Medco Energi explores rarely used convertible market

Indonesia's premier oil and gas producer attracts strong demand for only the country's second CB since Asian financial crisis.
PT Medco Energi has raised $176.9 million from IndonesiaÆs largest publicly marketed convertible bond issue since the financial crisis. The deal was made extra challenging by its launch on the very day Standard & PoorÆs revised its ratings outlook to negative.

Investors took little notice, however, focusing instead on the growth prospects of IndonesiaÆs premier listed oil and gas producer - at a time when demand is increasing and oil prices are hovering near the $75 per barrel level. The CB proceeds will be used for capital expenditures needed to fund that growth.

The Indonesian market is also seen as attractive in its own right with greatly improving fundamentals, a strengthening currency and a 31.8% rise in the benchmark stock index so far this year.

Meanwhile, the central bank yesterday marked an end to the upward interst rate cycle by cutting its benchmark one-month lending rate by 25 basis points to 12.50%. Some market watchers say this suggests that Bank Indonesia feels it has regained the confidence of international investors which fell to a low in the middle of last year - and hence no longer needs to artificially support its currency.

Observers also say the reasons S&P cited for its outlook revision û mainly the companyÆs high leverage and the amount of capital expenditures needed to develop its oil and gas assets over the next few years û are directly related to MedcoÆs aggressive expansion to meet the soaring demand and are already well-known in the market. In fact, the CB was structured to include a yield step-up feature to protect investors in case the credit ratings on the bonds were reduced.

For now though, the company retains the same credit rating as the sovereign, which makes it one of the strongest corporate credits in Indonesia.

The CB, which was jointly led by Credit Suisse and Deutsche Bank, may also have been helped by a scarcity of similar paper. In fact, this is only the second pure convertible out of Indonesia since the Asian financial crisis in 1997 following a smaller $50 million convertible arranged by Deutsche Bank for shipping company Berlian Laju Tanker last year.

The Medco bonds have a five-year maturity with a three-year put and were priced with a conversion premium of 45% over TuesdayÆs close of Rp4,775 for a conversion price of Rp6,923.75.

The premium was fixed in the middle of the offered 40-50% range, while the yield to put was set closer to the top of the offered 6.7% to 7.375% range at 7.25%. The fact that the company has a $325 million high-yield bond outstanding that could be used as a reference for the credit would have provided some extra comfort for investors, but the main reason why the yield could be set away from the wide was the strong demand, sources say.

At the final terms, the order book was said to have attracted $850 million worth of orders or about 4.8 times the amount on offer, split fairly evenly between Asia and Europe. Close to 80 accounts were believed to have participated, according to market sources. Those included all the usual suspects like specialist convertible bond funds, arbitrage funds and hedge funds, but also quite a few outright investors who were believed to have been attracted both by the growth story and the high yield.

The CB will pay no coupon and were issued at par. There is an issuer call option after three years, subject to a 130% hurdle.

MedcoÆs high-yield bond maturing in 2010 has a coupon of 8.75% and currently trades at a yield of 7.7-7.8%. Based on this, the bookrunners used a credit spread of 300 basis points, which gave a bond floor of 97.2%. They provided asset swaps for about 35% of the deal at that level.

Unusually, investors proved willing to pay a premium to the 29% historic volatility, which again underlined the strong confidence in the equity story. The implied volatility ended up at 31%.

The company's share price dropped 0.52% yesterday, but is up 41.5% year to date and 130% since the beginning of 2005.

There is a dividend yield protection above 3.5% and the stock borrow cost was assumed at 5%.

The yield step-up feature will kick in if the current credit ratings on the companyÆs bonds fall and will then result in a one-time 50 basis point increase in the yield. While designed to make investors more comfortable with the credit, it is a feature that doesnÆt cost the company anything unless the ratings do actually change.

The bonds are rated B+ by S&P and B2 by MoodyÆs.

The high premium is based on the companyÆs strong growth outlook which stems from the fact that it has made a number of acquisitions of new projects and greenfield assets that will soon start contributing to the bottom line. The new oil projects are aimed to help offset the dependence on the companyÆs existing fields that are maturing and therefore resulting in lower production levels and higher lifting costs.

The companyÆs oil and gas production fell to an average 82,700 barrels of oil equivalent (boe) per day in 2005 from 90,300 boe per day in 2004.

Over the weekend, the company said it would partner with state-owned PT Pertamina to spend $600 million to $700 million to develop a liquefied natural gas project on Sulawesi island, which will include the construction of a new LNG plant.

ôThe company gets 70% of its revenues from oil and gas production, which makes it a pure play on the oil price,ö one observer says.

However, S&P noted MedcoÆs deteriorating financial profile and said the company is likely to remain highly leveraged in the medium term, given a significant capex programme totaling $1.5 billion over the next three years. The company also secured $260 million worth of funding through a combined common share/GDR offering in July last year.

ôBased on our financial projections, the proposed (CB) issue would be insufficient to cover MedcoÆs planned capital investments and the company is likely to require another $400 million to $600 million in additional borrowings over the next two to three years,ö says S&P credit analyst Royston Quek.

Equity investors, on the other hand, will be pleased to see that the CB will result in no issuance of new shares since the bonds are convertible into Treasury shares.

ôWhile it does need the funds, the company is also using this deal to monetise its current holdings. If fully converted, the deal will take out almost the entire 6.7% stake sitting on the companyÆs own books,ö according to a source familiar with the deal

The fact that the company had a fixed amount of shares available to meet conversion calls, explains why the convertible was launched with a size range. Once the premium had been fixed in the middle of the offered range, the size was finalised at the mid-point of the indicated $170.8 million to $183 million range.
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