A Word From Sean Mathis —

Today's credit environment in the telecom sector is eerily similar to the industry bubble from 1998-2001. Back then, the telecom bubble burst with a vengeance in 2001 and some of the largest corporate defaults and scandals involved telecom companies like WorldCom, Qwest, and Global Crossing. In the aggregate, of all the high-yield bond issues by telecom companies from 1998 - 2001, almost 20% of them defaulted in that time period alone. If one were to include defaults in 2002 and 2003, then the figure rises to 45%.

After the major losses that were incurred by telecom investors in this period, many prognosticators assumed that high-yield issuance in the industry was going to slow to a trickle. However, the sector is definitely back in investors' good graces after a rather short hiatus. While 2002 was a very dry year for telecom in the high-yield market, with just 3 high-yield bond issuances in the sector, 2003 and 2004 have witnessed an absolute explosion of high-yield bond issuances by telecom companies. In fact, even if one includes 2002, over the last three years telecom was the second-most active industry in terms of high-yield bond issuances by dollar volume, with over $20 billion in junk bonds issued. Only the gaming & leisure sector issued a greater amount of high yield debt.

What is most surprising about this new surge in telecom high yield issuance is the low credit quality of the issuing companies. From 2002 - 2004, a time when most of us would have expected investors to have been very reluctant to buy low-rated bonds from telecom companies, it turns out that issues rated B- and below accounted for an amazing 68% of new high-yield issues. Even more amazingly, almost 2/3 of these issues were rated CCC+ or lower. We find these statistics to be absolutely astounding. Not only was telecom the second-most active sector for junk bond issuances over the last 3 years, but many of the industry's riskiest credits had no problems issuing debt.

The explanation for this explosion of telecom lending activity is relatively clear. The U.S. is experiencing a major credit bubble, with tons of money on the sidelines and an explosion in hedge funds chasing too few opportunities. Credit spreads have tightened dramatically compared to historical levels, and many deals that would never have gotten done just a few years ago are being financed now at very low rates.

What's our View?

The grim history of the earlier telecom bubble will likely repeat itself. Professor Ed Altman, a member of the Miller Mathis Advisory Board, has shown over decades of research that, historically, some 28% of B-rated and 47% of CCC-rated bonds default within 5 years of issuance. Given the heavy recent issuance of B-rated and CCC-rated telecom bonds, it is virtually certain that we will see a succession of telecom defaults in the next several years. The triggers can come from any number of sources - higher interest rates, regulatory changes and technological advances are a few that immediately come to mind - but the end result is clear.

We at Miller Mathis have been monitoring this environment closely, and are constantly looking for ways in which we can be helpful to companies and investors in light of these developments. For companies with highly-levered balance sheets, that means pursuing solutions proactively, before the market turns and they find that they have fewer options. And for those companies fortunate enough to have strong balance sheets and strong business models, that means helping them take advantage of the downturn in the credit cycle as an opportunity to consolidate and improve their competitive position.

STEEL INDUSTRY UPDATE

A Word From Peter Marcus (World Steel Dynamics) —

(The following was prepared by Peter Marcus, Managing Partner of World Steel Dynamics. Peter is widely recognized as the world's leading steel industry analyst. His annual steel conference in New York is attended by over 1,200 top industry executives and consultants.)

• Hot-rolled band (HRB) prices have rallied substantially in many parts of the world since early July when bargain hunters snapped up low-priced Russian and Ukrainian steel at approximately $300 per tonne
  • Since July, orders have risen strongly in North America, to a fair extent in Europe and the world market
  • Availability of HRB from Russian and Ukrainian mills is lessened at present time due to rising demand in the home market and prior export bookings that have filled up backlogs
  • United States HRB prices have rallied to $540-$560 per net ton from their July lows of $390-400 per ton
  • Western European HRB prices have rallied to $490-500 per tonne from their July lows of $410 per tonne; further price boosts of $30-40 per tonne are currently being planned for the fourth quarter\
  • World export HRB prices have rallied to $475 per tonne from their July lows of $390 per tonne
• However, the strength of the pricing recovery is still very much in question
  • The Chinese mills may increase their shipments to capitalize on higher prices; It may require interference by the Chinese government to prevent them from doing so
  • Steel mills across the world are increasing their shipments. However, deliveries to China are currently low and the excess steel may flood other markets. Steel mills in South America and Southeast Asia have particularly stepped up their production, and with demand in their home markets currently weak, they will look to export their products
  • Steel scrap prices may decline after a surprising rally this summer. The USA market may be dampened by greater generation of scrap in the USA Gulf Coast region
  • The price of slab is still only $325 per tonne on the world market
• Increasing volatility within input costs such as scrap and natural gas may contribute to additional steel price fluctuations in the future
  • Current scrap requirements of steelmakers worldwide are utilizing 97% of the world's scrap reservoir - an extremely high utilization rate which may lead to availability concerns among steel buyers. Steel buyers generally expect steel price movements to track scrap price movements with a lag of approximately one month
  • Natural gas prices have almost tripled since 2002; North American producers' reliance on natural gas instead of fuel oil which is used by steelmakers in other parts of the world has created more volatility within North American steelmakers' cost curves

CONSOLIDATION IN THE U.S. STEEL INDUSTRY

A Word From Mike Locker (Locker Associates) —

(The following was prepared by Michael D. Locker, President of Locker Associates, Inc., a New York-based consulting firm that specializes in providing advisory services to the steel industry. Mr. Locker is a member of the Miller Mathis Advisory Board.)

Steel experts and industry players continue to preach the gospel of consolidation. But a closer look shows that consolidation in the U.S. is more complicated than it seems. The key question which no one really wants to answer is - what is the right number of steel producers to ensure that the market remains both stable and competitive. Some argue that the U.S. has already reached this level of market equilibrium, while others feel that further consolidation is required to better stabilize prices and production, especially during the next substantial downturn.

The past few years have witnessed a significant growth in market share for US Steel, Nucor and Mittal Steel. By the end of 2004, the top five U.S. producers shipped about 56 percent of domestically produced steel, up from about 39 percent in 1995. And with the closing of the Mittal-ISG transaction in spring 2005, that number is even higher. However, consolidation advocates, especially the United Steelworkers, want to make sure that concentration continues to grow primarily by keeping the number of major players at the present level or even lower -- especially for producers of flat rolled steel. According to this point of view, newcomers to the market will be inclined to drop prices to establish market share, which would surely upset market equilibrium and drive down profits. Therefore, it stands to reason that consolidation among integrated producers will only occur if current U.S. or Canadian players take over remaining independent flat roll producers.

Currently, only five independent, integrated "orphan" mills remain in the U.S. and Canada -- AK Steel, Wheeling-Pitt, WCI Steel, Algoma and Stelco (Dofasco may also be in this group, but it could also remain a stand-alone mill). If these orphan mills are snapped up by producers with an existing presence in the U.S. and Canadian market, the number of total players will be reduced, contributing to greater supply-demand stability. However, if these orphans are snagged by new players entering the North American market, the market share concentration stays the same and the number of producers does not really shrink.

So what's most likely to happen to the flat rolled market, and what will it mean for North American market stability? Among the three largest producers, we believe that US Steel and Mittal may be eager to expand their already large shares of the North American market and are viable suitors for the orphans. We do not think that Nucor is likely to be involved with any of the orphans due to its refusal to buy unionized plants. Among the smaller producers, we believe that Severstal is the most likely contender to US Steel and Mittal. Severstal is currently a relatively minor player in the U.S. market by virtue of its ownership of Rouge. However, it has already announced plans to increase its flat rolled output with a majority ownership of John Correnti's new southern minimill - SeverCorr. In addition, Severstal was the main strategic suitor for Stelco during the company's CCAA process. We believe that Severstal could easily acquire some orphan mills or perhaps even make a move to take over one of the majors. Regardless of how the orphan assets are allocated, as long as the number of major players in the flat rolled sector remains at the 3-4 level, we believe that the industry should be healthy going forward.

In the world of long products, where numerous smaller mills still thrive, the results could be even more complicated. Among the remaining mills that will likely need a parent are Bayou, Chaparral, Roanoke, Insteel, Cascade, Kentucky Electric Steel, Charter, Oregon, Keystone, Quanex, Ipsco, Sheffield, Tamco, and Connecticut Steel. In our opinion, existing major players, such as Nucor, Gerdau, Commercial Metals, and Ternium (Techint), are the most likely candidates to make additional acquisitions. Therefore, we should see a real reduction in the number of domestic players in the long products area and hence, a much higher level of market concentration and stability.

Locker Associates publishes Steel Industry Update ten times a year. Contact Locker Associates for further information at lockerassociates@yahoo.com.

HIGH YIELD UPDATE

A Word From Prof. Ed Altman (NYU) —

(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.)

• The Altman NYU Salomon Center Defaulted Bond and Bank Loan indices both posted gains for the third consecutive month at the end of August; Each index reached new year-to-date (YTD) highs
  • The Defaulted Bond Index
    • Increased by 2.32% in August and is up 4.16% YTD, although half of the eight months in 2005 had negative returns
    • Positive-return issues outnumbered those declining by about 5:2
    • The market to face value ratio of the 67-issue index was 0.57, which is still above the historical median and average
  • The Defaulted Bank Loan Index
    • Increased by 2.21% in August and is up 3.94% YTD
    • Positive-return issues outnumbered those declining by about 5:2
    • The market to face value ratio of the 32-facility Index was 0.80, which is slightly above the year-end 2004 level
  • The Combined Defaulted Bond and Bank Loan Indices had increased by 2.26% in August and 4.05% YTD
    • The combined indices have outperformed the Salomon High Yield Bond Index, which returned 0.42% in August and 2.70% YTD and the S&P 500 Stock Index, which returned -1.12% in August and 0.70% YTD

If you would like to receive a free copy of Dr. Altman's upcoming high yield market update for the third quarter of 2005, please contact us.

UTILITIES UPDATE: ENERGY POLICY ACT

A Word From Bob Rowe (Balhoff & 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 Energy Policy Act of 2005 is the culmination of a multiyear effort to update the nation's energy laws. While some critics have panned the bill as unfocused, it is the most comprehensive legislative effort to deal with United States' energy needs since the passage of the Energy Policy Act of 1992 - the law which spurred the development of an independent wholesale power market. Since 1992, the continual development of energy markets has drastically changed the key issues that confront policymakers. Over that time, the Federal Energy Regulatory Commission (FERC), state utility commissions, and state legislatures have struggled to devise policies appropriate to developing efficient wholesale and retail markets. Many states decided to take different approaches and did not effectively coordinate their efforts. Not surprisingly, some initiatives proved to be false starts. Others had found their way to the courts. In an earlier "Thoughts" article I suggested a need for resolution of issues concerning transmission policy. The 2005 Act attempts to make meaningful progress on transmission matters among many other issues.

• The main issues addressed by the Energy Policy Act include:
  • Utility ownership
    • The legislation relaxes utility ownership limitations under the New Deal era Public Utility Holding Company Act (PUHCA)
      • Utility holding companies will now be able to acquire utilities in other states
      • Non-utility holding companies will be able to make utility acquisitions
      • There is a strong expectation that PUHCA repeal will unleash a wave of pent-up transaction activity, including consolidation within the sector and an infusion of capital from other industries
  • Transmission and distribution investment and policy
    • Infrastructure modernization
      • The provision of tax incentives aimed at encouraging investment in additional infrastructure
    • Rate reform
      • The legislation limits "must purchase requirements" under the 1978 Public Utility Regulatory Policy Act (PURPA), which often force transmission companies into unfavorable purchase agreements from Qualifying Facilities ("QFs") designated by the government
    • System operation
      • The legislation creates "National Interest Electric Corridors," where the Department of Energy will have "backstop authority" to potentially override state decisions on transmission policy
  • Energy efficiency and fuel source diversity
    • The provision of tax incentives aimed at encouraging the use of cleaner, more efficient fuels and technologies
  • Electric system reliability
  • Market oversight and consumer protection
• The Act is notable in its extensive use of tax policy to further its goals. While there is a long-standing debate over the use of tax-based approaches, in several cases, the passage of a particular measure was already being factored into planning and investment decisions by the private sector. For example, several wind projects were considered cost effective for inclusion in supply portfolios only if the relevant legislation was passed. A high level survey of tax provisions, which will be closely watched by various industry sectors and investors includes the following:
  • More favorable depreciation provisions to encourage investment in transmission and distribution infrastructure
    • Transmission property may be amortized over 15 years
    • Natural gas distribution lines may be amortized over 15 years (only applies to facilities that are placed in service between April 11, 2004, and January 1, 2011)
  • Favorable tax provisions to encourage utilities to restructure unprofitable operations
    • Utilities will have 8 years to pay the tax on any gain from the sale of property to implement a restructuring
    • Utilities may carry back net operating losses to any of the five years that precede the loss' taxable year
  • Favorable tax provisions to encourage investment in more efficient energy sources and pollution control facilities
    • A production tax credit for new advanced nuclear power facilities entering service before January 1, 2021
    • Several investment tax credits for clean coal facilities
    • New "Clean Renewable Energy Bonds" will provide the holders with a tax credit
    • A 20% credit for expenditures on certain energy research undertaken by certain consortia, such as the Electric Power Research Institute
    • Pollution control facilities may be amortized over 7 years
    • A 7 year recovery period for 60% of air pollution control facilities used in conjunction with coal fired generators not in operation before 1976

There is much hard work ahead implementing the myriad provisions of the Act. In some areas such as mergers and acquisitions, transmission and distribution infrastructure development, and resource investment initiatives, the effects of the Act should become quickly evident. In other areas, it will take longer to assess the effectiveness of the legislation. The ultimate effects on investors, sector participants, and consumers will develop for years to come.

Miller Mathis is an independent 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.