The European high yield bond market is a strange place at the best of times. Sometimes it is downright dangerous. Take the period of heavy issuance by cable companies between 1998 and 2000 for example: the fallout that followed made clear that many of these businesses simply could not support high yield within their capital structures. Generally speaking, cable's demise had a lot to do with high yield's problems after the markets crashed.
It took until the final quarter of 2003 before market practitioners began to detect signs that the high yield market was beginning to hot up again. Investor appetite for high-yield debt is coming back, even amongst buyers who have never bought this type of paper in the past. And improbable as it may seem, once again European cable companies appear to play a role in high yield's recent change of fortune.
One particularly noteworthy example was the issue in December for Telenet Communications. The deal, led by JP Morgan and Goldman Sachs, priced just before the Christmas break. Not only was the issue widely successful, but it also marked a return to market acceptance for a sector whose fall from grace dates back only a few years.
When Telenet's fundraising exercise began, however, there was no guarantee of a successful outcome. A capital markets professional at JP Morgan recalls: ?We were unsure of the amount of European demand for a cable company at the outset ? but it went much better than anyone could have expected?. That's not to say that those responsible for the issue simply took a chance. However, what started as a €350 million equivalent issue with a portion carved out for US-based investors was subsequently upsized: first to €400 million equivalent, then to €500 million equivalent. In the end, the tally stood at €500 million plus approximately $320 million (gross issuance proceeds) of discount notes: a total capital raising of €758 million, or more than twice the original target.
On this basis, one would expect an analysis of Telenet to point to a company with nothing less than a remarkable credit story. But this would be something of an overstatement. While Telenet does have a good story compared to some of its peers and a capital structure that seems to fit its situation, there are still risks to its business and, as with many comparable credits, attempting to analyse its historical financial performance is difficult given a series of acquisitions and related changes in ownership.
Telenet is the dominant provider of cable television, broadband internet and telephony services in the Flanders region of Belgium. The roots of the company lie in public sector promotion of cable television as the principal method of broadcasting in Belgium dating back to the 1960s. Incorporated in 1996, Telenet was effectively founded as the successor to various small, municipality-owned companies in order to support the development of digital services. Its ownership is complex, consisting of various consortia including several municipalities, the Belgian state as well as financial investors including Callahan, Merrill Lynch Private Equity and Caisse de Dép^t et Placement du Quebec.
The company's market position is strong: it boasts penetration levels of over 93 per cent in cable television and 15 per cent in broadband internet services. This is partly a result of its history, partly because of the relatively advanced development of cable services in Belgium.
But there is more to explaining why the company proved so appealing to high yield investors when it came to market. If one digs deeper, there are some distinguishing factors, some of which relate to the company, others to the market.
The first is that Telenet is not just EBITDA, but also cash flow positive. In fact, according to the offering memorandum, for the nine months to the end of September 2003, Telenet generated EBITDA of €167.2 million – a margin of 46.6 percent. Annualising this by taking the performance from the most recent reported quarter and multiplying by four yields €252.8 million, though a more conservative measure would be the actual results for the four quarters to this date, which show more modest, but nevertheless impressive, total EBITDA of €213.3 million at a margin of 45.7 percent.
Based on cash pay (or ?operating company?) debt of €1.46 billion, ignoring cash balances due to the impact of impending acquisitions and capital expenditure requirements, leverage is 5.8x based on annualised figures, or 6.8x based on actual figures. Total gross leverage, which includes the discount note that was issued at the holding company level without the structural support of the cash pay notes, is rather higher at 6.8x and 8x, respectively, though European investors in particular would probably pay little regard to this.
This is certainly racy, but for a growing business with huge operating leverage (as indicated by the turnaround in reported EBITDA margins, which have gone from negative to nearly 50 per cent in two years) it is acceptable ? just.
Then there is cash flow to consider. For the nine months to September 2003, Telenet reported cash from operations of €115.7 million, compared with a meagre €5.8 million a year previously. There is not enough information provided to permit the calculation of an annualised figure for cash flows. However, estimating the actual results for the last four reported quarters by looking at the ratio of cash from operations to EBITDA (not a particularly scientific approach, but illustrative nevertheless) leads to a figure of €137 million. This is just sufficient to cover 2004's estimated investment needs of €140 to €160 million. It seems likely that Telenet will have been strongly free cash flow positive for 2003 therefore ? something that cannot be said of many companies of its kind.
The financing structure also looks sound. Of the €1.7 billion of debt outstanding after giving effect to the refinancing resulting from the bond issue, €1.17 billion, or 68 per cent, is not subject to any amortisation. The discount note obviously does not carry a cash interest charge for five years. On top of this the company also has €140 million of available undrawn debt and a further €160 million of cash balances. As Telenet moves towards the launch of digital interactive television and voiceover-IP telephone services and continues to integrate its acquisitions, such resources will be necessary to provide a platform for growth. But these steps should of course also add to revenues and, provided costs can be controlled, to profit. If, in other words, the financing structure is genuinely sufficient to support medium-term investment needs, there are grounds to believe that the market may actually see something it has not before ? a delevering cable company. And if the high yield market likes to see one thing from its issuers, then it is delevering.
There were also a number of market-related factors that led to the issue's success. First of all, Telenet is, almost unbelievably, a first time issuer. Second, the issue represented a diversification opportunity as many investors have become increasingly saturated with automotive, chemical, packaging and other ?industrial? issuers.
?The demand side was overwhelming ? there was a genuine sense of excitement around this issue, everyone was curious,? said JP Morgan. This is reflected in the balance of the order book, which swelled to massive proportions as pricing drew near. Ultimately 25 per cent of orders came from the US ? evidence of significant appetite given the level of oversubscription.
But interest from Europe was simply staggering. In the end not only experienced high yield investors took part but others, ranging from hedge funds (not typical credit investors) to investment grade funds, also wanted a piece of the action. The result was pricing at the tight end of the talk ? though, according to JP Morgan, still wide of US benchmarks for the issue.
Investors must also have been happy with the structure, which incorporates the now ubiquitous operating company guarantees. The subsidiary guarantors actually only constitute around 50 per cent of the most recently reported EBITDA, but the fact that Belgium is among the weaker jurisdictions from the perspective of senior creditors won't have done any harm.
Good time for cable
Telenet's success suggests that European high yield is truly back. Structural considerations now seem to have been largely solved and the success or failure of an issue does now seem to depend on the underlying perception of credit quality. It seems likely that the market's claim of offering strong support for a ?good credit? is the central issue. Of course what exactly constitutes a ?good credit? is a difficult one to answer, and it is precisely this point that is likely to be tested in the months ahead by market practitioners.
What is certain, however, is that European high yield is winning back some friends of old and even making new ones. And the cable industry looks set to be among the beneficiaries of this upward trend. As Martin Reeves of Alliance Capital in London observes: ?The high yield market has done very well in the last 12 months and a lot of investors have been drawn to the asset class. There is demand for credit risk which gives high spreads. The cable sector has probably picked a perfect time to start issuing new debt again.?