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Gems in Investing’s Bargain Basement Analyzing Distressed Assets Gary JacobiKevin Starke A discussion of recent/current distressed situations.

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Presentation on theme: "Gems in Investing’s Bargain Basement Analyzing Distressed Assets Gary JacobiKevin Starke A discussion of recent/current distressed situations."— Presentation transcript:

1 Gems in Investing’s Bargain Basement Analyzing Distressed Assets Gary JacobiKevin Starke A discussion of recent/current distressed situations

2 Agenda: Distressed Debt Overview Current Distressed Opportunities Summary/ Q&A

3 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.

4 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 Types of distressed debt/companies Special Financings (DIPs, litigation financing) Equity: Usually no recovery (but some major exceptions) Unsecured Debt: Typical bonds have no collateral Other Types of Claim Secured Debt: Bank loans, mortgages, aircraft financings, some bonds Unsecured Claims: Unpaid bills due at time of filing Distressed Assets: Reorganizations, Liquidations, Special Situations Source: CRT Capital.

5 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

6 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

7 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% note,Price – 85.0, YTW – 10.27% Fannie/Freddie (FNMA/FMCC), $25.00 & $50.00 Preferred Stock Nortel (NT: default), 10.75% note, Price – 119.0, YTW/STW – N/A Success stories: American Airlines – and still improving. A look at some recent/current distressed events:

8 JCP (5 year CDS - LTM chart):OSG (5 year CDS – 24 month chart): Radio Shack (5 year CDS - LTM chart:) Currently Distressed Companies: TXU ( 5 year CDS - LTM chart): Source: Bloomberg

9 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

10 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: Prices/Trading levels for the DXM bond Source: Bloomberg Source: DXM investor relations

11 JCPenney: Lots of collateral – any value Secured debt:$2.70bn Lit value:$3.32bn Dark Value:$1.82bn Unsecured debt:$2.63bn Total debt:$5.32bn Term Loan Bank Debt: 05/2018 maturity: Rated: Caa2/B- Rate: 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 Source: JCP bank debt presentation Estimated current liquidity: Cash - $1.50bn, Revolver - $0.50bn

12 2 year price performance for the JCP 5.65% bond Source: Bloomberg

13 Source: Alvarez & Marsal presentation FNMA/FMCC – projected cash flows

14 Cash & Book equity builds at FNMA/FNMC through 2023 Source: Alvarez & Marsal presentation

15 Year 2023 liquidation proceeds at FNMA/FNMC in 2023 Source: Alvarez & Marsal presentation

16 FNMA Series H $50.00, 5.81% Preferred Stock Review Source: Bloomberg This is a non-cumulative, dividend stopper preferred stock that is not currently paying a dividend

17 TXU Valuation, Corporate & Capital Structure Chart TCEH EBITDA ≈ $1.90bn, at a high 10x multiple, recovery only for the 1 st lien EFH/ONCOR EBITDA ≈ $14.50bn, ONCOR debt ≈ $6.0bn, 1 st & 2 nd are money good notes, recovery for Sr. debt ?

18 Indicative Bond Prices for various TXU bonds As with, DXM, a bond for every level of risk appetite Source: Bloomberg

19 Case Study: American Airlines

20 Page 20 March 26, 2014 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.

21 Page 21 March 26, 2014 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.

22 Page 22 March 26, 2014 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)

23 Page 23 March 26, 2014 AMR’s Uncompetitive Labor Situation Source: Bankruptcy court documents.

24 Page 24 March 26, 2014 Standalone Value Calculation How things looked to distressed investors in summer 2012: 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. ($MM) AMR EBITDAR 3,644 Multiple (x)3.9x Value of Operating Business 14,212 Plus: Cash (after bankruptcy expenses) 5,500 Enterprise Value 19,712 Less: Reinstated Secured Debt 8,700 Capitalized Aircraft Rent 3,640 Pension 5,000 Distributable Value 2,372 Source: CRT Capital estimates.

25 Page 25 March 26, 2014 Why Things Improved Sec 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 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.

26 Page 26 March 26, 2014 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: Source: CRT Capital estimates.

27 Page 27 March 26, 2014 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. The merger context gave a handy solution: Use U.S. Airways’ stock price as a benchmark for value, and therefore, for recoveries. AAMRQ: Initial 3.5% $11.00 Double-Dip Claims – Get to full recovery faster as new stock rises $14.25 Single-Dip Claims – Covered by this level AAMRQ: Upside if AAL goes above $ Now at $36+ Source: CRT Capital estimates.

28 Page 28 March 26, 2014 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.

29 Page 29 March 26, 2014 The Big Catalysts The Ch 11 filing: November 29, 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 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.

30 Case Study: Nortel Networks

31 Page 31 March 26, 2014 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”)

32 Page 32 March 26, 2014 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.

33 Page 33 March 26, 2014 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?

34 Page 34 March 26, 2014 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.

35 Page 35 March 26, 2014 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.

36 Page 36 March 26, 2014 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.

37 Page 37 March 26, 2014 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.

38 Page 38 March 26, 2014 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)


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