Six Flags and Incremental Recoveries to Junior Bondholders

Approximately a year ago, we analyzed the debt of Six Flags. Our recommendation was to buy the bank debt at 72. Currently that debt trades at 101. In round numbers, about a 40% IRR. On an absolute basis a strong number, relative to where we could have played in the capital structure: Not so much...

Currently, the senior opco notes at Six Flags trades at 113-115 and the holdco notes trade in the 31-33 context. Those are doubles and triples from when we wrote the post a year ago. Hindsight is 20/20 of course - I sacrificed upside potential, for downside protection. A better question to ask: Has Six Flags fundamentally changed so much in one year that the intrinsic value is really that much higher?

Some background: Six Flags has gone through a number of plan iterations. First the bank debt holders were going to get the majority of the equity. Then the opco holders were going to get the majority of the equity. And finally the hold-co debt, as the plan is currently filed, will get a majority of the equity. Initially they said they were going to force current management out, but when the plan emerged and it was revealed management was going to get 15% of NewCo (yes, you read that right), it was plain to see that incentives were aligned for the holdco plan to be taken up and adopted by management.

A Dow Jones Daily Bankruptcy Review article points out that Avenue Capital (the driving bondholder representing the opco notes) will lead a challenge of the Chapter 11 confirmation. They will argue that the plan that gives the majority of the equity to holdco noteholders will leave the new Six Flags with a burdensome load of debt and will challenge the feasibility of the plan. Therefore nothing is decided at this point, but we fashion a guess that the hold-co plan, which now pays out senior lenders in cash (vs. reinstating) will be approved.

Nonetheless, back to the original question: Has Six Flags fundamentally changed so much in one year that the intrinsic value is really that much higher?

For one, multiples have moved higher in the industry. At the time, Cedar Fair traded at 6.5x; Now with the proposed Apollo buyout, it trades for 7.5x. Using 7.5x versus the projected 2011 EBITDA of 260M (I initially forecast slightly higher), derives an EV of $1.95B more than enough to pay off both senior lenders and opco bond holders. So I was too low on my multiple.

Secondly, credit markets are WIDE open right now. On both the bank and bond side, most deals (except for the hold-co dividend deals which are reappearing) are well oversubscribed and dealers are flexing terms. While the hold co note holders didn't technically NEED to appease the bank debt holders by paying them in cash versus reinstating their low coupon paper, they did it to ensure their plan gets accepted by one of the larger creditors groups in the case. Six Flags did a term loan a month or so ago that was to finance the opco plan- that deal was oversubscribed. That being said it wasn't a stretch to assume you could layer on more senior secured debt (second lien) to get more cash in the door to help pay pre-petition claims. Would I have guessed this the case a year ago? Frankly, no.

Finally, and something that very few people are talking about right now, but from what I have heard, hedge funds are no longer in "deal with redemptions" mode. As returns continued to be impressive throughout 2009, more redemption requests were withdrawn, and funds that were sitting with idle cash on the side, ready to meet redemptions, needed to put that money to work to at least keep up with this rocketship of a market. That being said, funds are more able and willing to backstop rights offerings or provide fresh capital to reorganized debtors without having to deal with their LPs on their backs. A year ago, no one fund, or even groups of funds, would be able to step up to the plate and execute a $600 or $700M rights offering.

In my opinion, higher valuation, easier access to exit/debt capital, and more parties willing to fight over providing fresh capital to debtors via right-offerings has been the real driver of returns in distressed land over the past 12-18 months. Yes, some companies have seen dramatic improvements in operating performance, but to me the real driver to this rally (which has disproportionately helped junior creditors and equity holders) has been the multiple expansion (valuation in the bankruptcy court still relies on comp analysis) and the capital markets being awash with liquidity.



Michael Burry Quotes

A week or so ago, we laid out a few of the better quotes we found from Michael Burry's Silicon Valley Thread. Unfortunately for me, I was beaten to the punch by a number of other fantastic bloggers that also went through his old writings and pieced together some of the stronger, more illuminating "Michael Burry quotes" from the thread. Well - as one not to be beaten (and remember, I reference Michael Burry in July 2009), I plan on writing a few posts on Burry drawing from the Silicon Valley thread as well as some of the more "off-the-radar" pieces out there. For example, I bet a number of you haven't seen this document: Burry on his RMBS short

I read the Burry thread chronologically - staying mainly on the Buffettology and Value Investing threads. The quotes I lay out will not be in chronological order though as my "Burry" document is over 30,000 words (and no, I will not post it).
IMO everyone thinks of their IRA/tax-advantaged accounts as the "sit back and forget about it" accounts. I have harped on this irony for years. Given my type of investing, you'd think it would have hit me like a ton of bricks, and it did. I am an aggressive unapologetic value-based trader in all my non-taxable accounts. Everyone should be. As Jim said, it's a big, exploitable advantage. I think even Buffett more or less said so when he said he could make 50% a year if he was smaller (I am guessing he might agree that most chip shots are of the microcap, and hence ben graham, variety.) In my taxable ones, I'm a bit more apologetic. If it fits one's personality and stock-picking ability, then the advantages are obvious to a buy and hold strategy, though.
I do not know how Dr. Michael Burry managed his fund (in terms of turnover). From his 1Q2001 letter:
To recap, January saw a rapid run-up in the value of your investment in the Fund. One competitive advantage of mine has been taking advantage of the fast times to raise cash for the next slow time, to rotate into less-appreciated securities, and occasionally to short into speculative excess. This can result in my investment strategy producing higher profit, higher turnover, and, yes, higher taxes. In the past, it has done so. In the future, I expect it to do so.
And further down in the Silicon Valley thread
It is Buffett, not Graham that espouses low turnover. Graham actually set targets: 50% gain or 2 years. That actually ensures rather high turnover.
So I venture a guess that he trades more than the stereotyped value investor. Many "value investors" should take notice of Burry's comments about exploiting the tax advantages of IRAs. From my perspective, given the amount of capital the majority of us our managing in our PAs, there are always 50 cent dollars out there just waiting to be scooped up.
When a stock is this misunderstood, and this many people have lost money on it, well, it's one of the better contrarian plays out there for the patient investor. And the patient investor should hope it goes lower, not curse the volatility.
How many times have you pitched an idea to a colleague or friend and just had it spit on? I am curious to see the relative performance of Value Investor Club or SumZero ideas with ratings less than a 4 or 5 respectively. Maybe in the microcosm that is the value investing community consensus is cheery, but I doubt it. Does it mean chasing after horrendous situations? And I respond: At what price? One of my favorite screens on Bloomberg is US stocks with at least five analyst ratings and the average rating less than 2 (on Bloomberg analyst ratings range from 1-5, 5 being strong buys, 1 being strong sells). Here is the list right now (excluding biotech for right now):
  • Post Properties (PPS) ... 1 buy, 2 holds, 12 sells
  • YRCW Worldwide (YRCW) ... 1 buy, 4 holds, 8 sells
  • Alon USA (ALJ) ...0 buys, 2 holds, 6 sells
  • K-Sea Transport (KSP) ... 0 buys, 3 holds, 5 sells
  • K-Swiss (KSWS) ... 0 buys, 2 holds, 3 sells
These are not well liked companies. In an issue of Value Investor Insight Jeffrey Tannenbaum of Fir Tree stated:
One of the first questions we ask about a possible investment is “Why is it mispriced?” If you don’t have a reason, there’s a good chance it isn’t really mispriced.
As WEB states, you pay a high price for a cheery consensus.

This ties in write with another of my favorite Burry quotes. Short and simple:
But who are you selling to? And what are they buying with?
I have a friend at a very well respected fund who's simple philosophy is he only buys situations where there is an uneconomic seller. While I will not take it this far, I understand the reasoning. We do not know who is on the other side of our trades or investments. Obviously it depends on the stock or market in which we participate, but there is a reason you can buy a security at today's market price: because there is a seller at that price. What does the seller know that you do not know? Is he just crazy? Is there a reason for his selling? Is it a temporary problem you that he views as permanent? Uneconomic sellers could mean companies dropping out of an index, fallen-angel bonds that need to be sold because accounts are unable to own high yield, a fund liquidating and putting pressure on a stock, a failed M&A deal, a situation that has become too complicated etc.

And, just to top it off...how about a full blown analysis of a stock from one of Dr. Burry's old writings:
May 18, 1999 (updated May 23, 1999): Silverleaf Resorts (NYSE: SVR) - Quick, first gestalt: time-share. Images of faded browns, unfashionably "retro" clothes and loud salesman fill my head. How about you? Well, now we have overtures of a growth industry. A pretty slick one too. Gone is "time-share." Now, we have "vacation ownership interest," or VOI. And forget those faded browns and past tenses. The story is much different, and it is happening right now. Big players such as Marriott and Disney have moved into the field, and the size of the VOI industry has more than doubled during the 1990's.

In fact, open-minded investors wishing to ride the biggest demographic trend to ever hit the US - the aging babyboomers - may have already stumbled onto this industry. It appears a good time - an entire industry's worth of stocks are in the dumps, and consolidation is in the cards with many players selling for at or below net asset value.

There is indeed value here, but the superficial numbers do not tell the whole story. One must dig a bit to understand.

There are several different types of operators in this field, and they appear to be accorded different valuations.

Despite the gross dissimilarities in returns, the general similarity in Price/Book ratios does suggest that the market is using current net asset valuations (note: book value is a decent proxy for net asset value, not its equivalent) to value these stocks rather than growth or return statistics. This makes sense, since the industry-standard way of accounting makes the growth and earnings numbers poor measures of value.

Silverleaf looks the cheapest. Notably, it is also by far the smallest market cap. This proves rather artifactual. If Silverleaf were accorded an industry multiple, it too would sit among the Trendwests and Vistanas in terms of market cap. So it really is not a size issue but rather a valuation issue.

And this is where it gets interesting. Silverleaf is an operator of "drive-to" VOI's. In other words, Silverleaf positions its resorts within reasonable driving distance from major metropolitan areas. The targets are middle-income customers, outside the targets of the Disney's and Marriott's. This greatly increases its potential customer base, and is a decent economic model that helps set Silverleaf apart from the crowd.

But the valuation is far from straightforward. Silverleaf is the cheapest of the bunch on both a price/earnings ratio and a price/book ratio basis. Its revenue gains are the greatest, but that is mainly due to a capital infusion in the form of $75 million in long-term debt last year. And the revenue gains are not sustainable without further capital infusions.

This is because Silverleaf, like other reputable VOI operators, typically books revenue at the time of sale of the interest, and matches expenses/costs of revenue generation to the period in which they are generated. However, most customers finance their purchase after a down payment, so Silverleaf is booking revenue that it has not yet received in cash. This is aggressive, and very important for intelligent investors to understand.

For instance, when a VOI is sold, the customer pays 10% down, and finances the rest over 7-10 years. However, for a given period, Silverleaf - using accrual accounting - books the entire purchase price as revenues. In addition, Silverleaf collects and books the interest received from customer notes receivable. There are also additional revenues from management fees for operating the resorts. But the key is that the principal payments - which will be received as installments over the next 7-10 years - have already been booked as revenue up front. This is aggressive accounting no doubt.

Because the remaining 90% of the principal has not been yet collected as cash, it goes into Silverleaf's accounts receivable. Silverleaf then uses the accounts receivable (the stream of future installment payments against principal) to secure up to 85% loan advances which it can use to help finance additional construction and development. These loans are the primary source of capital for Silverleaf. Other VOI operators use similar accounting. For instance, Fairfield regularly securitizes its accounts receivables to generate cash.

Because these loans are secured, the interest rates for such borrowings are lower, at a few percentage points over LIBOR, than they otherwise would have been. In fact, the weighted cost of Silverleaf's total borrowings including more expensive senior debt was just 9.1%, and interest income typical exceeds interest expense in any given period.

But in the most recent period, interest expenses amounted to a historically high 57.8% of the interest income received (via the steady stream of notes receivable). Blame the new, expensive long-term debt. Silverleaf cannot dip into that well repeatedly.

Now, there's the issue of inventories as well. What are they? The company's inventories are the VOI's it has either acquired, reacquired, or built but not yet sold. The inventories are on the books at the lower of cost or market price. The company did have a large amount of inventories acquired several years back at a low cost basis. It has depleted those, and is now selling out of inventory that it built at a higher cost. This is squeezing margins on VOI sales.

As well, management anticipates higher marketing expenses associated with several new ventures. The company may have miscalculated a bit and is being forced into stepping up marketing efforts more than it planned in order to sell interests in certain slower markets.

Future inventory will come from current inventory and VOI's not yet built. The wisdom of further long-term debt to finance this is questionable. So what happens when the company sells through its inventory and has maxed out its borrowing of 85% against accounts receivable at some reasonable level? The company's sales will basically crash. The lone recurring revenue will be net interest income (expiring over 10 years) and management fees.

The sum result is apparent in the company's cash statements, which show deepening negative free cash flow despite the record sales and earnings. Indeed, a risk factor listed in the firm's annual 10-K is "negative cash flow."

In an intended vote of confidence, the chairman, CEO, and majority shareholder Robert E. Mead has announced he will purchase up to half a million shares on the open market. The company's own share buyback plan has been stymied by covenants of its senior debt. So this is indeed a nice gesture, although he already owns over 50% of the outstanding stock.

Which brings us to a point that must be mentioned with regard to this inudstry - takeover valuations. As insinuated before, large players in the leisure industry such as Disney and Marriott are moving into VOI's. A confirmation of the demographic trends from some expert marketers, to be sure.

The greater meaning is obvious for players like Silverleaf which are trading well below book and up to a 50% discount from current net asset value. These are tantalizing numbers to would-be acquirers. In a takeover, just a fair price would be a big bump from current levels.

So given the inability to value this sector in terms of growth or simple ratios, the next step in the analysis is to figure out the current net asset value. We'll assume all liabilities are real, per Graham's instructions, and adjust the asset side of the balance sheet to reflect reality.

The inventories are recorded at cost. If we use recent history as a guide, those inventories are actually undervalued, as the company's cost of building VOI's is only about 1/7th of the amount received on sale. First, assuming conservatively that only 50% of the inventory is saleable, we get $40 million in saleable inventories. Allowing for the higher cost basis on more recent inventories, these will amount to nearly $200 million in sales. The present value of these sales would sit at about $160 million conservatively, or twice the recorded value.

According to industry standard the notes receivable have a securitizable value of about 15% more than their recorded value. This is due to the high 14+% interest rates charged to buyers. So the $198 million in accounts receivable could be adjusted to about $227 million. I'll stick with the $198 million figure to remain conservative.

The fixed assets are assumed worth 25% of stated value, cash is given full value, and minimal other assets are given 50% of stated value.

Using these adjustments, the adjusted total assets are actually about $400 million. Less total liabilities of $208 million, the net asset value sits around $192 million, or about $15 per share.

The market currently values the shares at about $97 million, or $7 1/2. Credit the huge disparity to the concentrated majority ownership - the market is betting that CEO and majority ownder Mr. Mead will not sell out. Still, the fact remains we have a dollar selling for about 50 cents. Makes one wonder when Mr. Mead himself will consider taking the company private rather than just buying a few shares.

The greater meaning is obvious for players like Silverleaf which are trading well below book and up to a 50% discount from current net asset value. These are tantalizing numbers to would-be acquirers. In a takeover, just a fair price would be a big bump from current levels.
A few takeaways from this:
  • Throughout the archives, I have found Dr. Burry to weigh heavily on relative valuation. For example, he would put up four or five companies in the same industry and gauge them on things like Price/Sales, EV multiples etc. Generally speaking - we all do this. But what he liked to do was to dig in and try to figure out WHY the market was pricing these companies where it was relative to the industry.
  • Burry also dug into the numbers of the companies he analyzed and tried to get a sense if the stated GAAP numbers were overstating or understating the true economic performance of a company.
  • Burry gives a reason for the market selling a dollar at fifty cents.
If you have any interesting Michael Burry quotes or writings you would like to share, please send them my way (hunter [at] distressed-debt-investing [dot] com).



High Yield Record

Over the past few days, I read a number of stories about high yield debt issuance for March 2010 being an all-time record. From Bloomberg:

March 29 (Bloomberg) -- Junk bond sales reached a record this month as rising profits and record low Federal Reserve interest rates foster lending and investment to the lowest-rated borrowers.

Companies worldwide issued $38.3 billion of junk bonds in March, passing the previous high of $36 billion in November 2006, according to data compiled by Bloomberg. Yields fell 0.95 percentage point to within 5.96 percentage points of government debt, the narrowest gap since January 2008, Bank of America Merrill Lynch index data show.

This is “an almost ‘Goldilocks’ environment for leveraged credit markets,” JPMorgan Chase & Co. analysts led by Peter Acciavatti, the top-ranked high-yield strategist in Institutional Investor magazine’s annual survey for the past seven years, said in a March 26 report to the bank’s clients.

Sales soared as investors plowed a record $33.6 billion into speculative-grade funds this quarter, according to Cambridge, Massachusetts-based research firm EPFR Global. Bonds of Stamford, Connecticut-based Frontier Communications Corp. and Consol Energy Inc. of Pittsburgh, which sold a combined $5.95 billion of debt last week, rose about 2 cents on the dollar to 102 cents.

That’s a turnaround from February, when companies canceled sales at the fastest pace since credit markets began to freeze in 2007 amid concern that the inability of European governments to trim their budget deficits will threaten a global recovery.
In February, I wrote a post about the weakening of the high yield market. This month feels the exact opposite. 95% of deals are well oversubscribed (similar levels in the loan market). From a bottom's up perspective, it is becoming increasingly hard to find value in the corporate space. It feels sort of like Jan/February 2007 when you would look out on the primary market/second market and know that it couldn't sustain itself - we would always ask the sell side: "What stops this train?" And most of them said, "We just don't see it stopping..." How did that work out for you?

Unfortunately, the momentum is self-fulfilling prophecy in an asset class like high yield. People read about returns, throw money into the asset class, bid it up higher, more articles, more capital, rinse/repeat. I did a poll of DDIC members on their expectations for the 2010 return on high yield. Over 80% believed it would be less than a 5% total return. Is that attractive? Maybe if you are comparing it to sub 50 bps savings accounts, and still quite low treasury yields.

As a contrarian, I am usually early leaving a hot market. When I read article after article about how great the high yield market is, I become more tepid about allocating capital to the space. Am I short? Not terribly - CDS on certain IG names looks very interesting for the optionality. Am I completely out of the market? Absolutely not - There are still a few interesting distressed debt, post-re org equities, and merger arbitrage opportunities that have offer a sufficient upside, with limited downside, combined with a catalyst. That is still where we like to allocate our capital.


Equity as a Distressed Investment Strategy

A few weeks ago, we discussed a letter the ad-hoc equity committee of Visteon sent to Visteon's Board of Directors. Late last week, the ad-hoc committee sent yet another letter. This in response to a new plan submitted by Visteon earlier in the week. I find this letter fascinating as the equity holders basically spell out how they went about valuing Visteon's equity...

Dear Members of the Board of Directors:

As you know, we represent an ad hoc committee of equityholders (the “Ad Hoc Equity Committee”), the members of which collectively hold 7.87% of the outstanding common stock of Visteon Corporation (the “Company” or “Visteon”). The Company’s most recently proposed chapter 11 plan, dated March 15, 2010 (the “Plan”), completely ignores the true value of the Company and, accordingly, wrongfully extinguishes shareholders and must be revised. Delaware corporate law requires a shareholder vote to sell substantially all Visteon’s assets, but the Company is undertaking to effectuate the same result as a transfer of virtually all of Visteon’s assets to certain creditors without a shareholder vote.

As with the initial chapter 11 plan proposed by the Company, the recent Plan is based on an unrealistically low valuation of the Company and its assets and a suboptimal capital structure, which together provide an indefensible windfall to the Company’s secured lenders at the expense of the Company’s other creditors and shareholders. The Ad Hoc Equity Committee’s analysis shows the Company is worth significantly more than the Plan and Disclosure Statement would lead the Court, creditors, and equityholders to believe for the following reasons, among others:

First, as pointed out in our letter dated March 8, 2010, the Company’s prior projections must be viewed with a healthy dose of skepticism.2 Relative to the improving macroeconomic picture, consensus assumptions for worldwide production volume growth in the industry and the improving market positions of the Company’s largest customers, the Company’s top line projections appear to present an unreasonably low revenue forecast.

Second, given the Company’s successful cost cutting (including exiting all of the Company’s US manufacturing operations, which will have the effect of lowering manufacturing costs significantly) and general margin improvement illustrated in Q3 and Q4 of 2009, it appears the projections do not reflect the operational improvements the Company has achieved.

Third, the Company’s valuation of its equity in its non-consolidated joint ventures is far below their fair market value. The Company values all these joint ventures at $195 million or about 5 times 2009 dividends, 2.5 times 2009 net income and 65% of 2009 book value. Our financial advisors are willing to provide you with numerous examples of comparable Asian automotive suppliers, which currently trade at forward net income multiples in the teens. If the Company truly considers $195 million to be a fair value for its non-consolidated joint ventures, the Ad Hoc Equity Committee recommends the Company offer these assets to the Ad Hoc Equity Committee at that price.

Fourth, the Company inappropriately values its 70% stake in Halla Climate Control Corporation (“Halla”) on a consolidated basis (using a market multiple in-line with US comparables, not the higher multiples afforded to Halla’s Asian competitors), and then subtracts out the market value of the 30% of Halla not owned by the Company. This creates an artificial, negative multiple arbitrage that results in a lower valuation. Halla’s value should not be up for debate or manipulation, as shares of Halla trade publicly; at the most recent closing price of Halla shares at current exchange rates, Visteon’s stake in Halla is worth $915 million before any premium for Visteon’s control position. A proper valuation of Halla would assign a premium to the current trading price for Visteon’s controlling interest in this valuable enterprise. The Company’s position that its 70% stake is worth ratably less than the 30% minority stake is not only incorrect but is also troubling.

Put simply, the sum of the Company’s $1.1 billion of cash on its balance sheet as of December 31, 2009, its $915 million stake in Halla (before including a control premium) and the Company’s overly-conservative valuation of the non-consolidated joint ventures is in excess of the Company’s estimated valuation in the Plan, before including any value for Visteon’s core business, which the Ad Hoc Equity Committee, Ford and the Company’s other customers firmly believe has value. Furthermore, using a reasonable valuation of both the Company’s non-consolidated joint ventures and Visteon’s core business (ex-Halla) together with the Company’s cash and the public market value of Halla would result in a total valuation well in excess of the $3.1 billion of total claims against the Company, leaving significant value for shareholders.

The Ad Hoc Equity Committee is eager to learn more about the Company’s motivations and processes by which it arrived at its valuations and reserves all rights to seek discovery on this issue and all issues.

Additionally, there are more optimal capital structures which preserve, create, and distribute value more fairly to all of the Company’s stakeholders. Any such structure should reinstate the existing bank debt or provide the bank debtholders with a new note at the lowest interest rate the law allows, and we urge the Company to do so.

Based on the Ad Hoc Equity Committee’s projected cash flows (and even using the Company’s onerously conservative projections), Visteon has ample cash flows to support both this interest expense as well as annual contributions to its domestic pension plans. Furthermore, the Company will generate significant cash over the projection period to address future maturities. Therefore, the notion that Visteon must be free of long-term debt is an unreasonable view that directly robs equityholders of value resulting from the preservation of the Company’s bank debt at an attractive interest rate. There are many comparable companies in the automotive sector, domestically and internationally, that have debt. Indeed, several of these comparable companies have emerged from bankruptcy with leverage and yet continue as important suppliers to Ford as well as to other Visteon customers.

The Company should also consider distributing shares of Halla to its guaranteed note holders. While the Ad Hoc Equity Committee believes there is great value to the Company’s majority ownership in and control of Halla, the Ad Hoc Equity Committee also believes there is very little incremental value or strategic benefit from owning 70% of Halla, as opposed to owning 51%.

Finally, the Company should satisfy remaining unsecured bonds with a combination of cash and convertible preferred securities. Cash can come from either excess balance sheet cash, or a $200 million rights offering.4 The convertible preferred securities should contain a mandatory dividend payable in securities at the Company’s option at an appropriate rate, be callable at the Company’s option, and be convertible into common equity in certain circumstances. Such a structure would enable Visteon to reinstate its existing equity (subject, of course, to dilution for the rights offering, if necessary, a management incentive plan, and the convertible preferred securities described above). Designed properly, such a structure ought to preserve the value of the Company’s significant net operating losses.

The Ad Hoc Equity Committee reserves its rights to seek termination of exclusivity to propose a plan and/or seek the appointment of an examiner to protect its interests, as well as all other rights granted by the Bankruptcy Code. The appointment of an examiner may be particularly appropriate given the wide gulf between the Company’s prior projections and actual results, the limited changes made in the Plan, and the issues the Company’s Plan raises as to whether the Company and its Board are carrying out their fiduciary duties.

Of course, the Ad Hoc Equity Committee’s preference is to work collaboratively with the Board, management, and the Company’s other stakeholders to ensure a consensual chapter 11 plan that treats all stakeholders fairly, and rewards management for improved performance. The shareholders are the Company’s owners, and we trust the Board and management will act in accordance with the shareholders’ best interests consistent with their fiduciary duty.
We look forward to your response.
/s/ Martin J. Bienenstock
Martin J. Bienenstock



Distressed Debt Book Review - The Big Short

On Friday, I picked up Michael Lewis' new book "The Big Short: Inside the Doomsday Machine" which chronicles the sub-prime short through the eyes of four different characters: Cornwall Capital, Steve Eisman, Michael Burry, and Greg Lippmann. To give you a sense of how much I enjoyed it, and how quick a read it was, I successfully finished the book last night. Despite the somewhat lukewarm review on Amazon and in the press, I really enjoyed this book and recommend it to readers.

For a little background, in early 2007, the fund with which I was working at the time was shorting both vintages of the 2006 ABX as well as a number of single name tranches of sub-prime. I learned how to analyze loan tranches using Bloomberg and Intex, stayed up on all the remittance data, and was greeted daily by email blasts from Greg Lippmann and co. A number of other distressed funds we were friendly with were also buying protection on the ABX and single named sub prime tranches. The fund had great returns but nothing like the likes of Harbinger, Paulson, or Scion.

Reading Lewis' account of the events of 2006-late 2008 for me was absolutely fascinating. I had seen Greg Lippmann present (along with Karen Weaver) but had no idea about the inner workings of Deutsche Bank and his relationship at the time. The story of Cornwall Capital was particularly interesting in that these guys started out with a little over 100k (yes: one-hundred thousand dollars), and somehow turned that into many and many of millions of dollars by betting with the fat tails (i.e. Black Scholes is wrong in assuming a normal distribution of stock prices...the better assumption may be that the tails are a lot fatter) or when the market was laying them a 100x payout for a chance they perceived at 1 out of 10.

The story of Steve Eisman is also spectacular. It is comical at times of how aggressive this guy and his analysts/traders were. On speaking about a meeting with Ray McDaniel, the CEO of Moody's:
..."But we're sitting there," recalls Vinny, "and he says to us, like he actually means it, 'I truly believe that our ratings will prove accurate.'" And Steve shoots up in his chair and asks, 'What did you just say?' - as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him. "With all due respect, sir," said Vinny deferentially, as they left, "you're delusional."
I love it.

The book chronicles from the very beginning: When Mike Burry was one of the first people to short sub prime (according to the book, Morgan Stanley was doing it before Burry but on a bespoke basis", through AIGFP being the counterparty to the short, through the CDO machine and the creation of AAA out of BBB- mezz tranches, through Lippmann pitching the trade to anyone who would listen, and through the inevitable decline in the prices of everything sub prime or CDO or bank which in my mind first began with the filing of New Century.

My favorite quote in the book came from Dr. Michael Burry when it seemed like the whole world was against him (including - which I did not know - Joel Greenblatt):
I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.
This quote resonated with me and it makes perfect sense. The example of Monish Pabrai or a young Warren Buffett come to mind. I know of two or three young managers pursuing the same strategy with mind boggling successes.

Nonetheless, you will not be disappointed purchasing this book. I definitely would say its the most enjoyable book I have read on financial markets in some time. Hope you enjoy.



Michael Burry of Scion Capital: The Next Berkshire Hathaway CIO?

Last week, we wrote a quick post on Michael Burry of Scion Capital. Because of that post I received about 50 requests to share any information I had on Dr. Burry. A few years ago, a friend told me about Michael Burry's archive on Silicon Investor. To all those interested, you can find the various threads and messages here (Michael Burry's Archive). It is amazing to me that he wrote 3304 posts in the span of 5 years. Over the next few months, I will try to add some commentary here and there from what I've learned from Dr. Burry. In the meantime though, I'd like to speak of two quotes I found from his archives that I think are particular provoking. (As an aside, I have no idea if Dr. Burry would agree with his own commentary 12 or so years after he wrote these in the last 90s).

"Wow, this is getting really interesting. People (read: more than one) are taking time out of their day to come the value investing thread and tell us how irrelevant value investing is. At about the same time, friends and acquaintances are losing all patience with my talk about value but perk up when someone says "this one will double by December." These are the same ones that say, "I'm making 40%" and expect it to continue. Recently two people approached me about helping them do commodities for even bigger gains - 30-40% in stocks isn't enough. One of them thinks commodities aren't enough, he wants options on S&P futures.

As I run a value investing web site, I can also tell you that I approach 200 hits/day when the market shakes out like in October and January, but am down to 60-70 hits/day now. People don't need ideas - they know to just pile into the stocks everyone talks about, a strategy that has worked well the last 15 years.
I tell my editor that Dell at 140 is an albatross that has just been shot, and he says no way, the money flow is just too strong. That money flow brought it to around 122 pre-split within a few days.

Certainly is interesting...last year I was bearish on valuation, but never before have I had so many people slap me in the face with their impatience with value investing."
Now - I need to give this a little context - Mike Burry used to run a value investing website. I know this from reading the aforementioned thread. As a disclaimer, I have never spoken with or met Dr. Burry. I did email him but never heard back. The only thing I know about him is from reading some of his investor letters, a few of his old MSN articles, Michael Lewis' new book, and a few articles like this one.

(Quick Tangent: In his 2007 Annual Letter to shareholders, Warren Buffett wrote:
Last year I told you that we would also promptly complete a succession plan for the investment job at Berkshire, and we have indeed now identified four candidates who could succeed me in managing investments. All manage substantial sums currently, and all have indicated a strong interest in coming to Berkshire if called. The board knows the strengths of the four and would expect to hire one or more if the need arises. The candidates are young to middle-aged, well-to-do to rich, and all wish to work for Berkshire for reasons that go beyond compensation.
I would wager that Michael Burry is one of those four people. Think about it - his relationship with White Mountain, his ability to write, his investing style, the timing of him winding down Scion versus the aforementioned WEB announcement, the age/wealth/background profile...it all makes perfect sense.)

So back to the quote - One of the most difficult things about value investing is the propensity of the market to overshoot. You could of been very correct in 2005/2006/early 2007 stating that finding compelling opportunities was becoming more and more difficult - but the market then went up in your face. And because you may not be invested, but your peers are, your relative performance begins to lag - and then you lose clients/capital/etc.

Unfortunately, people think in terms of short term incentives and only few understand the concept deep down that a long string up 15% annualized returns followed by one or two years of down 30%-40% returns doesn't really make for a good track record. Having faith in your convictions about intrinsic value, valuation, and being fearful when the crowd is greedy (and vis-a-versa) is the testament to a strong investor.

David Einhorn once said: "Our investment strategy has always reflected time arbitrage in that we position ourselves to benefit from having a significantly longer-term horizon than other market participants.” This is exactly what Michael Burry was talking about.

Now for one of my favorite quotes of the archive.
"IMO, the biggest impediment to investing in the spirit of Buffett is the idea that somehow we can be a 100% imitator of him and see the same success. That anyone could be a perfect imitator of his approach strikes me as ridiculous. Try compounding the 10% difference between even your best imitator and Buffett over 30 years.

I don't have it down yet. But in terms of investing in the spirit of Buffett (rather than in his mirror image), neither does anyone else here that I can see. I'm young. I'm reading a lot and continuously reviewing and updating my approach as new revelations occur. Remember I said "Buffett-like stock for me," not you. If it was that easy for you to see, I'd be disappointed. I'm certainly glad I can't find anyone to agree with me on this. If anything, it indicates I'm headed in the right direction."
None of us are Warren Buffett, Seth Klarman, David Einhorn, Bruce Berkowitz, David Tepper, Ben Graham, Walter Schloss, etc. Each of these people have their own tempermant and hard-wiring and expertise that will make their investing style unique and different. Yes, there may be common themes (value), but intricacies of style are unique to us individually. And we learn about those through trial and error.

If one wants to see a model of Dedicated Practice in investing and stock picking, one only has to look at the example of Michael Burry. I mean he did it. If you read his thread you get the sense that he read as many books as he could get his hands on investing, he developed his own style by taking what he had learned from his coaches (see: gurus he read about) and applying it to his knowledge/temperament, he bounced his ideas of people in the Silicon Investor forum, and he questioned his process on a daily basis to make it better. But most importantly in my opinion: He constantly was analyzing stocks and businesses. Repetition after repetition after repetition. What does Warren Buffett do all day? He reads annual reports. Repetition after repetition after repetition. If there was any magic bullet, that would be it.

Over the coming months, we will try to add more to discussion on Dr. Michael Burry of Scion Capital. Now back to the annual reports...


Distressed Debt Investing: Tembec

Every few months, I like to put up an example of the quality work the members of the Distressed Debt Investors Club are sharing with other users of the site. The DDIC now has over 100 members and as many ideas ranging from distressed bankrupt companies to equity shorts. Our forum has over 350 posts where users are sharing commentaries on the market, ideas, job discussions etc. It really has exceeded all my wildest expectations. Without further ado, here is an idea on Tembec.

(all figures in CAD $)

At 86, Tembec term loan allows one to create a Canadian pulp business with sales of $1.7bln at below liquidation value of current assets alone while offering a current yield of ~ 9% and a yield to a 2/28/2012 maturity of 17.2%. Catalyst: partial paydown of term loan from near-term asset sale/s and cash generated from the pulp business as a result of record pulp prices. If 30% of the bank debt is paid down before year-end, the IRR jumps to 23%.

During the latest conference call, management claimed they have a number of initiatives in place to raise $71mm over the next 12 months. The $71mm would come from asset sales they deem "non-strategic” which includes the sale of a hydroelectric dam and, IMO, its newsprint facilities. The dam generates 3-4MW, which at $2,000/kw should be valued ~ $7-10mm and should be easy to find a bid given the demand for these assets. Maybe they get $10mm from liquidating the idled Pine Falls mill (185k tons - newsprint) and maybe they could get $130/ton for the Kapuskasing, Ontairo mill (330K tons - newsprint) and bring in another $40mm. The Kapuskasing mill produces grades other than newsprint and is not idled so it should sell for above liquidation value. It seems that management’s liquidity initiative can be realized.

In addition to the liquidity initiative, management announced plans to sell two Kraft pulp mills in Europe (both idled) with total capacity of 565,000 tons, which at $70-$140/ton are worth $40mm to $80mm (note that I am being very conservative here - some analyst believe they can fetch ~$200mm). This is all gravy as after paying down the $81mm o/s on its revolver, I believe management will start paying down the term loan.

The pulp division is on fire. The devastating earthquake in Chile on February 27th resulted in closure for at least a few months of 4.9mm tons (just under 9% of global chemical paper grade market pulp). Already, there was a large amount of pulp at Chilean ports that was meant to be shipped to Asia which was destroyed or damaged. Bear in mind this is all coming at a time when global pulp supply/demand characteristics are very tight due to wood shortages from wet and cold weather (whose effects continue today) in the southern part of the United States, Northern Europe, Russia, and to a lesser extend Indonesia. Pulp prices are currently US$890/tonne and with the recent price increase will get up to $930/ton. For some context, average pulp prices in 2009 were $709/ton, which caused the pulp division to lose $61mm in EBITDA. However, in 2008 when average pulp prices were $875/ton, the pulp division generated $118mm in EBITDA and in 2007 when average pulp prices were $803/ton, EBITDA was $149mm. Year over year comparison relative to pulp prices is difficult because Tembec’s total shipment tons varied (they shipped just under 2mm tons in 2007 vs. 1.8mm in 2008 and 1.348mm in 2009), but it does give you a broad sense for what they are capable of generating when pulp prices are high. Estimates provided by consultants suggest 2010 pulp prices will average $865/ton. In its annual report, the company estimates that in 2010 every $25 increase in the price of pulp will add ~ $40mm to EBITDA. If we assume average prices in 2010 of $865/ton, then EBITDA for that division should be $180mm. Needless to say, I expect a lot of cash to come out of this business in 2010 and hopefully Jim Lopez will use it to pay down as much of the term loan as possible.

Unlikely as it may appear, barring asset sales, a turn in the market might cause Tembec to have to restructure, yet again (see paragraph on restructuring below). The company had liquidity of $129mm as of Dec 26, 2009 ($80mm in cash and $49mm in revolver avail) and bare bones annual cash obligations of $60mm comprising of $31mn interest and $25-30mn of maintenance capex. This is low compared to historical levels ($75mm in 2007 and $86mm in 2006), but I attribute that decrease to the capacity management has taken off-line. The company has seasonal working capital requirements which could exacerbate cash burn dramatically. In FY 2009, Tembec burned through $170mm of cash.

Quick Overview Industry Dynamics
The long-term demand story with any pulp player is that China has no fibre, so they have to import from northern Europe, Russia, Canada and Indonesia. Tembec is well positioned to benefit from this trend. There are no material new pulp mills coming online before 2013, so pulp prices should, all things being equal, remain strong for a while.

That noted, higher pulp prices, now having surpassed last year’s 13-year peak will tend to increase pulp supply at a time when paper demand is in secular decline. Consultants seem to believe that pulp supply will be pushed higher through Q2 and Q3 while demand should contract so that pulp prices are likely to move lower in the 2H of 2010. So far there is 3.235mm tons of capacity slated to restart/come online in late 2009 – mid 2010, or 5.57% of global capacity.

Looking at this from a liquidation lens, current assets alone should cover the secured debt. As of December 2009, the company had $80mm in cash, $259mm in AR, $318mm in Inventory. I assume NO value for cash since this company has been burning cash ($170mm in negative FCF in 2009). I discounted AR by 15% and discounted Inventory as follows: (finished goods by 15% and WIP and raw materials by 50%). I then took another $20mm hair-cut to account for further cash burn and fees. That leaves $402mm to cover $430mm of secured debt including the $307mm term loan. This suggests the secured debt is covered by 93% on a liquidation of current assets alone. Note that the book value of Tembec’s PP&E is $617mm - which I ascribe no value to for purpose of this analysis. Even if we assume a further max draw of $49mm from factoring facilities and the CIT revolver for total secured debt of $479mm, the secured debt would still be covered by 84%, or right around current trading levels.

On thing to bear in mind when considering a hypothetical liquidation for Tembec is the pension liability of $197mm and $24mm of “other long term liabilities” such as govt assistance, environmental, reforestation, etc. In the interest of erring on the conservative side, let’s assume the $24mm of govt assistance,reforestation & environmental liability is treated as a priority claim (in Abitibi, the Provence of Newfoundland is making the case that environmental liabilities should be treated as an administrative claim) and let’s assume $150mm of the pension liab (ex OPEB) is pari-passu with the secured debt (it is Canada, after all), then secured debt coverage from the liquidation of the current assets comes to 60%-65%. Needless to say, I view this as the worst case scenario – one that is mitigated by the current yield on the bank debt of 9% and any value coming from the liquidation of the plants which, even at $30-$50mm for the three pulp plantsm, should add another 5pts to 9pts of recovery (Tembec’s pulp mills have a book value of $454mm). Tembec also has $15mm of guaranteed notes (booked as “investments”) in West Feliciana Acquisition – a company that purchased a paper mill from Tembec in April 2009 (a portion of the consideration included these notes). WFA filed for bankruptcy in January 2010 and the ranking of the notes Tembec owns is still unclear so I am treating this as pure optionality, but still worth noting as it could add another 3pts to recovery.

Tembec’s EBITDA in fiscal 2009 (FYE Sept) was negative $108mm. Lately, things seemed to have turned a corner primarily as a result of the pulp markets. In the 1st quarter of FY 2010 (ending December 2009), the company generated $4mm of EBITDA. The Pulp division generated $17mm of EBITDA in the 1stquarter which was offset by negative EBITDA in other segments (forest products & paper). I think Tembec will shed its paper division (newsprint) and continue as a going concern with pulp, forrest products (the two are integrated) and the chemicals business. Based on my math, it is not unreasonable to assume that a going concern value for these three divisions is worth over $300mm. Add to that proceeds from hypothetical asset sales (there may be some double counting from the kraft mills in France - which historically may have contributed to the pulp division’s EBITDA) and it seems the term loan is money good.

Capital Structure
-$205mm CIT credit facility maturing December 2011, of which $127mm was available under the current borrowing base and $81mm was drawn and $36mm was reserved for LC’s. $9mm was unused.
-$307mm term loan (L+700) maturing February 2012 ($300mm USD @ exch rate of 1.024)
-$67mm of factoring facilities supporting the French operations. $27mm was drawn. $40mm was unused.
-$7mm Tembec Energie SAS capital lease obligation maturing in 2014
-$8mm Bionerg SAS 5.5% secured term loan maturing in 2020
-Total Drawn Secured Debt: $430mm
-Unsecured Debt: $53mm
-Equity Market Cap: $142mm (100mm shares @ $1.42)

Restructuring Background
In February 2008, Tembec went through an out-of-court restructuring which resulted in the $1.2bln of bonds receiving 95% of the equity with the remaining 5% going to existing shareholders. The bondholders backstoped the current $306mm term loan. The term loan pays L+700 and has a 1st Lien on assets other than receivables and inventory and a 2nd lien on AR and inventory. The loan has a prepayment premium of 3% in 2010 and 2% in 2011. There are certain covenants with respect to debt incurrence, permitted liens, limitation on guarantees and transactions. There seems is one financial maintenance covenant that matches the covenant in the company’s existing working capital facility. Needless to say, this is somewhat “covi-lite”. The market value at the time of the restructuring was ~ $570mm. Today’s market value is ~ $500mm.

As with any Canadian paper and pulp business, one has to keep in mind that there are severe cash flow swings resulting from exchange rate fluctuations. In Tembec’s case, a 1% increase in CAD$ vs. the USD equates to a $20-$25mm hit to EBITDA. Along those same lines, the competitiveness of Canadian producers relative to other major competing regions remains under pressure due to the high level of the Canadian dollar. With an exchange rate of around US$0.95/C$, Canada is one of the high-cost regions for the production of pulp, newsprint, and lumber. The Canadian dollar has also rapidly strengthened against the euro over the past three months, which has reduced the competitiveness of Canadian pulp producers relative to their European counterparts. Further, Tembec’s mills are smaller than their competitors and older and they have been under-spending on capex. Finally, Forest products division is obviously levered to housing starts. However, when demand comes back, that the Forest products division is poised to do well since there is a lot of operating leverage in that division as a result of low inventories and cost cuts that were implemented over the last few years.



Calling all Distressed / High Yield Recruiters

One of the additions we have made to the Distressed Debt Investors Club is a job forum for members. Currently I am receiving one or two job postings every few weeks from members of the site. We would like to get more opportunities in front of our members; to that end, if any distressed / credit / high yield recruiters would like to get their job postings in front of a very high caliber group of traders, analysts, and portfolio managers, please contact me at hunter [at] distressed-debt-investing [dot] com.



Chicago Distressed Investing & Restructuring Conference

Wanted to send a quick note out about the Chicago Distressed Investing & Restructuring Conference coming up on April 16th, 2010. Looks to be a very solid conference - professionals from distressed debt hedge funds, creditor and debtor restructuring advisors, a bankruptcy judge(Chris Sontchi - one of the more prominent judges in the Delaware bankruptcy court), and other bankruptcy professionals will be speaking on a number of different topics.

You can find more details about the conference here: 5th Annual Distressed Investing and Restructuring Conference



Shareholder Activism and Distressed Debt

Earlier in the week, I discussed some interesting details and facets about the bankruptcy of Visteon. Well today, Davidson Kempner, Brigade, and Plainfield Asset Management (all places I thoroughly respect and where I know analysts) filed a 13D on Visteon. According to the document, shares were bought between 2/26/2010 and 3/8/2010 meaning some of the lots were purchased in mid 20 cent range.

Along with the 13D, the ad hoc committee of shareholders filed a letter to Visteon's board of directors. It is a great read. Enjoy.

Dear Members of the Board of Directors:

We represent an ad hoc committee of equityholders (the "Ad Hoc Equity Committee"), the members of which collectively hold 7.3% of the outstanding common stock of Visteon Corporation (the "Company"). In light of the significant and ongoing improvement in the Company's financial performance and outlook, we believe it is imperative that the Board consult the Company's owners and their advisors to help develop a revised chapter 11 plan. Given that the Company is in the final phase of its chapter 11 case with a hearing pending shortly to approve its existing disclosure statement, we submit time is of the essence and the Board should consult with our clients immediately.

On December 17, 2009, the Debtors filed their Joint Plan of Reorganization and related Disclosure Statement. In general, the plan provides for recovery for the Debtors' secured debt in the form of new secured debt and more than 95% of the equity in the reorganized Debtors. The plan provides no recovery for general unsecured claimholders and, thus, no recovery for holders of the Company's equity securities.

The projections in the Debtors' Disclosure Statement, issued in support of its proposed plan just two weeks before the end of the 2009 fiscal year, present a portrait of the Company's fiscal health which appears increasingly inaccurate with each passing month of improved financial performance. On February 26, 2010, the Company filed its quarterly earnings and Annual Report which revealed that the Company produced sales, gross margin, EBITDA and net income for 2009 materially higher than that forecast in the Disclosure Statement. The Company's January Monthly Operating Report provides evidence that the financial performance continues to improve. Likewise, cash on hand, which had been projected on December 17th to be $777 million actually totaled $1.095 billion at December 31, 2009. The Company's Chairman and CEO, Donald J. Stebbins, underscored this improved financial outlook in a press release that coincided with the release of the Annual Report:

"As vehicle volumes increase and the macro- economic environment improves, we are well- positioned to win and retain business from customers around the world who recognize the benefits of Visteon's product quality, innovative technologies, and strong global engineering and manufacturing footprint."

Considering that the financial projections in the Disclosure Statement were prepared with the benefit of having actual results for the first three quarters of 2009, the magnitude of the difference between actual 4th quarter results and those implied by the December 17th forecast is all the more striking. Given current trading prices of the Company's debt and equity securities, which have increased sharply since February 26th, it appears that our clients are not the only ones who view your proposed Disclosure Statement's bearish financial projections used to justify a low valuation of the Company with an understandable dose of skepticism. As such, there is no meritorious basis for the Company to exclude its shareholders from significant distributions under a revised chapter 11 plan and the necessary discussions to overhaul the Debtors' proposed restructuring.

There is a practical incentive for creditors to argue for a low valuation of the Company in order to receive securities that will actually provide them a windfall well above payment in full of their claims, all at the expense of existing equity. Accordingly, the Board's fiduciary duty to its shareholders compels it to take immediate action to ensure that your proposed plan and disclosure statement are revised to reflect the new reality of the Company's financial picture and these chapter 11 cases.

We hope to work collaboratively with the Board and management to ensure that this happens. The shareholders are the Company's owners, and we trust the Board and management will act in accordance with the shareholders' best interests.

To that end, we request a meeting with the Board, financial advisors, counsel, and the Company's management no later than March 12, 2010 to discuss appropriate modifications to the Plan. Because time is of the essence, we ask that you please respond to our request for a meeting by 5:00 p.m. (New York Time) on Tuesday, March 9, 2010.

We look forward to your response.

/s/ Martin J. Bienenstock
Martin J. Bienenstock
Marc Kieselstein, Esq.

Sounds similar. In light of the credit markets simply being on fire, more marginal issuers can do high levered deals which means junior creditors and equity holders have a higher likelihood of being in the money. I know of a number of company in bankruptcy right now where they could surely get a deal done and give a larger slice of the buy to sub bond holders or equity. Keep turning over those stones and you will find some interesting distressed debt situations as well.



Distressed Debt Equity Example - Visteon (VSTNQ)

In the past, I have pointed readers to the concept of understanding incentives in a distressed debt analysis when it comes to evaluating disclosure statement, plans of reorganization, and financial projections. In my opinion, management teams will side with the creditor class in which they will benefit most financially. I do not mean to admonish management teams for this action - they are acting in their own best self-interest (read: incentives) which, as I have reiterated in the past, is one of the keys to understanding how a certain bankruptcy case will unfold.

Below, you can see a 1 year chart of Visteon's equity (VSTNQ):

And also below, you can see a 1 year chart of Visteon's 8.25% notes due 2010:

I doubt I need to point out to the reader that if you had invested in either of these securities at the beginning of 2010, you would have a proverbial "home run."

So what happened? How can a bond nearly quadruple in a matter of two months, or for that matter an equity increase exponentially in a few trading days.

On December 17th, 2009, Visteon filed its disclosure statement in the Delaware bankruptcy court. Here are is the salient passages from the document:
"Based on the valuation analysis prepared by the Debtors and their advisors (the "Valuation Analysis") and the Term Loan Lenders' secured position in the debtors' capital and corporate structure, the Plan contemplates that the Term Loan Lenders wil receive a 100% recovery on their Claims, which equates to an approximate 96.2% implied equity ownership interest in Reorganized Visteon and that the PBGC wil receive a 12% recovery on its Claims, which equates to an approximate 3.8% implied equity ownership interest in Reorganized Visteon."
96.2% + 3.8% = 100% = Nothing left for anyone else, i.e. the aforementioned bond holder and equity holders. But this all based on this Valuation Analysis. Let's take at what I view as important quotes / line items:
The Valuation Analysis is dated as of December 15, 2009 and is based on data and information as of that date.
Meaning they don't have full year numbers...(emphasis added below)
In preparing the Valuation Analysis, Rothschild has, among other thngs: (1) reviewed certain recent available financial results of the debtors; (2) reviewed certain internal financial and operating data of the debtors, including the business projections prepared and provided by the Debtors' management to Rothschild on December 15, 2009 relating to their businesses and their prospects; (3) discussed with certain senior executives the current operations and prospects of the debtors; (4) reviewed certain operating and financial forecasts prepared by the debtors, including the Financial Projections; (5) discussed with certain senior executives of the debtors key assumptions related to the Financial Projections; (6) prepared discounted cash flow analyses based on the Financial Projections, utilizing varous discount rates; (7) considered the market value of certain publicly-traded companies in businesses reasonably comparable to the operating business of the debtors; (8) considered the value assigned to certain precedent change-in-control transactions for businesses similar to the debtors; (9) conducted such other analyses as Rothschild deemed necessary and/or appropriate under the circumstances; and (10) considered a range of potential risk factors.

Rothschild assumed, without independent verification, the accuracy, completeness, and fairness of all of the financial and other information available to it from public sources or as provided to Rothschild by the Debtors or their representatives. Rothschild also assumed that the Financial Projections have been reasonably prepared on a basis reflecting the debtors' best estimates and good faith judgment as to future operating and financial performance. To the extent the valuation is dependent upon the Reorganized debtors' achievement of the Financial Projections, the Valuation Analysis must be considered speculative...
You will notice the sections I have bolded all have one thing in common: Management was driving the ship...

Then this:
Rothschild estimates the Reorganized debtors' implied reorganized common equity value to be $1.505 bilion based on the midpoint of the DEV range. The common equity value is subject to dilution as a result of the implementation of the Management and Director Equity Incentive Plans.
Management and Director Equity Incentive Plans...Let's take a quick look and see what that means...
Certain of the Debtors' management and directors wil be entitled to participate in the
Management and Director Equity Incentive Program, which shall be set forth in the Plan Supplement. The Management and Director Equity Incentive Program shall have an aggregate share reserve of up to 10% of New Visteon Common Stock issued in accordance with the Plan, on a fully diluted basis. The Management and Director Equity Incentive Program shall be deemed approved and authorized without further action by the New Board.
10% is a big slug of ~$1.5B of equity value. How much equity did management own before the bankruptcy? From their Visteon's recently filed 10K:

Hopefully you see the little asterisk represents less than 1%. So in aggregate management owned less than 1% and now they are getting 10% of the company?

Wait - hold on - Management and the board are getting 10%, but the PBGC is only getting 3.8% of the new company. What kind of stake did the pension have in the game? Again from Visteon's 10K:
Chapter 11 Plan of Reorganization

The Plan, as filed with the Court on December 17, 2009, contemplates that the Debtors may pursue the termination of certain of the Debtors' pension plans. The Plan provides for the Pension Benefit Guaranty Corporation ("PBGC") to receive a 4% equity interest in the Company upon emergence from the Chapter 11 Proceedings in exchange for any termination- related claims it may have against the Debtors and their "controlled group members." As of December 2009, the Company estimated that this claim could total approximately $460 million.
So in exchange for terminating their $460M claim, the PBGC gets 3.8% of the equity ... whereas management / directors are getting 10% of the equity when they collectively owned less than 1% of the company as of Feb 2010...

So back to the original question: Why did the bonds and stock rally so hard?

The company reported results well ahead of the aforementioned plan projections in which the valuation was based on:
  • Sales came in at $6.69B vs 2009 plan projections of $6.45B
  • Adjusted EBITDA of $454M vs plan projections of $302M
Weren't the projections completed in December? And you were off my $150M in EBITDA? Explanation?
"Our restructuring, ongoing cost-reduction initiatives and ability to keep overhead costs aligned with reduced sales helped drive significant year-over-year improvements in cash flow and earnings, despite significantly lower vehicle production volumes and challenging industry conditions," said Visteon Chairman and CEO Donald J. Stebbins.
Man - I never realized costs can be ratcheted down that dramatically in the last 2 weeks of the year. Color me surprised!

More recently, if you have been following the docket, you would have also know that a lot of action is going on behind the scenes - specifically those related to alternative plan structures which was really the catalyst for the initial bump in the bonds in the first month of the year. Lots of people want to own the equity of this company obviously - And to get the equity of this company, within the exclusivity period, you need two things:
  1. Management on board - how to incentive them? With a big check.
  2. A valuation assessment where your class consequently becomes the fulcrum security ... i.e. low enough that no one behind you gets equity, but large enough to be plausible.
Could one have predicted prior to the recent earnings announcement that Visteon was going to show a huge EBITDA number? I think so - with the right amount of due diligence combined with a bar being set low (for whatever reasons) can create for some interesting distressed debt investment opportunities.



Third Point 4th Quarter Investor Letter

Dan Loeb of Third Point has always been one of my favorite investors. Here is his 4th quarter 2009 letter.



Michael Burry: Hedge Fund Star

If you have not already seen the article on hedge fund manager Michael Burry from Vanity Fair, you can find it here: Michael Burry in Vanity Fair. This is from Michael Lewis' new book "The Big Short: Inside the Doomsday Machine" which I am very excited about reading.

In 2005, a friend of mine pointed me to an article about Burry and Scion Capital. Every since then I have followed his moves closely, read a significant chunk of his Silicon Valley Investor archive, and scoured the web for his old MSN Articles (he wrote a column a long long time ago for MSN Money), as well as his old websites (www.sealpoint.com and www.valuestocks.net). In fact, what is interesting about the article above, specifically about Greenblatt seeding him, Michael Burry actually interviewed Joel Greenblatt for one of his MSN pieces in the the late 90s.

Unfortunately, Michael Lewis beat me to the punch, as I had quite a long piece on Burry queued up for the blog - Now with him back in the limelight, will try to write some more select pieces on Mike Burry and Scion. The earlist investor letters from Scion can be found at Scion Capital Investor's Letters



Advanced Distressed Investing Concept

Grant, a member of the Distressed Debt Investors Club and guest contributor here writes a piece on the advanced distressed investing concept of intercreditor issues. Enjoy:

A feature of the last credit cycle was the growth of 2nd lien financing. While structures involving bank debt, high yield bonds, and/or mezzanine loans also involve inter-creditor considerations, many 1stlien/2nd lien agreements exhibit less standardization than for more traditional structures. Especially when considering rights, recoveries and remedies in a bankruptcy scenario for 1st or 2nd lien instruments where both senior and junior liens exist, developing a view of how the bankruptcy court will likely interpret and enforce the provisions of an inter-creditor agreement can be critical.

In a 2nd lien financing, the 1st lien lender and the 2nd lien lender share in the same collateral, with the latter receiving liens junior to the former. The inter-creditor agreement covers (1) subordination of claims and liens and (2) certain waivers of rights by the 2nd lien lender both inside and outside bankruptcy. While the focus of this post shall be specific to bankruptcy waivers, waivers under non-bankruptcy law are also extremely important and can have serious implications within as well as outside of bankruptcy. See Buena Vista Home Entertainment, Inc. v. Wachovia Bank, N.A. (In re Musicland Holding Corp.),374 B.R. 113 (S.D.N.Y. 2007) for a particularly serious example of a 2nd lien creditor suffering from a bankruptcy court’s interpretation of a general consent granted by the 2nd lien lenders in an inter-creditor agreement.

The bankruptcy courts have not always enforced bankruptcy waivers as consistently as many creditors perhaps would have liked: BRC§510(a) states “a subordination agreement is enforceable in a case [in bankruptcy] to the same extent that such agreement is enforceable under non-bankruptcy law.” However, some courts have held that the Bankruptcy Code mandates subordination is distinct from certain statutory rights creditors receive through the bankruptcy process that cannot be altered through pre-bankruptcy negotiations and waivers. Some important bankruptcy waivers include:

  1. Adequate protection
    • 2nd lien lender waives right to oppose adequate protection for 1st lien lender.
    • 2nd lien lender waives right to seek adequate protection for itself.

    Issue: BRC§361 provides three methods to provide adequate protection of a secured party’s interest in property to compensate for declines in the value of collateral: 1) cash payments, 2) replacement liens, or 3) the “indubitable equivalent” of the collateral. With a junior lien, declines in the value of the collateral will impair the 2nd lien instrument’s value first. Especially for collateral that declines rapidly in value, these waivers can constitute a significant risk for the 2nd lien holders, especially in longer-duration bankruptcy cases. Strict enforcement of this waiver could leave the 2nd lien holder severely under-secured, with only a general unsecured deficiency claim for the remaining balance of the loan.

  1. Use of cash collateral
    • 2nd lien lender consents in advance to, and/or waives objection to, use of cash collateral if 1st lien lender approves.

    Issue: Cash collateral is money earned from the sale of assets against which a lender has a lien, and the lender retains liens against these cash proceeds unless the bankruptcy court approves their use by the debtor. Particularly for asset-based loans secured by floating liens against receivables and inventory, the debtor will likely generate significant cash collateral as it collects pre-petition accounts receivable and sells pre-petition inventories. An over-secured 1st lien lender has little incentive to protect a 2nd lien lender’s lien in cash collateral and may support, or decline to object to, the debtor’s use of cash collateral. That action, especially when combined with a waiver of adequate protection, again would leave the 2nd lien lender unsecured with only a general unsecured claim for the deficiency.

  1. DIP financing
    • 2nd lien lender consents in advance to, and waives right to object to, DIP financing approved by 1st lien lender and priming liens granted in favor of DIP lender.

    Issue: DIP financing can be authorized by the bankruptcy court, which will grant a priming lien senior to existing pre-petition liens if (1) the debtor is otherwise unable to obtain such credit and (2) the existing lien holder remains adequately protected. Consider a scenario where there is a 1st lien claim for $50M, a 2nd lien claim for $40M, and the collateral is worth $80M. Without a priming lien, there is 100% recovery to the 1st lien creditor and 75% recovery to the 2nd lien creditor. Now consider a $30M DIP facility combined with an enforceable waiver against the 2nd lien creditor causing such creditor to lose the right to oppose the DIP loan. The 1st lien creditor still enjoys 100% recovery, while the 2nd lien creditor’s recovery drops from 75% to 0%. Often, the 1st lien pre-petition lender is also the DIP financing provider, so will have an incentive to prime the 2nd lien holder, especially if the 1st lien lender is receiving large fees from providing the DIP facility and/or other benefits afforded to DIP lenders such as a roll-up of pre-petition debt.

  1. Lien release
    • 2nd liens release during bankruptcy.

    Issue: Would turn the entire secured claim secured by a junior lien into a general unsecured claim if strictly enforced by the court.

  1. Post-petition interest
    • 2nd lien lender waives rights to seek post-petition interest, fees, and expenses.

    Issue: When a secured lender is over-secured, BRC§506(b) and case law provide for that lender to collect post-petition interest; and reasonable, contractually-determined fees and expenses, up to the amount which the secured lender is over-secured. In estimating returns to a 2nd lien instrument that appears over-secured, inability to collect post-petition interest, fees and expenses could have a material impact on return calculations, particularly in longer bankruptcy cases.

  1. Sale of collateral
    • 2nd lien lender waives right to object to sale of collateral if 1st lien lender consents.

    Issue: A numerical example illustrates the implications of this waiver. Using the same example as in (3) above, again assume 1st lien debt of $50M, 2nd lien debt of $40M, collateral worth $80M. Sale at $80M would yield 100% recovery to 1st lien creditor, 75% recovery to 2nd lien creditor. Now assume a “fire sale” of the collateral for $50M to which the 2nd lien creditor cannot object: The result is a 100% recovery to the 1st lien creditor, who is indifferent to whether sale occurs at $50M or any value above that amount, but a 0% recovery to the 2nd lien holder.

  1. BRC§1111(b) elections
    • 2nd lien lender waives rights to make BRC§1111(b) election without consent of the 1st lien lender.

    Issue: The BRC§1111(b) election allows a secured claimant to have its entire claim, to the extent allowed, treated as a secured claim instead of having it bifurcated into a secured and an unsecured portion, provided the secured party waives any deficiency claim against the estate for the amount which the secured party is under-secured (see BRC§1129(b) for details on the “cram-down” of secured parties). Without getting into extensive detail, this waiver would significantly affect recoveries for a 2nd lien creditor which is (1) under-secured and (2) expects recoveries for unsecured creditors to be low.

  1. Voting rights:
    • 2nd lien lender waives voting rights on a plan of reorganization, or assigns rights to 1st lien lender.
    • 2nd lien lender waives right to vote for or on the appointment of a trustee.

    Issue: The 2nd lien lender could be forced to vote for a plan that would provide a recovery significantly inferior to the amount to which the lender would be entitled even if “crammed down” in accordance with the provisions of BRC§1129(b).

To reiterate, there are doubts regarding the bankruptcy courts’ enforcement of bankruptcy waivers. One school of thought holds that 1st lien lenders and 2nd lien lenders are sophisticated parties, and that the 2nd lien lender waives rights, including bankruptcy rights, in exchange for a higher yield. However, some courts have held that the US Constitution vests in Congress the right to set uniform laws on the subject of bankruptcies, and that had the “Founding Fathers” intended private parties to pre-determine provisions of bankruptcy law between and among themselves, the Constitution would not have vested such authority in Congress exclusively. This tension has led to case precedents that can seem in conflict with one another. For example, in Bank of America v. North LaSalle Street Ltd. P’ship (In re 203 North LaSalle Street Ltd. P’ship), 246 B.R. 325 (Bankr. N.D. Ill. 2000) and in In re Curtis Ctr. Ltd. P’ship, 192 B.R. 648 (Bankr. E.D. Pa. 1996), bankruptcy courts reached seemingly differing conclusions regarding whether the 2nd lien lender’s waiver of the right to vote to confirm a plan of reorganization was valid. Other precedents that, on their face, may appear to contradict one another, exist for other bankruptcy waivers.

Furthermore, recent growth of 1st lien/2nd lien structure and the attendant proliferation of agreements and disputes regarding such agreements, some issues have not yet been fully adjudicated by the bankruptcy courts. While the “ABA Model Intercreditor Agreement” is a welcome development that may reduce uncertainty for new issues, many distressed analysts are currently considering secondary purchases of the issues that took place during the last decade’s credit expansion that lack standardized clauses and, accordingly, standard interpretations.

For a complete analysis of returns for a security significantly affected by inter-creditor issues, the lack of certainty regarding enforcement of certain clauses means that, while reading the inter-creditor agreement is a necessary first step, making educated guesses, almost certainly assisted by counsel, on how certain of its provisions could be enforced by the bankruptcy court may also become necessary.



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.