Better Performance in Convertibles

At the time of the XOXO Communications' bankruptcy filing, CEO Dan Atkerson was quoted saying, "I still do not know why we did not equitize our balance sheet when our stock was high."

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I don't mean to pick on Dan, but no kidding! poor capital structure management, unrealistic business assumptions and a weak economy have caused a number of high-profile bankruptcies. While management may feel some pain, they keep their jobs, and they get reoptioned when their company emerges from restructuring. Meantime, the shareholders register a big doughnut.

I believe balance sheet improvement will be the single most important investment theme of 2002. It will be bigger than the recovering economy. It will be bigger than accurate financial statements. It will be bigger than Lay, Skilling, and Fastow. I even think it will be bigger than Jaime Sale and David Pelletier.

After Enron's demise and the flurry of telecom bankruptcies, investors are taking a hard look at balance sheets. I can almost hear famed value investor Benjamin Graham applauding. There has been a clear dichotomy in the performance of stocks this year. Stocks with bad balance sheets have basically gone down, while stocks with good balance sheets have gone up.

Do Some Work Under the Hood

Any CEO or CFO who is not presently strategizing on how to improve their company's balance sheet should be fired. Forget about dilution: the name of the game is survival. Make sure that your company's balance sheet can handle a sustained business downturn. Don't make assumptions based on the best case. Make assumptions based on the worst case.

A wonderful investment opportunity exists in buying the depressed stocks of companies that take aggressive steps to improve their balance sheets. In other words, buy the stocks of guys who "get it." These stocks should trade higher because increased investor confidence in survivability significantly outweighs the cost of dilution to existing equity investors. If you really want to have fun, play the balance sheet improvement game through convertible securities.

Here are a few to check out:

Ford (F - commentary - Cramer's Take) recently issued $4.5 billion convertible preferred with a 6.5% yield and a 20% conversion premium. The economy is strengthening, auto sales are strong and new management is executing a turnaround.

General Motors (GM - commentary - Cramer's Take) recently issued $3.3 billion convertible preferred with a 5.25% yield and a 22.5% premium. GM is humming on all cylinders -- no pun intended. Earnings have been consistently guided higher, and sales continue to surprise to the upside.

Adelphia Communications (ADLAC - commentary - Cramer's Take) recently raised $1.5 billion in a stock and preferred offering with a 7.5% yield and a 20% conversion premium. I have written extensively about Adelphia on RealMoney. The cable sector has gotten unfairly punished with the rest of the communications stocks.

Gap (GPS - commentary - Cramer's Take) recently raised $1.2 billion in convertible preferred notes with a 5.75% yield and a 30% premium. Don't ask me for fashion advice, but I like the probabilities of Mickey Drexler turning the company around.

I expect that there will be an average of one sizable balance sheet improvement financing every week until Christmas. These trades work. Last year, we even made money on the Xerox (XRX - commentary - Cramer's Take), Lucent (LU - commentary - Cramer's Take), and Nortel (NT - commentary - Cramer's Take) financings.

I may even nibble on Qwest's (Q - commentary - Cramer's Take) upcoming deal. My gut tells me that Mr. Anschutz's patience with Mr. Nacchio has to be running out. Either way, I think Qwest will actually make it. Still, I'll wait to make the bet until it raises some dough.

Nothing excites me more than finding a workable investment theme. They are extremely hard to find, but well worth the effort. I think the balance sheet improvement thesis is the best investment opportunity of the past several years. With convertible securities, investors can improve their placement in the capital structure and get paid to wait.

And in an environment of positive-but-modest equity returns, the yields are quite interesting.

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Brett Messing is a managing director at Neuberger Berman LLC. The views expressed are Messing's and do not represent the views of Neuberger Berman LLC, its portfolio managers, employees or affiliates. At time of publication, Neuberger Berman or its clients were long General Motors, Ford, Adelphia Communications and Gap, although positions may change at any time. This material is not intended to be a formal research report or recommendation and should not be construed as an offer to sell or the solicitation of an offer to buy any security. Before acting on any advice or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Messing appreciates your feedback and invites you to send it along.