The converts have come in about 0.75 points over the past month. My guess is that outrights are looking to exit after a strong run-up in the stock. Additionally, AIMC’s realized vol. has declined with the stock’s upward move but has been much higher in past years.

Theo delta for the convert is 71, which is where I initially want to be but I would look to aggressively buy stock on pull backs to get to as much as 10 deltas light.

To the upside, on 71 delta, the converts nuke to 141.7 at the soft call trigger of 35.586 (11.7 points). The converts are soft-callable on 3/1/15 (about 2 years) with a max make-whole of 8.25 points decremented PV of coupons. I would expect the bonds to expand by about 2 points at this price.

To the downside, the converts cross par at 2.75% up 40.2% at 19.51, which seems reasonable for a 5 yr maturity.

Additionally, we actually sold these converts in July 2012 at 92.81 vs. 14.92. If we nuke down on a 71, the converts nuke to 88. Granted, time has passed and the converts were subject to theta decay but it does show that this particular name has held well to the downside even in a less favorable convert/credit environment.

AIMC currently pays 8c quarterly dividend (1.21% yield) but the converts are fully dividend protected from zero. Borrow is GC.  You make 3.5 points on a $36 cash take-out.

Business Description

Altra Holdings (AIMC) is a manufacturer of a wide range of mechanical power transmission (MPT) for a diverse group on industries including energy, mining, transportation, and turf and garden. Products include 1) clutches and brakes for elevators and commercial lawn mowers, 2) gearing for conveyors and packaging machinery, 3) engineered couplings for turbines, 4) Power transmission components for machine tools, and many more industrial type products.

AIMC is the world’s largest manufacturer of clutches and brakes, which are used to hold a piece of industrial equipment to keep it from moving. You can find these on top of an oil rig to control the cables that goes down into the ground to extract the fuel or in a helicopter to keep the rotors from spinning only in one direction and not letting them back drive. In gearing, AIMC is one of many manufacturers in a highly fragmented market. These are used in conveyor systems, military vehicles, and sewage plants. Industrial couplings connect two pieces of rotating equipment in applications such as oil refineries.

All together, AIMC sells into 36 different industrial markets with a mix of early (20%), mid (40%) and late cycle (20%) industries. The company’s products serve many niche markets that are difficult for competitors to enter.

40% of sales were from the aftermarket.

55% of sales North America; 31% Europe; 14% Asia and rest of world

AIMC is the number 1 or 2 player in over 50% of the products segments that is serves.

17% of US employees are unionized; 59% of European employees are unionized

Industry Description

The industrial power transmission products market generated $36B, divided into three areas 1) Mechanical Power Transmission (MPT), 2) Motors and generators, 3) Adjustable speed drives. AIMC only competes in MPT, which is a $19B market but very fragmented with over 1,000 small manufacturers.

Equity analysis

AIMR stock trades at 14.6x PE to 2013 estimated EPS of $1.81 and 12.3x PE to 2014 estimated EPS of $2.12. Management has been conservative in the guidance in past years and is likely too low for 2013 given the recent pick-up in industrial activity. AIMC participates in a broad range of industrial markets that are seeing significant strength. Revenue growth for 2013 is expected to be 2% and for 2014 to be 5%. These numbers could be too low in a strong cyclical rebound. I think the company could earn as much as $3 in 2014, which using a 12 multiple get to $36 per share.

However, the stock is up 21% year to date and could be due for a pull back. We could get lighter delta on weakness.

AIMC stock has been volatile on earnings with fairly large moves in 6 of the last 8 quarters including one quarter when the stock was down 27%.

Potential volatility events include:

AIMC is in the middle of a 3 year transition to a SAP implementation. These large scale changes could often lead to disruptions from quarter to quarter. We have seen SAP cause short term problems for many companies.

The company has a large exposure to Europe (31%), which could have unexpected results.

AIMC is hosting an analyst day for the first time in the company’s history on May 16, 2013.

Credit analysis

AIMC has low leverage with net debt/ebitda of 1.67x. Management has a strong history of maintaining a strong balance sheet and one of its goals is to pay down $27m of debt in 2013 using free cash flow.

The company has generated positive free ash flow in each of its 9 calendar years since it began in 2004, including 2008 and 2009.

The negatives are that AIMC is a small cap company at only $713m. It also has a history of making acquisitions which could potentially increase leverage.

Cash =$85m

Revolver due 11/20/17 = $79m ($200m size)

Term loan due 11/20/17 = $100m

2.75% Convert put 03/01/18 = $85m

Total debt = $264m

LTM EBITDA = 107m

Debt/EBITDA = 2.46x

New Debt /EBITDA = 1.67x

LTM CFFO = $60m (2013 expected $80m)

Capex = $31m (2013 expected $30m)

LTM FCF = $29m (2013 expected $50m)

Market cap = $713m

I like the EXXI position for the arb book. EXXI convertible preferred was offered at 303.24 vs. 28.32 on March 22.

We currently own 6,700 pref shares (1.67m in bond terms) on a 64 stock only delta and short 152 June 29 strike calls for an effective delta of 74. Using assumptions of 750 credit and 30 vol., I get theo delta of 72.

I would like to increase the position to 20,000 pref shares (5m in bond terms) and move to a 62 stock delta and 72 effective delta. Below I adjusted numbers into bonds points to make it easier to analyze.

Cash flows from the coupon (3 more quarterly payouts) to the soft call date is 4.2 points. If EXXI stock moves up to the call trigger ($32.969), on a 62 delta, the converts would nuke to 2.66 points for a positive 1.5 points gain. (My reading of the prospectus is that holders will get the last coupon on a soft call)

Shorting the June 29 strike calls at 1.3 would give us additional income if they expire worthless. If they get into the money, then the EXXI prefs should move up as there would still be 6 months to the soft call date.

To the downside, the converts should hold up due to the high yield. At $19.6 on 62 delta, the converts cross par at 5.6% current yield up 30% premium. These converts should hold well to the downside.

This is a position where we should let the stock run before re-hedging delta.

The converts are dividend protected from zero. The common stock pays a 7c quarterly dividend.

Credit Analysis

The key to this trade is being positive on the credit of EXXI.

EXXI is a Houston based independent oil and natural gas exploration and production company with operations focused in the US Gulf and Gulf of Mexico. The company is the third largest oil producer in the Gulf of Mexico Shelf with interests in six of the eleven largest oil fields in the GOM shelf. About 70% of revenues is from oil.

In recent quarters, EXXI has guided production down several times, which has caused weakness in the stock. The latest guide down came on 3/20/13, when the company lowered March Q volumes to 44 mboed from 47 mboed due to continued infrastructure downtime and lower than expected production from recent wells.

However, analysts value EXXI’s proved reserves at about $30 per share (using $95 oil and $4 gas) and an additional $5 for exploration upside. The company has low leverage at 1.2x debt/ltm ebitda. I think the stock is close to a bottom and the credit will hold up sell barring an oil price collapse.

Cash = $41m

Revolver ($925m undrawn)

Debt = 1B (9.25% bonds due 2017 $750m, 7.75% bonds due 2019 $250m, rated B+)

LTM EBITDA = $820m

Debt/EBITDA = 1.2x

Expected 2013 capex = $800m

Market cap = $2.2B

The 2017 bonds trade at 350 credit spread and the 2019 bonds trade at 500 credit spread.

Horsehead Holding  (ZINC) is the largest producer of zinc products in the US and the largest recycler of EAF dust in North America. It is an integrated producer using recycled zinc feedstock and low-cost recycled electric arc furnace (EAF) dust to produce its zinc products. The company diversified into nickel recycling when it acquired International Metals Reclamations Company (INMETCO) in December 2009 for $39m. In November 2011, Zinc acquired Zochem, a Canadian zinc oxide producer for $15m. Current operations include seven facilities across four states and Canada. No customer accounts for more than 10% of revenues.

Convert Analysis

ZINC 3.8% converts are offered at 100.25 vs. 10.93. Using 850 credit, implied vol. is 33.6 compared to options vol. in the high 30s/low 40s. 100day realized vol. is 32 and has been steadily declining to reflect the improving credit and lower risk of the new facility that is scheduled to come on-line in July 2013. I am positive on the stock and credit with targets of $14 for the stock and 700 for the credit, driven by production in the new facility expected to begin in July 2013 that should contribute $100m EBITDA on an annual basis. I would like to own 4m on a 57 delta (5 deltas light).

At $14, the converts nuke to 111.9, compared to fair value of 115.9 using 700 credit and 32 vol.

Borrow is full.

Cash takeout is flat at $14 and 57 delta.

Stock analysis

My price target is $14 based on 5.5x 2014 EBITDA of $150m (post new plant completion), which would bring it closer to its peer group average of 6.1x. The new plant is 70% done so management should have a good grasp of the progress of completion.

Given the impending zinc mine closures, zinc fundamentals are improving and prices are trending upwards. About 50% of zinc demand is related to steel demand. Even without price increases, ZINC should be able to grow earnings with the new plant, cost improvements and byproduct credits. The company also has put options (0.85c/lb) through 1Q14 as downside protection.

Horsehead’s product segments

New zinc plant

ZINC is constructing a new zinc plant (slated for operational start-up in 3Q13) that should drive down the company’s cost structure dramatically. Once operational and fully ramped, the new plant should permanently reduce the cash breakeven point from 0.65/lb to 0.4-0.45/lb vs. low-cost mined zinc that carries breakeven costs at 0.80/lb. This would make ZINC one of the lowest cost producers of zinc products in the world.

The new plant focuses on higher grade, higher margin zinc that offers a large market opportunity. Currently, most of Zinc’s metal is the lowest grade called Prime Western (PW) zinc that sells at a lower premium because it is not suitable for continuously galvanized products such as steel used in automobiles and appliances. The new plant will focus on special high grade (DHG) and continuous galvanized grade (CGG) zinc, which has lower lead content and sells at a higher premium ($50-$60/ton over PW metal). The CGG market is 10x the PW market. The new facility is expected to generate $100m EBITDA per year.

ZINC has 65-70% market share of available EAF dust (byproduct of carbon steel galvanizing process), which acts as an effective barrier to entry against other metals recyclers gaining a market foothold. Most of ZINC’s EAF dust supply is from long term contracts (10+ years) with leading mini-mills such as Nucor and Steel Dynamics.

Zinc market

Zinc is produced via conventional mining and Electric Arc Furnace (EAF) dust recycling. EAF dust is classified as hazardous waste and is produced from steel and mini mills such as Nucor and Steel Dynamics. This dust, which contains 20% zinc, is collected by Horsehead and other competing EAF dust removal services from steel mills. About 50% of all zinc slabs in the US are produced by recycling EAF dust. Zinc is levered to steel demand as roughly 50% of all domestic zinc consumption is as an anti-corrosion coating in the production of galvanized steel.  Zinc is also alloyed with copper to make brass or bronze. Other uses include alkaline batteries, rubber, paint and pharmaceuticals. The US market currently consumes about 1m tons of refined zinc. About 70% of supply comes from imports (Canada, Mexico, Peru).

Credit analysis

ZINC has secured debt that is rated B2/B-and trading at about 700bps credit spread. The converts are not rated. As of 12/31/12, the company had $244m in cash, $75m in access to the revolver, and $30m of operating cash flow through 2013 to cover the remaining $200m needed to complete the new plant. The company is highly levered at 7.1x so the bet here is on the credit and the completion of the new plant.

Cash = $244m

Revolver ($75m, 09/2016) = undrawn

10.5% senior secured notes due 6/2017 = $175m (rated B2/B-)

3.8% convertible notes (7/2017) = $100m

Total debt = $285m

Market cap – $481m

EBITDA 2012 = 40m

EBITDA 2013 = $52m

EBITDA 2014 = $132m

Debt/EBITDA (2012) = 7.1x

Debt/EBITDA (2013) = 5.5x

Debt/EBITDA (2014) = 2.2x

The secured notes trade at 108 (spread of about 700). I would use 850 spread assumption for the converts.

Remaining capex to complete the new zinc plant is $210m

Wabash (WNC) is a manufacturer of truck trailers for the North American market. The company reports in three segments: 1) Commercial trailer products (71% of sales), 2) Diversified products (26%) and 3) Retail (7%).

Convert Analysis

WNC 3.375% converts are offered at 116.25 vs. 9.66. Using 500 credit, implied vol. is 38.6, compared to 50 day vol. of 45 and 100 day vol. of 42. Options are not very liquid but imply mid-40s vol. Delta is 66 using 500 and 40. I would like to own these bonds at 56 delta (10 deltas light) due to my thesis that the stock will go up with a price target of $14.

We currently own 1.2% position in the outright book.

At $14, the converts nuke to 137, compared to fair value of 143 using 400 credit 35 vol.

Borrow is full.

Cash takeout is flat at $14 and 56 delta.

Stock analysis

My price target is $14 based on 8x 2013 estimated EBITDA of $175m. At similar points of prior cycles, WNC has traded between 8x- 10x forward EBITDA. I believe that we will see a strong trailer replacement cycle over the next two to three years and WNC’s recent acquisitions in the tank trailer space should significantly improve margins and reduce earnings volatility.

WNC reported solid earnings on 2/6/13. However, the report fell short of heightened expectations going into earnings. In the following two days, the stock sold off 11%. I believe the sell-off is an opportunity to buy the converts on a light delta. The truck trailer cycle should be good this year but there will be hiccups along the way. This provides good trading opportunities and volatility.

WNC is the leader in trailer manufacturing with about 22% market share. Going forward, the company is focusing on profitability even at the expense of losing some share. Early indications are that pricing has held up well, especially in the more technologically sophisticated product offerings such as liquid tank trailers, added through the Walker acquisition, which are less commoditized, higher margin businesses.

There is significant pent-up demand for truck trailers caused by deferred replacement spending during the recession. Additionally, in the up cycle 2004-2006, fleets focused their capex on tractors rather than trailers to pre-buy ahead of the 2007 EPA emissions standards. After 2007, fleets were to re-focus on buying trailers but the recession cut that cycle short. As a result, the total trailer population shrunk from a peak of 3.1 million in 2007 to 2.8 million in 2011. The average trailer age increased to an all time high of 8.5 years in 2011.

Credit analysis

WNC is rated B1. The company does not have any debt maturing until the converts in 2018 and has ample liquidity with $39m cash and $150 undrawn revolver.  WNC also generates significant free cash flow of over $100m per year. I think a fair spread assumption is 500.

Cash = 39m

Revolver 5/8/17 = 0 drawn; $150m available

Term Loan 5/8/19 = $300m

3.375% converts 2018

Total debt = $450m

Market cap = $668m

Enterprise Value = $1.079b

2012 EBITDA = $120m; capex $15m

Secured debt/EBITDA = 2.5x (term loan covenant <4.5x)

Total debt/EBITDA = 3.75x

Interest coverage = 5.7x (term loan covenant > 2.0x)

The SGY 1.75% convertible bonds due 3/1/17 trade at 89.75 vs. $20.81. Using 500 credit, the converts imply 31 vol., which is cheap to 100 day realized vol. of 41 and options implied vol. in the mid 40s. The 500 credit spread assumption is based on the trading levels of SGY’s 8.625% bonds due 2/1/17 and 7.5% bonds due 11/15/22 (both pari passu with same subsidiary guarantees as converts).

The yield/premium relationship does not look good optically but if we set the converts up on a 40 delta, the converts cross par (at 31.95) at a reasonable 33% premium, which is also where the converts were issued about 10 months ago. The converts traded +3 on the first day. Using 500 credit and 35 vol. at that stock price values the converts at 103, using 500 and 40, the converts are valued at 105.

We can also sell 21 strike Jun call options for 2.4 to generate income. Per 1m converts, we can sell 50 call options on a 55 delta. This would generate up to 1.2 points in income with breakevens at $17 and $26 with an effective delta of 40 and stock delta of 29.

The key to this trade is to be comfortable with the credit so that the converts can be set up on a 40 and still be able to make money (or at least hold value) to the downside. I am comfortable with the credit due to SGY’s strong liquidity ($250m cash and $400m undrawn revolver), its large reserves ($21/share of proven reserves), and its oil hedges on 61% of oil production at $98.87. There is no secured debt ahead of the converts and senior notes. I also feel that the stock is trading near the low end of its valuation range of $20 to $30.

SGY has no maturities until 2017 when the converts and 8.625% bonds mature and although the company is not expected to be free cash flow positive in 2013, it has more than enough cash on hand and undrawn revolver to fund its cash needs in even the most dire scenarios. SGY should be free cash flow positive in 2014. The converts are pari passu with the bond with identical subsidiary guarantees, rated B- by S&P, and there is no debt ahead of it in the capital structure.

Business description

SGY is an independent oil and gas company with properties in the Gulf of Mexico Deepwater (21% of proved reserves), GOM shallow water shelf (50% reserves), Marcellus shale (28% of reserves) and Eagle Ford shale (1% reserves). About 50% of 2013 production will come from oil and 50% from natural gas. The company has hedged out 47% of total 2013 production (61% of 2013 oil production at $98.87 and 24% of gas production at $4.86) and 31% of total 2014 production. All the oil comes from GOM which is priced at a $20 premium to WTI.

Capital structure

Cash = $250m (pro-forma 7.5% senior note issued on 10/23/12)

Undrawn credit facility = $400m

Debt = $975m

$300m = 1.75% converts due 3/1/17

$375m = 8.625% bonds due 2/1/17

$300m = 7.5% bonds due 11/15/22

Market cap = $1.03B

Expected capex 2013 = $650m

Expected cash flow from operations 2013 = $550m

Expected cash needs 2013 = $100m

Equity valuation

SGY currently trades at 9.8x 2013 estimated EPS of $2.12, down from $3.40 as recently as July mostly due to tightness in the deepwater rig market. The company had expected a platform rig to be on location at Pompano in 2013 but that has now been pushed back to mid-2014. SGY’s shallow water drilling will also be delayed by several months due to tightness in jack-up rigs. Although, 2013 EPS estimates were lowered, the company is set up well for a ramp up in EPS to over $3 in 2014.

A good way to value E&P companies is to look at the sum of the parts broken down by proven reserves, unproven reserves, and net debt.  E&P stocks typically trade between the value of proved reserves and unproven reserves (net of debt).

For SGY, the stock should trade between $21 (value of proven reserves) and $31 (value of proved and unproved reserves) at current oil and gas prices.  This leaves significant upside potential for the stock. Additionally, SGY has the potential to add to its proved and unproved reserves through new exploration and development. (After the close on 1/15/13, SGY announced that it had grown its proved reserves by 28% from last year.)

Cash flow scenario analysis

Based on Barclay’s research, the following table details SGY’s cash flows based on different realized oil and natural gas prices. Even in a stressed scenario of $60 oil and $2 gas, SGY would be able to generate $479m in operating cash flow (due largely to hedges detailed in the next table). With $650m of liquidity and no maturities, the company could easily cover $650m of capex, which in reality would likely be less due to the lower energy prices.

Capex budget

The company’s expected 2013 budget of $650 will go towards the following:

1)      29% on deep water projects covering Pompano infrastructure and exploration activities

2)      27% on development wells and facilities on continental shelf

3)      8% on a third La Cantera deep gas well and related exploration

4)      36% onshore, liquids rich areas of Marcellus, and exploration in Eagle Ford

Convert specifics

Pay dates March 1 and Sept 1

Record date

Get last coupon before maturity if converting

Convertible only if stock is 130% of conversion price for 20 of 30 days ending the previous quarter.

SGY can choose settlement in cash, stock or a combination of cash and stock

Flat PNL on cash takeout at $32

Fully adjusted for cash dividends

These contracts typically last for 5 years. Last time when these contracts were up to renewal in late 2007/early 2008, the stock went from $28 in June 2007 to $11 in March 2008 due to speculation about a contract loss. This time, the stock went from $23.04 in Sep. 2012 to $17.84 currently due to fears that contract renewals will result in significant discounts on price and would thus pressure margins and EPS in 2013. I believe that the stock price decline is overdone and the stock will rise when the contacts are settled.

I see the stock trading back to $24 (12x PE) in a bull case scenario or down to $13 (2011 lows) in a bear case scenario. I would put the trade on a slightly light delta of 45 delta because this will make the trade more balanced since the convert has a lot of points (31) to the upside. I also think that the most likely scenario is that CSGS will be able to renew the contracts at favorable rates in addition to winning other new contracts in 2013 year.

CSGS is rated BB by S&P. However, the convertible bonds are senior subordinated bonds and are not rated. The company has no other bonds other than the converts and only $178m of term loans due 2017. The company reports earnings in Feb 2013.

Company profile

CSGS provides outsourced customer care and billing solutions primarily to the cable and direct broadcast satellite industry in North America. In 12/10, CSGS acquired Intec Telecom Systems, which is focused on telecom carrier billing.

The top 4 customers account for 51% of sales. These are:

1)      Comcast (19% of sales) – uses dual vendors with the contract split between CSGS (16m subs) and Amdocs (8m subs). Both contracts are up for renewal on 12/31/12

2)      Time Warner (10% of sales) – uses dual vendors with the contract split between CSGS (5.6m subs) and Convergys (7.2 subs). Both contracts are up for renewal on 3/31/13

3)      DISH – (13% of sales) Uses CSGS exclusively (13.7m subs). The contract runs through 12/31/17

4)      Charter (9% of sales) Uses CSGS exclusively (6m subs). The contract runs through  12/31/14

Cable and Satellite customers account for 60% sales with the remainder coming from Telecom Providers (30%) and Utilities (10%). CSGS gets paid on average about $10 per customer per year although this varies depending on the level of services.

Competitors – in-house systems, Amdocs, Convergys (satellite and cable), Accenture, Comverse (wireless and wireline)

Credit Analysis

CSGS is a solid credit with low leverage and a high percentage of recurring revenues. Even if CSGS loses one or two customers, I believe that the company has a large enough base of other customers with long term contracts and recurring revenues to allow it to right size itself into the current capital structure. The negative is the company’s small market cap. CSGS is rated BB by S&P but the convertibles are senior subordinate bonds.  I believe 400 credit spread for the convertible bonds is appropriate.

Cash $185m (plus $100m undrawn revolver)

Total debt $300m ($150m converts 3/1/17 and $150m term loan due 12/31/17)

Debt/EBITDA = 1.71x, Net Debt/EBITDA = 0.66x

EBTIDA/interest = 10x

LTM FCF = $117m

LTM Capex = $23m

Market cap = $601m

CSGS is a consistent FCF generator (see below) due to the company’s recurring revenues and low cap ex requirements.

Covenants:

Debt/Ebitda < 4x (current 1.72x)

Ebitda/Interest > 2x (current 11x)

Equity analysis

At $17.83, CSGS stock trades 8.4x PE to 2012 estimated EPS of $2.13. This is below DOX at 11.2x and CVG at 19x. Part of the reason for the discount is uncertainty about the upcoming contract renewals, which includes not only getting the contract but the pricing of the contracts and the split between vendors.

I believe that the contract negotiations could create some large moves in the stock with the bull case being that CSGS stock trades up to $24 (12x PE) and the bear case going down to $13 (2011 lows). The stock has also had decent sized moves on earnings as shown in the table below.

Convert specific

Due to CSGS’s small size and leading position in the industry, the company could be a takeout target. On 45 delta, the breakeven takeout price is $22.75 (28% premium). I believe a takeout would be higher than $23 given the stock’s low valuation and market position.

Get the last coupon if converting before maturity.

Full dividend protection

Net share settle; 20 day averaging period

Exterran Holdings (EXH) $355m 4.25% converts due 6/15/14 trade at 107.75 vs. 18 for 3.9% current yield and 38.6% premium. Using 500 credit spread, the implied vol. is 38 and delta is 55. This seems cheap given the historical realized vol. of over 50. The credit also has potential for tightening as we get closer to maturity.

On 8/7/12, EXH announced that its Venezuela subsidiary completed the sale of assets nationalized in 2009 to PDVSA Gas for a total consideration of $442m ($177m initial payment and $265m in periodic payments through 3Q 2016). Proceeds will be used to repay $50m of previously collected insurance money with the remainder to reduce debt and for general corporate purposes. This development significantly improves EXH’s credit profile, particularly for the two convertible bond issues due in 2014, the next maturing debts ($144m 4.75% converts due 01/2014 and $355m 4.25% converts due 06/2014).

Following the news, EXH stock was up 17% to $18.21. The converts were up about 1 point on a 48 delta. The 7.5% straight bonds of 2018 traded up 2 points with the spread tightening from 570 to 512. Even prior to this news, EXH was in the process of delivering, with Debt/EBITDA declining from 4.3x to 3.7x in the last 6 months.

EXH is highly leveraged to the natural gas market, particularly production volumes. While the natural gas market in North America remains challenged, the international natural markets remain robust (about 30% of profits). The company generated about $400m of EBITDA in the last 12 months with expectations of $530m in 2013. In the bull case scenario, EXH can trade at 5x 203 EBTIDA of $580m for an implied stock price of $25. In the bear case, EXH can trade at 4x 2013 EBTIDA of $320m for an implied stock price of $8.

Company profile

EXH is the largest compression services company in the US with about 50% market share. The company packages compression equipment from suppliers, which is then leased or sold to the natural gas E&P operators.  The company assembles a compressor (Ariel or Dresser-Rand), engine (Waukesha or Caterpillar), and a cooling system onto a truck mountable skid for easy transportation. Roughly 30-35% of onshore US operators outsource compression services. Larger E&Ps (such as CHK) are more likely to use their own compressor equipment.

EXH does not manufacture compressors but instead assembles these components into a compressor package. The company adds little value in the assembly process but does add value (which E&P’s are willing to pay for) through services to reduce downtime and logistics. Services provided include designing, sourcing, owning, installing, operating, servicing, repairing and maintaining compressor equipment. Advantages to using EXH services: 1) Upgrade/downgrade equipment with other EXH customers, 2) Better equipment service, 3) less capital required.

Contracts are fee based over several years, which EXH then either keeps them on its books (about 50% of horsepower) or sells to its majority owned MLP (Exterran Partners).

Compression equipment is used in several natural gas production applications including: 1) at the well head (field compression), 2) through gathering systems (field compression), and 3) along long-haul pipelines.

As natural gas wells mature, production levels naturally decline as reservoir pressures fall. Once pressures fall below a certain level, field compression is needed for boosting onto the gathering system. But even with compression, production will continue to decline and will require steadily increasing compression levels to maintain production.

Compressor leasing revenue roughly tracks total gas production. However, in 2008, natural gas producers ordered extra compression equipment at the top of the market, thus creating an overhang for the entire market. Unconventional shale plays need compression equipment later in its life cycle than conventional sources thus pushing out demand even further.

EXH gets revenues from 3 segments:

Contract compression (41% revenues, 70% gross profit) – 42% of the gross profit is from North America and 28% is from international (Latin America, Middle East, Indonesia)

Fabrication (48% revenues, 23% gross profit) – equipment sales that are not part of the contract compression leasing business. This includes assembling compressor systems as well as more complicated equipment for refineries and petrochemical plants.

Aftermarket (11% revenue, 7% gross profit) – after market services provide support services for compression systems.

MLP model

In this structure, the MLP (Exterran Partners) purchases assets from Exterran holdings and distributes all available cash earnings from those assets to investors in the MLP quarterly. Currently, the dividend yield on Exterran Partners (EXLP) is 8.9% assuming a constant .5025 quarterly distribution.

Exterran plans to use the MLP as a vehicle to sell the slower growing North American contract compression business and invest the proceeds in the faster growing International business. Selling the assets to the MLP is ideal because of the arbitrage created through the sale as EXLP typically trades at a higher multiple than EXH, mostly due to the favorable tax treatment of the partnership structure and a lower cost of capital. The partnership will most likely have the opportunity to purchase the remaining portion of the US contract operations in the coming future. Exterran Holdings (EXH) has historically transferred about 250,000 horsepower to Exterran Partners (EXLP) a year so at that rate the entire North American contract compressor business would be transferred to EXLP in about 10 years. The public owns 70% and EXH owns 30% of EXLP.

The partnership buys customer relationships and all equipment and service deals with that customer. The recent 8/12/2010 transaction included the drop-down of 43 customers and 580 compressor units, representing about 255k HP. The partnership buys assets from Exterran (EXH) by issuing shareholder units to the company, assuming EXH debt, or paying cash. Typically units are issued, which the company can sell in the open market at a later date to raise capital. The sale price of the assets is treated as an arm’s length transaction and monitored by the conflict of interests committee (three independent board members). This becomes more important as more of the partnership shares are owned by the public.

Credit

I feel that using 500 credit spread for the 4.25% convertible bonds is appropriate given that the convert has less than 2 years remaining. The 7.5% straight bond (higher rank due to sub guarantees) due 2018 trades at 550 spread. The company is rated B+/Ba2.

Although EXLP is only 30% owned, its financials are consolidated into EXP when presented.

Cash = $21m (6/30/12), 30% Ownership of EXLP = $319m

Total debt = $1.68B (EXH stand-alone = $1.079B) PF 06/30/12 for Venezuela asset sale

4.75% convertible bonds due 1/2014 = $144m (no sub guarantee)

4.25% convertible bonds due 6/2014 = $355m (no sub guarantee)

EXLP Revolver due 2015 = $493m drawn ($57m available)

EXLP Term loan due 2015 = $150m

Revolver due 2016 = $250m drawn ($670m available)

7.25% senior notes due 2018 = $350m (guaranteed by subs)

LTM EBITDA = $402m (stand-alone = $320m)

Debt /EBITDA = 4.6x (stand alone and covenant purposes = 3.3x)

EBITDA/Interest expense = 2.6x (stand alone and covenant purposes = 4.0x)

Secured debt/EBITDA = 1.2x

Market cap = $1.2B

Covenants:

Debt/EBTIDA < 5.0x

EBITDA/Interest expense > 2.25x

Secured debt/EBITDA < 4.0x

The 4.75% converts were originally issued by Hanover Compressor and were considered structurally senior to the 4.25% converts which were issued by the holding company. However in 2Q12, the 4.75% converts were assigned to the holding company in a corporate restructuring that eliminated Hanover Compressor. Currently, the two converts are considered pari passu.

Cash flow

EXH is a consistent cash flow generator. Capex can fluctuate and should be offset by equipment sales and sales to EXLP since much of the capex is used for contracts sold to EXLP.

Stock reaction on earnings

4.25% Converts specifics:

Lose 4 points on a $25 takeout using 55 delta. I don’t think a takeout is likely since EXH is the market leader and there isn’t a larger natural buyer.

Dividend protected from zero.

Get last coupon before maturity if converting.

CSGS 3% convertible bonds are offered at 101 vs. 17.15 (JP Morgan). The issue is $150m with 4.6 years to maturity. Using a 500 credit spread, I get implied vol. of 27 and delta of 49. The stock has historically realized about 30 vol over the past few years if you take the outlier periods out.  In the past two years, the stock has been as high as $21.34 (May 2011) and as low as $12.34 (October 2011). We will likely see more volatility in the next 12 months as CSGS has two large contracts that are coming up for renewals in December 2012 (Comcast 19% of sales) and March 2013 (Time Warner 10% of sales).

These contracts typically last for 5 years. Last time when these contracts were up to renewal in late 2007/early 2008, the stock went from $28 in June 2007 to $11 in March 2008 due to speculation about a contract loss. This time, either the overhang of the contracts uncertainty lifts and the stock trades much higher or the loss of the contracts will cause the stock to decline.

I see the stock trading to $24 (12x PE) in a bull case scenario or down to $13 (2011 lows) in a bear case scenario. I would put the trade on a slightly light delta of 45 delta because this will make the trade more balanced since the convert has a lot of points (31) to the upside. I also think that the most likely scenario is that CSGS will be able to renew the contracts at favorable rates in addition to winning other new contracts this year.

CSGS is rated BB by S&P. However, the convertible bonds are senior subordinated bonds and are not rated. The company has no other bonds other than the converts and only $178m of term loans due 2015. The company reports earnings on 8/7/12.

Company profile

CSGS provides outsourced customer care and billing solutions primarily to the cable and direct broadcast satellite industry in North America. In 12/10, CSGS acquired Intec Telecom Systems, which is focused on telecom carrier billing.

The top 4 customers account for 51% of sales. These are:

1)      Comcast (19% of sales) – uses dual vendors with the contract split between CSGS (16m subs) and Amdocs (8m subs). Both contracts are up for renewal on 12/31/12

2)      Time Warner (10% of sales) – uses dual vendors with the contract split between CSGS (5.6m subs) and Convergys (7.2 subs). Both contracts are up for renewal on 3/31/13

3)      DISH – (13% of sales) Uses CSGS exclusively (13.7m subs). The contract runs through 12/31/17

4)      Charter (9% of sales) Uses CSGS exclusively (6m subs). The contract runs through  12/31/14

Cable and Satellite customers account for 60% sales with the remainder coming from Telecom Providers (30%) and Utilities (10%). CSGS gets paid on average about $10 per customer per year although this varies depending on the level of services.

Competitors – in-house systems, Amdocs, Convergys (satellite and cable), Accenture, Comverse (wireless and wireline)

Credit Analysis

CSGS is a solid credit with low leverage and a high percentage of recurring revenues. Even if CSGS loses one or two customers, I believe that the company has a large enough base of other customers with long term contracts and recurring revenues to allow it to right size itself into the current capital structure. The negative is the company’s small market cap. CSGS is rated BB by S&P but the convertibles are senior subordinate bonds.  I believe 500 credit spread for the convertible bonds is appropriate.

Cash $189m (plus $100m undrawn revolver)

Total debt $328m ($150m converts 3/1/17 and $178m term loan due 12/31/15)

Debt/EBITDA = 1.72x, Net Debt/EBITDA = 0.65x

EBTIDA/interest = 11x

LTM FCF = $111m

LTM Capex = $20m

Market cap = $607m

CSGS is a consistent FCF generator (see below) due to the company’s recurring revenues and low cap ex requirements.

Covenants:

Debt/Ebitda < 4x (current 1.72x)

Ebitda/Interest > 2x (current 11x)

Equity analysis

At $17.40, CSGS stock trades 9x PE to 2012 estimated EPS of $2. This is below DOX at 11.2x and CVG at 19x. Part of the reason for the discount is uncertainty about the upcoming contract renewals, which includes not only getting the contract but the pricing of the contracts and the split between vendors.

I believe that the contract negotiations could create some large moves in the stock with the bull case being that CSGS stock trades up to $24 (12x PE) and the bear case going down to $13 (2011 lows). The stock has also had decent sized moves on earnings as shown in the table below.

Convert specific

Due to CSGS’s small size and leading position in the industry, the company could be a takeout target. On 45 delta, the breakeven takeout price is $22 (23% premium). I believe a takeout would be higher than $22 given the stock’s low valuation and market position.

Get the last coupon if converting before maturity.

Full dividend protection

Net share settle; 20 day averaging period

CNQR has 2.5% convertible bonds due 4/15/15 ($288m) trading at 140.375 vs. 66.28. Using 300 credit spread, the model implies 34 vol and 77 delta. The convert trades at 10.9% premium pct and 13.8 points. With a 2.5% coupon and 2.77 years remaining (7 points), this seems attractive and cheap vol for a tech growth stock that trades at 41x PE to $1.66 2013 EPS. The stock is near new all time highs and has developed a cult like following among tech investors and momentum players. Short interest is high at 16% but the borrow is full and rebate is GC. Historical 90 day vol is 37, 250 day vol is 47, and options are not active. I would put the trade on a slightly higher delta of 79, as I believe the current technology spending environment is likely to have a negative effect on the company’s near term earnings. We have seen several software companies guide down such as INFA (down 27% on the day) on 7/6/12.

There aren’t any identifiable catalysts for CNQR other than earnings reports. However, I expected vol. to be elevated as the stock price now factors in very optimistic assumptions for growth. The stock also moves with contact announcements and news about competitors.  For example, on 6/4/12, CNQR stock was up 7% on news that it won an e-travel contract with the General Services Administration (GSA). This contract is now being protested by other software companies on the grounds that the contract gives CNQR a monopoly on providing travel management to a government agency.

Palisade’s equity group owned this stock earlier this year but sold in the low-mid 50s earlier in 1Q 2012. I exchanged emails with Lisa Chai who follows the stock and her thoughts are that the company is well positioned but she is not comfortable with the valuation. There has also been a series of insider selling in recent months in the mid-high $60s.

This trade would work well to the downside. If the stock trades down to $50, convert nukes to 115.8 with fair value at 118.6 and crosses par at $39.6 at 32% premium. To the upside, stock trades up to $85, convert nukes to 168.6, or 6.2 points of premium. Given that the convert is 2.5% with 2.78 yrs remaining, bonds should expand by at least 1 point.

The risk of the trade is that the stock doesn’t move or trades in a tight range.

CNQR stock moves for previous 5 earnings reports:

Company profile

CNQR is a software-as-a-service (Saas) provider focused on corporate travel and expense management. The company’s software allows travelers to book trips from the web on a PC or mobile device, keep track of their plans during the trip, and then submit an expense report after the trip. Currently, CNQR has the best software out there with little competition although big players including Oracle and SAP and looking to enter the market. Most revenues are from the US (85%) and Europe (10%). The company has about 10,000 customers. CNQR sells software though a direct sales force and partnerships with ADP and American Express.

Bull case

CNQR has a first mover advantage, has built a comprehensive software solution, and gained content management expertise that would be difficult for another vendor to quickly replicate. The corporate travel market is large with most expense management still done on excel spreadsheets. The market for automated travel software solution has only penetrated about 10% of the total travel management market. Customers using CNQR software can reduce administrative and processing cost while cutting down reimbursement time. The company is expected to grow sales by 25% and EPS by 30% annually for the next few years.

Bear case

For the past few years, CNQR has had little competition as the market for corporate travel management is relatively new. However, in recent months, SAP and ORCL have focused on improving their software offerings and will focus on selling the new modules to its existing customer base. A global economic slowdown would hurt sales because corporate travel and spending generally slows in this scenario. CNQR stock is highly valued at 41x 2013 EPS so any hiccup will lead to a large fall in the stock.

Credit

CNQR is a strong credit which I estimate to be BB and 300 spread for 2.8 year convert credit. The company ended 3/31/12 with $476m in cash and its only debt being the $288m convertible bonds. The market cap is $3.8B. The company has been a very consistent FCF generator of about $50m per year. Most of its sales are on 1 year subscription contracts that have high rates of renewals (over 90%) so the company can plan its future expenses around sales expectations. Typically, once a customer is set-up on the system, it is already invested and highly unlikely to switch vendors.

Convert characteristics

Lose 2 points on $90 cash takeout on 80 delta

Get last coupon before conversion

Full dividend adjustment

I like the GET 3.75% convertible bond that is trading at 150.375 vs. 38.87. Using 600 spread, the converts imply 29.5 vol., 88 delta and trade at 7.73 points of premium. This is a very low premium for a convert with 3.75% coupon with 2.24 yrs remaining. I calculate the converts to have 5.6 points of cash flow to maturity after financing.  I would run them on theo 88 delta as I feel that the stock risk is balanced to the upside and downside. As the stock moves up, the points premium would likely hold given the cash flows. To the downside, I believe vol. would pick up on any large drop in the stock which would also benefit the converts. The converts trade at such a low premium because investors fear that volatility in GET will contract substantially after expected REIT conversion in 1/1/13. However, I see several reasons why this may not be the case.

1)      Unlike other REITS, Lodging REITS have realized decent vol. in the range of 30-35. This could be due to the nature of Lodging REITs, which essentially leases space on a daily or weekly basis, compared to Office REITs or Shopping center REITS that have leases of 10+ years and much higher visibility.

The table below shows a list of Lodging REITS and their realized vol. over the past quarter, half year, and year. This leads me to think that GET may not see a de-rating of its implied volatility even after REIT conversion.  If we compare to HST, there’s no reason to think that GET should trade at a lower volatility, especially given that we are using 600 for the 2 yr credit spread assumption for GET while HST has a credit assumption of about 250. A stock with a higher credit assumption should usually trade at a higher vol., all else being equal.

2)      GET has only 4 properties (Nashville, Dallas, Orlando, Washington DC). This should make the stock more volatile since the concentration of assets exposes GET to more company specific risk. For example, in 2010, an historic flood occurred in Nashville and GET’s Opryland was significantly damaged. After insurance payouts, the net cash impact of the flood was ~$150 million, or ~$3 per share.

Aside from freak occurrences such as floods or other unpredictable events, limited diversity also puts GET at risk of; 1) market specific slowdowns, 2) union labor strikes (16% of GET’s employees are unionized), or 3) the negative impact of new supply in a specific market.

3)      Although GET has agreed to the brand name sale/REIT conversion, there is some risk that the deal falls through. In this case, we could see a large drop in the stock followed by a volatility spike.

What if vol. does go down to 25

In the case where I am wrong and vol. does collapse, I would expect to see a corresponding tightening of credit spread. If implied vol. were to drop to 25 and credit spreads tighten to 250, it would be neutral to the valuation. I do not see much risk to the downside even if vol. were to decline.

Company profile

Gaylord Entertainment (GET) is a hotel company that focuses on large groups and conventions. The company has 4 properties:

1)      Gaylord Opryland (Nashville) – 588k sq. ft. total meeting and exhibit space

2)      Gaylord Texan (Dallas) – 400k sq. ft. total meeting and exhibit space

3)      Gaylord Palms (Orlando) – 200k sq. ft. total meeting and exhibit space

4)      Gaylord National (Washington DC) – 470k sq. ft. total meeting and exhibit space

These four large properties serve as an “All in one place” solution for large group meeting planners. GET derives about 20% of sales from transient customers and 80% from groups. Group business tends to correlate with corporate spending (50% of groups business) and associations (34%).

GET had originally planned to build a 5^th property called the Aurora in Denver but decided to postpone the plans following the REIT conversion announcement.  GET will no longer commit large amounts of capital to new projects but will explore other ways to fund projects that require less capital from GET.

Conversion into REIT

GET will sell its Gaylord brand to Marriot International for $210m and convert itself into a REIT effective 1/1/13. Marriot will manage the hotels for a fee, while GET will own the real estate. GET will distribute a dividend of $415 to $450m ($8.3 to $9 per share) to shareholders consisting of $83 to $90m in cash ($1.67 to $1.80 per share) and the remainder in stock.  The converts are fully protected for cash and stock dividends. The deal should benefit Gaylord hotels by being on the Marriot reservation system.

Credit analysis

The pari passu straight bonds of similar maturity (11/15/14) trade at a z-spread of about 600, which is a good assumption for the converts. I view GET as a solid credit, especially if it turns into a REIT and abandons risky new projects such as the Aurora. The converts are the first debt due. The pari passu senior notes will likely be called and refinanced later this year.

Cash = $20m

Debt = $1.06B

3.75% convertible bonds 10/1/14 $360m

6.75% notes due 11/15/14 $152m (callable at par in 11/12)

Term loan 8/1/15 $400m

Revolver 8/1/15 $185m ($525 size)

Market cap = $1.9B

Debt/ebitda = 5.0x

GET is expected to generate $100m of FCF in 2012

Covenants:

Funded debt to assets less than 65% (currently 41%)

Tangible net worth more than $850m (currently $1.1B)

Min fixed charge coverage ratio more than 1.75x (currently 3.3)

Debt service ratio more than 1.6x (currently 3.3)

Equity analysis

There are a couple of reasons why GET stock should continue to rise, even though the stock is already up over 60% year to date. First, GET has not realized the full re-rating of converting into a REIT. Lodging REITS average 12.4x EV/EBITDA  (2013) compared to 11.0x for lodging non-REIT stocks. This is due to a more efficient tax structure for REITS among other things. If GET were to trade at 12.4x 2013 ebitda, the stock would reach $44. Second, with the new operating efficiencies of the REIT structure and access to Marriot’s reservation system, we could see EBITDA 5-10% higher, thus giving another lift to the stock.

To the downside, GET has risks including a slowing corporate travel market, competition from new hotels near its properties, a convention revival in Las Vegas, and concentration risks of its 4 properties. On 6/20/12, a fire at Opryland caused the stock to drop 3%.

Convertible characteristics

Full cash dividend protection

Get last coupon if converting prior to maturity

Lose 2.7 points on a takeout at $50 on 88 delta (I feel a takeout is unlikely because GET explored all options including takeouts prior to the REIT conversion announcement)