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More companies are opting to issue now, pay later.
Ian Springsteel, CFO Magazine
December 1, 1997
Intermedia Communications Corp. needed cash last winter to continue its aggressive growth strategy, but circumstances blocked the way. Covenants on $160 million of Tampa-based Intermedia's existing $353 million in senior debt ruled out another trip to the bank. The second option, issuing equity, seemed too costly. Investors had begun questioning the prospects of upstart local exchange phone companies, causing Intermedia's stock to fall by 40 percent from a record high of $38.50 a share in late 1996 to $23 a share last February.
But Robert Manning, Intermedia's senior vice president and CFO, pressed the company's investment bankers at Bear, Stearns & Co. to find an alternative. Their proposal: exchangeable preferred stock with a "payment- in-kind" (PIK) dividend. The benefits were threefold. First, Intermedia could pay investors in more shares of exchangeable preferred stock. And in addition to slipping past debt covenants, the company could avoid diluting existing owners because the PIKs could be exchanged for debt when cash flows and covenants allowed, at the company's election. "We looked at the security and found that it fit our capital structure and our situation very well," says Manning.
Devised in the mid-1980s, PIK securities lost favor with investors along with the rest of the high-yield market in the early 1990s, a time of defaults and bankruptcies among junk issuers. But investors in the past two years haven't seemed to mind that history. Says Manning, "It didn't hurt that yield-hungry investors were buying these things up like hot cakes."
So Intermedia took the plunge last March, raising $300 million in a Rule 144a offering that paid a 13.5 percent dividend, with mandatory redemption in 2009. To compensate for their non-debt junior nature, investors demanded 150 to 200 basis points more than for an issue of senior debt, typical for this kind of issue by a single-B company like Intermedia.
A Growing Roster
The offering helped build a small wave of similar deals this year. All together, 27 mostly telecommunications and media companies raised $3.9 billion in the first 10 months of 1997, most featuring PIKs. This year's heady pace follows $3.1 billion raised by a dozen similar deals in 1996, including $1.6 billion in PIK exchangeable preferred stock issued in April by Time Warner Inc.
Still, companies issuing exchangeable preferred stock face several drawbacks. In addition to the higher yield, the securities pay dividends, not interest, negating a deduction from pretax income. However, many high-yield debt offerings sold at deep discounts do not pay interest immediately, and they often fall under restrictive federal tax rules, limiting current and eventual deductions. Companies posting net losses, moreover, don't pay taxes currently, as was the case with Intermedia.
Also, sizable bullet payments or refinancing may await issuers of PIK securities, which can create needling tax issues. "Deferred dividends can create a cash-tax event for investors, even though in some cases no cash will have ever passed to the investor, if paid when the company has current or accumulated earnings," warns Rick Halpern, a partner at Eckert, Seamans, Cherin & Mellott LLC, a law firm in Pittsburgh.
This effect limits the pool of investors for PIKs, which already fluctuates depending on the flow of cash to less-tax-sensitive funds. "Issuers need to know when the money is flowing heavily into the right pension and mutual funds in order to place PIKs well," says Richard Lukaj, an investment banker at Bear, Stearns.
But despite the drawbacks, the exchangeable preferreds helped Intermedia stay on track, boosting its stock into the $30s by summer. That, and favorable shifts in the bond market, enabled Manning to tap the markets twice more for an additional $1.04 billion this year in deals combining convertible stock and debt. This included an October issue of $250 million in senior debt paying 8 7/8 percent, due in 2007--less than 300 basis points off the 10- year Treasury--despite its still-single-B rating from Standard & Poor's.
So despite the high price of the PIKs, Manning is without regrets. "Would I recommend PIKs to other companies? In the right situation, sure," he says. "But I've got to tell you, raising high-yield debt at 8 7/8 is a lot better."