Distressed Debt Investing Example - Idearc

For our first distressed debt investing example, I present to you Idearc. Idearc is a yellow pages directory publisher. On March 31, 2009, Idearc announced that it would restructure its balance sheet and file for Chapter 11 in the U.S. Bankruptcy Court for the Northern District of Texas, Dallas Division.

In its press release, Idearc noted that it had obtained an agreement in principal with the agent bank and the bank steering group on certain elements of its re-organization. A bank steering group is a group of bank lenders (numbering 3-7 lenders usually) that generally have the largest holdings on bank debt. They try to represent, with the help of the agent bank, the broader interests of the bank group as a whole.

Now this was a pre-pack. The company expects to file its plan of re-organization in 30 days, and emerge quickly after if the plan is approved. The company will not need debtor-in-possession (DIP) financing because it already has substantial cash and generates lots of free cash flow.

As a quick aside, and for those new to the Chapter 11 process and distressed debt investing, many times a company entering bankruptcy has negative cash flows. To get them through this period, lenders will extend debtor in possession financing (DIP) to the debtor. The size of the DIP is almost always argued in courts because the more DIP financing you layer in ahead of everyone (they get paid out first), the less recovery for the junior claimants (i.e. equity and subordinated debt securities).

Under the agreement, Idearc's total debt will be reduced from the current level of $9 billion to a pro-forma level of $3 billion secured bank debt at a 12% rate and a 6 year term. The debt will amortize (be paid down) at $60M a year from the first two years following plan confirmation and $40M a year thereafter. An interesting stipulation in the prepack is that 32.5% of cash flow will be retained and the remainder will be used to pay down debt. The company will emerge with $150M of cash. The remainder of the bank debt and bonds will be converted to equity. We will talk more about this as it comes up a lot in distressed debt investing.

The company looks to have approximately $600M of cash collateral at the date of filing. $250M of that will be used to pay bank lenders to use the remaining cash collateral through the bankruptcy process - otherwise known as adequate protection.

Now that we have the introductions and formalities done, let's get our hands dirty. When looking at a bankrupt company and investing in distressed debt, we need to know where to find the bankruptcy documentation. Generally they can be found at:

1. The company's website
   
2. The claims administrator's site
3. PACER - The government site for all court dockets that cost money
4. On Bloomberg

For Idearc, I did some digging on the company's website and found a link for "Claims Information and Court Documents" Bingo. I want to first go to the "First Day Motions" section. In a bankruptcy, specifically Chapter 11 proceedings, debtors generally ask the court a number of provisions and protections on the first day - the use of cash collateral, making sure the power companies don't cut their power, hiring of advisors, the ability to pay employees, etc. 9 times out of 10 these first day motions are simple and will be approved by the court.

One of the first things I read in a Chapter 11 proceeding is the initial affidavit. For Idearc, this can be found at this link: Idearc Bankruptcy Affidavit. This gives a good summary of the business, why the company is in bankruptcy, the corporate structure, etc.

I will try to summarize this affidavit here:

• Prepared by Samuel Jones, CFO and Treasurer of Idearc
• Idearc is one of the largest publishers of yellow-pages directories in the United States. They are in 350 markets in 34 states
• 2008 sales of $2.9B primarily from their print product advertising sales and online media advertising sales
• Idearc was spun off from Verizon in 2006, through a tax free distribution of shares to Verizon's shareholders. In that spin-off Idearc incurred $9.1B of debt comprised of $2.85B of bonds and $6.25B of senior bank debt. Some of this money raised was paid to Verizon. $2.4B to be exact. That's a good trade right there!
• The bank lenders are owed $6.4B and JP Morgan is the agent on the deal
• In addition, Idearc has interest rate swaps that are pari - passu (equal in ranking) with a terminating payment of $500M
• Why did the company go bankrupt: Downturn affected advertising, secular shifts in the advertising market (going online vs going to print), bad debt expense increased. An interesting statistic: Overall references to print yellow page directories in the U.S. have declined from 14.5B in 2005 to 13.4B in 2007.
• The the affidavit goes on to list "first day motions": joint administration (consolidating a number of entities into one case), payment of wages and salaries, use of bank accounts, prohibiting utilities from cutting service, use of cash collateral, finding secured interest are adequately protected, critical vendor payments, payment of pre-petition taxes, honoring certain customer obligations (warranty and promotional programs), maintain existing insurance policies, filing a list of creditors, retention of legal and financial counsel and advisors, and retaining a claim's processing agent.

So, we got that out of the way. As a distresed debt investor, we need figure out how much this thing is worth. As a reference, here are dealer quotes on the various securities:

• Idearc Bank Debt: Term Loan A and Term Loan B: 42.5 (up from 32 the week before the filing)
• Idearc Bank Debt: Revolving Credit Facility: 41.5
• Idearc Bonds: 2
• Idearc Equity: $.03

Now when I run the numbers, last twelve month's EBITDA is $1.275B, 4th quarter EBITDA was down 18% year over year, and the company expects to realize approximately $30M of cost savings in the next year. My estimates for 2009 EBITDA is $900-1000B (low end - high end).

Unfortunately, we do not know how much post-re org equity is going to the bondholders. Theoretically speaking, because the bank group is impaired, the bondholders and equity should get nothing. That being said, giving the bond holders some equity lowers the chance that they make this a long protracted bankruptcy (a nuisance value payment).

The way I look at this situation is to say, similar to what many value investors do when valuing companies, if I were to buy all the debt today, what would I get in exchange. Well, to buy all the bank debt today, I would have to pay the amount of bank debt outstanding ($6.4B) times the price (42% of par) which is equal to $2.68B. In exchange for laying out that capital, I receive:

1. $250M of cash for adequate protection payments (see above)
2. A $3.0B note at a 12% rate
3. Some portion of residual equity value
   
4. Interest payments during the bankruptcy

We know that $250M of cash is solid, unfortunately we have no idea how much that $3.0B of note is really worth as well as the residual equity value. For this exercise I will ignore the interest payments made during the bankruptcy because it is to small (very short bankruptcy).

Some readers may be questioning why a $3.0B note could be worth less than $3.0B. Well, for Idearc, I am assuming that they will generate somewhere between $900M and $1.000B of EBITDA in 2009. That would make the new post - reorg Idearc levered somewhere between 3.0-3.3x. If, in reality though, the economics of Idearc and the yellow pages business necessitates a valuation of 2.0x, Idearc would only be worth $1.8B-$2.0B and our note would be worth 60-67 cents on the dollar.

As such, it comes down to building a cash flow model and making some conservative predictions. Here are two models I quickly built, overly simplistic, but it gives you an idea.

Model with 5% EBITDA decline

Model with 15% EBITDA decline

As you can see, the differences are pretty dramatic. At a 15% EBITDA decline, the company's leverage increases dramatically and its cash flow generation declines. At a 5% EBITDA decline, the company is nearly at a steady state where debt paid down is enough to drop interest expense in line so that Free Cash Flow is nearly stable.

Now if you believe the 15% decline in EBITDA, you probably would not want to buy Idearc's bank debt at these levels. While your note will be paid down nearly a $1B through the life of the loan, at the end of the day you will have $1.8 of net debt versus $339M of EBITDA. You basically are back where you started.

But if you believe the decline is closer to 5%, you may want to buy the Idearc Bank Debt at these levels. Not only does your note get paid down nearly $1.5B, but you also have nearly $550of cash in the coffers at the end of 2015. Net debt is only $905Mvs $662M of EBITDA. As long as the value of Idearc is more than 1.5x EBITDA, you will have residual equity value. And probably lots of it. At the end of 2015, under the 5% decline, Free Cash Flow is $267M. Who knows what multiple this thing would command, but let's say it is 5x free cash flow (I know...incredibly low). Or $1.3B of operating value with $550M of cash or $1.9B of value.

Summing it all up, you paid $2.68B today to receive $250M of cash in a few months, $1.5B of debt principal payments over the next 6 years, 6 years of interest expense at 12%, and $1.9B of residual equity value. This translates into approximately an 18% IRR. Maybe a little light with all the risks. If we wanted a 30% IRR, we would be buyers of the bank debt at 31 cents on the dollar - interestingly enough - the bank debt traded at those levels 2 weeks before the bankruptcy. Definitely a good purchase down there if you believe the 5% decline scenario.

Update: April 16th, 2009: Idearc released a presentation in the Form of an 8K.  The presentation can be found here. Some quick takeaways:

• Base Case projections: EBITDA goes to $700M in 2013.  Internet growth offets some of the decline of the print business.
• Downside Case projections: EBITDA goes to $485 in 2013.  Internet grows, but print declines substantially more.
• Bank debt holders could get 100% of the equity

Continue following this blog as we detail and review more distressed debt investing examples and concepts.

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Distressed Debt Investing - Example 1

So back to our example. Let me just grab what I just wrote so it's easy to access...

But for now, let us use a hypothetical example. Let's say I am involved in distressed debt investing. A company that I am looking at has 100M of EBITDA. EBITDA is Operating Earnings + Depreciation and Amortization - non recurring one time items. And let's say I think this company is worth 5x EBITDA, therefore I think that if the entire enterprise was sold, someone would pay somewhere around 500M. Now let's say that this company, we will call it Overlevered Co. has 2 billion dollars of debt.

Ok. Now let's say in this particular example, the company decides to pursue a Chapter 11 reorganization. In distressed debt investing, we are familiar with this process as we sit in the Delaware courts often. Unfortunately, many of us are not lawyers, so we rely on counsel or our judgement in helping us make better investment decisions.

Ok. Let's say the bankruptcy process is fairly standard because there is only a few class of creditors:

1. The lawyers and other admin, who get paid first
2. The bond holders
3. The equity holders

In a bankruptcy process, there is something called an administrative claim which must be paid in cash and gets paid out first before anyone else. That is why being a bankruptcy lawyer is so appealing (1000 dollars an hour...). If the admin claims cannot be paid in cash, more than likely the case turns into a Chapter 7 liqudiation which we will talk about in future posts. That is a whole other distressed debt investing topic.

In a bankruptcy, generally interest is not paid on the pre-petition bankruptcy debt claims unless the judge grants it to you. He/She would only do that if you were way more than covered. But in our example, let's say no one is getting paid interest.

The bankruptcy, for simplicity purposes goes on for one year. In that year, the company generated enough free cash flow to pay out all the administrative claims in cash. So now you, the owner of 2 billion worth of bonds, which you paid 10 cents on the dollar for (200M), want your take.

There is a valuation hearing, restructuring bankers argue (again we will dig into all these issues in the future), and the judge decides that this company is worth $400M. Less than you had hoped, but you are still looking pretty. In addition, everyone agress that this company can take on 200M of debt after the bankruptcy in a new note (That would make it 2x levered...2ooM debt / 100M of EBITDA) which will be distributed to you the sole bond holder. In addition, the bond holders will get 75% of the equity, management will get 15%, and old stock holders will get 10% of the new companies equity.

Why do you ask do we not get all the equity? Well management needs some incentive to stick around and former equity holders can sometimes be a nuisance. If our capital structure were more complicated, then I doubt they would get anything. Again, a topic for another post down the road.

The company finally emerges from bankruptcy, with 200M debt that you are the sole owner of and new equity owners, mainly you. This company is now private. You and your people from your fund go on the board and try to make things (magic) happen. And let's say your company invents a new product and its EBITDA doubles. Now its EBITDA is 200M. But now, with all the great opportunities this new product has to offer, people are willing to buy this company from you at 7x EBITDA. So now your company that you own 75% of is worth 1.4B dollars. Subtract the 200M of debt you own...the equity is worth 1.2B...you own 75% meaning your equity is worth $900M. Your total investment is worth $1.1B (900M of equity + 200M of debt)

Let me break this down for everyone that has not been following along. You paid $200M, and wll be getting back $1.1B in a few years. Let's say the WHOLE process takes 3 years.

That is ~75% annualized return. Distressed debt investing FOR THE WIN.

Now if you are also in the field of distressed debt investing, I apologize for the simplicity of this post. It does make a pretty interesting case study. Now I just have to find this exact same investment in the real world.

In the next post, I am going to talk about a real distressed debt investing example. One that many of my colleagues have been following for quite a while now. And I will follow that one up with more distressed debt investing concepts.

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