Qwest’s bond tender offer

February 27, 2010

Some of my more loyal reader(s) will recall that one of the very first stocks I suggested on our site was Qwest, on the grounds that it had on the order of $750 million in depreciation expenses that was not being made up for with additional capital expenditures. Considering that the firm has a P/E ratio of about 12 without the excess depreciation added back in, it is pretty clear that the market is ignoring it, since $750 million in added depreciation more than doubles Qwest’s earnings.

Of course, eventually depreciation and capital expenditures should reach a steady state, but until then excessive depreciation is free money (the technical term is “free cash flow”), and Qwest has to find something to do with the extra cash while it lasts. On the one hand they could think offensively, deciding to modernize, move into the high-premium, growth areas of the telecom market in order to combat line loss, or they could think defensively. The only thing they should not do is not think at all and keep the cash on hand earning a ridiculously low return until the CEO decides he needs to redecorate the executive suite.

Instead of buying $6000 shower curtains, Qwest has actually chosen the defensive route of announcing a bond buyback. They are attempting to retire early two debt issues that mature this year and next year, which carry interest of 7.9% and 7.25%, before taxes.  I suppose it is better than earning less than 1% before taxes by holding cash, and also produces some deleveraging. Of course, utilities have stable operations and are allowed to hold a lot of debt; Windstream has an interest coverage ratio of 2.33, which is considered dangerously low for a non-utility. Qwest’s coverage ratio is 1.81, so the need to deleverage might be a little more pressing.

But at the same time their pretax operating profits, with the additional depreciation, come to 2.75 billion, which given their 20.38 billion in total assets is  a 13% profit margin, which is why I am suggesting that they should purchase a valuable business instead, but this calculation is itself complicated by the possibility that accelerated depreciation has caused their asset value on the books to be below their actual economic value.

But I think the deciding factor is that the company will shortly have to pay the bonds back within a year or two at any rate, and keeping the money hanging around on the balance sheet until then is going to cost them a great deal of money. And at any rate, paying down debt early saves them interest and also frees up their borrowing capacity until they decide to do a leverage-based expansion.

So this buyback does increase the firm’s flexibility and on those grounds it is defensible, even if in terms of cost of capital or defensive saving versus expansion decisions. Of course, the other alternative is a big fat special dividend, but the company may in fact be afraid of where interest rates are going to be by the time they have to roll their debts over.  And not everyone has the same sanguine notions of inflation that I do.

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