MCI Communications Corp.

, 1983

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas

The Telecom Industry

Long-term: Rents for Happy Few

• AT&T dominates, but limited by threat of re-regulation
• Few surviving firms share the rest
 Economies of scale ==> Few firms will survive
 High CAPX ==> Entry is unlikely
• Oligopoly + Slow steady growth [Exh.9] ==> High profits

Short-term: Cut-throat Competition

• Entire market is up for grabs (city-by-city elections)
• Massive advertising campaign needed (requires $$$)
• High CAPX
• Uncertainty: (Re)-regulation, competition, technology
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MCI’s Business Strategy

Execunet:
• 1976-78: Court rules against promising Execunet (until 1978)
• 1978-80: Poised to grow after Execunet court order lifted

1982, Deregulation ==> New growth opportunity

• Formidable competitors: AT&T, GTE, IBM, ITT
 Richer, more established, better known, more reputable,
larger, more diversified
 Maybe slower (?)
• MCI needs to invest or die ==> Needs access to capital markets

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Forecast Financing Needs (Exhibit 9A)
1984 1985 1986 1987 1988
Uses
CAPX 890 1,467 1,931 2,760 1,457
Sources
After-tax income 210 235 371 588 731
Depreciation 173 272 412 601 749
Increase in deferred taxes * 65 88 106 120 140
Need 442 872 1,042 1,451 -163
Cumulative 1,314 2,356 3,807

* Provision for taxes

• Excess cash of $500M ==> Need $3.3B over next 4 years

• More if start-up hits bad times
• Contrast with AT&T: Plant capacity + Generate cash

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Current Capital Structure
MCI AT&T GTE IBM ITT
Debt ratio 55% 43% 57% 14% 38%
Current ratio 2.2 0.9 1.0 1.6 1.3
Interest coverage 4.2X 3.6X 2.4X 18X 2.5X
Bond rating NR AAA BAA AAA A

• Leverage ratio = 55% (37% with Cash)

• Competitors: Less leverage + Less risky

 AT&T overstated as just raised $2B
 IBM low
 GTE similar to MCI, but larger and more tangible assets

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Target Capital Structure: The Checklist

• Expected Distress Costs: Potentially Enormous

 Lots of short-run uncertainty
 If MCI finds itself unable to raise funds, it’s dead meat.
 Rivals would seize the opportunity to get rid of MCI by
outspending it into the ground (see AT&T’s deep pocket)
• Tax Benefits of Leverage: Small

1983 1984 1985 1986 1987

Taxes paid* 17 18 -30 17 86

• Provision for taxes - Increase in deferred taxes.

• Bottom Line: More equity is needed.

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 Financing Options
• Straight Debt: $500M, 12½% interest, 20-year maturity

• Common stock: $400M

• Convertible (+ callable) debt

 Debt: $1B, 7 5/8% interest rate, 20-year maturity;
 Conversion price $54/share (one $1,000 bond ==> 18.52 shares);
 Callable (by MCI) and call-protected for 5 years.

• Synthetic convertible (+callable) debt: Raise $1B in bundles of:

 One bond: $1,000 face value, 7½% interest rate, 10-year maturity
 18.18 warrants: Call options each for 1 share, maturity 1988
 Strike: $55/share in cash or one $1,000 bond;
 Warrants are callable by MCI and call-protected for 3 years (1986).

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Background on Convertible Bonds
• What is a convertible?  Bond + option to convert into stock
• How does option work?  Conversion ratio

Example: MCI’s convertible debt (option c)

• Investors can convert one $1,000 face value bond into 18.52 shares
 Conversion ratio of 18.52
 Reported as “conversion price” of $1,000/18.52=$54/share.

• Recall: All (but zero-coupon) bonds tend to be issued at par.

• The coupon on a convertible bond is lower than on a comparable
straight bond, since investors also get an option.
• The more valuable the option (the lower the conversion price), the lower
the coupon required.
• Price: Essentially sum of values of (discount) bond and option.

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Conversion
• Conversion value:
 Value of option if exercised today;
 A convertible can never trade below its conversion value.

Example: MCI’s convertible debt (option c)

• If stock price rises to $60, conversion value = 18.52 * 60 = $1,111.2

• Conversion strategy:
 Investors are generally better off not converting voluntarily --
(unless the stock pays high dividends)
 Recall: American option ==> Leave option open (unless the
underlying asset pays large dividends).

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Forced Conversion

• Most convertibles are also callable (by the issuer).

• Investors can be “forced” to convert if the issuer calls the bond.

Example:
• Conversion value = $1,111.2
• MCI can call the bond (i.e., buy it back) for $1,000
• When the bond is called, investors will choose to convert it.

Note:
• Cannot force conversion if stock price is too low.
• Forced conversion only if conversion value exceeds call price.

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Call Protection Period

• The issuer cannot call the bond for a certain period

 usually 1 or 2 years

• All else equal, longer call-protection period

 convertible more attractive to investors
 lower coupon rate.

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 MCI’s Financial History (Exhibits 1 and 6)
• 1972: $27M in IPO at $5; rest mainly bank debt

• 1975: $8M in stock and warrants at 85c

 Warrants can be exercised at 1.25
 Basically 2-for-1 sale as all value of stock is in option

• 1976-78: Court rules against promising Execunet (until 1978)

 Turns to leasing

• 1978-80: Poised to grow after Execunet court order has been lifted
 Convertible preferred (12/78; 09/79 and 10/80)
 Junk bond (7/80)

• 1981-83: Raise about $1B to finance addition to PPE

 3 convertible bonds + 2 straight junk bonds
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Why Leasing?

• Leasing:
 Loan secured by asset
 The lender (lessor) owns the asset at least until maturity
 Usually, the borrower (lessee) has an option to buy the asset

• For MCI, leasing was attractive for two reasons:

 Secured lending avoids debt-overhang problems.
 Lessors can deduct the depreciation from taxable income
 With little taxable income, MCI could not exploit this fully

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Why Convertibles?

• Typical user has relatively high R&D, high debt, volatile cash-
flows, high market-to-book ratio.

High-tech growth company is a classic example.

• Why? Two possible explanations:

1. Convertibles as “back-door” equity. Gets equity into the

capital structure while avoiding the price hit associated with
a direct stock issue.

2. Convertibles as “sweetened” debt. Give lenders an option,

to prevent the misalignment of incentives – reduces the
shareholders’ temptation to take risks that leave lenders
holding the bag.

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MCI’s Past Use of Convertibles

• MCI has used converts with huge success (almost $1B)

• Forced conversion of first 5 of 6 issues

• No direct equity issue since November 1975

• MCI has been reluctant to issue equity for fear that it will “knock
the props out from under the stock.”

• Convertibles as “back-door equity”

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 15

What About Now?

• Now, the environment is totally new

• Deregulation + “Equal access” ==> Potential risk:

 If issues equity, even if old converts are not converted
D/TC = 444 / (444 + 1165) = 28%

 If issues converts and no conversion

D/TC = 1444 / (1444 + 765) = 65%

• Bottom Line: Not clear cut. Straight equity issue may be a

better idea because the window of opportunity is so small.

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What Actually Happened?

• MCI issued synthetic convertible debt (largest issue ever)

• Got into trouble:

 AT&T big winner with 80% market share
 Lower revenues than projected (1/2 of case projection)
 In 1986, MCI undertakes major layoffs, CAPX cut,...
 Stock price collapse ==> Cannot force conversion of last 2
issues
 June 1986: IBM buys 18% stake paying with its SBS
subsidiary

• Eventually, recovered but nearly missed the opportunity

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 17

MCI Summary
• Two key issues: Identifying the target + Getting there.

• Target for MCI circa 1983:

 Minimal tax shields.
 Costs of financial distress are potentially high.
 Conservative capital structure is probably the way to go.

• Getting to the target:

 Firms are reluctant to issue equity because of price hit.
 Convertibles are a good trick: Back-door equity.
 But, in risky environment, can end up being back-door debt!

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 18

WorldCom: MCI Acquisition

Wall Street Journal, New York, N.Y.; Sep 15, 1998: The closing, announced with little fanfare,
marks the end of a nearly two-year saga that began with British Telecommunications PLC's
bid to buy MCI and evolved into one of the biggest takeover battles in history as WorldCom
and surprise suitor GTE Corp. both sought MCI.

WorldCom's $51-a-share $37 billion offer ultimately prevailed, but European regulators
threatened to scuttle the deal over concerns that the combined MCI-WorldCom would
dominate the Internet's "backbones." To appease regulators, MCI earlier this year agreed to
sell its Internet assets to Cable & Wireless PLC for $1.75 billion. The Federal
Communications Commission gave its final blessing to the deal yesterday.

As expected, Bernard J. Ebbers, WorldCom's chief executive officer, is president and CEO
of the combined company. MCI Chairman Bert Roberts becomes chairman of MCI
WorldCom. The company, with revenue of more than $30 billion, now has more than 75,000
employees and 22 million customers. It will trade on the Nasdaq Stock Market under
WorldCom's existing stock symbol, WCOM.

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 19

WorldCom: Other Acquisitions

• From its inception, WorldCom grew significantly as a result of

numerous acquisitions.
 On December 31, 1996, WorldCom acquired MFS
Communications, which owned UUNET, one of the world’s most
extensive Internet backbone networks.
 On September 14, 1998, WorldCom acquired MCI Communications
Corporation, one of the world’s largest providers of
telecommunications services.
 On October 1, 1999, WorldCom acquired SkyTel Communications,
Inc. (“SkyTel”), a leading provider of messaging services in the
United States.
 On July 1, 2001, WorldCom acquired Intermedia Communications
Inc. (“Intermedia”), a provider of voice and data services, and, as a
result, a controlling interest in Digex, Incorporated (“Digex”), a
provider of managed web and application hosting services.

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WorldCom: Debt Financing

• These acquisitions, along with large capital expenditure

programs, greatly expanded WorldCom’s network operations, its
customer base, the range of services it provided and the
capabilities of its sales, service and technical personnel.

• However, these acquisitions and capital expenditure programs

contributed to a sharp increase in WorldCom’s outstanding debt,
which was over $30 billion as of June 30, 2002.

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WorldCom: Fraud and Filing for Bankruptcy

• On June 25, 2002, WorldCom announced that, as a result of an internal audit of

its capital expenditure accounting, it was determined that its previously issued
financial statements had not been prepared in accordance with accounting
principles generally accepted in the United States. Following a comprehensive
review, WorldCom restated its consolidated financial statements for the fiscal
years ended December 31, 2000 and 2001 and for the first quarter of 2002. The
restated 2000 and 2001 financial statements were audited by KPMG LLP
(“KPMG”), which replaced Arthur Andersen LLP (“Andersen”) as WorldCom’s
external auditors in May 2002.

• On July 21, 2002, WorldCom and substantially all of its U.S. subsidiaries filed
voluntary petitions for relief in the U.S. Bankruptcy Court for the Southern
District of New York under Chapter 11 of Title 11 of the U.S. Bankruptcy Code.
On April 20, 2004 (the “Emergence Date”), WorldCom’s plan of reorganization
was consummated and WorldCom emerged from bankruptcy. On the
emergence date, WorldCom merged with and into MCI whereby the separate
existence of WorldCom ceased and MCI became the surviving company.

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 22

Appendix: Convertibles as an Answer to
Informational and Dynamic Considerations

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas

Hybrid Instruments

• Hybrid instruments (e.g., convertible debt) may be attractive as

a means of mitigating financing problems associated with
information asymmetry.

Evidence:
• Less negative price reaction than equity issues.
• Typical issuer of convertible debt has relatively high R&D, high
debt, volatile cash-flows, high market-to-book ratio.
• High-tech growth company is a classic example.

• The following example illustrates why that might be the case.

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Example

• XYZ’s assets in place are subject to idiosyncratic risk:

 With probability 1/2, PV = $150M or PV = $50M

• New investment project:

 Discount rate: 10%
 Investment outlay: $12M
 Safe return next year: $22M ==> PV = 22/1.1 = $20M

NPV = -12 + 20 = $8M

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Example (cont.)

• Suppose XYZ has no cash and cannot issue debt, because of

high costs of financial distress.

• Absent information asymmetry, XYZ could raise $12M by selling

12/(150+20) = 7.06% of its equity (after issue)

• Suppose XYZ has 1M shares outstanding.

 It can issue 76,000 shares
 New share price: 170/(1+7.6%)= $158

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Example (cont.)

• Assume that:
 Today managers know the true value of XYZ’s to be $170M
 Today, the market does not know the value of XYZ
 But next year, it will realize that it is $170M.

• XYZ can issue $12M worth of convertible debt

 convertible (by investors) with conversion price $157.9
 callable (by XYZ) at face value
 interest rate set so that trades at par ($12M together)

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Example (cont.)

• When the information becomes known, XYZ can force

conversion because:
 If investors do not convert, they get $12M
 The conversion value is (just above) $12M
==> XYZ needs to issue: 12M/157.9 = 76,000 shares

• Altogether, as under symmetric information, XYZ has:

 Raised $12M
 Issued 76,000 shares

MFIN 301 Corporate Finance - Spring 2014 - Oguzhan Ozbas 28