Gems in Investing’s Bargain Basement
Analyzing Distressed Assets
A discussion of recent/current distressed situations
Gary Jacobi
Kevin Starke
Agenda:
• Distressed Debt Overview
• Current Distressed Opportunities
• Summary/ Q&A
Why distressed debt is and will be a fertile field for Investors:
While much of the speculative/high yield debt will mature without any issue,
several billion in maturing debt, could yield a number of opportunities in the
Coming years.
Source: CRT Capital.
Types of distressed debt/companies
A broken company: DXM?
A broken Balance Sheet: TXU, OSG?
A broken company and B/S: JCP?
A broken political process: FNMA/FMCC?
None of the above: NT
A success story: AAL
Unsecured
Debt: Typical
bonds
have no
collateral
Equity:
Usually
no recovery
(but some
major
exceptions)
Secured Debt:
Bank loans,
mortgages, aircraft
financings,
some bonds
Distressed
Assets:
Reorganizations,
Liquidations,
Special
Situations
Unsecured
Claims:
Unpaid
bills due at
time of
filing
Other
Types of
Claim
Special
Financings
(DIPs, litigation
financing)
Source: CRT Capital.
What constitutes a distressed company?
• A company that has debt/equity trading at record low levels and that is likely
• to restructure and file in the foreseeable future.
o Where distressed investment opportunities might exist:
• Secured & unsecured lenders
• Senior and subordinate lenders
• Preferred & common shareholders
• Employees (current & retired)
• Customers
• Suppliers
• Others
3 key questions to address in analyzing distressed situations:
A.
What is the maximum value and optimal structure of the resultant estate?
B.
How to maximize the value of the estate?
o Liquidate
o Sell parts of the business
o Merge/acquire another entity
o Close parts of the business
o Fix the B/S, change nothing operational
C.
Who is entitled to the value
o Secured lenders
o Senior lenders
o Preferred/common shareholders
o Others (Employees, retirees, suppliers, customers,
litigants, claimants, etc.
Keys to success:
o Buy right: Know the liquidation value – likely the worst case
o Due diligence – what caused the problem
o Preferred/common shareholders
A look at some recent/current distressed events:
A failure:
• Borders – a liquidation
Outcome still uncertain:
• DEX Media (DXM: ,14% Sr. Sub note, 01/2017 maturity
• Energy Futures Holding (TX: various ratings).
A complex structure – where is there value – in this ongoing estate
• Overseas Shipholding Group (OSG: unrated), 8.125% Senior note
o Bonds are not interesting, the value will either go to the to
bank debt holders 0r to the existing equity. The bonds
(which are in the middle) will either be reinstated or redeemed
– an unusual outcome.
• JCPenney (JCP:Caa2/CCC-), 5.75% - 2018 note,Price – 85.0, YTW – 10.27%
• Fannie/Freddie (FNMA/FMCC), $25.00 & $50.00 Preferred Stock
• Nortel (NT: default), 10.75% - 2016 note, Price – 119.0, YTW/STW – N/A
Success stories:
• American Airlines – and still improving.
Currently Distressed Companies:
Radio Shack (5 year CDS - LTM chart:)
JCP (5 year CDS - LTM chart):
TXU ( 5 year CDS - LTM chart):
OSG (5 year CDS – 24 month chart):
Source: Bloomberg
Dex Media – Is there a Yellow pages in the future?
• DXM has a Market Cap of $169.50mm. The stock has rebounded nicely
from its LTM low of $4.32/share, but is well of its LTM high of $23.86/share.
• There is $2.44bn in bank debt outstanding – issued by 4 different corporate
entities at DXM.
• There is a $243.0mm, Sr. Sub note outstanding issued by the parent,
trading at 65. This note pays 12% cash and 2% PIK interest.
• DXM reported 2013 adjusted EBITDA of $866.0mm, down from 2012
EBITDA of $1.085bn – a decline of 20%.
• DXM is FCF positive and has leverage of 3.0x –
both positives, but can the steady decline of
revenue/EBITDA be stemmed?
Source: DXM investor relations
Dex Media – Is there a Yellow pages in the future (cont.)?
A level of risk for every appetite in the bank debt at DXM:
Bank debt trades between 63 – 82.50, depending on the tranche:
Source: DXM investor relations
Prices/Trading levels for the DXM bond
Source: Bloomberg
JCPenney: Lots of collateral – any value
Secured debt:
$2.70bn
Lit value:
Dark Value: $1.82bn
Unsecured debt:
$2.63bn
Total debt: $5.32bn
$3.32bn
Term Loan Bank Debt:
05/2018 maturity:
Rated: Caa2/BRate: L+500, 1.0% floor, Price – 99.0
Indicative Senior Bond: $400.0mm
06/2020 maturity
5.65% coupon
Price – 77.0, YTW – 10.70%, STW – 897
Estimated current liquidity:
Cash - $1.50bn, Revolver - $0.50bn
Source: JCP bank debt presentation
2 year price performance for the JCP 5.65% - 2020 bond
Source: Bloomberg
FNMA/FMCC – projected cash flows
Source: Alvarez & Marsal presentation
Cash & Book equity builds at FNMA/FNMC through 2023
Source: Alvarez & Marsal presentation
Year 2023 liquidation proceeds at FNMA/FNMC in 2023
Source: Alvarez & Marsal presentation
FNMA Series H $50.00, 5.81% Preferred Stock Review
This is a non-cumulative, dividend stopper preferred stock that is
not currently paying a dividend
Source: Bloomberg
TXU Valuation, Corporate & Capital Structure Chart
• TCEH EBITDA ≈ $1.90bn, at a high 10x multiple, recovery only for the 1st lien
• EFH/ONCOR EBITDA ≈ $14.50bn, ONCOR debt ≈ $6.0bn, 1st & 2nd are money
good notes, recovery for Sr. debt ?
Indicative Bond Prices for various TXU bonds
As with, DXM, a bond for every level of risk appetite
Source: Bloomberg
Case Study: American Airlines
From Low to High
• Bonds:
•
traded as low as the teens. Ended up being worth 120% or more of face
value. One bond is even worth 280% of face value.
Stock: traded as low as 26 cents. Now worth close to $30.
March 26, 2014
Page 20
How Did Some People See Value Here While Others
Didn’t?
• Distressed investors had been burned on the other airline bankruptcies. It became
•
•
•
•
a sector that many didn’t want to touch ever again
“Is it different this time?” A great way to lose your job if you say “Yes” and you’re
wrong.
AMR management talk of capacity expansion.
Old fleet replete with old MD-80s that need to be retired. Massive capex needed.
Issue of treatment of potential claim for pension liability on behalf of the Pension
Benefit Guaranty Corp.
March 26, 2014
Page 21
What the Bulls Saw at the Time
• Hard to be wiped out at unsecured level since much of the pension claim would
•
•
•
•
•
•
end up here. It was clear as early as March 2012 anyway that the pension would be
frozen, not terminated.
Industry was at trough earnings multiple. Hard to see it going lower, and nothing
on the horizon to lower profitability. Even a 0.1x turn in multiples has major
valuation ramifications. Favorable asymmetry.
The primary obstacle to restoring the American brand and profitability was an
unsustainable set of labor agreements. A fixable problem. Labor was 28% of costs.
Section 1113 process produced a lot of useful detail and valuation information to
show that if fixes were applied, the airline could rejoin and maybe leapfrog
competitors.
Shortly after the case began, there was another bid in the market: U.S. Airways.
Consolidation might not only help AMR and U.S. Airways, but might lift the entire
industry.
Reasonably stable, though elevated, fuel cost environment (36% of costs in 2012)
March 26, 2014
Page 22
AMR’s Uncompetitive Labor Situation
Source: Bankruptcy court documents.
March 26, 2014
Page 23
Standalone Value Calculation
• How things looked to distressed investors in summer 2012:
AMR EBITDAR
Multiple (x)
Value of Operating Business
Plus: Cash (after bankruptcy expenses)
Enterprise Value
Less:
Reinstated Secured Debt
Capitalized Aircraft Rent
Pension
Distributable Value
($MM)
3,644
3.9x
14,212
5,500
19,712
8,700
3,640
5,000
2,372
Source: CRT Capital estimates.
• Would have meant about a 55% recovery on some claims and 33% on others. Zero
•
•
for equity.
Was generally a function of how far you were willing to look out on the earnings
improvement curve and what multiple you would assign (4.5x-7.5x historical
range).
Market was clearly putting pension aside, looking farther ahead, and expecting a
merger.
March 26, 2014
Page 24
Why Things Improved
• Sec.
•
•
•
1113 process led to better collective bargaining agreements, saving $60-$100
million per month. Created operating leverage, growing revenue but holding costs
down, at least for a few years.
Industry performance was improving across the board. Industry multiples crept
up. Now trading at mid-to-high 6’s on 2013 EBITDAR and high 5s for 2014.
AMR, the creditors’ committee and their advisors created a “bid” for AMR’s assets
that U.S. Airways had to top.
It did. The 72:28 split of the combined company recognized this. It was also clearly
the outcome favored by labor and creditors.
March 26, 2014
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Complicated Problem
• When
•
a company starts to seem solvent in bankruptcy (value of assets exceeds
liabilities), a fight can brew. Equity wants a cut, but creditors argue for lower
valuation.
There was also an intercompany issue that could cause an even bigger fight. How
things stood in December 2012:
Combined $3.3 billion
recovery is in excess of the
$2.8 billion in double dip
claims. Creditors can't
keep the excess. They
might get post-petition
interest, but there might
still be value left over, and
this could go to AMR
stockholders.
$2.8 billion in claims
would receive the $1.5
billion in value that flows
up to Holdco from Opco in
the Plan
Creditors with
Double Dip Claims
(Holdco's only
creditors)
The same $2.8 billion in
claims would receive a
63% recovery, or $1.8
billlion in value.
AMR Corp.
("Holdco")
$2.4 billion owed to
Holdco by Opco. A 63%
recovery would mean $1.5
bilion of value flowing up
American Airlines
Inc. ("Opco")
Claim pool here should total around $9.4 billion
Source: CRT Capital estimates.
March 26, 2014
Leaked USAir proposal would give stock worth $5.95
billion to creditors
Page 26
Elegant Solution
• AMR sidestepped this problem. Since it
•
wanted that topping bid from U.S.
Airways, all parties had an interest in
maximizing the value of AMR.
A plan was negotiated with this in
mind. The main ingredients:
All but ensure that double-dip creditors are
paid in full
 Give AAMRQ holders 3.5% of the merged
company up front.
 If all single-dip creditors are made whole
based on market value, existing
stockholders receive additional value.
AAMRQ: Upside if
AAL goes above
$14.25. Now at $36+
$14.25

• The
merger context gave a handy
solution: Use U.S. Airways’ stock price
as a benchmark for value, and
therefore, for recoveries.
$11.00
Double-Dip
Claims – Get
to full
recovery
faster as new
stock rises
Single-Dip
Claims –
Covered
by this
level
AAMRQ: Initial 3.5%
Source: CRT Capital estimates.
March 26, 2014
Page 27
AAMRQ Stock Movement
• Big legs up on:
WSJ story in mid-December, 2012
 Weil Gotshal letter January 8, 2013
 Plan and merger announcement February
14, 2013
 DOJ settlement November 12, 2013
• Low to high:
1/4/12: $0.24
 4/23/14: $29.70 (our calc. of intrinsic)


• 131x appreciation
Source: Bloomberg.
March 26, 2014
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The Big Catalysts
• The Ch 11 filing: November 29, 2011. Big surprise to almost everyone. Stock opens
•
•
•
•
•
•
•
•
at about 20 cents, down from $1.60. The 6.25% notes fall from 40s to teens.
U.S. Air takeover chatter surfaces by February 2012. Bonds back in 40s.
Section 1113 process from April to June 2012: Bonds push to 50s.
Section 1113 ruling on pilots, autumn 2012: bonds in 60s.
Merger talk heats up, November-December 2012: bonds in the 80s.
Debtors’ counsel’s letter to U.S. Trustee, January 2013: Bonds in the 90s.
Plan and merger announced, February 14, bonds rise above par.
DOJ suit August 13, 2013: Bonds retrace down to low 90s from around 120. Stock
from $6 down to $2.50.
DOJ settles November 12, 2013: Bonds to 120s. Stock jumps from $9.50 to $12.
March 26, 2014
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Case Study: Nortel Networks
Case Overview
• Nortel was a well known telecom equipment maker.
• Its bankruptcy filing in January 2009 was the result of competitive weakness, too
•
•
much debt, and the onset of the financial crisis.
Often too much leverage means too little investment in the business. Nortel is a
poster child of this problem.
Nortel is a good case study for some key topics in distressed investing:
 Asset sales in bankruptcy
 Cross-border insolvency proceedings
 “Pot Plans”
 Intercompany claims and double dips; lopsided outcomes
 The payment of interest accruing after a bankruptcy filing (“post-petition
interest”)
March 26, 2014
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Asset Sales in Bankruptcy
• Nortel
•
•
•
•
•
decided in the first year of the case not to reorganize but to liquidate,
selling off assets in batches, by business line.
Generally, asset sales are subject to a court-supervised auction process to help
ensure maximization of value.
Things started well: in November 2009, 10 months after the bankruptcy filing, the
company announced the sale of its CDMA and LTE assets to Ericsson for $1.1
billion.
A month later, Avaya bought the enterprise solutions business for $900 million.
Asset sales continued, with proceeds being deposited in an escrow account,
leaving until later resolution of the question of how they would be split up among
the various international units of the company.
What no one could have predicted was that, in June 2011, Apple, Microsoft and
others banded together and bid $4.5 billion for Nortel’s patent portfolio.
March 26, 2014
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Asset Sales in Bankruptcy
• The bonds moved quickly. Below, the 6 7/8% Notes, traded from 30 up to 80.
• But you would have done well to sell them after this, because they now trade back
•
in the 40s.
What has gone wrong?
March 26, 2014
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Cross-Border Insolvency Proceedings
• Nortel
•
•
•
•
•
•
is really three cases in one: a case in the U.S., another in Canada, and
another in the U.K. (There are also proceedings in other countries where it did
business, but these are not important to the discussion).
Creditors of each estate want the best outcome for themselves. There is $7.7 billion
in asset sale proceeds sitting in an escrow account. Each estate also has its own
unique assets (U.S. has over $1 billion of its own cash).
But there’s over $10 billion in claims.
It’s not as simple as to give everyone a 70-80% recovery on their claim. Each claim
has unique attributes and rights to different piles of cash.
The U.K. has the worst hand to play. It has very little claim to the assets, but it has
a claim pool of over $3 billion, mostly pension-related. Pensioners are going to lose
their retirement income, but they haven’t got a leg to stand on. They have adopted
a scorched-earth litigation strategy that is likely to fail, but there’s nothing to lose.
This takes a lot of time and money.
Mediation has failed twice.
Legal fees have eaten up $1 billion in value in five years. The clock is still ticking.
March 26, 2014
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Pot Plans
• Totally different type of investing than typical reorganization.
• Many examples: Nortel, Wamu, MF Global, and, the granddaddy
•
•
•
•
•
of them all,
Lehman.
Discreet universes, uncorrelated to the markets. Typically just piles of cash waiting
for distribution.
Litigation is often a big part of the outcome. Need to understand the corporate
structure, the indentures and credit agreements, the way value flows through the
structure.
Nortel’s central issue is that most of the bonds were issued by the Canadian
operating company, but guaranteed also by the U.S. operating company. They thus
have a claim on both entities. They can get a much bigger share of the asset sale
proceeds than claimants who just have rights to assets at one “box.”
While Canadian pensioners are not going to lose as badly as their U.K.
counterparts, they are in for some pain. They are likely to recover less than half of
their retirement savings.
Meanwhile, the markets indicate that holders of those “double dip” bonds are
going to get over 100% recovery.
March 26, 2014
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Intercompany Claims and Double Dips
• When
•
•
•
•
•
•
companies go bankrupt, the entities within them often owe each other
money. These are debts just like any other, typically.
Nortel U.S. has a $2.4 billion claim on Nortel Canada. So even if Nortel Canada
wins litigation on asset sale proceeds (and gets bigger share), it still ends up paying
some of that back to the U.S.
Similar to the American Airlines case, but there’s no surplus of value to solve all
problems here. There’s a finite amount of cash.
The double-dip bonds can recover about 40% of their claim from Canada, then
turn to the U.S. entity and get the other 60%.
Canadian pensioners can only get the 40% or so. They have no good argument to
lodge a claim against the U.S. company. They were not its employees.
On top of this, the U.S. intercompany claim of $2.4 billion dilutes them heavily. If
it didn’t exist, they’d probably get 50% or more.
So, UK pensioners could end up with close to zero, Canadian pensioners could end
up with 50% or less, and U.S. bondholders could end up with over par.
March 26, 2014
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Interest on Claims
• A perennial hot topic in distressed investing.
• If equity is going to get a recovery, shouldn’t creditors be completely compensated
•
•
•
•
•
first? Shouldn’t that include their contractual rate of interest?
Judges are divided on this. Wamu established negative precedent for bondholders,
but is not a universally accepted ruling.
In the Nortel case, there’s a wrinkle: it’s not a question of value going to Nortel
parent company shareholders. Rather, it’s a question of whether Nortel Canada, as
parent of Nortel U.S., can recover value on its equity ownership of the American
entity before creditors get paid interest.
Remember, the double-dip bondholders get 40% from Canada, then the other
60% from the U.S., but that leaves money left over at the U.S. box. Where does that
go?
It can go first either to: 1. creditors in the form of interest on their claims (six or
more years of accrual at some very high rates), or 2. to Nortel Canada as parent and
equity owner of Nortel U.S.
If the latter, it would help Canadian pensioners out a lot. If the former, it will make
some U.S. hedge funds very rich. The markets are betting on the former.
March 26, 2014
Page 37
Interest on Claims
• The
•
10.75% notes, with a double dip on both U.S. and Canada, and a massive
interest accrual of $840 million versus face value of $1.185 billion.
Downside: 108 (-11). Upside: 133 (+14). Modest asymmetry. Timing: Unknown.
Maybe 2015 (12% IRR). But could easily take until 2017 (4% IRR)
March 26, 2014
Page 38