2009 Ira Sohn Conference Notes

See below for notes forwarded to me from a friend. If anyone else has Ira Sohn Conference notes and would like me to throw up on the blog, let me know.

This is a summary of ideas expressed at the Ira W. Sohn Investment Research Conference today, Wednesday, May 27, 2009. The Ira Sohn Research Conference Foundation is dedicated to the treatment and cure of pediatric cancer and other childhood diseases.

NOTE: The notes below were taken in real time, but we apologize in advance for any transcription errors. THESE ARE THE OPINIONS OF THE SPEAKERS, BTIG DOES NOT AGREE OR DISAGREE WITH ANY OF THE STATEMENTS.

Peter Thiel, Clarium Capital
Thiel is taking a long term time horizon and contrarian perspective as to whether this is a financial crisis at all. He asserted that productivity growth is the key to increasing the standard of living. Thiel explained that there are 3 ways to create productivity: Additional Leverage, Globilization and Science & Technology. We are witnessing the results of the Additional Leverage. Thiel believes the virtuous effects of Globalization are behind us. Instead of the disinflationary influence it has had over the past two to three decades, inflationary forces will take hold as nations compete for resources. In the area of Science and Technology, Thiel believes that things are not healthy in the ever expanding universe of human knowledge. Major research is turning out to be fraud and there is actually less progress than there appears to be in science. Technology, the application of science and also has not made much progress. Examples include the venture capital community, which has not made money in 10 years, there is no money being made in IPOs and the poor conditions of the State of California.

Thiel believes this is not a new problem and this has been going on for a very long time. 1969 may be the year that progress died. Innovation has been barely enough to keep up with global constraints. Thiel referred to the Tech boom of the late 1990s as a fraud. He questioned how you get high returns in a world with such little innovation. You get the high returns through high leverage. High leverage is a symptom and cause of failed innovation of the past 40 years.

Thiel believes there will be no V shaped recovery until the productivity issue fixed. He also noted that he believes the U.S. Government is nowhere near being on the right track. And he would fade the recovery trade, we will see inflation in assets we need (commodities) and deflation in assets we own. He believes the U.S. is radically misdiagnosing the problem. Washington is dominated by lawyers and economists and not the scientists that are necessary to correct the problem. Thiel referred to the situation as the myth of technological progress and asserted that most innovation we have received is hype. He discussed large cap tech names in a pejorative manor stating that betting on established Technology companies like Cisco, Microsoft and Intel is a bet on no innovation. He thinks we should be looking for companies that are truly innovating, of which there are only a handful.

Joseph Healey, HealthCor
Healey outlined the great demographics behind the Health Care industry while analogizing the current Health Care reform movement to the Hillary Care movement of the early 1990’s. Healey noted that Health Care is projected to become 20% of GDP by 2018. Advances in Health Care have increased life expectancy from 47 years in 1900 to 78 years today. Uncertainty about the Administration’s push for Health Care reform is creating an overhang in the group, similar to Hillary Care overhang in the early 1990’s. From the time Clinton took office to the time Hillary Care was quashed in 1994, Health Care underperformed the market and when Hillary Care was quashed, Health Care drastically outperformed. Once reform begins to take shape and there is clarity to the situation the stocks will improve. He believes the overhang created by this uncertainty creates a good investment opportunity.

Healey discussed 3 companies that he believes have significant upside potential. First, he discussed Valeant Pharmaceuticals (VRX). The cornerstone for Healey’s thesis was the potential for its epilepsy drug, retigabine. Glaxo has partnered with Valeant on the drug. Wall Street has significantly underestimated the upside potential for the drug. Healey noted it is his belief that if Glaxo does not acquire or take over the company, then the stock has potential to rise to the $40 to $50 range. The second stock Healey discussed was Hologix (HOLX), which he believes has potential to double from current levels. He described it as one of the most compelling new product stories in the MedTech group. The business is 70% consumables with a razor-razor blade model and has a Free Cash Flow yield of 10%. Healey’s final idea was Life Technologies (LIFE), where he noted the 8% Free Cash flow yield and upside potential of 60% from current levels.

Mark Kingdon, Kingdon Capital Management
Mark Kingdon opened up with a slide on Bank of America titled “An extraordinary opportunity?” Kingdon noted that Bank of America (BAC) is trading 5x normalized earnings. He discussed the severity of the Government’s SCAP (Stress Test), which he noted was rigorous. Kingdon noted his firm’s analysis arrives at a Tangible Book Value of $11 per share for BofA. Kingdon noted the franchise businesses of BofA and its position as the largest Commercial and Retail bank. Kingdon arrives at Normalized Earnings per share is $2.24 using inputs of 1.2% for the loan loss provision and net interest margin of 2.75%. The loan loss provision is quite high based upon net charge offs over the past 20 years, with the exception of a short period of time around the S&L crisis and the current environment. Kingdon believes the net interest margin of 2.75% is conservative and should expand since the Fed has created a steep yield curve and there is less completion in banking industry. His firm’s analysis leads Kingdon to believe that BofA has potential to rise above $20 in a year.

Steve Mandel, Lone Pine Capital
Mandel started by noting the two components he looks for when seeking a margin of safety: price paid and strength of business franchise. If given a choice of one or the other, Mandel’s preference is strength of the business. In the current market, great franchises have been stagnating while cyclical rally is occurring. Mandel believes that Strayer Education (STRA) is one of those companies with a superior franchise. There is a huge, underserved demand for working adult secondary education and traditional universities not set up to serve these customers. Strayer’s graduation rate is above community colleges and its student loan default rate is low. The Company has partnerships with corporations to educate employees. Strayer’s operating margins are in the mid-30% range. The company needs little capital to operate and grow its business. In 2008, only 20% of $100 million in cash flow was necessary to grow business and the balance was returned to shareholders through various means. Mandel believes sales and profits should grow 8x over the next 10 years. Currently, the company is trading 25x this year’s earnings and 20x next year’s earnings. Those multiples should contract quickly as the company grows. The $2.5 billion market should be much larger by the time STRA is a fully national company.

Jim Chanos, Kynikos Associates
Chanos’ presentation was titled “For profit social services from the trough to the slaughter house.” Following the 30 year deregulation boom in Health Care, Education, Financial Services, Defense and Government Services, the Government will be looking for payback. Health Care faces significant reform. Education is becoming a right and not a privilege and that will cut into margins. Investors find themselves questioning the very foundations of society. The Administration believes Health Care and Education are civil rights and part of its legacy. Chanos refers to the groups at risk of seeing their profit margins cut by Government reform as Capital Offenders.

Chanos highlighted For Profit Education where federal funding represents 73% of revenues at the top 4 companies. The margins for the group are 27% much higher than the 12.5% of the S&P 500. Instructional costs as % of revenues declining, not reinvesting in educating the students. Government funding has fueled double digit student growth. Students at these proprietary schools are saddled with more than 58% than students at traditional school. The companies valuations leave no margin for error.

Chanos also highlighted the challenges to Health Care. Margins in the group are approximately 50% greater than that of the S&P 500. Big pharma spends 3x more on advertising than they do on R&D.

Currently Health Care represents 16%-17% of GDP that is 2x that of the rest of world with worse outcomes. There are 45 million Americans without health insurance the administration’s attempts to insure these individuals will cut into margins. Health Care gross margins range from 30%-70% and operating margins are 50% better than the S&P 500. Government will look to take these actions to contract margins. Chanos is shorting Lincare (LNCR) where margins are still among the highest in the industry. He believes it will be poster child for what is about to happen to the Health Care industry.

Peter Schiff, Euro Pacific Capital
The U.S. Government is interfering with the free market forces trying to fix the economy. We lived in a phony “bubble” economy. The Government is trying to reflate the bubble. Americans are trying to rebuild their balance sheets and save to build wealth. As any drug addict knows if you stop using drugs you will go through withdrawal. Government is making the situation worse. We don’t need any more stimulus, we are suffering from the stimulus we have already been given. Alan Greenspan and Federal Reserve got everyone drunk on easy credit. Government has created moral hazard, i.e. Fannie and Freddie. The housing bubble was Fed and nurtured by the government. America is broke and our creditors are acknowledging that.

What is going on in the global economy will not last and is beneficial to the rest of the world. Foreign nations will retool factories and create products for themselves. Our ride on the global gravy train has come to the end. The whole service sector economy has to go away. If companies are not profitable they need to go out of business. Nobody talks about the productive jobs the Government destroys by saving jobs at GM or AIG. The damage this time around can be far greater than Hoover and Roosevelt created during the Depression. Hoover attempted to bail out the economy and business, Roosevelt only followed his failed policies on a much larger scale. Bush has followed bailout policies like Hoover, now Obama’s is following Bush’s failed policies only on a much larger scale.

Japan was in a good position when they busted, we are in the opposite position. We can’t solve a crisis that is the made of borrowing and spending by more borrowing and spending. Our creditors will stop lending to us. Inflation is going to run out of control. Ultimately that inflation is going to cause prices to go through the roof. We will not be able to purchase items to go on store shelves. This not a major collapse, it is a restructuring. The decoupling concept is here, but the US is not the engine it is the caboose.

You need to own assets in countries where economies will thrive and prosper like Asia, and stay away from US assets. This is the beginning of an inflationary depression.

Lee Hobson, Highside Capital Management
Lee Hobson of Highside Capital presented two straight forward investment ideas, one long and one short. Hobson cited the opportunity in emerging markets where low (wireless) telecom penetration = high growth potential. Hobson noted countries who introduced wireless technology later have faster growth curves and adoption rates thanks to cheaper technology. Hobson like Millicom International (MICC) to play this trend. Cellular service in emerging markets proven trend that offers affordability and high utility to the consumer. He equates it Coca cola 50 years ago. Building a strong internationally recognized brand among consumers who crave the product. MICC sells their service internationally under the Tigo brand. The product is accessible, affordable , available (strong networks) and serves the consumers need to communicate. Millicom has a 25 year emerging market history. They serve growing less developed countries with a total of 290 million people. Wireless penetration ranges from 10% to 80% in their markets –in developed markets penetration is above 100% (multiple phones). The company trades 3.6x forward EBITDA and is growing cash flows at 20%. The companies growth can be self funded an it can grow secularly for a long time with consistency.

Hobson suggested betting against auctioneer Ritchie Bros. The company is an auctioneer of used industrial equipment. It earns a 10% commission rate on what the auction price. To grow earnings they need to grow revenues. The company is trading 29x earnings and 16x EBITDA. Earnings growth accelerated over the past 5yrs transitioning from single digits before to high teens. Company has a 15% market share and company claims it will grow through market share gains.

Hobson states the real growth driver for the company has been equipment price inflation (as a result of the building boom). The company also did a significant amount of capital intensive site builds, but their “same store sales” only grew at a rate of 2%. The volume trends of the business are not likely to be countercyclical as the company suggests. Company had to spend 90% of cash flow to grow revenues but in both the slow and fast growth environments their capacity increase CAGR was 6%. Commercial Construction lags the economy, non residential orders and are backlog collapsing. Management is selling stock and made sales as recently as last week. EPS likely peaked in 2008

Paul Singer, Elliott Associates
Investor have become accustomed to the post war solid growth model. It is likely the solid growth, stable inflation model is gone. There will be a period of deleveraging in an environment of high inflation with areas of deflation. Certain elements of current environment concern Singer. Singer discussed regulation and fears this era of anti capitalistic behavior. He expects a global scheme on the limitations of leverage. Hedge funds did not blow up the world, regulated entities did. Singer is concerned about the treatment of investors in the secondary market for debt. He fears restrictions on the ability for investors to exercise their rights will prevent the flow of capital to markets.

Singer discussed the rule of law. He noted it is devilishly hard to preserve private capital for a long time. Rule of law is a necessary but not sufficient condition. The color of money can change over time. Capital will flow to where it is treated best. Arbitrary actions that circumvent the law for the purpose of achieving a short term government objective will have long term consequences. Rule of law needs to win over the rule of enlightened elite. The government is elephant in the room- hope it the government cares what the room looks like after it is done stomping around the room. It is important to get through this challenging time with our time tested principles intact.

Bill Ackman, Pershing Square Capital Management
Bill Ackman laid out an in depth case as to why the equity shares of General Growth Properties (GGWPQ) are a good investment despite being in bankruptcy. It all breaks down to the company’s assets are greater than their liabilities. Through several potential workout agreements or a court appointed “cram down” the equity should greatly benefit from the likely scenarios. As far as a business General Growth’s malls have over the country 24,000 tenants. The company has 73 “Class A” malls, and high profile names like Faneuil Hall and South Street Seaport do not even garner that high rating. At General Growth 50 of the 200 malls create 50% NOI. Malls historically generate high stable cash flows. General Growth has fixed rates on 83% of debt. This is a business where inflation is an asset. In losing Circuit City the company lost a tenant paying below market rents. The company’s problems result of the CMBS market collapsing. The credit market shutdown prevented them from rolling their debt. They have the second highest occupancy of any mall company. The NOI is actually from the levels where the company’s market capitalization peaked.

Ackman made the analogy between General Growth and the situations that occurred at Alexanders and Amerco (U-Haul). These were bankruptcies where assets are greater than liabilities. During bankruptcy a creditor entitled to their claim but no more, and in this case the equity will be left with value. Ackman suggests two potential options- either an extension of current debt 7 years or a debt for equity swap. He notes either scenario would create approximately a per share value emerging from bankruptcy $20 go to $35. Another option would be if the bankruptcy court forced a “cram down.” In this event Ackman exhibited precedents where the company’s interest rates would be lowered creating a better scenario for the company. Ackman notes the likelihood of forced liquidation by the court is minimized because of the extreme pressure it will place on the commercial real estate market and other REIT’s.

David Sokol, MidAmerican Holdings Company (Berkshire Hathaway)
Sokol is not seeing the green sprouts -- but that is not surprising to them. Government intervention can draw this out longer than necessary, but is useful in some circumstances. Unemployment will rise north of 10%. They are not seeing much improvement in housing. 92% of loans they have seen this year are all conforming. Although there are in excess of 1 million household formations per year, Sokol believes the backlog of 10-12 months is actually 2x that amount of yet-to-be-foreclosed homes. Sokol expects it to be mid-2011 before a balanced home sales environment emerges (6 months of inventory).

In regulated energy the headwinds are greater than any time in his 30-year experience. Inflation and rising borrowing costs are challenging headwinds. The utility industry can handle carbon emissions restrictions, but the cap & trade legislation as currently written will drive up energy prices for consumers to levels that will be hard to digest.

David Einhorn, Greenlight Capital
The theme of David Einhorn’s presentation was the curse of the AAA. Obama administration is following the same policies of the Bush Administration. The administration is reflating the economy back to 2006 levels. For the economy to recover underwater entities need to restructure their debt. The willingness for banks to negotiate in this environment depends upon where the positions are marked. The Obama loan modifications lack the most important aspect of restructuring –debt reduction. The debate in the banks was too narrow with only two options discussed - Nationalizing versus Taxpayer Bailout. There is a 3rd option, debt or preferred equity conversion to common equity. Attempt to induce debt of equity conversions without creating a downdraft in the group. Banks are not materially more solvent today than they were two months ago. Regulatory forbearance has created this rally in banks. We should be overcapitalizing the banks and direct them to restructure the debt of their borrowers. The Government spending and guarantees put the U.S. AAA credit rating at risk. US debt need s to be managed responsibly.

Einhorn took to task Chairman Bernanke’s assertion that AIG failed because there was a hedge fund at the top of an insurance company. AIG failed because it was not a hedge fund, but a AAA rated highly rated regulated insurance company. This status gave false security to investors and counterparties. Hence the curse of the AAA, most of the institutions that ran into major trouble were AAA rated entities. Fannie, Freddie, AIG, monolines, GE all were AAA rated. Einhorn says he is betting against Moody’s (MCO). He describes the situation as such if your highest rating is a curse of those who have it what value do you have? If your goal is to destroy the brand would you do anything differently than Moody’s has done. Why reform them if we can get rid of them? Ratings system is inherently pro-cyclical and destabilizing. Regulators can improve the stability of the financial system by eliminating the ratings agencies. Company is 19x estimated earnings, balance sheet is upside down with negative shareholder equity.

Einhorn and his colleagues at Greenlight announced they were donating $7 Million of their profits from the Allied Capital short to charity.

Great stuff from the Ira Sohn conference!

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HBSCNY Distressed Investing Roundtable

Who can pass up drinks and distressed debt networking?  If anyone is going to this, please contact me.

Thanks to Steven for sending me the event details:

Globally felt bankruptcies have created unparalleled opportunities for specialists in distressed investing. Hear leading experienced and successful distressed investors from hedge fund and private equity industries at this investing roundtable.

Event Date: Tuesday, June 2nd, 2009 at 6:00pm

Click here to make a reservation

Record numbers of companies are struggling as a result of the financial crisis and recession, and the shock waves created by major bankruptcies like Lehman and Chrysler are being felt around the globe. These dislocations have created unparalleled opportunities for specialists in distressed investing. Please come to hear some of the most experienced and successful distressed investors from both the hedge fund and private equity industries at the club’s Distressed Investing Roundtable. The event will be followed by a networking reception.

Panel: 

Eric Edidin, Managing Partner, Archer Capital Management 

Jed A. Hart, Senior Managing Director, Centerbridge Partners 

Tiffany Kosch, Managing Director, H.I.G. 

Victor Khosla, CIO and Managing Partner, Strategic Value Partners 

John M. Reiss, Partner, White & Case

Networking Reception: Come meet invited hedge fund and private equity managers, your fellow HBS alums, and other key industry contacts. 

Eric Edidin, Managing Partner, Archer Capital Management

Mr. Edidin is Managing Partner of Archer Capital Management, a middle market distressed investment firm. Prior to founding Archer Capital Management, LP, Mr. Edidin was a Portfolio Manager of York Credit Opportunities Fund, LP ("York Credit") and a Managing Director of York Capital Management, LP ("York"). Mr. Edidin joined York in 2001 as the second hire in the credit business and helped develop York Credit as one of York's core strategies within its current $10 billion of capital under management. York Credit was ranked by Hedge Fund Research as the #1 performing distressed securities hedge fund measured by its three-year IRR ended September 30, 2005, the quarter prior to Mr. Edidin's exit from York to co-found Archer.

Prior to working at York, Mr. Edidin was a Vice President and Director of Business Development for Etrana, a venture-backed software firm. Prior to Etrana, Mr. Edidin was a member of Morgan Stanley Capital Partners' global private equity investment team. Mr. Edidin began his career in 1993 in the Restructuring and Reorganization Advisory Group of The Blackstone Group, LP where he was involved in advising debtors and creditors in mid-to-large capitalization restructurings, including the structuring of numerous debt financings. During his career, Mr. Edidin has served as a credit committee member and board member for numerous companies. Mr. Edidin graduated with Highest Distinction with a B.B.A. from the University of Michigan in 1993 and earned an M.B.A. from Harvard Business School in 1998. 

Jed A. Hart, Senior Managing Director, Centerbridge Partners 

Jed Hart is a Senior Managing Director at Centerbridge Capital Management. Prior to joining Centerbridge, Mr. Hart was a Managing Director and Chief Portfolio Manager for the distressed securities funds of Angelo, Gordon. Before joining Angelo, Gordon in 1995, Mr. Hart worked in the High Yield Trading Group at Merrill Lynch & Co., focusing on distressed and special situation investing. Prior to that, Mr. Hart worked in investment banking specializing in financial institutions at Fox-Pitt, Kelton Inc. Mr. Hart has served on numerous official and ad hoc creditors committees, including Refco, Doral Financial, Healthsouth, Harnischfeger, Conseco, Finova, Worldcom (MCI), Comdisco and Cornerstone Propane. Mr. Hart received a B.S. from the Wharton School of the University of Pennsylvania. 

Tiffany Kosch, Managing Director, H.I.G.

Tiffany Kosch is a Managing Director of H.I.G. Capital and is a senior member of H.I.G.'s Bayside distressed investments team. She has over ten years of private equity investing experience in a broad range of industries including business services, manufacturing, distribution and retail. Ms. Kosch has been involved in all aspects of the investment process including sourcing, transaction structuring, financing, and execution of post closing growth strategies. She currently serves on the board of numerous H.I.G. portfolio companies.

Prior to joining H.I.G., Ms. Kosch was a Director with Levin Leichtman Capital Partners. In this role she was responsible for investment analysis and working with the management of portfolio companies to create value. Prior to Levin Leichtman, Tiffany worked in the private equity group at Patricof and Co. and Perry Capital. Ms. Kosch earned a Bachelor of Science from Georgetown University and an M.B.A. from the Harvard Business School. 

Victor Khosla, CIO and Managing Partner, Strategic Value Partners 

Victor Khosla is CIO and Managing Partner of Strategic Value Partners, LLC (SVP), a leading global alternative investment firm focused on distressed/deep value and turnaround opportunities. Victor oversees a team of 167 professionals including 61 investment professionals with offices in Greenwich, London, Frankfurt, Tokyo and Delhi. SVP manages approximately $3.5 billion in distressed and deep value investments across a hedge fund strategy, a specials situations private equity strategy and a control-oriented private equity strategy. Prior to forming SVP in 2001, Victor Khosla had a history of successful investing in global distressed opportunities and in building and managing large global investment teams in credit and distressed investments. From 1999-2002, Mr. Khosla managed a $671 million fund that invested in distressed debt in Japan in a joint venture with Moore Capital Management, LLC. From 1998-1999, Mr. Khosla was President of Cerberus Capital Management, L.P., where he participated in the management of a $5 billion private investment fund focused on distressed assets and built the Japanese business. From 1993-1998, he was Co-Head of the Distressed Products Group at Merrill Lynch & Co. where he built and managed a premier distressed debt proprietary trading business with $2 billion in corporate and real estate investments and a team of 40 analysts and traders in New York, Tokyo, London and Hong Kong. Prior to his tenure at Merrill Lynch, Mr. Khosla held various positions at Citibank, Booz Allen Hamilton and General Motors. Mr. Khosla has a Bachelors in Commerce from Delhi University, an M.A. in Economics from Vanderbilt University and an M.B.A. from the University of Chicago. 

John M. Reiss, Partner, White & Case

John M. Reiss is the Global Head of White & Case's Mergers and Acquisitions Group. He represents parties in mergers and acquisitions, private equity transactions, securities transactions, and financings of all types. He also regularly represents clients with relation to distressed debt transactions as well as Boards of Directors in connection with corporate governance and fiduciary duty issues. Mr. Reiss plays a leading role on headline deals in both corporate and private-equity markets and regularly represents leading multinational corporations such as Royal Ahold, SSAB Svenskt Stål AB, First Republic Bank, Excel Maritime Carriers and WellPoint, Inc. He also represents leading private-equity firms and hedge funds such as Harvest Partners, Appaloosa Management, Harbinger Capital Partners, Quad-C Management and Starwood Capital. His recent representations include SSAB Svenskt Stål AB in connection with the US$4.038 billion sale of its North American tubular business, IPSCO Tubulars to Evraz Group, S.A.; Harvest Partners, LLC in the sale of Aquilex, a Harvest Partners portfolio company, to Teachers' Private Capital; and Ahold NV in its $7.1 billion sale of US Foodservice to a private equity consortium consisting of Kohlberg Kravis Roberts & Co. LP and Clayton, Dubilier and Rice Fund VII. 

Mr. Reiss graduated from the University of Pennsylvania (B.S., J.D. and M.B.A.) and is ranked for both Corporate/M&A and Private Equity by Chambers USA 2008. He also recently co-authored a chapter on "Important Tools in Distressed M&A Transactions" for Aspatore Books' "M&A Strategies for Bankruptcy and Distressed Companies - Leading Lawyers on Asset Valuation, Deal Structure, and Risk Management".

Event Date: Tuesday, June 2nd, 2009 at 6:00pm.

· Location: White & Case, 1155 Avenue of the Americas (at 45th Street), New York City.

· Time: Registration 6:00pm; Panel 6:30pm-7:30pm; Networking Cocktail Reception 7:30pm-8:30pm. 

· Cost: $25 Members; $75 Non-Members & Guests; Free if you sign-up to become a member of HBSCNY or renew your membership (call 212-947-5544). NOTE: You must be a HBS alum to become a paid member of the Club. 

· Attendees must sign-up for this event at least 24 hours in advance for security reasons. No walk-ins will be allowed. 

· Organizers: Ken Shoji, '92; Alison Rosenzweig‚'98; Hemali Dassani '99 

· Event Sponsor: White & Case

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Managing a Distressed Debt Portfolio

I am amazed of some of the resources you can find out there if you know how to massage the Google Search. I was running a search on distressed debt portfolio management (for all you followers out there, the exact search was: "Distressed Debt Portfolio" filetype: pdf). What I found was a fascinating PDF entitled: "Risk Management for a Distressed Securities Portfolio" by Marti Murray. This is a great read for any distressed investor.

You can find the document here: Risk Management for a Distressed Securities Portfolio

This is a must read document for those interesting in distressed debt securities. One of the case studies is on the Worldcom/MCI Bankruptcy, which is a spectacular example of a complex bankruptcy where risk adjusted returns were there for those who did LOTS of digging.

Murray points out one of the keys of distressed debt analysis and bankruptcy investing is to determine the key drivers that will make or break an investment. Sometimes it is two or three variables, and sometimes it is significantly more. As a topical example, the bank debt of General Motors has been on a tear as of late (the revolver is 92, the term loan is 95 - both up 40-50 points from the lows). The two main drivers of that analysis were:

1. Is the security granted for either the revolver or the term loan (they are different) greater than the amount of debt outstanding. Most market participants agreed that that was indeed the case.
2. How much will the government crush you? That is where the discrepancy and the mismatch of price vs intrinsic value really came down to.
   

We are beginning to see that the government (unlike in the Chrysler bankruptcy) is going to play ball with the secured lenders at GM. (As an aside: if any lawyers can explain why the differentiation, leave a comment). So the bank debt rallies in response.

Stay tuned in the coming weeks for some interesting feature (more case studies, interviews, more profiles of distressed debt fund managers) we have been cooking up at Distressed Debt Investing.

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Distressed Debt Research - Blockbuster TLB

For our next distressed debt example, I present to you (with the help of a friend) Blockbuster's bank debt (currently quoted 69-70).

Synopsis: A recent amendment gives Blockbuster the breathing room to complete its operational restructuring and a runway to refinance maturing bank debt that comes due in 2010. We believe that the bank debt is worth par under either a refinancing scenario or a Chapter 11 proceeding, offering investors a weighted average IRR of nearly 40%.

BLOCKBUSTER OVERVIEW

Dallas based Blockbuster, Inc is the largest operator of movie/video game rental retail stores in the world. It currently operates 7,267 stores, comprised of 5,742 company operated and 1,525 franchised locations.

The first Blockbuster opened up in Dallas, TX in 1985. The 1000th store was opened in 1989 and Viacom purchased the entire company in 1994 for $8.4B in stock (and debt assumption). Viacom then carved-out 18% of the company in an August 1999 IPO. In October 2004, Viacom divested the remaining 82% of BBI through a leveraged transaction (the result being the levered structure we see today).

After a failed attempt to acquire Hollywood Entertainment (which was bought by Movie Gallery, which subsequently filed Chapter 11 in 2007), and a series of management missteps, investor confidence in Blockbuster was shot. Carl Icahn attempted to wrestle control of the company (winning three board seats in 2005) and a new management team was installed in June 2007; James Keynes, former CEO of 7-Eleven, was named Chairman and CEO.

Since then, Keynes has made formidable steps into fixing the mistakes of previous management. The company closed under-performing domestic stores (which still remains an important strategic initiative), rolled out new store layouts, simplified rental pricing and terms, stopped the aggressive marketing war with Netflix on the mail order business, franchised and divested a number of foreign stores, changed store designs, entered the vending business (in a partnership with NCR) and the online/on-demand market with the acquisition of Movielink. Furthermore, its DVD by mail service, Total Access, recently announced it would begin a pilot program for renting video games by mail in 2Q09 and fully commence the operation in 2H09. These results have helped stabilize comps and EBITDA margin degradation.

BLOCKBUSTER CAPITAL STRUCTURE

RECENT CREDIT FACILITY AMENDMENT

On March 19th, 2009, Blockbuster (in its 4th Quarter Result Press Release) announced that it had entered into an agreement in principal with its revolver lenders (JPM, Silverpoint and Monarch). Leading up to this, market participants were worried that the company would be unable to refinance the up-coming revolver maturity (at the time, there was ~$160M outstanding) and the company would have to seek bankruptcy protection. Consenting revolving lenders were well compensated with a one-time 8% fee for the amendment. The amendment was finalized on May 11th. Terms of the amendment are as follows:

• Rate set to LIBOR plus 10.00% (3.50% LIBOR floor)
• Maturity date extended to September 30th, 2010
• Size set to $250M (from $325M) with $52.5M available for LCs
• Amortization Schedule Set: December 15th, 2009: $25M, January 31st, 2010: $20M, February 28th, 2010: $20M, March 31st, 2010: $20M, April 30th, 2010: $10M, May 31st, 2010: $15M, June 30th, 2010: $50M, July 31st, 2010: $10M, August 31st, 2010: $10M
• 50% Excess Cash Flow Sweep established, Fixed Charge Coverage Ratio set to 1.25x up to January 3, 2010 and 1.30x thereafter
• Leverage Ratio amended to 2.75x (previously 3.00x)
• $30M Capex covenant in 2009 and $40M in 2010 (with a $10M carryover option); this is in-line with maintenance capex for the company.
• Removes “Going-Concern” default language resulting from FY2008 Auditor’s Opinion

MOVIE GALLERY BANKRUPTCY – A WINDOW TO THE FUTURE?

On October 16th, 2007, Movie Gallery filed for bankruptcy in the Eastern District of Virginia. Movie Gallery was Blockbuster’s #2 competition for in-store movie and game rental, operating a portfolio of 3,000 retail stores across the United States. Sopris Capital, as the lead creditor, converted a large portion of their second lien investment and subordinated bond investment (in tandem with a subsequent rights offering), to gain control of Movie Gallery’s equity. More important to our discussion is the fact that the first lien (Class 3 claims) was reinstated at a significantly higher rate (Eurodollar Rate + 1000, 3% points in fees).

Movie Gallery filed for one reason: Too much debt from the failed Hollywood Acquisition. Some background: In April 2005, Movie Gallery completed its acquisition of Hollywood (BBI had previously bid). Hollywood had a predominantly West Coast, urban store base, complementing the existing footprint of Movie Gallery. Unfortunately for Movie Gallery, the integration is still not completely finished. The acquisition cost Movie Gallery nearly $900M that was financed 80% in debt. The company successfully refinanced that facility in the credit heyday of early 2007. That being said, as the company’s result languished in mid 2007, the trade became incessantly tighter on their terms (LCs are very common in this industry). This caused a covenant violation at Movie Gallery, which caused more contraction in trade (including COD), forbearance was established to work a pre-pack and the company eventually filed.

Upon emergence, and using 2009 projections for the baseline, Movie Gallery was to be levered 4.0x through the first lien debt and 4.7x total. Coverage was to be 1.3x. The company needed approximately $100M in a DIP throughout the bankruptcy. We use this information in walking through a possible Blockbuster Bankruptcy below.

VALUATION AND INVESTMENT OPINION – BBI BANK DEBT

Before moving on to the Chapter 11 Going-Concern Valuation, we want to highlight our projections for cash flow for the next few quarters.

If the company is unable to refinance their debt in the first half of 2010, we expect the company to run out of cash in the 2nd quarter of 2010 or 3rd quarter of 2010 (depending on how working capital shakes out). At that point, the company, under our assumption of a 9% drop in same store comp, will be running at an LTM EBITDA level of $295M. Given where leverage is projected to be at the time (below 1.5x on a gross basis), we believe the company will have no problem refinancing their debt. Assuming a takeout in June 30th, 2010 at a price of 68.5 leads to a return of 45%.

Chapter 11 Going Concern Valuation

We assume, similar to what happened at Movie Gallery that BBI will need some sort of DIP to pay off its existing LCs and be able to conduct ordinary business properly. Based on size alone relative to Movie Gallery, we assume a $150M DIP below.

Possible upside to this model include cash generated throughout the bankruptcy (we believe banks would stay current on their interest rates) where the bond holders would not receive interest. At the current market price of ~70 cents on the dollar, the market is anticipating a 55% drop in run rate EBITDA, an asserting we do not agree with. Under this scenario, bank debt would be reinstated (or refinanced with an exit facility depending on the credit markets). We assume a 2 year bankruptcy, commencing in June 2010, and a repayment in 2012. Assuming default interest of L+575 (current rate of L+375), at a purchase price today of 68.5 leads to a return of nearly 35%.

The weighted average of these two scenarios (refinancing and Chapter 11), at a 50% expected probability of both lead us to our assumed return of 40%.

CONCLUSION

We believe that a 40% weighted average return (IRR) to investors more than compensates them for the downside risk inherent in investing in Blockbuster. While risk of technological disruption, industry secular changes, and a weaker global consumer are definitely present, management seems to have a handle on these issues and are working through them diligently. While cash constraints could derail the operational restructuring, we believe that a bankruptcy would be a net positive to bank debt lenders by diverting cash flow from junior creditors to senior creditors. The low leverage (as well as the recent amendment) gives us comfort that Blockbuster will be able to refinance its debt, albeit at a high rate. Either scenario though brings a par recovery for bank debt lenders even under the most severe of circumstances. This is a very interesting distressed debt investing case study.

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"Will it be death by fire – hyperinflation – or death by ice – deflation?"

When I set out to start a distressed debt investing blog, I promised myself I would focus on bottoms-up investing and analysis. Bankruptcy, valuation, and fundamental analysis is where I get my edge. 

That being said, sometimes I read articles, blog posts, or emails sent to me from colleagues or friends that need to be shared with a larger audience because they are just that insightful and informative. I bet every single one of us would have liked to hear John Paulson's thoughts on the U.S. Housing Market and the Securitization Market in 2005 - and then we all would have subsequently made billions of dollars shorting subprime.

Today, I received an email from Sahm Adrangi, who I met at Monish Pabrai's annual meeting a few years back. Sahm used to work at a large distressed debt hedge fund before striking out on his own and forming his own investment advisory firm.  I would recommend everyone that enjoys what follows to email Sahm (sadrangi [at] kerrisdalecap [dot] com) and get on his Bi-Weekly email distribution list. Incredibly inciteful stuff (including A LOT of commentary on distressed debt investing). You will not be disappointed.

I think there are a lot of interesting investment ideas that come out of this commentary (especially with distressed companies that have the ability to raise prices), we will talk about those in a future post.  Without further ado...

The Dollar Crisis

Quick Synopsis:

• Abandoning the gold standard in 1971 has resulted in large global trade imbalances and a massive buildup of foreign currency reserves
• These trade imbalances and buildup of foreign reserves have resulted in frequent booms and busts since 1971
  
• The Japanese bust of 1989, the Asian economic crisis of 1997, and the current US credit market collapse have resulted from the post-1971 paper money monetary system
  
• Abandoning the gold standard has gradually resulted in a very overvalued US dollar, and that the dollar is headed for disaster
•  “The dollar standard is inherently flawed and increasingly unstable. Its collapse will be the most important economic event of the 21st century.”

This week, I’m doing another book review, this time on “The Dollar Crisis” by Richard Duncan. Before I begin, I’ll make a prediction, since I’m an investor and my job is to predict. I increasingly believe that the dollar will collapse, and its ramifications could be as violent as when the credit markets cracked in July 2007. Currency collapses are nothing new, just as the bursting of a credit market bubble was nothing new. A dollar collapse could very well lead to carnage in domestic asset markets, whether it be the stock market, bond market, etc. Also, US imports and the overvalued dollar are fueling many of the export-oriented economies abroad, so a dollar collapse could wreak havoc on foreign asset markets as well. And once it happens, we’re going to view the collapse of the dollar as an obvious event that we should have long seen coming. Just as we now view the subprime wreckage and bursting of the real estate bubble as an event we should have easily predicted.

The problem is timing. Does the dollar collapse in 2009, or 2015? And is it a slow depreciation, or a sudden 50% fall? Those are tougher questions. Richard Duncan predicted the dollar’s demise in 2002. His error of timing discredited an otherwise brilliant book.

In a sentence, “The Dollar Crisis” is about how the world changed in 1971. That was when Richard Nixon dropped the gold standard (or its close cousin, the Bretton Woods international monetary system). Here’s the youtube video: Youtube Bretton Woods. The end of the gold standard ushered in a new era of large trade imbalances and the buildup of foreign currency reserves, and these trade imbalances and large foreign currency reserves have had significant impacts on the global economy that many people don’t realize. Huge trade imbalances and large foreign reserves didn’t really exist during the gold standard. During the gold standard, a country’s money supply was determined by the amount of gold it had. Banks’ reserves were either gold or indirectly tied to gold, and so the amount of money they could lend, and that the nation could print, was backed by the nation’s gold reserves. To see the implications of that sort of monetary system on trade imbalances, let’s take a hypothetical United States and China, where the US is buying lots of goods from China. The US gets goods; China gets dollars. China takes its excess dollars, gives them to the US, and gets gold in exchange. The US gold reserves would decline, causing credit contraction in the US. This would lead to recession; prices would adjust downwards; and falling prices would enhance the trade competitiveness of the US. The US would stop exporting so many goods from China as China’s costs of production begin rising relative to the United States’. The US would stop being a net importer; gold would flow back in; and equilibrium on the balance of payments would be re-established.

Under the gold standard, trade imbalances were unsustainable and self-correcting.

Today, in the system of fiat money, that’s no longer the case. The US gets goods; China gets dollars. China takes its excess dollars, and invests them back in the US, whether in the form of treasury bonds, Freddie Mac mortgage-backed securities, or US corporate bonds. The US takes those dollars and buys more Chinese goods. China gets more excess dollars and reinvests in the US. The US buys more Chinese goods. And on and on, until the US credit market debt as a % of GDP goes from 150% in 1970 to 350% in 2008. Just as reference, that number was 130% in 1950. During the gold standard, debt-to-GDP hardly grew. Under fiat money, it has soared. America isn’t awash in debt because we’re inherently greedy, profligate consumers. It’s because money is no longer backed by gold. China and Japan eagerly reinvest their dollars back in the United States so as to keep their currencies low relative to the US dollar. American consumers and companies happily borrow the money foreigners are throwing their way. The party lasted until 2007, when Americans finally began having trouble paying their enormous debts.

Duncan’s book discusses the implications of the large trade imbalances and buildup of foreign reserves that resulted from the new paper money system introduced in 1971. The book is lengthy and detailed and this email will not do it justice. But I’ll discuss some of my favorite topics from it.

First, the massive Japanese stock market and property bubble in the 1980s, and subsequent decade-long recession in the 1990s, was the product of its large trade surplus and massive buildup of foreign currency reserves. To understand this, we need to see how trade surpluses are analogous to money creation and asset inflation. When a country has a trade surplus, its reserve assets increase, and this essentially leads to credit creation. If a dollar comes into Japan due to a trade surplus, two things can happen. First, it can go into a Japanese bank, increasing the total amount of reserves that bank can lend off of, and thus resulting in credit creation. Or it can be bought by the central bank with newly printed currency, which again is new money entering the Japanese bank, again leading to credit creation. The only way the Japanese central bank can prevent this credit creation is by issuing enough bonds to soak up an equivalent amount of the new money that’s just entered the banking system as a result of the trade surplus. If they don’t, the result will be massive credit creation. And credit creation leads to asset inflation, because the new money has to be invested somewhere. That somewhere is usually stocks, property and debt.

Japan’s total reserves minus gold rose from around $5bn in 1970 to $100bn in 1989. Its money supply (including M2 and CDs) grew from 50 trillion yen to 450 trillion yen by 1989. Without the gold standard, Japan’s trade surplus persisted, leading to massive reserve buildups and huge credit creation. All this newfound credit had to find a home, and it went into the Japanese stock market and property markets. The Japanese stock market went up by more than 12 times from 1970 to 1989, with the Nikkei index trading at more than 60x PE before it crashed (today, it’s under 10x PE). Domestic credit as % of GDP went from 140% to more than 250%. Ultimately, incomes could not rise fast enough to catch up with the tremendous asset inflation that was occurring. In 1989, the Japanese stock market and property bubbles popped as debtors couldn’t pay their creditors; the Japanese banking system became flush with bad loans; and a painfully long recession ensued.

Second, Duncan paints a similar story for the Asian financial crisis that occurred in 1997. He shows how foreign reserves multiplied dramatically from 1988 to 1997 in Indonesia, Korea, Malaysia, and Thailand, rising 3 to 6 times over that period depending on which country you’re looking at. Their reserves buildup was due to Japan relocating its manufacturing capacity to the rest of Asia in response to a sharply appreciating yen. Foreign capital entered the banking system and resulted in excessive credit creation. Like Japan, those economies experienced rapid economic growth and rapid asset price inflation. Overcapacity resulted, and ultimately, the bubble popped, leaving a lot of bad loans in its wake.

Third, he discusses how the original Great Depression in the US was also the result of reserve buildups. During World War I, governments dropped the gold standard in order to print enough money to finance the wars. The result: huge trade imbalances resulted, leading to credit creation in the US. Specifically, the United States was the producing the goods that the Allies were using to fight the war. US gold reserves rose 64% from 1914 to 1917 as Europe exchanged its gold for American goods. The US also began accepting government debt from the Europeans. The Europeans had to drop the gold standard, because Europe couldn’t afford to suffer the recession and credit contraction that would result from their fast-depleting gold reserves. In the US, the increase in reserves led to a doubling of the credit base from 1914 to 1920, which led to a boom in industrial production. When the real economy was no longer able to profitably invest the available liquidity in new plant and equipment due to overcapacity and falling prices, increasing amounts of money were shifted into the stock market. Ultimately, the bubble popped, share prices plunged, credit contracted and a banking crisis developed. Duncan’s thesis: it wasn’t infectious greed that caused the Roaring 20s and subsequent Great Depression. It was excessive credit creation that resulted from trade balances during and after World War I, which in turn resulted from the gold standard being temporarily dropped during World War I.

Duncan also makes an interesting comment about just how much more frequent banking crises have been since 1971. He quotes a Bank of England study in 2001 that referenced a historical study by Bordo, Eichengreen, Klingebiel and Martinez-Peria that said that only 1 major banking crisis occurred in the quarter of a century after 1945, but 19 since. During the Bretton Woods period, systemic banking failures were not common because international reserve assets grew slowly. But when the world’s monetary base began expanding exponentially, they became pandemic.

After recounting various examples of how trade imbalances that were not sustainable under the gold standard have created boom-bust cycles post-1971, Duncan discusses the unsustainability of the current dollar standard that has replaced the Bretton Woods system. Over the last 30 years, the United States has been transformed from the world’s largest creditor into the world’s most heavily indebted debtor. The dollar standard has incentivized countries with trade surpluses to reinvest their dollars back into US dollar-denominated assets, because that’ll keep their currencies low and fuel their export-oriented growth economies. The problem is this: at some point, the US will reach a point where it can’t pay its debts. So at some point, surplus countries will be forced to convert their dollar currencies into their own currencies, causing a sharp appreciation in their currencies and a sharp decline in the dollar. That shift will restore equilibrium to the US balance of payments, but it will also throw the major exporting nations into recession (or exacerbate current recessions) as their exports to the United States collapse (or further collapse).

Duncan has a fascinating chapter called “Global Recession: Why, When and How Hard”. When you pick up the book, turn to page 175. Written in 2002, the chapter is stunningly prophetic. When Duncan’s book came out in 2003, it was soon discredited, because the boom from 2004 to 2007 appeared to prove him dead-wrong. But his ability to predict the events of the past two years in gory detail, back in 2002, is somewhat mind-numbing. For instance, he has a subchapter titled “When?”, with the following sentence reading “When the U.S. property bubble pops. In 2002, the global economy is being supported by an American shopping spree that is being financed by a bubble in the U.S. property market…. The housing bubble is the main explanation for the resilience of the American consumer. Sadly, bubbles pop… In August 2002, the 30-year fixed-rate mortgage fell to a record low of 6.13%. Rarely has global prosperity relied so heavily on one number.” Sounds like obvious stuff nowadays. But written back in 2002? Neat. He also discusses the securitization markets, and accurately predicts the implosion of the asset-backed securities markets. And the collapse of Freddie Mac and Fannie Mae. And the massive banking failures currently sweeping across the nation. His problem was an issue of timing – Duncan was too early in his forecast, and didn’t sufficiently account for governments’ abilities to temporarily reflate their economies by lowering interest rates and pumping money into the world. But these sorts of temporary solutions could only last so long – at some point, a country with rapidly expanding debts becomes no longer able to pay those debts.

There’s one final topic I want to address. One of the more complicated ideas of the book, for me, was his discussion of inflation / deflation. Duncan explains how the global credit creation that resulted from abandoning Bretton Woods has led to global overcapacity. This overcapacity has led to disinflation / deflation, since there is too much global supply in the world relative to global demand, resulting in low prices. Overinvestment causes excess capacity, and excess capacity causes deflation. Second, trade imbalances have allowed export-oriented economies to keep their currencies low relative to the dollar (the currency of the world’s largest consumer), which has also been disinflationary / deflationary. It’s an interesting discussion, because it addresses a question I’ve always had: If we’ve had such strong economic growth from 1982 to 2007, why was there so little inflation (at least until 2004 to 2007, when commodities began surging). Duncan’s answer is (i) ‘global overcapacity’ and (ii) ‘trade imbalances + free trade’. When the world goes into recession, these deflationary forces should only accelerate. He also questions fiscal and monetary policies in this deflationary recessionary environment. He writes “Monetary policy works through credit expansion. When the government wishes to expand the money supply, it buys assets (such as government bonds) from the banks, increasing their liquidity. In theory, the banks, in turn, lend more to businesses… thereby eventually stimulating consumption and the economy overall. In a post-bubble economic environment, characterized by excess capacity, bankrupt corporations, and overly indebted consumers, monetary policy does not work… there are neither a sufficient number of creditworthy borrowers to lend to… nor a sufficient number of clients who want to borrow, due to the lack of money-making investment opportunities left in the gutted marketplace. Consequently, the increased money supply never reaches the consumers and personal consumption does not revive.”

So today, we’re in the following situation: (i) global overcapacity and declining demand; (ii) governments printing money; and (iii) potential collapse of the dollar due to the trade imbalance. The question is: are we heading for deflation or inflation? Duncan seems to admit that he doesn’t really know. In the 2005 edition of his book, he appends an additional chapter discussing how the US and Japanese central banks revived the global economy in 2003 to temporarily stretch out the disequilibria several years longer. He ends that final part, and the book, with a chapter titled “Bernankeism: Anticipating the Policy Response to Global Deflation”. He lays out various scenarios by which the temporary boom can end (the ultimate scenario ended up being a combination of scenarios #2 and #3 (#2 was “A US asset price bubble that drives property prices so high they can’t be financed even at very low interest rates” and #3 “A meltdown of the under-regulated US$200 trillion derivatives market”). He discusses how the dollar will collapse under any one of the scenarios.

Then he writes: “the only option left to stimulate aggregate demand would be to drop paper money from helicopters. That too would fail, however, for who would accept paper dropped from helicopters in exchange for real goods and services? Hyperinflation would quickly set in. Economic transactions would then be conducted through barter rather than via the medium of a debased script. Eventually, a gold standard would re-emerge… Exactly how these events will unfold is impossible to forecast; nevertheless, the eventual outcome is within sight. The dollar standard is inherently flawed and increasingly unstable. Its demise is imminent. The only question is, will it be death by fire – hyperinflation – or death by ice – deflation? Fortunes will be made and lost, depending on the answer to that question.”

I look forward to any comments you may have.

Sahm Adrangi

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Calling all Metals & Mining Analysts...

I am working on a projecting involving a metals & mining company. If you are well versed in the topic and wouldn't mind taking a few minutes to answer my questions, please contact me at hunter [at] distressed-debt-investing [dot] com

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Chart of the Day

If you remember a few weeks ago, we talked about a few steps in my due diligence process for researching potential short investments.

It looks like we were on the right track with a consumer discretionary company (for me, eating out is a discretionary item). Hat tip to the Market Seer Blog for this chart below. Telecom looks to be one the cheapest sectors out there - Leap Wireless, a post-reorg equity (our favorite kind of equity), could be an interesting one to take a look at...

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Distressed Debt Video from the Milken Institute

If you want to hear a very intelligent conversation about the credit crisis and what is going on in the world right now, please watch this video: Milken Institute Credit Panel.  

At the risk of being labeled a Milken fanboy: In my opinion, if Michael Milken was not barred from the securities industry nearly 20 years ago, he would be one of the richest men in the world.  I encourage those not familiar with him to read his Wikipedia Page or better yet read my two favorite book on the history of the junk bond market: The Predator's Ball and (the relatively unknown, but probably the better of the two) Fall From Grace: The Untold Story of Michael Milken.

When I first started in leveraged finance, my boss gave me his copy of Fall from Grace. Unlike many books of the era that painted Milken in a negative light, this one is neutral and readers can not just form their own opinion, but can also learn about the history of the high yield market and distressed debt market. Fascinating stuff.  

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Distressed Debt Investing - AbitibiBowater

First of all, thank you all for participating in the Distressed Debt Investing Poll.  Your feedback has been helpful in allowing me to better guage our reader's interest.  As you can see from the poll results, Distressed Debt Investing is going to start zeroing in on distressed debt concepts and distressed debt case studies.

In that regard, a reader has sent me a very interesting write-up on AbitibiBowater's Bankruptcy.  I have been following the situation for quite sometime and present to your some thoughts on the bankruptcy, the valuation, etc.

First off, here is the link to the AbitibiBankruptcy U.S. Docket: ABH U.S. Docket as well as a link to ABH's Restructuring Information on their website.

Warning, this post is highly technical and complicated and this case is a complicated one. But that should not stop us from probing to see if we can find some hidden value. To simplify things, we are going to focus solely on one debt instrument here.  In future posts, as we continue to dig into the situation, we will expand the analysis to include other debt instruments.

To start, some background. From the company's website:

"AbitibiBowater produces a wide range of newsprint, commercial printing papers, market pulp and wood products. It is the eighth largest publicly traded pulp and paper manufacturer in the world. AbitibiBowater owns or operates 23 pulp and paper facilities and 30 wood products facilities located in the United States, Canada, the United Kingdom and South Korea. Marketing its products in more than 90 countries, the Company is also among the world's largest recyclers of old newspapers and magazines, and has third-party certified 100% of its managed woodlands to sustainable forest management standards."

On April 16, AbitibiBowater Inc. (ABH) and its primary subsidiaries, Bowater Inc. (BI –U.S. assets), Bowater Canada (BCFPI – Canadian assets), Newsprint South (NS – U.S. assets), Abitibi Consolidated (ACI –Canadian assets), and Donohue (Dcorp – U.S. assets) filed for protection from their creditors in a complex cross-border filing under both Chapter 11 bankruptcy in the US (Delaware case #09-11296) and the Companies’ Creditors Arrangement Act in Canada (Montreal). 

For those reviewing the company for the first time, think of ABH as holdco for the Abitibi and Bowater groups of the business (separate legal, capital and cash flow structures). The Abitibi group controls the ACI and Dcorp entities while Bowater has BI, BCFPI, and NS.  (Didn't I tell you this could get confusing!)

After various exchange offers made to bondholders earlier in the year failed, the clock ran out on ABH.  It found itself simply over-levered (nearly 12x levered), unable to raise capital for debt maturities, and stuck in secularly and cyclically declining newsprint and specialty paper businesses.  

ABH’s challenge is now to execute a textbook reorganization in hopes of extracting value to its most meaningful stakeholders at this time – creditors and employees.  The equity is out of the money with little or no chance of recovery.  Operationally, ABH will need to restructure around its core, low-cost paper mills, close unprofitable facilities, and complete several announced and valuable (hydro) asset sales while pursuing others (timberlands).  Of ABH’s 16,000 employees, 11,000 reside in Canada.  

Management recently reminded an investor audience that they employ more people in Canada than GM and it may not be coincidental that the government of Quebec has both indirectly bid on ABH’s valuable Quebec hydro assets and provided a below-market guarantee for ABH’s incremental DIP.  In doing so, it helps support the timing and process of this critical asset sale while providing additional super-priority funding to help ABH pay for some of the costs to close facilities, pay advisors and maintain adequate working capital.

Here is a listing of  ABH's debt securities, and how what assets (per entity) secures that debt:

For this post alone, we are going to be focused on the 13.75% Secured Notes.

You ask why this particular instrument? In 2008, ABH had their backs against the walls and needed to do a refinancing of maturing debt. To accomplish this, the company needed to pledge virtually all of its available fixed assets to the new securities. And that is exactly what they did. The 364 day Term Loan (we will post on that one soon) got working capital and the 13.75% Senior Secured Notes due 2011 got the fixed assets (the paper mills and the hydro assets).

More specifically, the secured notes ($413M principal plus $28M accrued) are secured (actually second to up to $87 million priming DIP lien – motion currently in front of court) by hydro assets with an announced sale value $540 million plus a first lien in 11 of ACI’s paper facilities with a book value of $1.4 billion (3.6M tons of capacity) and estimated 2008 Ebitda generation of $260M.

Assuming a very conservative case of over a 50% drop in EBITDA to $125M and a 4x multiple, gives us a value just on the 11 paper facilities of $500M.  This also equates to a $ per ton value of $139 (500M/3.6M tons of capacity), which in my opinion is quite conservative.  9 of these facilities are operating, and a recent court document suggests that based on 2009 EBITDA, these mills are worth $750M. Nonetheless, at Distressed Debt Investing, we like to be conservative and thus will use the lessor of the two or $500M.

Assuming the mills are worth $500M and the Hydro assets net $540M, there would be $1.040B of value that the noteholders would be able to get their hands on. In front of them, would be the current and future DIP draws (currently $87M) and bankruptcy administration fees (conservative estimate of $75M).  In other words, there is $878M ($1.04B-$87M DIP - $75M bankruptcy fees) vs $413M of notes, or over 2x coverage. However, if the hydro sales do not close as planned or cash restructuring costs mount, coverage will drop. 

In our opinion, ACI’s 13.75% Secured Notes at 85 cents may offer value at a 26% annual yield over a twenty-four month holding period, with a substantial margin of safety.  However, it is unclear whether post-petition interest will be paid in cash or accrue and the extent to which incremental DIP lending with priming liens will be required to affect ACI’s side of the reorganization.

Lastly, uncertainty surrounding exit financing for a difficult business cannot be overlooked.  If all goes well with ACI’s restructuring and the company can successfully pare down around a more profitable core, then the Secured Notes should be paid off or refinanced upon exit from bankruptcy.   If industry conditions continue to deteriorate at the ongoing rate, however, its uncertain how the core will look relative to liabilities to pay.

In future posts on Distressed Debt Investing, we will look at the 364 Day Term Loan, as well as some of the other debt instruments. For now, the 13.75% Senior Secured Notes look to offer the best risk adjusted return.

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Distressed Debt Investing Poll

In an effort to guage various reader interest, I created this terrible looking poll. Sorry for the incredibly ugly graphics. My HTML skills fail!  

Have a great weekend all!

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