The U.S. financial markets have experienced a great deal of turbulence in recent months. Although the economy is growing at a healthy pace, much of that growth has been the result of cheap financing that has allowed many companies and individuals to increase their spending. Low interest rates, combined with record budget and trade deficits, have sent the dollar into an effective free-fall. The confluence of these factors has become a source of great concern to many investors, who fear that the current situation is unsustainable and that the expected subsequent market correction will lead to an economic slow down and a sharp increase in corporate and personal defaults.

Our trade partners, notably the ones in East Asia, have been financing our deficits by purchasing US government bonds. However, given the weakening dollar and the relatively low yields, many of them are now less receptive to purchasing these securities. We believe that the Fed will have little choice but to raise interest rates further, and may have to raise them even faster than expected, in order to make dollar denominated bonds more attractive. This sharp increase in rates may cause significant problems for the multitude of companies and individuals dependent on cheap money.

One of the primary casualties of a rise in interest rates could be the non-investment grade, or high yield, bond market. From 2002-2004, some $350 billion of high yield bonds were issued, including a record $147 billion in 2004. Many of these new issuers represent sub-par credits. Because of the lenders' low cost of borrowing, these companies were able to find a market for their debt that may not have existed in a higher interest rate environment. However, the combination of a big supply of available debt capital and a number of suspect issuers may lead to another high default cycle when the economy cools off.

Research by our Advisory Board member, Prof. Ed Altman, shows that, from 1971-2004, within four years of issuance some 24% of B- rated credits and 45% of CCC- rated credits defaulted on their obligations. However, largely due to the cheap cost of financing and strong economic growth, the high yield bond default rate was only 1.25% in 2004, representing the lowest total since 1996 and well below the weighted-average default rate of 4.84% since 1971. Many of the suspect credits that have recently issued bonds are also carrying revolving credit facilities at variable interest rates. As the cost of financing begins to increase and the shrinking supply of cheap money cools off the economy, many companies are likely going to feel a substantial cash flow squeeze.

What’s our View?

Companies in sectors such as auto parts manufacturing (e.g., Tower Automotive, which recently filed for bankruptcy protection), already under increasing pricing pressure from high input prices and foreign competition, will find themselves in an even worse predicament as interest rates rise. We have analyzed all the B- rated and CCC- rated high yield issues by industry and have determined that the Top 10 sectors with the highest dollar exposure among these credits are the following:

• Telecommunications
• Gaming and leisure
• Chemicals
• Utilities
• Auto parts
• Consumer products
• Publishing
• Metals and mining
• Broadcasting
• Cable

Together, these sectors account for more than $100 billion of B- rated and CCC- rated high yield bond issues from 2002-2004. When the next default cycle comes, look for these industries to be the biggest casualties.

STEEL INDUSTRY UPDATE
(With assistance from Peter Marcus of World Steel Dynamics)

• The run up in the steel industry in 2004 was primarily the result of a global steel shortage
  • The world export price for slab remains above $500 per tonne
  • The weakness of the U.S. dollar is still supporting the market
• The first part of 2005 should continue to be very good for steel companies
  • Pricing has generally been sustained so far this year, although it has suffered a decline from the top of the cycle in 2004
  • Chinese pricing is currently at $510 per ton for hot-rolled band. World export pricing for hot-rolled band is currently at $575-$600 per tonne FOB the port of export, and the spot price in the USA is at about $610-$630 per net ton
• However, the outlook for the second half of 2005 is not encouraging
  • World Steel Dynamics puts the odds at 75% that the global steel sheet shortage will end in 2Q05
  • If so, world export prices may decrease significantly as early as March 2005
• Nine key factors are affecting the global steel industry at this time:
  1. Discontinuity
     • This refers to the transition between old and new ways in the steel industry
     • This discontinuity includes the effects of metallics shortages and China on the industry (see below)
  2. Age of Metallics
     • The world is undergoing a sweeping change in the supply/demand balance for steel scrap, coking coal, coke, iron ore, pig iron and steel scrap substitutes, all of which are necessary ingredients for the manufacture of steel
     • This change affects the availability and pricing of metallics
  3. Tyranny of large numbers
     • Due to the overall size of the steel industry, which is now roughly 1 billion tons of production a year worldwide, if it continues to grow at historical rates (3% per annum) this will place even more pressure on steelmakers’ metallics
  4. Consolidation
     • The steel industry is undergoing a wave of consolidation, with a handful of companies trying to obtain dominant worldwide positioning
     • The industry upturn in 2004 has left potential acquirers flush with cash and with lofty stock prices, while potential sellers are considering exiting at the top of the cycle
     • As a result, every steelmaker – large or small - must now decide whether it is a seller, a buyer, or does it try to hold its position
  5. China
     • China continues to dominate the steel industry
     • China is producing steel at an annual rate of over 300 million tonnes versus 129 million tonnes in 2000
  6. Weak U.S. dollar versus Euro
     • The weak dollar has helped American steel companies
     • But, the U.S.’s 5.5% current account deficit is not sustainable
  7. Revolutionary technologies
     • E.g., extraction of iron from ore without coke
     • These technologies may affect the metallics situation
  8. High profits
     • Are likely to continue in the first part of the year
  9. Improved profitability over the cycle
     • The industry’s profits have grown from $60 billion in 2003 to $113 billion in 2004
     • $95 billion projected profits in 2005

HIGH YIELD UPDATE

A Word From Ed Altman --

The following was prepared by Dr. Edward I. Altman, Max L. Heine Professor of Finance and Director of the Credit and Debt Markets Program, NYU Salomon Center at the Stern School of Business. Prof. Altman is a member of the Miller Mathis Advisory Board.

• High Yield Bond defaults in 2004 continued to decline significantly from the record default levels in 2002 and relatively average default rate in 2003, heralding a benign credit cycle that has been in effect for about 15 months.
• Defaults were $11.7 billion in 2004, down from $38.5 billion in 2003. The dollar-denominated default rate tumbled to 1.25%, with the fourth-quarter rate of 0.32%. Quarterly default rates in 2004 ranged from 0.19% to 0.41%. The annual rate was the lowest since 1996 and far below the annual weighted average rate of 4.84% over the past 35 years.
• The default loss rate for 2004 declined to just 0.61% based on a weighted average recovery rate of 57.7% -- the highest recovery rate since 1987 and consistent with a very benign credit environment.
• Only two defaulting companies had some issues that were originally investment grade and their issues had a minor effect on the adjusted default loss rate. A new study on fallen angel default returns during the reorganization period shows preliminary results indicating positive absolute and excess returns compared with all defaulting issues.
• High-yield bond returns for 2004 broke into double-digits fueled by a late-year surge, closing the year up by 10.79% and an excess return over ten-year Treasuries of 5.92%. Yield-spreads dropped to only 314 bp, the lowest end-of-year level since 1984. New issues totaled a record $147.2 billion and the market size swelled to about $980 billion at year-end.
• The Defaulted Debt markets had another banner year in 2004 with the Altman-NYU Salomon Center’s Combined Defaulted Bond and Bank Loan Index increasing by about 15.0%. With Defaults continuing at below average levels in 2005 and most of the upside on past investments already realized, investors will be challenged to duplicate 2004’s performance.
• Like most analysts, we had expected a higher default rate in 2004, although some last- minute tactics (e.g., Delta Airlines) and refinancings prevented a default rate that would have been very close to our prediction of one year ago. In late 2005, and especially in 2006, we are expecting an acceleration in default rates to 3.0% in 2005 and higher in 2006, perhaps to near average annual levels.

If you would like to receive a copy of Dr. Altman’s Special Report, “Defaults and Returns in the High Yield Bond Market: The Year 2004 in review and Market Outlook”, please call us for a free copy.

TELECOM UPDATE

A Word From Bob Rowe --

The following was prepared by Robert C. Rowe, former Chairman of the Montana Public Service Commission and a founding partner of Balhoff & Rowe, LLC, an advisory firm focused on the telecommunications industry. Mr. Rowe is a member of the Miller Mathis Advisory Board.

• The Incumbent Local Exchange Carriers (“ILECs”) are facing several critical challenges
  • Increasing competition from IP-based services such as cable and internet providers that are actively bundling cable, internet and phone services at discounted rates.
  • Residual UNE-P losses to Competitive Local Exchange Carriers (“CLECs”) that were using the ILECs’ networks to compete against them. This has largely been resolved through litigation and recent FCC decisions, but uncertainty about the final wholesale rules remains.
  • Competition from municipally-owned networks is a growing concern to ILECs, but also to cable providers.
  • The increasing substitution of wireless for wireline services has particularly hurt those ILECs that do not offer a wireless product. (Resale of wireless is a second-best substitute.)
    • The Regional Bell Operating Companies (“RBOCs” or “Baby Bells”) are annually losing 4% of their lines compared with about 3% annual growth ten years ago – however, the three largest RBOCs also have wireless companies that are positioned to capitalize on the technology substitution.
    • Rural Local Exchange Carriers (“RLECs’) are annually losing 1-2% of their lines compared with 3%-5% annual growth ten years ago.
    • It is difficult to distinguish “service substitution” (wireless for a second line or for long distance, DSL for a second line) from access substitution (wireless taking the place of the primary wireline connection or voice over IP replacing primary lines), but access substitution appears to be growing.
  • The advance of new technologies is requiring significant capital expenditures to stay competitive, with companies taking somewhat different approaches to upgrading networks—fiber to the node, to the curb, to the premises—where they face the greatest threat.
• What has been the ILECs’ response?
  • The Bells are seeking to achieve more scale by acquiring once rival, and now weakened, long distance carriers (e.g., SBC / AT&T and potentially Qwest / MCI).
  • The Bells are pushing for more market-based regulation, deregulation, and a rewrite of the Telecommunications Act of 1996, whereby they would face fewer wholesale and retail requirements, and have greater flexibility in responding to competitive threats. The Bells each have somewhat differing views of the Universal Service Fund (“USF”) to support carriers that provide service to high cost rural areas, and of intercarrier compensation payments between customers. They are all concerned with the level of payments.
  • Telecommunications taxation is an increasing concern, especially for the Bells, both as to structure and rate.
  • RLECs are concerned about preservation of support systems—both USF and intercarrier compensation—to maintain high quality rural networks, and to achieve a predictable and stable environment for network investment as technology evolves.
  • RLECs are also concerned about the sustainability of growth in the USF, especially in light of the post-2001 practice of increasingly liberal payments of support to rural wireless providers that “compete” with them. Wireless providers currently receive support that is identical to the per-line support provided to RLECs, even though wireless operating costs, network functionality, service and regulatory obligations are different from those of the RLECs.
• Key trends to watch
  • Will the Bells and other voice providers be able to maintain their positions primarily through acquisitions of companies in adjacent (traditionally voice) markets when the product is being commoditized by cable and internet providers that are offering voice as a part of a bundle of services at discounted rates? Might they have to consider merging with a complementary service provider such as a cable company? For instance, Qwest has been losing large numbers of customers in certain competitive markets even in rural states like Nebraska and Montana. How long can it survive as an independent with its leveraged financial structure and an increasingly competitive operating environment?
  • Will the Bells and the RLECs be able to agree on a policy framework that will allow both groups to achieve desirable regulatory environments for their businesses?
  • Consolidation – Will large companies sell service territories to enable more aggressive investment in their core areas? Will the smallest providers find the current market and regulatory uncertainty so risky that they wish to exit? How will regulatory uncertainty and competition affect valuations for the properties in question?
  • Will the largest wireless companies (e.g., Verizon) continue to refrain from seeking Universal Service support? If not, how would the resultant upward pressure on the fund affect policy? How do universal service receipts affect the transaction value of companies such as Western Wireless? Will regulators begin to discipline universal service eligibility, for example by distinguishing competition policy from universal service policy, or by setting a higher threshold for receipt of support?

Miller Mathis is a boutique investment bank that provides its clients with sophisticated insights and creative solutions for complex business issues.

The views expressed herein are those of Miller Mathis only. Nothing contained herein should be considered as investment advice. Miller Mathis disclaims any and all responsibility.