Addressing readers questions about BCE

The leveraged buyout of BCE Inc. has become a microcosm of the sub prime credit crunch. A deal or no deal is predicated on the ability of the partnership to raise capital in a very tight market.

The price of the takeover is $42.75 and is expected to be completed by the end of the first quarter 2008. Although, the deal is still valid as long as it is completed by the end of June 2008.

With the stock trading at $34.91, equity traders are betting the deal will not get done. Option traders are less certain. There are no options with any real trading opportunities outside of the May series. Specifically, the May 40 calls which at the close of trading Thursday, were bid $1.15 and offered at $1.25. This suggests that option traders are doubting whether the deal will be extended beyond May. It will either get done or collapse.

Speculators are buying the BCE May 40 calls because a deal consummated before the May expiration, means a double on this series. Perhaps more importantly, if the deal does not go through, the most traders can lose is the cost of the option. Which is less than the potential downside on the stock should the deal not go through.

So what about access to capital? Certainly, the Ontario Teachers Pension Plan has capital to invest. The others; private equity firms Providence Equity Partners Inc. and Madison Dearborn Partners LLC, both have deep pockets. Although perhaps not deep enough on their own to swallow BCE.

We know that interest rates are declining and that the US Federal Reserve has promised to provide ample liquidity for the financial markets. Because the Fed is keenly interested in making sure loans to creditworthy customers are not cut off while banks re-structure their balance sheets.

We know that BCE is a cash cow. With good management, BCE could streamline its operations funneling more of that revenue to the bottom line. And with this strong cash flow, might actually discover new growth opportunities. Perhaps not double digit year over year growth. But with the leverage inherent in this deal, you won’t need much growth to excite the incoming shareholders. Which is to say, these stakeholders still have a keen interest in seeing the deal through.

But… what if the deal does not go through?

Obviously, BCE would trade at a price significantly lower than the current price. Estimates run the gambit, from $28 to $30 per share at the high end (this would be my best guess should the takeover fail), to $22 to $24 at the low end.

Of course, in that scenario, other players might step up to the plate, albeit at a lower price. Telus remains a possible suitor. Perhaps partnering with players like KKR, or even Goldman Sachs.

Goldman suffered no real impact from the credit crunch. If deal flow for 2008 is as slow as some analysts are predicting, BCE may be a very appealing to an investment bank like Goldman. And let’s face it, there is always the possibility that this deal could get re-structured with the current players at a lower price point.

The problem is that with current management, the market does not see BCE as a growth company. Which was why private equity came to the table in the first place. If it is not a growth company, then it will trade like a utility. Good yield, with little prospect for capital appreciation.

But in that scenario, BCE’s cash flow would continue to be paid out as a dividend. An increase in the dividend is also a possibility. In an environment where interest rates are declining, the dividend on BCE would look quite attractive to income oriented investors. Which should provide some downside support.

Assuming an annual dividend of $1.41 per share, the yield is 4.13% at current prices. At $30 per share, the yield is 4.70% and at $22 per share, the yield is 6.41%.

Given that scenario, there is one strategy that option traders might consider. You could buy the stock at some price below $36 and write the May 40 call at $1.15. This would give you some downside protection, and if the deal does go through you are not giving away much on the upside.