As you may know, one of my favorite asset classes is high yield bonds, as this market has a small natural constituency and a tendency towards inefficiency, and one of the tenets of value investing is to look for the unpopular and neglected. To this end, I sometimes just run a screen for bonds with high yields and go down the results until I find something interesting.
This time, I got as far as the A’s. Alaska Communication Systems is a highly leveraged provider of phone services in Alaska, which has recently engaged in a joint venture with its largest competitor to form a wireless entity that is intended to ward off an expansion into its territory by Verizon. I’ve found in the past that rural telephone companies spit out remarkably attractive cash flows in the past as they transition from providing basic services to high-speed Internet and business services, and Alaska Communication System is attempting the same transformation. As one may expect, though, the company has been reliant on federal subsidies to provide connectivity to high-cost customers, and apparently these funds have been struck by the dreaded Sequester. But the rate of decline in Alaska’s cash flows seems to be moderating, and the company is entitled to a preferential up-front cash distribution from its wireless joint venture that will take some of the pressure off from its creditors.
The bonds in question are $120 million of a 6.25% convertible issue due 2018, which sits in line behind $320 million in bank debt. The bonds currently trade at around 81.50, for a yield to maturity of 12.6%. I believe that the company will be capable of meeting its debt burdens, and if not, there is enough cash flow to carry these bonds through the unlikely event of bankruptcy.
As I stated before, Alaska Communications is, like most rural phone companies, moving from basic connectivity to high speed Internet and business services. The company reports that the transition is proceeding adequately, particularly with regard to business services. Also, the company points out that Alaska’s economy is highly dependent on oil, and I think with the high prices of oil expected to persist indefinitely, the forward march of exploration and extraction technology tend to bode well for the business atmosphere in the near future. The company also owns an underwater fiber optic cable between Alaska and its holdings in Washington and Oregon through which to provide Internet connectivity.
Alaska Communications formed a joint venture in June of 2013 called the Alaska Wireless Network, or AWN, with its direct competitor, GCI. The deal seemed to be highly favorable to Alaska, given that GCI is roughly four times the size of Alaska Communications. Alaska Communications transferred all of its wireless assets to AWN, as well as agreeing to provide it with all of its wireless subsidies. In exchange, Alaska Communications is 33% owner of AWN, and is entitled to a preferential distribution of $50 million for 2014 and 2015, and $45 million for 2016 and 2017, if AWN has the free cash flow to pay it. As of the first two quarters of 2014, this distribution has exceeded Alaska’s 33% earnings share by over $7 million. However, because AWN is not consolidated with Alaska’s financial statements, there is on paper a notable decline in sales.
I often find it interesting to see what other people think of my ideas, and a good source of information, at least for the views of the well-informed public, is at seekingalpha.com. To my surprise, the consensus among the writers there was that even the equity of Alaska Communications is a worthy investment. I find that view unjustifiably optimistic, as I shall discuss further below, but I should point out that as these bonds are convertible, they carry some slight exposure to the price of that equity as well.
Turning now to the figures, in 2013 sales were $349 million, and operating expenses as reported were $96 million. However, operating expenses included an offsetting $204 million in capital gains from forming the AWN venture, as well as $1.3 million in impairments, and stock-based compensation of $2.9 million, which of course the creditors of the company don’t need to care about. The company incurred $42 million in depreciation and amortization and $48 million in capital expenditures, producing operating cash flows of $47.8 million. Also, the company reported depreciation and amortization of debt discounts and debt issuance costs of $6.9 million. This amount is a noncash expense, and normally is additional cash flow available for paying down debts. However, the company has incurred $3-4 million in both 2012 and 2011 for debt issuance, and as the company’s credit facility falls due to be renegotiated in 2016, and the bonds in question in 2018, we creditors should be aware that there will be issuance costs lurking in the wings. Also, the amortization of debt discount is a genuine expense, since the company is bound to repay the full amount of its bonds, not the discounted amount.
So, sticking with this $47.8 million, with the caveat that there might be a few million more for a more optimistic analyst to find, we have to look at the company’s debt obligations. The company’s credit facility, which is senior to our bonds, had a balance at the close of 2013 of $346 million and bears an interest rate of LIBOR plus 4.75%, or 6.25%, whichever is greater. The company is also required to make $13.2 million in principal payments in 2014 and $14.7 million in 2015, and as the company has only $5 million in excess cash as of its second quarter 2014 balance sheet, the principal repayment should be considered a claim against cash flow. So, 6.25% of $346 million is $21.6 million, plus the repayment obligation, leads to $34.8 million in prior claims on the company’s cash flow. Thus, the credit facility has an interest coverage ratio of 2.21 times, and a fixed charge coverage of 1.37 times.
This leaves $13 million available for the bonds and our equity holders. These bonds also bear an interest rate of 6.25%, resulting in $7.5 million in interest charges for the entire $120 million issue, and these bonds bear a fixed charge coverage of 1.13 times, and an interest coverage of 1.64 times not counting the principal repayment obligation. I should point out also that the $45 or $50 million in preferred distributions from AWN already exceeds AWN’s required interest and principal repayments. In 2012, sales were $368 million and operating cash flows came to $54 million, and in 2011 sales were $349 million and operating cash flows were $75 million, so at least the decline in operating cash flows is moderating. Also, the current stringency in the federal budget that has frozen the high-cost accessibility subsidies at their 2011 levels may be having an effect, but it can reduce cash flows once but not twice, at least if we can avoid further austerity from our elected officials.
For the first half of 2014, sales were $159 million as compared to $189 million for the first half of 2013. Operating expenses as reported were $140 million as compared to $152 million, producing operating earnings of $19 million as compared to $37 million. In the first half of 2014 capital expenditures exceeded depreciation by $0.6 million, while in the first half of 2013 depreciation exceeded capital expenditures by $10.5 million. Furthermore, equity-based compensation was $1.2 million in 2014 and $1.8 million in 2013. This works out to $19.6 million in 2014 versus $49.3 million in 2013. Furthermore, Alaska Communications received an additional $7.3 million as part of its $50 million in preferred distributions from AWN, of which $25 million has been distributed year to date, so the actual operating cash flow for this quarter is $26.9 million. I am curious that Alaska’s free cash flow for the first two quarters of 2013 exceeded its free cash flow for the entire year, but some of that is attributable to higher capital expenditures in the latter half of 2013.
I would also point out that the company has paid down $18.7 million in long-term debt in the first half of 2014, which includes the early repayment of the $13.2 required principal payment and an extra $5 million voluntary repayment. If, as it seems, the company is directing all of its excess cash flow towards debt repayment, then those who are calling the equity of this company attractive are unduly optimistic, as it will be many years in the future before the cash flows of the company can be considered distributable to them.
So, what “should” these bonds be worth? Well, Aswath Damodaran, author of some excellent books on valuation, has computed the credit spread corresponding to particular credit ratings and interest coverage ratios. His figures are available at
The interest coverage ratios are particularly useful for bank debt or unrated bonds like these. According to his table, the bank debt, counting the required principal repayments, would carry a B rating and a 6.5% spread, while our bonds would be rated CC and carry a 9.5% spread. Taking the 2 year and estimating the 4 year Treasury rates from the Treasury website, the bank debt should carry roughly a 7% interest rate and our bonds roughly 10.8%. Since these bonds, as I stated, trade with a yield of 12.5-12.6%, there is a premium over even their theoretical value. Also, these bonds are technically convertible into shares at a price of $10.28, but the company currently trades for $1.80 and, as I’ve stated, are a long way from receiving any distributable cash flow. Still, I was pessimistic about the stock of Western Refining reaching the conversion price some years ago when I was discussing its bonds, and I was pleasantly surprised.
The sticking point in all this is the fact that the bank debt is due to be refinanced in 2016, before the maturity date of our bonds, and how well or badly that will go depends on how robust Alaska Communications’s cash flows are and how much principal the company has managed to pay down. I think the voluntary additional principal repayments are a good move to make Alaska seem like a responsible borrower and so if things go well the refinancing process would not produce a problem for bondholders as long as cash flows have not deteriorated and interest rates have not increased substantially. Also, as I have stated, the preferred distribution from AWN which the company will receive through 2017 already exceeds the company’s fixed charges, so that money is at least a source of interest and additional principal payments as long as it lasts.
Therefore, I can recommend the Alaska Communication Systems 6.25% bonds due 2018 at their current price as a candidate for portfolio inclusion for those investors who are interested in and have the stomach for high yield investing. Also, you may find, as I did, that brokerages have some difficulty finding these bonds to sell you.
Disclosure: At the time of this writing author owned the bonds referred to in this article.
Snow-Covered Telephone Wires, 1938
Photograph by Ansel Adams
Collection Center for Creative Photography
© The Ansel Adams Publishing Rights Trust