Colt: under fire

Colt Telecom is staring down the barrel of a court case brought by one of its bondholders, hedge fund Highberry, which insists that Colt will soon be facing insolvency and so should be put into administration. David Watts looks at each side’s arguments and the story behind the case.

Colt Telecom’s marketing slogan is ‘We make business straightforward’. But a court case being brought against Colt – the most immediate challenge facing its business – is anything but straightforward.

The fundamentals of the case are simple enough: Highberry, a UK hedge fund and owner of Colt bonds, claims the telephone company is facing inevitable bankruptcy and an inability to repay its bonds. Even if Colt’s cable assets are sold off to the highest bidder, says Highberry, this will raise negligible funds because bidders for telecom networks are thin on the ground at the moment, to put it mildly. Colt’s auditors, PriceWaterhouseCoopers, value the network, which makes up the majority of Colt’s assets, at £1.6 billion.

The next pillar in Highberry’s argument hangs on the woolly language of UK insolvency law. In the UK, a company that is, or is likely to become, insolvent can be placed under the control of an administrator so that the assets can be sold off and the creditors paid back any cash.

Highberry is arguing that Colt qualifies for the ‘likely’ category since bankruptcy is imminent and any assets, when sold, will not be enough to cover the liabilities – the bonds and trade payments.

An open-and-shut case, if you ask Highberry; the company should be wound up and the money doled out to the long-suffering creditors.

Other bondholders would probably not complain too vociferously. The company’s bonds have not traded above 90% of their face value since May 2001 and throughout November they were trading at roughly 50 pence in the pound.

As Lior Jassur, high-yield credit analyst at Dresdner Kleinwort Wasserstein, writes in a report on Colt, published at the end of October: “With £978 million in cash and £1.16 billion in bond debt, taking all the cash and distributing it to bondholders would result in recovery value of around 85%, significantly higher than current bond prices.” And although the actual recovery value might be less because of liabilities to suppliers and customers, it would still be higher than the current 50 pence on the pound.

This of course would suit Highberry nicely – the fund owns Colt bonds with a face value of £75 million, which it bought at a price significantly below that level.

But the case is likely to be anything but open and shut. As John Doherty, Colt’s director of investor relations, says: “Highberry is trying to accuse us today of an offence based on unseen events in the future.”

“We believe it will be difficult to determine in a court room whether Colt will be solvent at some future date given all the variables involved,” says Al Mattera, high-yield analyst at Barclays Capital in London.

The problem, according to Nigel Sillis, credit analyst at Baring Asset Management in London, is “the letter of the law for insolvencies is very vague. It says either the company is insolvent or likely to become insolvent but no timescale is attached to the second clause.” In the case of Colt, Sillis says it will be very difficult for a judge to rule with any certainty that the company will become insolvent in the future.

Highberry will need to convince the judge first that Colt has no future and then that its assets are practically worthless.

The second part of this argument is probably the easier; if Colt does go bankrupt then there is plenty of evidence that its assets will not fetch much in the current market. Last August, Hutchinson Whampoa and Singapore Technologies paid just $250 million for a 65% stake in US telco Global Crossing, whose assets include a cross-Pacific telephone cable that originally cost $4 billion to lay.

But Colt is not bankrupt yet. So, what is crucial to this case is Colt’s ability to repay or refinance its debts and so stave off bankruptcy.

Colt unsurprisingly describes the case as “absolute nonsense” and says there is no possibility of its bankruptcy. Doherty at Colt points to the firm’s £1 billion cash pile. And though Colt is currently burning through its cash pile at a rate of knots, it is expected to become cashflow positive in 2005.

Dresdner forecasts that the firm will have roughly £560 million in cash remaining in 2005: almost exactly the same amount as the value of the firm’s outstanding bonds and convertibles that mature in 2005 and 2006. “They will need to roll over some debt but not the 2005 or 2006 bonds,” says Dresdner’s Jassur. “Colt is unlikely to have enough cash to repay all its bonds but that hardly makes it unique; most companies are dependent on rolling over debt.”

But Highberry says there is not a hope Colt will be able to refinance those longer-dated bonds. Auditors KPMG, working on behalf of Highberry, say that for Colt to borrow new money it would be forced to pay at least 20% interest. Colt’s euro-denominated 2009 bonds were yielding almost 22% in November and the company’s other bonds between 25% and 30%.

“At those sorts of interest rates the cost of debt is really a hypothetical question since no firm would approach the market at such levels,” says BarCap’s Mattera.

But Doherty disagrees that the current yields are representative of Colt’s cost of debt: “The average cash interest rate on our bonds is just over 5%. With nearly £1 billion of cash we do not need to raise money in the short term. As we have said many times we are confident about our ability to repay or refinance our bonds when they become due, which in any event is not until between 2005 and 2009.”

Also some of the cash that Colt has been spending has been used to buy back debt in the market and so lessen the overall burden. “We have been opportunistic,” says Doherty, “so far we’ve bought back roughly £336 million of the face value and spent about £179 million doing that.”

And finally Colt argues that the bulk of its network has now been built so any further capital expenditure will be success driven, and so “directly related to winning new customers or generating new revenues”.

Peter Kernan, telecoms analyst at Standard & Poor’s, agrees: “Colt has gone through the backbone build-out phase and is now in the position where it can sweat the network.”

But Colt’s business acumen and its current ability to focus spending only where it can win business might not be enough. Analysts are worried that Colt’s market is simply growing too slowly and that the firm may fail to become cashflow positive by 2005: third-quarter revenues were just 0.3% higher than the second-quarter figures.

Kernan adds: “It will be challenging for Colt to grow sufficiently to be making cash by 2005, especially given the weak economic environment in Europe and the UK, which will affect development.”

And the outlook for the sector itself is not rosy. According to Raj Modi, analyst at Ovum, a technology consultancy covering the telecoms market: “There is huge potential for things to get a lot worse, the shake-out has not been far reaching enough to eliminate some of the over-capacity.”

Against this backdrop S&P’s definition of a B rated credit, like Colt, sounds especially apt: “An obligor rated ‘B’ currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation.” In fact because of the poor operating environment S&P downgraded Colt to B- in mid-November.

Nevertheless, compared with many of its peers, Colt is in much better shape. Two UK rivals, cable operators NTL and Telewest, have both missed interest payments on their debts and both look set to restructure their debts.

Modi at Ovum says: “If you do an analysis of the European telecom companies in this sector then Colt is one of the better ones.” And S&P’s Kernan agrees: “Colt is absolutely one of the best high-yield creditors in this part of the market.”

But, analysts say, the source of Colt’s strength is also the reason Highberry is bringing its costly court case. Without Colt’s cash pile, the recovery value of its bonds would be nowhere near the 85% of the bonds’ face value predicted by Dresdner. Late last year, Colt looked set to become another high-yield telecom forced to restructure its debts until an £494 million open offer – similar to a rights issue – rescued the company. It is this money, say analysts, that Highberry is ultimately trying to get its hands on.

In fact, analysts speculate that Highberry originally began buying Colt bonds in the expectation of a restructuring, but after the open offer injected enough cash to keep the firm in business at least for the foreseeable future, Highberry looked for alternative options.

But this shareholder show of support for Colt is likely to prove problematic for Highberry in the upcoming court case. To win the case Highberry must argue that Colt will have no option but seek financing in the debt capital markets or from banks in several years’ time. And because the cost of its debt is so high, Highberry will argue that both avenues are shut to the firm. However if Colt can convince the judge that more equity financing is not out of the question then the cost of debt may be irrelevant. Colt’s shareholders – including Fidelity, which holds a 56% stake – are unsurprisingly reluctant to give absolute promises of support, but they are certainly not leaving Colt in the lurch.

A spokesperson for Fidelity in Boston, tells Credit: “Fidelity continues to have faith in Colt, its management and its prospects and has confidence to take a long-term view of its investment. Highberry’s allegations have not caused Fidelity to change its view.”

In fact some of Colt’s management are Fidelity men: Barry Bateman, Fidelity’s vice chairman, takes over as Colt’s chief executive when incumbent James Curvey steps down at the end of this year. And Andrew Steward, also with Fidelity, has been standing in as Colt’s chief financial officer until his replacement joins at the start of 2003.

But Highberry’s argument is not really based on whether Colt will go bankrupt but more when. In its statement on the case, released in mid-October, the hedge fund said: “Highberry believes that insolvency is inevitable, especially given Colt’s long history of failure to meet forecasts and targets.”

And in apparent response, Colt’s third-quarter figures, released a fortnight later, duly beat analysts expectations for Ebitda, albeit marginally, rising £4.3 million between the second and third quarter to reach £19 million.

As Simon Surtees, credit analyst at Gartmore Investment Management, says: “If Colt shows it can meet its expectations, that rather spikes Highberry’s gun.”

There are suspicions that Highberry has also been spiking guns in preparation for the court case. Highberry informed Colt of its intention to seek a court order placing the telco under administration in August. In June Colt received a letter from the law firm Linklaters acting on behalf of bondholders. The letter complained that Colt’s bond buy-backs constituted preferential treatment for certain creditors.

But, according to Colt, when it approached Linklaters about opening a dialogue with the bondholders the law firm failed to respond. Linklaters was also unable to give Credit any further information about the letter or the relevant bondholders. But some analysts speculate that the letter may have been sent anonymously on behalf of Highberry as a precursor to the case.

It is not known when Highberry bought its bondholdings in Colt but Colt’s Doherty says: “We suspect they didn’t buy them at issue.” Colt suspects Highberry bought them over the past year when they were trading at a substantial discount.

A spokesperson for Highberry says the fund bought the bonds approximately a year ago and definitely did not buy the bonds just to bring a case against Colt. Instead, the spokesperson says, Highberry is bringing the case purely because it is concerned about bondholders’ prospects.

Highberry released a statement in response to Colt going public on the court case in October, saying that it “is concerned that the approximately £1 billion of cash Colt currently has left is being and will be depleted by further expenditure on investments and associated unprofitable trading, which are unlikely to produce a reasonable economic return”.

And to a certain extent Highberry’s case does echo concerns of Colt bondholders. As one fund manager says: “Not only has Colt used up all its equity but now it is using up all the debt. That is not only unfair, it’s illegal.”

He adds: “From the point of view of a shareholder in Colt, the company is so far down the road in its network building programme that the equity is valueless. If there is a pile of cash that belongs to creditors, shareholders will obviously want the company to continue spending it.”

And a high-yield corporate bond analyst says: “It is pretty obvious that Colt’s money will just get burnt given that every firm in this sector has defaulted or restructured.”

But by no means all bondholders and credit analysts have rallied to Highberry’s cause. As one high-yield analyst says: “I think Highberry are trying it on.”

According to Doherty, an overwhelming majority of the bondholders he has spoken to back Colt. And though that may be an exaggeration, many investors are probably not convinced by Highberry’s show of bondholder concern. As Doherty says: “Highberry has a track record of using the courts.”

Highberry is part of New York hedge fund Elliot Associates and is run by Gordon Singer, the son of Paul Singer who heads up Elliot in the US. A familiar name to readers of the financial press, Elliot Associates has built a reputation for itself as a hedge fund that seeks to exploit legal technicalities.

In October 2000, the firm forced the Peruvian government to pay $58 million for the full repayment of bonds and capitalised interest after the country had already successfully negotiated a debt restructuring with other bondholders. The action made Elliot Associates $47 million profit after the firm had bought the bonds with a face value of $20 million for $11 million in the secondary market. This almost forced the country into default on its $3.7 billion of debt, and in the process made the hedge fund a pariah amongst aid organisations campaigning for third-world debt relief.

At the time, debt forgiveness charity Jubilee 2000 said in a press release: “Elliot Associates are picking over the bones of the Peruvian economy like a pack of vultures.” And according to Jubilee 2000, Elliot Associates has brought similar actions against Panama, Ecuador, Poland, Côte d’Ivoire, Turkmenistan and the Democratic Republic of Congo.

Less controversially and less successfully, the firm’s Liverpool hedge fund took Telecom Italia to court for €19 million. The case centred on the April 1999 acquisition of Telecom Italia by Italian computer manufacturer Olivetti. Part of the deal consisted of a commitment to buy back as much as 33% of the telecom company’s saving shares – shares with no voting rights. When the buy-back was completed in 2000, only one-sixth of the shares had actually been bought back.

Analysts say Highberry’s strategy in the Colt case is very similar to the Peru case. However, there is speculation that the plan may have backfired on Highberry, with the hedge fund originally seeking to force Colt into a settlement rather than bankruptcy. Not a single analyst, investor or lawyer canvassed by Credit expects Highberry to be successful in this case. As Dresdner’s Jassur says: “My guess is, if Colt’s legal council thought Highberry might have a chance then Colt would have settled without going to court.”

And another high-yield analyst points out that if the market backed Highberry’s chances of success in the court case, the bonds would be trading nearer where they are expected to be redeemed.

Some analysts suggest that in the unlikely event of Highberry winning the case, Colt’s bonds may rally somewhat on the positive sentiment, but this will largely depend on how much of the debt is held by hedge funds. If speculative investors hold a substantial proportion of the debt, the bonds may fall if Colt wins the case. And even if the bonds were to rally, most believe it would only be by a few percentage points – “more a movement than a rally really,” says one analyst, and still much lower than where the bonds traded immediately Fidelity’s cash injection.

But while no one expects Highberry to win, analysts point out that the market clearly agrees with the hedge fund’s argument. Colt’s bonds are currently priced on the assumption that the company will run out of cash in 2005 and its assets will be sold off at roughly three times its predicted 2005 Ebitda. “That is why the bonds trade where they do: everybody has sat down and done this analysis,” says a high-yield credit analyst.

Similar attempts by bondholders to persuade a company to wind up its operations and hand back their money are not unheard of – in August 2001 Atlantic Telecom’s creditors tried to persuade the company to voluntarily close itself down. What makes the Colt case unusual is that it has made it to court.

It appears Highberry has attempted to bluff Colt into settling out of court and Colt in turn has called Highberry’s bluff. As one analyst says of this case: “I think Highberry made a mistake, I can’t see Fidelity throwing in the towel and allowing them to win.”