorter bonds will outperform.

How good a trade is this?
You are risking 6 points to make between 5 and 20 points. In reality, if things go south you lose 3 points if the situation improves you will make 5-10 points. The difference is -- things have already improved!! - the complex has already rallied. So we are just waiting for the relationships to get back in order. The complex is currently in dissarray after the exchange. Investors have too many new issues to look at and some of the prices are out of whack. This opportunity exists because large holders of specific issues have decided in a vacuum whether they want to buy or sell the issue they own and the new bonds they recieved in the exchange. As soon as people become more comfortable with the new capital structure and the general high yield base returns as holders of the bonds - we will make money. I look for this trade to make money in the very near term yielding an acceptable annualized return with very little risk of permanent capital loss.


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