Gary Brandt, treasurer of WorldCom, Inc., could not remember a year quite like the last. WorldCom had

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Gary Brandt, treasurer of WorldCom, Inc., could not remember a year quite like the last. WorldCom had stunned the financial community in November 1997 with a $37-billion bid for MCI Corp., besting rival bidsby British Telecommunications (BT) and GTE. Now WorldCom was about to do the same in the corporate bond market as it readied to issue what could be the largest corporate debt issue ever. With the MCI deal scheduled to close soon, financing had to be arranged to repurchase the 20% stake BT held in MCI. WorldCom announced—through its investment banker, Salomon Smith Barney—intentions to market $3 billion to $4 billion of debt in the first week of August 1998. If there was sufficient demand, the offering could be increased to $6 billion, exceeding by a considerable margin the previous record of $4.3 billion, set by Norfolk Southern Railroad in May 1997.1 The market reception and pricing of the bond were made more difficult by the turbulent conditions in the bond and equity markets in recent weeks. Brandt had received some preliminary estimates of the costs of the issue from his bankers. But because it would be the firm’s task, not the bankers’, to see that the terms of the debt were eventually met, he decided to develop his own estimate of the costs of the new bonds.

Company

WorldCom was started in 1983 in Hattiesburg, Mississippi, as Long Distance Discount Services (LDDS) by Bill Fields and a group of investors that included Bernie Ebbers.2 The breakup of AT&T, in 1983, encouraged other companies to enter the long-distance telephone business. LDDS leased a Wide Area Telecommunications Service (WATS) line and resold time to other businesses. The firm initially did well until WATS line prices increased.

Following a period of losses, the board appointed Ebbers chief executive officer (CEO) in 1985. Ebbers immediately instituted cost-control measures, began stressing customer service to new clients, and customized each client’s service to its calling patterns. Within six months, LDDS was back in the black.

LDDS capitalized on its own success by acquiring other long-distance start-ups experiencing similar trouble. Employing the same turnaround procedures with other failing companies, LDDS was able to greatly expand its business at low cost. In 1989, LDDS merged with Advantage Company, a publicly traded long distance telephone company, making LDDS public as a result. By the end of 1991, the company had purchased five additional companies, for a total of $100 million, expanding its network to 27 states. In 1992, LDDS merged with Atlanta-based Advanced Telecommunications and became the fourth-largest long distance carrier in the United States.

The pace of acquisitions increased as the prominence of the company grew. In 1993, LDDS merged with Metromedia Communications and Resurgens Communications Group. LDDS Communications merged with IDB Communications Group, a satellite-communications company, in late 1994. The next year, the company spent $2.5 billion for William Cos. subsidiary WilTel’s 11,000-mile fiber-optic cable network. To reflect its growing global aspirations, the company changed its name to WorldCom in 1995.

The Telecommunications Act of 1996 substantially rewrote the industry’s rules by allowing local-access telephone companies and long-distance companies to compete against each other. WorldCom took advantage of the change with the $14.4-billion purchase of local-access provider MFS Communications in 1996, which included the subsidiary UUNET Technologies (an Internet access provider). With WorldCom’s subsequent acquisitions of the America Online networks (ANS Communications) and CompuServe networks (CompuServe Network Services), the company became a leader in this rapidly growing market. As a result of the MFS merger, WorldCom became the first company since the breakup of AT&T to offer local and long distance services over its own network.

All of the previous acquisitions, however, paled in comparison to WorldCom’s offer to purchase MCI Corp. for $37 billion in November 1997. The offer nullified MCI’s previous pact with British Telecommunications and beat a rival bid from local-service provider GTE. Completion of the deal would move WorldCom from being the fourth-largest long-distance telephone company in the United States to being second only to AT&T. The combined company, MCI-WorldCom, would have more than $30 billion in 1998 revenues. The boards of directors of both companies unanimously approved the transaction.

The Bond Issue

In January 1998, the firm filed a shelf-registration statement with the U.S. Securities and Exchange Commission seeking permission to raise up to $6 billion over the next two years. 3 Most market observers expected WorldCom to raise this amount of funding through several smaller debt offers, and thus were somewhat surprised to learn in July that all $6 billion might be raised in one offer. WorldCom planned to use its own stock to buy the public shares of MCI that did not belong to British Telecommunications. As part of the deal, WorldCom agreed to pay BT $6.94 billion in cash for its 20% stake in MCI. WorldCom had a large commercial-paper program, however, and MCI was cash rich following the sale of its Internet business to Cable & Wireless for $1.75 billion. In addition, WorldCom had recently agreed to a new $12-billion bank credit facility. The credit facility consisted of a $5-billion term loan due in 2002 and a $7-billion, 364-day revolver that could be renewed for two more years. All these factors seemed to argue in favor of a smaller public offer. WorldCom did appear to have continuing cash needs to fund future acquisitions and large-scale capital improvements. Just the previous week, MCI had announced the purchase of Brazil’s long-distance carrier, Embratel, for $2.3 billion. WorldCom was spending $2.5 billion a year to improve its infrastructure.

For his part, Brandt believed that WorldCom had ample need for the funds, and he was hopeful that

market conditions would be such that the firm could raise $6 billion in one shot. Initially, he planned to use

the bank debt to pay BT, and thereafter to pay off the bank debt with the newly issued bonds.

The issue called for four tranches of debt to be offered:

 $1.5 billion in 3-year notes

 $1.0 billion in 5-year notes

 $2.0 billion in 7-year notes

 $1.5 billion in 30-year bonds

Following market convention, the debt issues would carry an annual fixed coupon rate, but interest would be payable to holders on a semiannual basis. No specific assets or collateral were pledged on the bonds, and only a few standard covenants appeared in the indenture. In the words of one market observer, WorldCom’s offer was “plain-vanilla debt—a whole lot of plain-vanilla debt.” Exhibit 1 lists the covenants on the credit facility and proposed public bond issue.

From the firm’s point of view, now seemed to be a good time to issue. The MCI merger had boosted awareness and interest in the firm. Investors had responded favorably to the announcement of the merger. (Exhibit 2 presents evidence on the stock-price response to recent telecommunications mergers.) The company had cobbled together various communications companies to offer business customers everything from domestic and long-distance telephone service to Internet access, and by the summer of 1998, many observers viewed WorldCom as the industry leader. “They’re the farthest ahead in giving the customer endto- end telecommunications solutions. They have the model that the other phone companies are trying to emulate,” said Patrick Cassidy, an analyst at T. Rowe Price.5 In addition to the glow of the MCI-WorldCom merger, WorldCom had recently reported second-quarter revenues of $2.61 billion, a 45% increase over the same period of the previous year. Net income was $228 million, compared with $44 million the previous year.

Exhibit 3 gives selected information on WorldCom’s financial performance. Exhibit 4 compares WorldCom with other long-distance telephone companies. It was widely believed by market observers that WorldCom’s debt, which was currently rated Baa2 by Moody’s Investors Service and BBB+ by Standard & Poor’s, would be upgraded to the low single-A area in the upcoming year. Exhibit 5 provides the bond-rating definitions.

Market Conditions

The devaluation of the Thai currency in June of 1997 precipitated a major financial crisis that spread to Malaysia, Indonesia, Korea, Hong Kong, and other regional markets over the ensuing months. In its wake, these countries experienced depressed economic conditions and plummeting equity markets. U.S. financial markets also experienced considerable turmoil and uncertainty over the extent that the global crisis would hurt the U.S. economy. These concerns were most acute in the months following the Hong Kong crisis in October 1997, and eased somewhat in the first half of 1998, as the U.S. economy showed continued strong performance. In mid-July, however, fears of a deepening crisis resurfaced. The Japanese yen deteriorated to an eight-year low against the U.S. dollar, as investors lost confidence in the government’s ability to resolve its banking crisis. The weakness in Japan threatened to engulf China, which had resisted devaluing its currency. In addition, the domestic U.S. economy showed signs of slowing corporate profitability in the second quarter.

Finally, a mounting political crisis threatened the U.S. president, Bill Clinton, raising concerns about his effectiveness and tenure in office. All these factors combined to take a toll on the U.S. equity markets. The Dow Jones Industrial Average dropped 99 and 300 points on Monday and Tuesday of the projected issue week. Tuesday’s drop was the third-largest percentage loss in Dow history. Similar percentage losses were registered for the S&P 500 and NASDAQ averages. Analysts were sharply divided on the portent of these

events for future economic activity. As money left the stock market, some flowed into corporate and Treasury securities. Exhibit 6 gives information on the movements in interest rates in recent weeks.

Exhibit 7 provides a longer-term view of corporate and government rates and spreads. A second factor of concern was the large volume of debt issues scheduled for issuance in the first week of August. A heavy calendar of debt issues had been a feature of the market all year. Investment-grade issues were on course to beat last year’s record, while high-yield issues were already within striking distance of last year’s record.6 Some $40 billion in debt issues, two to three times the usual amount, was scheduled to price the same week as WorldCom’s issue. The large supply coming to market put pressure on corporate bonds.

The recent turmoil had also raised concerns among investors about the quality of the debt. Jacques de St. Phalle, head of fixed income at Bear Stearns, noted that “investment-grade companies were taking two to three days to market deals before pricing them. That’s something only junk-bond investors with complicated stories used to take time out for. And when new deals do get sold, they are priced at a concession to issues already outstanding.”7 Long-term corporate yield spreads over Treasuries had increased over the last several weeks. Further widening of the spread could occur if the markets did not settle soon (Table 1).

In the days leading up to the issue, the firm’s investment bankers gathered information from market sources in anticipation of the final pricing meeting, scheduled for August 6. The syndicate desk at Salomon Smith Barney was responsible for pricing the new bonds. The pricing process began by determining the “price talk” for the new issue. Basically, this amounted to finding the approximate spread over Treasuries that investors would demand for each tranche of debt. Once the syndicate desk set the price talk, the deal was marketed to investors and the “book” was built. The book was simply the number of orders for WorldCom bonds received at each spread level in the price talk. If investors were clamoring for the deal, then the bond would carry a low spread and yield to maturity (i.e., price at the tight end of the price talk). Otherwise, the syndicate desk would need to increase the spread in order to attract enough investor interest.

Exhibit 8 contains basis-point spreads for corporate debt over comparable-length Treasury securities for various bond-rating categories. Although the spreads pertained to industrial issues, Brandt believed they would offer some basis for estimating the yield to maturity on WorldCom’s new bonds. In addition, he had assembled data on the recent prices of the bonds of telecommunications and media firms (Exhibit 9), which might serve to indicate what investors expected by way of return.

1. Is it a good time to issue? What factors favor issuing now and what factors do not?

2. What risks does WorldCom face in issuing up to $6 billion in debt? How will investors and the market react to the large size of the offering? Would a series of smaller issues be a better strategy?

3. How does financing with corporate bonds typically differ from a bank loan?

What are the major uncertainties that a firm faces when it issues securities?

4. Estimate the expected costs (percentage yields) that WorldCom will incur on the 3-, 5-, 7-, and 30-year notes. How would you attempt to explain to someone who is unfamiliar with credit markets why the bonds would be priced in this manner?