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.

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Advanced Distressed Debt Lesson #4

It has been a few months since we had our last advanced distressed debt lesson. More the previous editions, here you go: Advanced Distressed Debt Lesson #1, Advanced Distressed Debt Lesson #2, Advanced Distressed Debt Lesson #3 (needs a follow-up post).

A friend asked me my opinion of something Whitney Tilson said in his most recent email regarding GGP. Here is the relevant text.

"Hovde’s most serious mistake is misunderstanding (or misrepresenting) what will likely happen to GGP’s unsecured debt. Hovde assumes that it either remains outstanding (throughout its presentation, Hovde calculates GGP’s leverage and interest payments assuming that the debt remains outstanding, which is the main reason its analysis differs from Pershing’s and ours – see page 63, for example) or that it converts to equity, which will result in “significant dilution” (page 72). Hovde makes explicit this assumption when it claims that Pershing “does not use consistent assumptions” regarding what happens to the unsecured debt on page 35 of its report.

Hovde doesn’t appear to understand bankruptcy law and what will likely happen to the unsecured debt. There is almost no chance that it will remain outstanding: it will either be refinanced or, more likely, be converted into equity (this is what Pershing assumes – there is no inconsistency). But here’s the key: it will NOT BE DILUTIVE because it will convert AT FAIR VALUE, as determined by the bankruptcy judge. Of course, if the judge determines that fair value is $1/share, then it would be massively dilutive, but that’s not going to happen. The judge has a great deal of discretion in determining fair value, but will certainly take into consideration the current stock price, comps and the price of any equity offering(s) GGP might do.

For example, as soon as GGP exits bankruptcy and its stock is relisted (it currently trades on the pink sheets, which means most institutional investors can’t own it), it will be a must-own stock for every REIT fund (a big catalyst Hovde misses). To meet this demand and pay down some debt, GGP might issue equity – and the negotiated price at which this stock is sold would likely weigh heavily on the judge’s determination of fair value (and would not be dilutive). Of course, if someone like Simon were to buy GGP at, say, $20, the debt would convert at this price – and again, it wouldn’t be dilutive."

This in response to Hovde's response to Pershing Square's response to Hovde's short thesis on GGP. What a mouthful! And like a lot of financial bloggers out there, I love the back and forth. And why not jump into the fray and learn something here? For all those following along at home, I have embedded Hovde's presentation below.

There has been a number of press reports recently about Brookfield Properties buying GGP's unsecured debt. Here is a WSJ article that also mentions Simon Properties buying GGP's debt. Now, who knows what instrument either enterprise is buying. It could be the Rouse bonds or it could be GGP's unsecured term loan on the GGPLP LLC side.

We know from the original Rouse proxy (when GGP acquired Rouse in 2004), that there was indeed a bidding war for Rouse's assets. Read the background of the merger here: Rouse and GGP background of merger. So it is likely that yes, assuming that Company A or Company B in the merger agreement were Simon or Brookfield, people indeed have interest in Rouse. Why would Brookfield or Simon buy the unsecured debt of GGP or Rouse? Well, they could be making an investment thinking the bonds are undervalued and will be taken out at par+accrued.

Or they could be positioning themselves to have a nice big seat at the table.

Let's talk about incentives for just a little bit, because it is crucially important to any analysis of a possible distressed debt investment. Rational players want to maximize their return on capital given like amounts of risk. They would much rather have a 100% return than a 10% return on the same amount of capital. Who wouldn't? An example that has been discussed on this blog in the past is Six Flags. The HoldCo note holders want to maximize their return, and not get rail-roaded by the Op-Co note holders plan, so they propose their own plan, backstopping an equity rights offering taking out the opco note holders, reinstating the bank debt, and getting the vast majority of the equity. Likewise, the op-co holders want the equity (they believe they are creating it cheap), have offered a plan to take out the bank debt, de-lever the company with a rights-offering, get the majority of the equity and give a sliver of the equity to the holdco.

Similar to what is going on in the Trump bankruptcy between Carl Icahn/Beal Bank and the Ad-hoc Committee / Donald Trump. Both parties want the equity. Owning the equity of levered company in an economic recovery can be lucrative (see: DTG stock). Both have submitted plans, objected to one another plans, maybe a compromise is made, votes are cast, votes are tabulated, judge approves, plan confirmed, and off we go.

Trouble is, valuation is always subject to disagreement. As noted in a previous post on this blog (Now you too can value GGP's equity), small changes in cap rates have enormous effects on the valuation of GGP's common stock. I can argue just as well that cap rates should be 6%, as I can that they should be 9%. In the very fun case back in 2007, Nellson Nutraceutical, had 4 different valuation experts representing the company, and three different creditors group (each with their own). These valuation experts did what we all do: They applied assumptions to discounted cash flow analysis along with using multiples applied to different metrics and came up with a value for Nellson. The debtor's valuation of its own business was ~$75M higher than the other valuation business - why? It is my belief, that the equity sponsor wanted to be in the money. Higher valuation accretes value to lower claimants...i.e. stockholders.

Valuation is rarely litigated in the court. More often, different creditor or equity constituents will offer submit a plan of re-org and disclosure statement that has an implicit valuation based on testimony/work of a valuation expert. For example, from an earlier disclosure statement from the Trump bankruptcy:

"Solely for purposes of providing a distribution for Allowed Second Lien Note Secured Claims and Allowed General Unsecured Claims as set forth in the Plan, and in order to avoid a lengthy and expensive litigation process in these cases, the Plan Proponents refer to the valuation analysis prepared by the Ad Hoc Committee in connection with the AHC Plan (the “AHC Valuation Analysis”), which estimates the range of reorganization value of the Debtors to be approximately $464 million to $534 million (with a midpoint value of $499 million) as of September 17, 2009"

What is interesting: in the Trump case, Icahn and Beal Bank use the valuation proposed by the Ad-Hoc equity committee. The difference lies in who gets what via the plan. And how well they argue their case. For example, Icahn/Beal may say that the plan proposed by the Ad-Hoc committee may put too much debt on the company or maybe the fees proposed are too high etc etc. In one hand, the subscription/rights offering winds up in Icahn/Beal's hands, in the other, in the hands of the Ad-Hoc committee...the winner gets control of the company.

So what does this all mean for GGP? Unsecured debt sometimes is not converted at fair value. If it were converted at fair value, why would distressed debt investing even exist? Why would I buy a distressed piece of paper that I think is fully valued? And using prevailing security prices to determine where a judge may/may not confirm a plan is foolish. See: Delphi's bonds and equity circa Jan 1, 2007. Security prices do changes when different plans are filed. See: Visteon in the last few weeks...Term Loan skyrockets, bonds get hammered. Why? Because current plan proposes the vast majority of the equity goes to the Term Loan lender. No doubt this will be fought.

So why would Simon or Brookfield be buying unsecured debt? Like I said, to get a seat at the table. Let's take a hypothetical example here. Shall we? And as noted in previous posts, I have no position one way or the other, and am just laying out an instructive scenario that may or may not occur in the future.

Let's say the rumors are true. Brookfield and Simon have bought $1 billion of GGP unsecured debt. And let's say specifically they bought $1 billion of the Rouse bonds. They do not want to overburden their investment grade ratings, so they want Rouse to emerge with less debt. So they offer to backstop a $1.5 billion dollar rights offering, and cancel their bonds for, lets say 75%, of the equity at Rouse. Remember, you cannot look at GGP as one consolidated entity ... you have to bifurcate between Rouse and GGPLP LLC.

What did they do here? They spent (call it) 80 cents on the dollar for the Rouse bonds (so $800m spent) and put up an additional $1.5B to retire the remaining Rouse bonds they do not own. They spent $2.3B of value to acquire 75% of Rouse's equity.

How much did GGP's stock holder get from this transaction - They are left with 25% of Rouse. And that affects valuation greatly.

Could this happen? Maybe. Simon and Brookfield want to buy this asset on the cheap, NOT at fair value. Once exclusivity is done, they could propose their own plan (i.e. backstopping a rights offering to buy Rouse), arguing that the Debtor (Rouse in this case) would be woefully over-levered upon emergence. If the equity holders do not like it, then they should do an equity offering to take them out...$2.7B of claims ($2.44B of face at 110%...par+accrued)...versus a current market cap of $3.6B. You do the math.

In the bull case of course, which is also just as likely, every piece of debt gets reinstated (or unsecured bonds across the cap structure get refinanced by committed bond financing, and the judge does not think the company overly levered), operating results shoot to the moon, equity holders see their stock go to $40 and some acquirer top-ticks it. Pershing looks like a miracle worker and Hovde ends up flat out wrong. Look to Pilgrim's Pride as an example of an acquisition a Chapter 11 company where equity holders kept their interest, but got diluted (current ownership now 36%), where the stock could be really cheap (trading at 4.0x EV) and could surely take off...it definitely can happen.

Remember distressed debt valuation is only one piece of the puzzle - figuring out which plan will get confirmed and what / how much of the pie they are getting is really where the money is made in this business.

General Growth Properties - 2 - Hovde

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Guest Post - American Axle

Contributor Nathan, has penned an ex-post facto distressed debt analysis of American Axle. We had been working on the case study and all the big news hit - timing is a bitch sometimes. Hope you enjoy.

AMERICAN AXLE – DISTRESSED SCENARIO ANALYSIS

For this entry we will be doing an ex post facto analysis of the American Axle situation as it existed in early August. Those that have followed this situation know that it appears Axle has escaped bankruptcy (for now), which obviously takes a lot of the fun out of presenting this case study. However, we think this entry will provide a good example of some core distressed investing concepts, namely capital structure trading and scenario analysis. The remainder of this entry will refer to the Axle situation as it existed August 5th, which is when the author initiated his positions in the bonds (long) and stock (short) following the company’s 2Q earnings announcement. On that date Axle stock closed at $3.75, up some 43% on the day, while the unsecured bonds ended the day quoted 42-44 (w/o accrued).

American Axle (“Axle”)—along with the vast majority of its auto parts supplier peers—has reached the crossroads of default thanks to the unprecedented decline in new vehicle production. Axle’s acute bankruptcy risk manifested itself in the form of a credit agreement covenant violation for the period ended June 30th. Shortly after quarter-end the company announced via an 8-K (July 7th 8-K) that it had entered an agreement with its bank lenders to waive the covenant violations through July 30th, in exchange for a security interest in its cash collateral, among other things. The waiver was subsequently extended to August 20th.

So unlike a case where bankruptcy is either existing or unavoidable, it is necessary to determine both the probability of bankruptcy and the approximate security prices in both survival and bankruptcy scenarios. Starting with the probability estimate, it is important to note some of the offsetting factors unique to the Axle situation that gave conflicting signals as to whether or not the banks would ultimately push the company into bankruptcy.

The reasons not to accelerate are fairly straight forward. First and foremost banks generally do not want to force bankruptcies if there are any feasible alternatives. Also, Axle’s secured leverage is reasonable relative to industry multiples, implying decent asset coverage for the bank lenders. Assuming a fully drawn revolver, Axle’s secured leverage is approximately 3.0x the 2010E consensus EBITDA estimate compared to the standard industry multiple of 4.0x-5.0x.

On the other hand there are other reasons that make a filing a real possibility. For starters, last November Axle and most of its revolving credit lenders agreed to extend $370 mln of its $475 mln revolving credit commitments to December 2011 from April 2010. This created a fairly unique dynamic whereby the non-extending creditors will mature before their extending peers. This is a big problem for Axle because there is nothing the banks despise more than pari passu or junior creditors getting paid before them. Along the same lines, Axle is expected to burn cash in 2H09 due to working capital outflows and a $40 mln buy-down payment to its remaining UAW employees. Obviously, the worst case scenario for the banks would see Axle narrowly redeem the April 2010 revolver and then file shortly after, avoidable preference notwithstanding.

So after examining the most prominent pros and cons of a bankruptcy filing (from the bank’s perspective) we assign a “highly scientific” near-term probability of default of 50%. Now we will estimate Axle’s security prices under the two scenarios. Starting with the non-bankruptcy scenario we estimate that the bonds would rally to $68 (with accrued), which with a 15% YTM would leave Axle’s bonds a little cheap to similarly rated issues of TRW and ArvinMeritor. With regard to the stock I assumed the market would assign Axle an enterprise value of approximately $1.5 bln ($300 mln 2011E EBITDA * 5.0x multiple). I further assumed net debt would increase by $50 mln to $1.1 bln, leaving $420 mln of equity value divided by 55.4 mln shares for a $7.50 price.

For the bankruptcy scenario we will assume that the stock goes to $0.75 and did a recovery analysis for the bonds (Appendix 1). Based on a base case unsecured recovery value of 47%, discounted at 25% for 1.5 years, we think the bonds will fall to 34% (32/34 bid/offer) if Axle is forced to file. So with the final piece of the puzzle in place we can now take a look at what a cap structure trade would look like.

Based on my assumptions Axle’s bonds and stocks are clearly mispriced relative to each other. By putting this trade on in the above sizes, I have an expected value of over $200K per $1 mln of capital. Now, you might be asking, if you really think the probability of a bankruptcy is 50/50, why wouldn’t you size the positions to maximize profitability in each scenario? The short answer is that I thought the probability of a bankruptcy was lower than 50%, with the unseen scenario of Axle pulling off some form of dilutive equity deal (probably involving GM). This scenario would obviously be good for our bond position and “less good” for the stock.

Fast forwarding a week to August 12th, Axle made the coupon payment on their 5.25% ’14 Notes, which sparked a huge rally in the bonds, while the equity really didn’t budge. The next day we sold our bonds (7.875% ’17) at $60.50 ($57+165 days of accrued) and covered the stock at $3.48 for a nice 75% return on capital, less the borrowing costs on the stock (L+350 for five trading days). Not bad for a week’s work.

Admittedly, this type of analysis is more art than science. I’ve taken a dynamic situation with several potential outcomes and (over)simplified it into a binary framework. I’ve also made highly subjective estimates about forward security prices. The very fact that I made a 75% return on a trade where my “best case” scenario targeted only a 30% return shows how imprecise these exercises can be. However, I believe I used reasonable judgment in shading the inputs to the conservative side for each scenario and firmly believe the risk of a permanent loss of capital was very low given the attractive entry prices. And as a doctor friend of mine once remarked, “Everything is more art than science, even science.”

	AMERICAN AXLE & MANUFACTURING, INC.
	Bankruptcy assumptions:				Duration	1.5 yrs
	Company files on Sept 30, 2009				Exit lev	3.0x
	New money DIP				DIP amt	250.0
	Trade payables, Pension and OPEB rolled				DIP rate	10.0%
	Intercompany payable pledged to secured creditors
	RECOVERY WATERFALL			Base
	2011E EBITDA	225	250	275	300	325
	Multiple	4.00x	4.00x	4.00x	4.00x	4.00x
	Asset Value	900	1,000	1,100	1,200	1,300
	Cash at filing	280	280	280	280	280
	+ New money DIP	250	250	250	250	250
	+/- Op cash burn	-160	-160	-160	-160	-160
	- Admin fees (5% of base EV)	-55	-55	-55	-55	-55
	- Less DIP interest	-38	-38	-38	-38	-38
	Net cash build / (burn)	-253	-253	-253	-253	-253
	Minimum cash	150	150	150	150	150
	Excess cash	128	128	128	128	128
	Distributable value	1,028	1,128	1,228	1,328	1,428
	DIP Facility	250	250	250	250	250
	Remaining value	778	878	978	1,078	1,178
	Domestic ops (33% of value)	257	290	323	356	389
	Foreign ops (67% of value)	521	588	655	722	789
	Intercompany notes	308	308	308	308	308
	Equity	213	280	347	414	481
	Equity value of foreign ops at 66%	141	185	229	273	317
	Domestic ops	257	290	323	356	389
	Total value to secured claims	705	782	860	937	1,014
	Pre-petition secured creditors	720	720	720	720	720
	Secured creditor recovery %	98%	100%	100%	100%	100%
	Residual value to unsecured	0	62	140	217	294
	Value of ops not pledged	72	95	118	141	164
	Total distributable value to unsecured	72	158	258	358	458
	Senior unsecured bonds	550	550	550	550	550
	Recovery %	13%	29%	47%	65%	83%
	Discounted recovery at 25%	9%	20%	34%	47%	60%
	TRADE P&L
8/6/2009	Buy 7.875% (flat)	-44	-44	-44	-44	-44
9/30/2009	Company files	0.00	0.00	0.00	0.00	0.00
3/31/2011	New Co. Emerges	13.16	28.64	46.82	65.00	83.18
	IRR %	(51.9%)	(22.9%)	3.8%	26.7%	47.1%

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