Dell Bondholder Submission Seen in Debt Curve: Corporate Finance

Dell Inc. bondholders increasingly expect they will be subordinated to new lenders in a potential $24 billion leveraged buyout.

Yields on $1.5 billion of Dell notes maturing in five to 10 years have increased to 4.05 percentage points more than obligations due in less than three years, from about 2 percentage points less than two weeks ago, according to Bank of America Merrill Lynch index data. That’s the widest difference among the 50 largest U.S. borrowers, which have an average gap of 2.3 percentage points.

Dell’s existing bonds don’t have terms limiting total indebtedness at the Round Rock, Texas-based company, leaving creditors vulnerable to new obligations that may rank senior to current debt, according to research firm CreditSights Inc. A buyout, discussions for which were revealed last week, may push debt to 4.5 times earnings, according to Fitch Ratings, which would make Dell the world’s most-leveraged computer hardware maker, data compiled by Bloomberg show.

“The market is showing that it expects the longer-dated Dell bonds to be subordinated to new LBO debt,” said Alan Shepard, an analyst at Madison Investment Advisors Inc., which oversees about $16 billion in Madison, Wisconsin.

Takeover Talks

Dell’s bonds have plummeted since Bloomberg News first reported its buyout discussions with private-equity firms, leaving investors with a 10 percent loss in January as U.S. corporate notes on average rose 0.1 percent, Bank of America Merrill Lynch index data show.

Its longer-term debt including $600 million of 5.875 percent notes maturing June 2019 and $400 million of 4.625 securities due 2021 have declined 13 percent this year. That compares with a 1 percent drop on its near-term securities.

Dell’s five-to-10-year bonds yielded an average of 5.6 percent yesterday, higher than average borrowing costs of 5.15 percent for similar-maturity BB rated bonds, the highest junk tier, and more than three times the yield on Dell debt due in less than three years, which pay 1.55 percent, index data show.

If a buyout happens, “typically they will try to refinance the real short-dated stuff just so they have some operating room,” said Noel Hebert, chief investment officer at Bethlehem, Pennsylvania-based Concannon Wealth Management LLC, which oversees about $250 million. “When you start reaching over the horizon to longer-maturity debt, you have the subordination risk, you have prospective ratings downgrades, and you have higher operating risk.”

David Frink, a spokesman for Dell, declined to comment on how a private takeover would affect existing creditors.

Microsoft Contribution

The company is getting closer to clinching a leveraged buyout with Silver Lake Management LLC, and Microsoft Corp. is discussing contributing about $2 billion for the deal, according to people with knowledge of the matter. Silver Lake and Dell are negotiating a price in the range of $13.50 to $14.25 a share, said one of the people, who requested anonymity because the talks are private. Dell shares traded at $13.08 at 11:56 a.m. in New York, up 29 percent for the year.

Gemma Hart, a spokeswoman for Silver Lake, declined to comment, as did Frank Shaw, a spokesman for Redmond, Washington-based Microsoft.

It’s likely that a leveraged buyout would leave room to refinance Dell’s short-dated debt maturing between 2013 and 2016, Ping Zhao, an analyst at New York-based CreditSights, wrote in a Jan. 21 report that downgraded Dell to “underperform.” The plunge in long-dated bonds still doesn’t reflect potential post-LBO trading levels, she said.

‘Event Risk’

“Dell can incur significant amounts of debt that is structurally senior to existing debt,” Zhao said in the report. With Dell’s existing notes issued at the holding company level, any debt sold or guaranteed by the firm’s units would be structurally senior, she wrote.

While Dell’s indentures have certain limits on issuing secured debt, there are “many ways” to pledge assets such as cash, patents and accounts receivable that may allow the company “to issue many billions of dollars of secure debt,” according to the report. “Event risk for bondholders at this time is substantial,” Zhao said.

Potential Collateral

Dell has about $9 billion to $10 billion of assets that could be used as collateral in secured debt, according to Mark Pibl, head of credit strategy at Cortview Capital Securities LLC. “It’s a huge concern. As always with LBOs, there’s always the potential for deep subordination with the acquisition-related debt,” Pibl said in a telephone interview.

“Corporate-bonds investors are extremely concerned about the downside of their positions, which even with the recent sell-off could be still substantial,” said Pibl, who expects a deal to be completed.

Five-year credit-default swaps tied to Dell’s debt, which typically rise as investor confidence deteriorates, reached a record 417.5 basis points on Jan. 18, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. That’s up from 178 points on Jan. 10. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The difference between the one- and five-year contracts soared to the most on record last week, reaching 362.5 basis points on Jan. 18 as traders priced in longer-term credit risk, CMA data show.

The five-year swaps, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, today rose to 409 basis points from 405.5 yesterday.

Investor Downgrade

Dell has already lost its investment-grade status in the eyes of credit investors, according to Moody’s Corp.’s capital markets research group. The derivative prices are at levels that imply the debt should be rated B2.

The computer maker is ranked A by Fitch, A2 by Moody’s Investors Service and A- at S&P.

An LBO may boost Dell’s leverage ratio, or debt to earnings before interest, taxes, depreciation and amortization, to between about 3.5 times and 4.5 times, John Witt, a credit analyst at Fitch in New York, wrote in a Jan. 17 report. That’s an increase from 2.09 on Nov. 2 and would be the highest among global competitors with at least $1 billion of long-term borrowings including Toshiba Corp. and Hewlett-Packard Co., Bloomberg data show.

‘Excellent Opportunity’

It would also swell Dell’s total debt to more than $15 billion, from $9 billion in November, according to Bloomberg data based on trailing 12-month Ebitda of $4.3 billion. While Fitch estimates a transaction would push Dell’s credit rating to the single-B category, private buyers stand to benefit from the lowest borrowing costs on record. Yields on junk debt fell to an unprecedented 6.46 percent yesterday, Bank of America Merrill Lynch index data show.

“This is an excellent opportunity, if the funds are available, to do an LBO given the low interest rate environment,” Madison’s Shepard said.

Dell, which Chief Executive Officer Michael Dell founded in 1984 in his University of Texas dorm room with $1,000, is struggling to contend with weak computer demand in a market increasingly pinched by high-end products such as Apple Inc.’s iPad and competition from Asian manufacturers for low-cost machines.

Dell shares, of which its founder owns almost 16 percent, trades at 8 times its latest 12 months earnings, lower than 96 percent of companies in the Standard & Poor’s 500 stock index. The market value of the company’s shares is $22.8 billion, Bloomberg data show, and under the current negotiations, Michael Dell would roll his stake into the buyout, according to a person familiar with the talks.

Desktop Sales

Desktop PC’s accounted for about 23 percent of Dell’s $13.7 billion of sales in the third quarter, Bloomberg data show. The company said in a December regulatory filing that its “most attractive areas for profitable growth” include data-center management and so-called cloud computing.

“Whether it’s public or private, the issue is the business model and the life cycle of the PC, and I’m not sure that the situation that confronts them is going to change, regardless of the capital structure,” Bonnie Baha, head of global developed credit at Los Angeles based DoubleLine Capital LP, which oversees about $53 billion, said last week in a telephone interview.

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