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Skip Navigation LinksHome :: Back Issues :: The sting in the tail of the good times

March 2002

The sting in the tail of the good times


As German media empire Kirch begins to buckle and telecom firms are again making headlines for all the wrong reasons, contingent liabilities are suddenly a hot topic for credit fund managers. What’s particularly worrying them is the number and size of put options that might force cash-strapped companies to overpay for assets.




       

View graph.
As put options emerge as yet another sting in the tail of an overoptimistic view of market prospects, investors are zooming in on companies that are already stretched to breaking point - among them the telecoms and some auto manufacturers. "We sold out of France Telecom in November because we were concerned about its off-balance-sheet obligations," says a rather smug fund manager. But some lower-profile names are now also looking strained.
Put options are nothing new. It is fairly common for companies to come to an agreement over profit sharing when transferring assets between them, for example. When the business being sold is likely to grow fast, rather than the buyer paying a high price upfront the seller may retain the rights to some of the expected equity upside. Or a transaction might be staggered so that the change of ownership takes place in two or three stages - as Pinault Printemps Redoute agreed with Gucci - often with the price established in advance.
That's fine when equity prices are heading up. The danger comes when the option involves a fixed price and the market collapses in the interval between the agreement being signed and completion. "Some companies overestimated their ability to reduce debt," says Emmanuel Weyd at JPMorgan. "They thought they would have time to restore balance sheets but have not achieved this and so have to face the impact of a put option at a time when their balance sheets remain weak."
Just ask Leo Kirch. In January, German media group Axel Springer exercised a put option on its 11.5% stake in ProSieben, a subsidiary of Kirch. A sudden cash call of e767 million ($670 million) pushed Kirch to the brink of insolvency.
Among the many pressing issues now keeping Kirch's founder awake at night is how to find e1.7 billion in cash to meet a put option granted to Rupert Murdoch's British Sky Broadcasting. Murdoch has the right to force Kirch to buy back the 22% stake in its pay TV business that it currently owns, an option that expires in October.
During a downturn, it's clear that put options tend to harm the companies that have written them. Take France Telecom. In January, news broke that German utilities company E.ON has an option to oblige France Telecom to buy back the e1 billion-worth of shares it holds in Orange at a premium - e9.25 per share compared with their present market price of around e6.60. E.ON can exercise this option from June 2002 and unless the Orange share price bucks up significantly, doing so is a no-brainer.
Then there's the package of measures agreed between France Telecom CEO Michel Bon and Gerhard Schmid of Mobilcom, motivated by the French company's ambitions in Germany. First, Schmid can offload his 36% of MobilCom onto the French firm at any point between 2003 and 2006, probably forcing it to consolidate Mobilcom's e7 billion of debt into its own accounts. Secondly, France Telecom is committed to propping up the German company's efforts to roll out its 3G network in its domestic market. That's part of the deal it struck with the German government in return for getting its hands on a UMTS licence.
At the height of the telecoms boom, this type of agreement no doubt seemed extremely clever. That's no longer the case. "Where we have an issue with some of the telecom and auto companies is that it's actually hard to figure out the rationale for these options," says Bob Janjuah, head of credit-trading strategy at ABN Amro. That's because they were designed with the markets of two years ago in mind.
Paying a high price for selling puts
France Telecom's list of liabilities goes on. It has an agreement to buy back shares from Vodafone, used to pay for Orange, for e5 billion - over three times their market value. It has also just renegotiated a put option with a consortium of banks that bought shares in cable company NTL on France Telecom's behalf as a way of maintaining relationships while circumventing regulators' concerns about banks' exposures to telecoms.
"These other things are not a big deal on their own but put them all together and you have a catalogue of contingent liabilities that doesn't bode well for France Telecom," says one analyst. Bradley Bugg, telecoms analysts at Dresdner Kleinwort Wasserstein, adds: "You need to look at the scale of the contingent liabilities in relation to current debt exposure. The reason people are so concerned about France Telecom is that it could increase their debt by e10 billion to e15 billion, which is really quite significant."
Investors certainly think so. Spreads on France Telecom bonds have widened dramatically since the beginning of the year as investors act on information already made public as well as their suspicion that there's more bad news to come (see graph). Often the very existence of put options makes investors wary.
"Put options are certainly a warning flag," says Joe Biernat, head of research at European Credit Management, a fixed-income investment house based in London. "We want full disclosure and often you don't get that because companies don't want this information to be in the public domain."
Karl Berqwist, head of fixed income credit investment process at Barclays Global Investors, agrees. "Anything that exposes the balance sheet to market risk is clearly something that is a concern," he says. "How concerned we are will depend on the type of industry and how mature it is. Anything potentially volatile is more risky."
Investors tend to be more indulgent towards companies that have at least been honest about the extent of their liabilities. It was widely expected that DaimlerChrysler would exercise its option to sell its 49% stake in debis Systemhaus, its joint IT operation with Deutsche Telekom, back to the telecom company. This liability of around e4.6 billion was already priced into Deutsche Telekom's bonds, meaning that spreads did not widen quite so dramatically as those of its French counterpart had when the put was announced, suggesting that its honesty was appreciated. Not that it makes the bill any less difficult to swallow.
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