Description

CCZ is the ticker for an exchange-traded (NYSE) subordinated debenture, called a ZONES, of Comcast Corporation (NASDAQ: CMCSA) that is exchangeable into shares of Sprint PCS (NYSE: PCS) which is the wireless tracking stock of Sprint Group. Sprint’s remaining operations (long distance, local, internet) are traded as FON Group (NYSE: FON). I believe the market has mispriced these bonds. In addition, the bonds are subject to two clear catalysts that may cause the market to value the bonds more appropriately.

Catalysts

1. Merger between FON and PCS
2. Credit rating upgrade of CMCSA

Background

Comcast has two issues of subordinated debt securities that are exchangeable into shares of Sprint PCS. My focus is on the exchange-traded bond (NYSE: CCZ) that matures 10/15/29 that has 16.1 million ZONES outstanding. The other issue matures 11/15/29 and has 8.1 million ZONES outstanding. Both issues have a 2% coupon. I prefer CCZ because of the size of the issue and the liquidity and transparency the exchange-traded capability offers, and because it has the lowest conversion premium and hence the most exposure to changes in the price of PCS, which I believe is extremely undervalued at current levels. That being said, the second Comcast issue has similar characteristics, as do two exchangeable bonds issued by Liberty Media: the 4% due 11/15/29 and the 3.75% due 2/15/30.

CCZ Summary Description

Recent Price: $31.59 per ZONES
Principal Amount: $71.52 per ZONES
Interest Payments: 2% or $1.4304 per ZONES per year paid quarterly PLUS the amount of any dividends paid on the PCS shares (or shares into which PCS may be converted or exchanged)
Maturity: 10/15/2029
Exchangeability: Into the cash value of 2 shares of PCS at maturity or 95% of the value thereof prior to maturity
Optional Redemption: At any time for $71.52 per ZONES
Ranking: Unsecured and subordinated

Valuation

If you do a simple discounted cash flow analysis of the interest payments plus the principal amount for each CCZ, you get to a value of about $31 per CCZ using a 6.75% discount rate. As a reference point, Comcast’s senior (non-callable) bonds have a YTM of just under 6.5%. I have added 25 bps for subordination. Given the current trading level of CCZ, this implies that I am getting the exchange option into PCS shares for very little. My Bloomberg (OV function) tells me that a 26 year option on PCS shares with a strike price of $35.76 is worth about $5. With each CCZ exchangeable into 2 shares of PCS, the expected trading level of CCZ should be $31 plus 2 x $5 equals $41 or 30% higher than current levels.

FON-PCS Merger

Most Sprint Group observers (and the company) have commented that a merger is likely between PCS and FON. The merits of such a transaction can be debated although it would seem to make sense that the company have all of its telephony operations under one roof for marketing and other operational purposes (like Verizon, for example). The PCS tracking stock was originally created to be a financing mechanism, anyway. I believe a transaction is most likely to occur when PCS becomes cash flow positive, which is anticipated in 2004. Thus, PCS would be able to contribute to dividend payments for the Sprint Group overall.

If a combination occurs and we assume FON (market cap $14 billion) acquires PCS (market cap $6 billion) and, to be conservative, offers no premium to PCS shareholders, FON would issue $5.76 (recent PCS price) divided by $15.20 (recent FON price) equals 0.38 shares of FON for each share of PCS. Assuming FON does not cut its dividend, which would probably be unacceptable to FON shareholders, the two shares of PCS underlying each CCZ would be entitled to 0.76 shares of FON and dividends on these FON shares (0.76 x FON dividend of $0.50) would be passed on to the CCZ holders. Adding these dividends to the existing $1.43 annual interest payment on each CCZ gives an annual interest payment of $1.81 or a 26% gain not allowing for any potential increase in FON dividends. This translates into a bond value for CCZ of about $36 using the 6.75% discount rate. Adding an option on 0.76 FON shares with a strike price of $94.37 ($35.76 divided by 0.38) with a volatility of 45% (a blend of PCS and FON levels) worth about $2.50 yields a total value per CCZ of about $38.50. This is still a nice premium to the current market.

CMCSA Credit Rating Upgrade

Another clear catalyst that should cause CCZ to trade higher would be an improvement in Comcast’s credit ratings. Since Comcast is under pressure to reduce debt following the acquisition of AT&T’s cable operations, I believe this is very likely over the next year or so. Events that might prompt an upgrade include: the receipt of cash from the sale of securities received as a result of the sale of QVC to Liberty Media; other monetization transactions such as the sale of AOL shares that Comcast owns; the sale of non-strategic cable systems; or the sale of the stake that Comcast has in Time Warner Cable.

Words of Caution

Clearly, this analysis does not take into account all of the factors that impact a convertible security’s valuation; however, I believe it covers the essentials. Also, an outright purchase of CCZ is subject to interest rate risk although this can be hedged (at a cost, of course). Even so, CCZ should merit a valuation some 20% to 30% higher than current levels.

Catalyst

1. Merger between FON and PCS
2. Credit rating upgrade of CMCSA