Distressed Debt Case Study

A few readers asked me if I would walk them through an analysis of a distressed debt investment case study on the blog. Well - this weekend, someone sent me Icahn Capital's 4th Quarter Investor letter (no - I will not post it...have you seen the lawyers that guy has?). In it, he talked about his position in Realogy - which is a well publicized position of Carl Icahn's fund. I have yet to look at Realogy, and thought I would walk readers through the process of getting up to speed on a credit in real time. This will be part 1 of a 3 part series.

First, of all, for all those interested in following along, here is Realogy's Investor Relations website.

Generally speaking, the first thing that I do when looking at a credit (after having a simple understanding of what the business does) is understand the company's history, both operationally, but more importantly financially - I try to answer the question: "How did the company end up with the capital structure that I am looking at today?" Was it an LBO? Was there a dividend to the sponsor? Were there exchange offers? Etc Etc. In this, I start to formulate an assessment of the players involved - and as we have discussed constantly on this blog, it is imperative that one understands the incentives of the various parties to get a better sense of the likely outcomes - whether that be "going-concern", restructuring, etc.

In Realogy's case, there is a long-history. Realogy was spun out of Cendant in 2006. Then Apollo (through: Apollo Management VI, L.P.) acquired Realogy in 2007 through an LBO. In 2009, the company issued a $650M in second lien term loans. The "Financial Obligations" section of Realogy's 2009 10K is quite lengthy - The bottom line:

So total debt of ~$7B (including securitized debt) with about $730M available under its revolver.
Knowing the capital structure, I then go look to see where the various debt instruments are trading (as of Feb 21st, 2010) based on my messages in Bloomberg and TRACE. Starting from the top:

Term Loan: 89-90
Delayed Draw Term Loan: 88 - 89
Second Lien Loans: 109.5-110.5
10.5% Fixed Rate Senior Notes due 2014: 84-85
11% Toggle Notes: 83 - 84.5
12.375% Senior Sub Notes: 69.5 - 70.5

Now, I shouldn't have to tell you, but those Subs are quite yieldy: Using the YTC function in Bloomberg: Yield to worst at the offer side is 22.3%. The Term Loan - obviously not as yieldy if you look at it on a straight yield to maturity...but what if the term loan gets refinanced early with the opening of the loan market, or what if the company exchanges them into new higher yielding securities, or the company goes into reorganization and the term loan is the fulcrum. We cannot dismiss a security simply because its yield to worst is single digits - we have to evaluate each security on a risk/reward basis under various scenarios.

After I get a general sense of the capital structure, I look back as far as possible in the financials. Unfortunately, given that Realogy was a part of Cendant, it may be a little harder to figure out what this company has earned historically. Luckily though, the prospectus from the bond deals/S1 issued in 2007 offer a little help.

For example, we can see that in 2005, Realogy earned a little more than $1.038B before tax on a little more than $3.5B of allocatable equity - or a 30% return on equity. EBITDA that year was $1,167.

This year on the other hand - I calculate Realogy's EBITDA at around $465M (the company then adjusts this EBITDA for its covenant calculation, which we will discuss in a future post) Obviously, the weakness of the real estate market has had its effects on this company. But the question becomes: is this a temporary problem (i.e. cyclical) or a secular problem. If it's a temporary problem (I think it is), what is the ordinary run-rate cash flows of this business and when will normality return to the business - if it is not expected to return for a long-long time, then market prices will reflect that. But if you have an opinion that things might turn around sooner, then you may be compelled to buy these securities.

Let's look a little closer at the 4th quarter and 2009 results: 4th Quarter: Revenue up 11% y/y. EBITDA for the quarter was $89M ($104M before restructuring) - up $70M y/y. The company ended the year with $219M of readily available cash. For the year, revenue was down 17% to $3.9B with $427M of EBITDA before restructuring vs $411M last year. That translates to an EBITDA margin of 11%. In 2004 though, EBITDA margins were 21.5%.

Importantly - on the recent earnings release:
"As of December 31, 2009, the Company’s senior secured leverage ratio was 4.66 to 1, which is below the 5.0 to 1 maximum ratio required to be in compliance with our Credit Agreement. The senior secured leverage ratio is determined by taking Realogy’s senior secured net debt of $2.89 billion at December 31, 2009 and dividing it by the Company’s Adjusted EBITDA of $619 million for the 12 months ended December 31, 2009."
So with the covenant compliance, and the aforementioned cash, it looks like liquidity is solid for this company. Seeing this, I started to do a little digging in the most recent 10K and found this gem:
"On February 15, 2010, Apollo advised the Company that, through one of its affiliates, it owns approximately $995 million in aggregate principal amount of Unsecured Notes."
That's a big number if you also consider that Apollo put up a substantial amount of capital in the initial LBO. At this point, I am at least interested in this situation - If the company can get back to a 2003 run-rate revenue and conservative EBITDA margin of 15%, this company would be doing a little more than $800M of EBITDA or 6.8x levered through 10.5% Senior Notes. Is this favorable to the valuation that Apollo paid for the company of 10.7x (11.6x if you include contingent liabilities?). Maybe - but we need to do more work. We need to dig into the business drivers, more detail on who the players are in this case, covenant / credit agreement analysis, etc. Lots more work to be done - but at least we have a beginning framework for analyzing Realogy's debt.


Anonymous,  2/21/2010  

you can find Ichan's letter here

Anonymous,  2/22/2010  

thanks hunter!

bigboss 2/23/2010  

AWESOME. this type of stuff is EXACTLY why I love this blog. great stuff for learning. thanks Hunter

Jack 3/07/2010  


What online brokerage do you recommend for bond investing? I use Fidelity and OptionsXpress but neither have inventory for distressed debt, such as Realogy 12.375%. Thanks.


Real-vestor,  3/15/2010  

Great, straight-forward approach, Hunter - thanks. It's about time attention returned to the Balance Sheet vs. focusing on the Income Stmt...
You say this blog is part 1 of a 3 part series; I look forward to the other two parts of your analysis.

Real-vestor,  3/16/2010  

I meant to add this to my comment yesterday: there's a widely held assumption that when(ever) the Real Estate market improves, that it will return to prior levels of activity, if not of pricing. One should recognize however that such a strong return is very unlikely - not just because of structural factors, but because of the primary R.E. market drivers such as Demographics.

One of the better papers re U.S. Housing in the next decade is at:
[http://www.uli.org/~/media/Documents/ResearchAndPublications/Fellows/McIlwain/HousinginAmerica.ashx] which e.g. asserts: "As the economy recovers, markets will stabilize but the old “normal” will not return." (And see esp. part 3 re Demographics.)

Thus, as a case in point, it remains very tentative whether Realogy's earnings in the next 3-4 years, from its owned & affiliated brokerages, will be able to satisfy its heavy debt obligations when they mature...


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.