This report contains a summary of the pending LME transactions, its impact (if the transactions close as planned), and an FAQ from clients.
- Liability management offers limited to only TSA creditors (for now). We scrutinized the TSA language and believe that the exchange offers contemplated are initially available to the ~$7 billion of TSA creditors and not to all stakeholders. We believe that anyone in the TSA will exchange and those left out will face risk of subsequent coercive exchanges or, in the event of eventual bankruptcy, potential impairment. Should the exchange proceed as planned, we believe these transactions set a bad precedent for the many complicated capital structures in HY TMT.
- Price discovery is going to be challenging for quite some time. Trading desks are quoting Level 3 and Lumen debt based on TSA levels (option to exchange into better economics and position in the capital structure) and non-TSA levels that would get primed by the planned LME. Last we checked, the price differences are approximately 10 points give or take and note that non-TSA Level 3 unsecured bonds are off by 10-15 pts and Lumen 1L by ~10 pts WoW. With non-TSA holders pushing back on the exchange and proposing their own new money deal, we think price discovery will be challenging for quite some time.
- We think bankruptcy risk still quite high, even with this LME. Management suggested the exchanges provide the company a clear pathway to 2029, giving an additional two years to execute its planned turnaround. However, unless more exchanges are forthcoming (which is possible and another reason price discovery will be difficult), the LME transactions involving only the TSA group could leave a still-challenging maturity wall in 2027 of nearly $5 billion by our math. We note that Lumen is also cutting back on headcount (4% jobs reduction) and capex investment in order to pay more in debt service, which we think is an unsustainable strategy.
- TSA investors get best seats at the table. TSA investors get the double benefit of much bigger coupons in Level 3 first-lien and a better position in the capital structure in the second-lien Level 3 and super-priority at the Lumen holdco level. We note that the new-money investors get an 11% coupon, at least $200mn in backstop fees and first-priority claim on Level 3 assets and the intercompany loan that has super-priority rank at Lumen. While the 2025 debt repayments give Lumen more breathing room until 2027 (and avoids any alleged Level 3 default entanglement), we think the TSA investors have clearly aimed to hedge themselves if the turnaround is not effective (and likely hold CDS positions reflecting such view).
- Everyone else left hanging in the balance. Non-TSA lenders and bondholders are getting primed many times over in this series of deals and we also believe Lumen has cost itself good will in the credit markets for the foreseeable future. Level 3 unsecured holders bear the brunt of the pain by getting primed by the new-money 1L and the 2L uptier exchange. Lumen first-lien holders that aren’t part of the exchange get primed by the uptier into super-priority debt and Level 3 intercompany loan, Qwest holders lose 49% of its assets getting upstreamed to Lumen, and finally, Lumen unsecured holders get the shortest end of the stick, ultimately behind all of these classes of debt. Not to mention, the minimum requisite consent requirements suggest Lumen may look to even strip collateral from the non-TSA Level 3 1L and Lumen 1L (explaining the sharp downward move in these securities).
Trading Commentary: Price discovery is going to be very challenging in the near-term. Trading desks are quoting Level 3 and Lumen debt based on TSA levels (option to exchange into better economics and position in the capital structure) and non-TSA levels that would get primed by the planned LME. Last we checked, the price differences are approximately 10 points give or take and note that non-TSA Level 3 unsecured bonds are off by 10-15 pts and Lumen 1L by ~10 pts. With non-TSA holders pushing back on the exchange and proposing their own new money deal, we think price discovery will be challenging for quite some time. We still do not know how much of each class the TSA group owns and whether or not these are liquid markets since many holders are still restricted. Nevertheless, we thought it would be helpful to explain some of the market moves over the past week in light of the TSA and substantial noise and confusion for investors.
Lumen Technologies (LUMN)
LUMN 4% Sr. Sec. Notes due 2027: The non-TSA price of these bonds is down 8 pts WoW to 57 dollar price (23% YTW). The concern for these notes is that if Lumen gets the 66.7% requisite consent support, the company can then strip collateral from these notes. Bloomberg reported that a rival group has amassed a blocking position in these notes to preserve their status, but we are watching this situation carefully.
LUMN 5.625% Sr. Notes due 2025: These bonds (only $206mn outstanding) are not part of the TSA and would presumably be paid off at or prior to maturity with proceeds from the assets sales/new-money bonds. As a result, the bonds are up 6 pts WoW to 84 dollar price. The bonds still yield 19%, implying either concern of further LME or that the transactions contemplated to not solve Lumen’s restructuring risk.
LUMN 7.2% Sr. Notes due 2025: These bonds (only $45mn outstanding) are not part of the TSA and would presumably be paid off at or prior to maturity with proceeds from the assets sales/new-money bonds. As a result, the bonds are quoted up 10 pts WoW to 80 dollar price. The bonds still yield 19%, implying either concern of further LME or that the transactions contemplated to not solve Lumen’s restructuring risk.
LUMN 5.125% Sr. Notes due 2026: Holders of $263 million of the 2026 notes are part of the TSA and can exchange into existing 4% Lumen 1L bonds. The remaining $149 million would get primed in the transactions. However, the maturity would be smaller and within the 2027 wall, so prices (currently 52 dollar price, flat WoW) have held up better than the longer-end of LUMN unsecured.
LUMN 2028-2042 unsecured: There has already been so much damage on Lumen unsecured paper due to fears of LME and priming risk, the reaction saw these bonds only quoted down minimally. Bonds in this part of the structure are quoted in the high-20s, suggesting significant impairment in any restructuring.
LUMN TLB due 2027: The non-TSA price of the TLB due 2027 is up 2 pts WoW to 75 dollar price (17% YTM).
Level 3 (LVLT)
LVLT 3.4% 1L Notes due 2027: The non-TSA bonds in this part of the structure have collapsed nearly 10 pts to 83 dollar price, or 9% YTW. If the requisite 66.7% of these bondholders consent and exchange into the new 1L paper, the concern is that Lumen can strip collateral from these notes, rendering them back to the bottom of the capital structure. Post-exchange, there would only be $250 million outstanding, so these 2027 bonds have held up better than the 2029s since restructuring risk is lower.
LVLT 3.875% 1L Notes due 2029: The non-TSA bonds are quoted down 15-20 pts WoW to 73 dollar price (still only 10% YTW). If the requisite 66.7% of these bondholders consent and exchange into the new 1L paper, the concern is that Lumen can strip collateral from the remaining notes, rendering them back to the bottom of the capital structure. Post-exchange, there would only be $250 million outstanding but high impairment risk in the event of a restructuring.
LVLT 2027-2029 unsecured: Only 51% of these bondholders get the opportunity to uptier into second-lien paper. The remaining 49% (or $1.97 billion) would get primed by the $1.97 billion in second-lien bonds as well as the $1.2 billion new-money first lien bond, thus pushing them to the bottom of a $10 billion debt load at Level 3. Not surprisingly, these bonds have fared the worst, with the 2027s and 2028s down 10 pts to 59 dollar price and 47 dollar price, respectively. The 2029 bonds are down 12-13 pts to close to 40 dollar price.
LVLT Term Loan B: The Level 3 term loan B due 2027 traded down 4 pts WoW to 89 dollar price (11% YTM).
On October 31, 2023, Lumen announced that it entered into a “Transaction Support Agreement” (the “TSA”), which contemplates a series of commitments and transactions to provide Lumen, Level 3, and Qwest (collectively, the “Company”) with new money and maturity extensions. Appended to the TSA is a series of exhibits that comprise a Term Sheet that outlines the proposed terms for the transactions. We assume that our readers are generally familiar with the TSA and the Term Sheet, which can be found here. Definitive documentation remains subject to negotiation and completion.
We’ve reviewed the TSA and Term Sheet and have spoken with many clients about it. Our sister publication, Covenant Review, has also published two reports with their initial impressions on how the TSA implicates the Company’s bonds and credit agreements. Covenant Review’s bond report can be found here and its credit agreement report can be found here.
Proposed LME Summary
Among the key points on the transaction are:
- $1.2 billion in new Level 3 1L paper due 2029. The transaction proposes $1.2 billion in new first-lien Level 3 notes (11% coupon, 11/15/29 maturity date). Proceeds from the notes would be upstreamed to Lumen via intercompany loan that will be pari passu with new Lumen holdco super-priority debt at the parent level and held as collateral for the 1L and 2L Level 3 notes. We note that the backstop lenders get an additional $50 million of these notes as a “fee.”
Level 3 LME Transactions
- Level 3 1L higher-coupon exchange. Holders of low-coupon Level 3 first-lien bonds in the TSA group have the option to exchange into higher-coupon notes with longer maturity dates. The 3.4% Sr. Sec. Notes due 2027 can exchange into 10.75% first-lien notes due 2029 and the 3.875% Sr. Sec. Notes due 2029 can exchange into 11% first-lien notes due 2030. The transactions are conditioned on getting 66.7% of holders to consent/exchange.
- Level 3 unsecured into 2L exchange. Holders of unsecured Level 3 bonds in the TSA group have the option to exchange into new second-lien Level 3 notes up to $2 billion in notional amount (51% of total), getting a 25-bp step-up in coupon and extending out 21 months in maturity. The transactions are conditioned on getting 50.1% of holders to consent/exchange.
- Level 3 1L and 2L holders get access to Lumen value via $1.2 bn intercompany loan. Lumen first-lien bonds currently have access to Level 3 via a pledge of equity from the Level 3 parent entity. However, post-transactions, the tables are flipped. Lumen first-lien loses the equity pledge and, instead, the intercompany loan being extended to Lumen holdco will be pari passu with the Lumen super-priority debt (see Lumen section) and serve as collateral to the 1L and 2L Level 3 bonds.
- Remaining Level 3 unsecured get left behind. The $1.94 billion in remaining Level 3 unsecured bonds will be stripped of covenants and primed by both the new-money first-lien bonds ($1.2bn) and the uptier of $2bn in unsecured paper moving up to the 2L position.
Lumen LME Transactions
- Lumen term loan into 85% superpriority debt, 15% cash. Holders of Lumen term loans in the TSA group will have the option to exchange for 85% in new super-priority term loans and 15% in cash. The transactions are conditioned on getting 50.1% of holders to consent/exchange.
- Lumen 4% 1L Notes due 2027 exchange into 4.25% superpriority. Holders of Lumen first-lien notes The transactions are conditioned on getting 66.7% of holders to consent/exchange.
- Lumen 5.125% Sr. Notes can exchange into existing 4% Lumen 1L notes (up to $263mn). Holders of the 5.125% Sr. Notes due 2026 in the TSA group can exchange into the existing 4% Lumen 1L notes, up to $263 million.
- Remaining Lumen 1L bonds and Sr. Notes get primed. Lumen first-lien debt that is not part of the TSA group is getting primed by 1) the $1.2 bn new-money TL at Level 3, 2) the 1L loans and bonds that are jumping from 1L to super-priority, 3) the 49% of Qwest assets being transferred to Lumen for supporting the super-priority debt and 4) the $1.2 billion intercompany loan that sits pari passu with the super-priority debt. Lumen unsecured would be behind all four of those line items as well as behind the 1L debt being left behind.
- Qwest TL gets repaid, 49% of assets move up and out. Qwest is getting its $215 million term loan repaid, presumably to allow 49% of the assets to move up to the Lumen level. Qwest would still have $2 billion of debt outstanding and lose nearly half of the assets that support that entity. As a result, we expect leverage at Qwest to move materially higher and downgrades likely.
Frequently Asked Questions (FAQs)
Q: Has the TSA been executed?
A: We believe that it has. Lumen’s recent 8-k said that it “entered into a Transaction Support Agreement” on October 31, 2023. We believe that creditor counterparties have already signed the TSA, although we have anecdotally heard that some members who were part of the larger negotiating group were excluded from the group of “Consenting Parties,” did not sign anything, and were never restricted.
Q: Who is allowed to participate in the new money financing?
A: Our understanding is that the new money financing (11% Level 3 1L Notes due 2029) is limited to “Consenting Parties” who have received “New Money Subscription Rights,” which permits them to purchase new money notes. To the extent the notes are not fully subscribed, the “Backstop Parties” are obligated to fund the shortage. To the extent the notes are oversubscribed, people will be cut-back pro-rata based on their holdings of Level 3 debt. In consideration of the backstop commitment, these investors get 5% of the new-money notes commitment in cash ($60mn), and an additional $200mn fee consisting of $150mn in cash and $50mn in additional new-money notes.
Q: Who is currently allowed to participate in the exchange offers?
A: The TSA appears to provide (for now) that holdings of existing debt held by “Consenting Parties” as of the execution date (Oct. 31) are the parties permitted to participate in theRevolver Transaction, the Term Loan Transactions, the Level 3 Senior Unsecured Notes Transaction, the Level 3 2029 Exchange, the Level 3 2030 Exchange, the Lumen Tech Secured Exchange, and the Lumen Tech Unsecured Notes Transaction. For this reason, we believe markets are being made in “TSA” bonds/loans that have exchange rights in the new economics and “non-TSA” bonds/loans that do not.
Q: Can holders that are not parties to the TSA join the TSA and participate in the Transactions?
A: We understand that consent from the Company (and probably a majority of the “Consenting Parties”) must agree to let others participate in the transactions. To the extent that the Company has the requisite levels of consent, we would expect the Company to deny access to other investors.
Q: How is the New Money First Lien Notes Prepayment Premium treated in a bankruptcy?
A: The Term Sheet provides that the “New Money First Lien Notes Prepayment Premium will be payable in the event of a bankruptcy filing or other insolvency event by the Issuer or any of the Guarantors.” We caution, however, that notwithstanding the parties’ best efforts to ensure the make-whole premium will become due and owing in a bankruptcy case by careful legal drafting, several prominent courts have recently concluded that make-wholes must be disallowed as unmatured interest. We have examined make-wholes and their allowability in bankruptcy cases in two recent notes.
Q: Is the company going to strip collateral from the Level 3 1L obligations?
A: We cannot be sure, yet. The closing condition thresholds (TSA, § 3(b)) for the Level 3 secured notes (50.1%) implies that the supplemental indentures could modify the payment priority or even strip some or all of the collateral from existing Level 3 secured indebtedness, but we would need to see the amendments and supplemental indentures to be sure. Due to this uncertainty, the non-TSA Level 3 1L notes were down sharply this week by 10-20 pts.
Q: Can creditors who are not parties to the TSA pursue litigation?
A: We expect that lawyers for the Company have studied the debt instruments to make sure the proposed transactions can be accomplished with the requisite consents. Nonetheless, it would not surprise us if clever litigators for aggrieved investors comb through the instruments in an attempt to identify potential claims for breach of contract. That exercise may prove to be difficult, but not impossible. By way of example, legacy noteholders filed suit against Embarq after its LBO closed on the theory that certain new money debt violated its indenture. You can see our report on Embarq here.
Alternatively, investors might pursue claims for breach of the implied covenant of good faith and fair dealing, which is a duty “implied in every contract, to the effect that neither party ‘shall do anything which has the effect of destroying or injuring the right of the other party to receive the fruits of the contract.’” See Serta. This claim achieved limited success in the cases of Boardridersand Serta where, in both instances, courts denied motions to dismiss the claim. But in the end, creditors in Boardriders settled and creditors in Serta faced significant headwinds after Serta filed for bankruptcy.
It is conceivably possible that investors obtain injunctive relief to prevent the transactions from closing. However, injunctive relief would be difficult to obtain because it requires the court to balance a number of factors that probably weigh against investors. The court will consider whether the investors would ultimately succeed on the merits and whether money damages are insufficient. By way of example, a temporary restraining order was denied in Serta on these grounds, and the transaction closed.
In the end, the strength of any claim will likely depend on the facts and circumstances, many of which are developing in real time. That being said, our initial impression is that litigation may be difficult to the extent that the transactions are otherwise permitted by the text of the debt instruments.
Q: Does this transaction reduce the risk of bankruptcy?
A: Management suggested the exchanges provide the company a clear pathway to 2029, giving an additional two years to execute its planned turnaround. However, unless more exchanges are forthcoming (which is possible and another reason price discovery will be difficult), the LME transactions involving only the TSA group could leave a still-challenging maturity wall in 2027 of nearly $5 billion by our math. We note that Lumen is also cutting back on resources (4% jobs reduction) and capex investment in order to pay more in debt service, which we think is an unsustainable strategy.
Impact of Proposed LME
Sources and Uses. First, we estimate the $1.2 billion raised from the new-money transaction is being used to repay $800 million in TLAs due 2025 and the 15% cash portion of the Lumen TLB and 1L Notes exchange of $293 million and $125 million, respectively. Second, we estimate the $1.5 billion in net proceeds from the EMEA sale go to pay down 2025 debt maturities ($452 million), the remaining TLA and Revolver ($709 million), legal fees of $100 million and the backstop fees of $222 million.
Debt maturities still loom in 2027 even after LME. In looking at the pro forma debt maturities table below, we show that the LME transactions clearly allow a pathway for the EMEA proceeds and new-money bond to repay all of its 2025 maturities (TLAs and certain bonds) and reduce the 2026 bond via exchange into new Lumen super-priority debt. However, despite all of the LME activity, the 2027 wall moves from $10 billion pre-LME to $5 billion post-LME. The 2029 and 2030 towers are much larger as a result at $5.8 billion and $3.7 billion, respectively. We believe management is aiming to get more runway so that it has additional time to try and execute a turnaround.
Free cash flow does not materially improve post-LME. We estimate Lumen generates near zero FCF before the LME transactions, based on $4.5 billion in EBITDA (after EMEA sale and 23E), $2.9 billion in capex and $1.2 billion in interest costs. We estimate that Lumen’s LME transactions increase interest costs by $200 million to $300 million and management says it plans to reduce capex by a similar amount (~$300 million) to compensate for the higher debt service.
“Pull-forward” on NOL benefits high-coupon bondholders, penalizes longer-term investors. Lumen noted on the 3Q earnings call that it is “pulling forward” NOL carryforwards in tax refunds of $200 million in this quarter and $700 million in 1Q24. This additional liquidity will benefit any cash needs within the next two years and ensures that the high-coupon noteholders in this exchange will get more certainty on at least two, maybe three, years of coupon before the 2027 wall hits (albeit reduced by 50%). Lumen has not explained how it came to figure out this refund, not to mention how it has substantial carryforwards since management had communicated NOLs were consumed in the Brightspeed deal. We also have received little info on how much FCF is pressed down in the out years with the cash tax burden extended.
Level 3 more levered. As shown below, we include historical levels of leverage, as well as our estimated pro forma leverage impact by credit silo (Level 3 and Lumen). We estimate Level 3 leverage increases from 2.3x at 3Q23 to 3.4x on a first-lien basis (assumes no further exchanges or collateral strips) with the $1.2 billion in new-money bond and loss of EMEA EBITDA. Meanwhile, the LME introduces a second-lien layer up to 4.5x leverage and, finally 5.6x all-in when including the unsecured bonds that remain. We did not net out the intercompany loan when calculating leverage at Level 3.
Lumen cap structure incredibly complicated. Although we do not forecast a material increase in pro forma leverage for Lumen, which moves only slightly up from 4.0x to 4.1x pro forma. The new-money bonds and EMEA proceeds largely go to pay down debt, while there is leakage in the form of legal and backstop commitment fees. The result, however, is that the cap structure is carved up in even more ways, with three layers at Level 3 and even more layers at Lumen, considering Level 3 and Qwest debt, the new super-priority layer at Lumen, followed by first-lien and unsecured. We also note that Level 3 now has a lookback to Lumen, limited to the $1.2 billion intercompany loan that is pari passu with the superpriority debt.
LVLT and QC Financial Summaries
Davis Hebert, CFA
Head of Telecom/Media
Senior Analyst, Special Situations
Mark Lightner, Esq.
Head of Special Situations Legal Research
Associate Analyst, Telecom/Media