NOT AN ANALYST

In recent months, several high –profile bankruptcy cases saw a high involvement from shareholders represented by a formal Equity Committee. The formation of an ad hoc committee representing the owners of the Company appears to have recently taken the US bankruptcy world by storm and will likely impact how future restructurings are handled. If bankruptcy is a tool that creditors use to protect their interest, should shareholders have similar rights in these proceedings?

Rational for an Equity Committee

According to the absolute priority rule in the Bankruptcy Code, shareholders are forced to the bottom of the capital structure. However, if the Debtor still maintains a viable business, all stakeholders want to obtain some value from the reorganized entity. Equity participants believe that their interest are not adequately protected in bankruptcy and therefore feel it necessary to appoint a formal Committee. The US Bankruptcy Code doesn’t provide any assurance of “adequate protection” and the degree of protection for shareholders is determined on a case by case basis. Usually solvency is the “make-or-break” feature regarding the appointment of an Equity Committee.

The concept of solvency

The Board of Directors of a Corporation has a fiduciary duty to its shareholders. However, when a Company becomes insolvent, the fiduciary duty now extends to its creditors. Solvency is the most used applicable legal standard when deciding whether or not to appoint an Equity Committee. If the Debtor is hopeless insolvent, justification can be made that there is no need for shareholder representation, as the cost required and charged to the bankrupt estate for professional representation of the shareholders outweighs the adequate representation interest of the shareholders and it would be burdensome to the bankrupt estate. Usually an Equity Committee  can only exercise a meaningful weight on the restructuring process when bankruptcy is not the result of insolvency.

Role of the Equity Committee

Similarly to the Creditors Committee, the Equity Committee participates in the restructuring process and communicates with the Debtor, Advisors and other stakeholders, negotiate specific terms and conditions relating to the Debtor’s Plan of Reorganization (POR) and participate in the confirmation of the POR. The goal of the Equity Committee, along with the Creditors Committee, is to maximize value and to divide that value in order to satisfy all stakeholders. To accomplish their goal, Equity Committees typically try to:

ü  Be involved as early as possible in the case in order to have more negotiation power

ü  Ensure an open communication with all stakeholders, specially the Debtor and its Advisors in order to limit litigation costs

ü  Ensure the debtor is awarded the maximum value of the enterprise

Recent cases

The Equity Committee has the potential to promote conflicts regarding the valuation of the enterprise, assigning a higher valuation to the estate and therefore diluting the value to creditors. It can be argued that the increasing involvement of Equity Committees in the restructuring process has been a liability for Creditors. Let’s look at General Growth Property’s case for example; here the Equity Committee probably has more weight on the restructuring process than the Creditors, even if they are forced to the bottom of the capital structure.  Another meaningful example is Accuride Carp case. On February 9, shareholders won a delay of the company’s reorganization schedule to develop an alternative plan that includes new $400 million exit loan. One major point of the dispute was valuation. The shareholders claimed the Company is worth about 823 mm, or 260 mm more than what was estimated by the Creditors.  Shareholders would receive 26.5% of the new equity, instead of 2% under the original plan. The battle is still ongoing in court.

Based on the 4Q earnings released few days ago,  we have the following updated information:

2009 full year NOI = 2,417 mm
Total debt = 27,815 mm

Given its current stock price of 13.50, and using FY 2009 NOI, GGP trades at an implied cap rate of 7.50%:

NOI = 2,417 mm
Debt = 27,815 mm
Equity value = 13.50 x 314 mm shares = 4,239 mm
Enterprise value = debt + equity = 27,815 mm + 4,239 mm = 32,054 mm
Implied cap rate = 2,417 mm/ 32,04o mm = 7.54%

SPG, on the other hand, trades at an implied cap rate of 6.75%.

The quality difference between SPG and GGP’s portfolio’s is marginal. SPG’s overall quality is slightly higher but GGP owns higher quality assets. If SPG wants to purchase GGP, then it must bid to an implied cap rate that better reflects the value of an A quality portfolio. Realistically, a 7.00% implied cap rate is a fair value for GGP. Arguably, if you want to purchase it, you must bid a premium; therefore a 6.75% implied cap rate should be warranted.

At a 7.00% implied cap rate:

Enterprise value = NOI / implied cap rate = 2,417 mm / 7.00% = 34,528 mm
Equity Value = Enterprise value – total debt = 34,528 mm – 27,815 mm= 6,713 mm
Stock price = Equity value / total shares = 6,713 mm / 314 mm shares = 21.38

A 10 bps reduction in cap rate, it implies a stock price of 22.97, which means that a 10 bps adjustment in cap rate affects the stock price by 1.60. That’s significant.

The management of the Debtor cannot allow SPG to steal the Company at their initial bid of $9 which corresponds to an implied cap rate of 8.00%. This will be a catastrophe not only for GGP shareholders but for the CRE market as well. It would mean that cap rates based on recent deals have increased, therefore decreasing the value of the stocks in the REIT industry.

20-25 dollars per share is a more plausible bid for GGP’s assets.

SPG offered $6 per share in cash to GGWPQ shareholders and par plus accrued interest to all unsecured note holders for a total offer of $10,000 m. This implies a 9% cap rate to value the entity, assuming NOI around 2,400 m and without accounting for the Master Planned Community Business. Every 10 bps change in cap rate (or 9.8 bps to be more accurate) equates to a $1 per share increase/decrease to GGP shareholders.

NOI=2,400

Total Secured Debt=18,000

Bank Debt=3,000

Bonds=4,000

Total Unsecured=7,000

Total Debt=25,000

Equity @ $6/share=1,885

EV=26,885

Implied cap rate=8.92%

Assuming a price of $3 per share to the Master Planned Community Business, the implied cap rate is reduced by 30 bps only. The deal failed to materialize.

Based on the press releases, GGP is pursuing a dual track process: soliciting offers for the whole company and attempting to emerge from bankruptcy as a standalone company through a large capital raise to de-lever and have the capital to payback the unsecured creditors. This may cause large dilution to shareholders, but it’s a less likely process, as the Company will look for potential bidders first. The sales process is expected to get underway in early March. The press release also indicated that they held discussion with “other interested parties” in coming to the conclusion to not preempt a full process with multiple bidders. Brookfield Asset Management (BAM) is likely Simon’s biggest competitor in a bid, though Simon still has the upper hand given their ability to drive greater synergies. Other interested parties are Westfield and Vornado.

Here is Simon’s offer made on Feb 16:

Dear Glenn and Adam:

We are prepared to acquire General Growth Properties, Inc. (“GGP”) in an all-cash transaction which will result in a favorable outcome for all of GGP’s creditors and shareholders, and a prompt conclusion to GGP’s reorganization proceedings. This letter is intended to provide you with the specifics of our proposal which are outlined below.

Consideration. Simon Property Group, L.P. (“Simon”) would provide a full cash recovery (par plus accrued interest and dividends) to GGP’s unsecured creditors, the holders of its trust preferred securities, the lenders under the GGP credit facility, and the holders of Exchangeable Senior Notes. Simon would also pay the holders of GGP common stock $6.00 per share in cash, and distribute to them all of GGP’s ownership interests in the MPC assets. We are willing to discuss consideration consisting (in whole or in part) of Simon common equity in lieu of the cash portion of the consideration to GGP’s stockholders, and perhaps certain of its unsecured creditors, for those who would prefer to participate in the upside associated with owning Simon stock.

We believe the current trading value of GGP’s common already includes a takeover premium, and given its high percentage of insider ownership and the fact that the stock trades in an over-the-counter securities market, reflects a price that cannot be realized in a stand alone reorganization. Any reorganization has a highly uncertain outcome which can be achieved only after an extended period of time, while incurring considerable additional expense, and may result in significant dilution of the current equity holders to the extent creditor claims are satisfied through the issuance of additional equity and/or GGP is recapitalized with proceeds from the issuance of new equity.

No Financing Contingency. We have, or have access to, all of the financial resources required to consummate this transaction, and the transaction would not be subject to any financing contingency or condition.

Due Diligence. The terms described above are based on publicly available information and subject to confirmatory due diligence. We and our team of advisors have thoroughly analyzed GGP, its assets and the ongoing bankruptcy proceedings, based upon publicly available information, and we are prepared to proceed immediately to undertake and complete confirmatory due diligence and to enter into and consummate this transaction as promptly as possible. Simon has an unmatched track record of completing large and successful acquisitions, and we are prepared to commit the resources necessary to address all issues and finalize a mutually beneficial transaction between our two companies.

We are convinced that a transaction with Simon is superior to any proposal you may be contemplating. We trust that when considering our proposal, you will take into account the many benefits of having GGP’s equity holders receive full and fair compensation for their interest versus the uncertain value in any other scenario. The fact that the proposal is all cash and pays unsecured creditors in full will bring certainty to the reorganization process and accelerate its completion which will have the added benefit of eliminating GGP’s significant bankruptcy related expenses.

Our proposal is not open-ended, particularly given the uncertain economic environment that exists today. We look forward to hearing from you soon and working together to consummate a transaction.

Very truly yours,

David Simon

And here is the response from GGP management:

Dear David:

 
Thank you for your letters dated February 8 and 16, 2010 in which you indicated Simon’s interest in acquiring General Growth Properties, Inc. (the “Company”). We appreciate that you took the time to meet in person with management, UBS and Miller Buckfire to explain your indication of interest, as well as provide your view on the timing and diligence process you require in order to convert your indication of interest into a fully documented definitive proposal. We have been discussing your letter with your financial advisors during this past week. Our advisors have also discussed our position with you as recently as yesterday. We and our board of directors have given considerable thought to your indication of interest and have concluded based on discussions with other interested parties that it is not sufficient to preempt the process we are undertaking to explore all avenues to emerge from Chapter 11 and maximize value for all the Company’s stakeholders.

As we indicated during our meeting, we are about to commence a process to explore several potential options for the Company’s emergence from Chapter 11, including a sale of the entire Company as you have proposed as well as a capital raise. The Company and its advisors have been working over the past several months to prepare the Company to launch this process. We will be providing detailed information on the Company, including a confidential information memorandum, financial projections, and asset level information to participants. We will also provide access to an electronic data room. As we are committed to fully exploring all potential options available to the Company, we would like to include Simon as part of this process. We believe the information we would provide to you as part of this process will enable you to better understand the Company, get to a higher valuation, and provide a fully documented offer.

We understand from our meeting with you and the press release you issued this morning that time is of the essence. We feel the same, and intend to run our process in an efficient and expeditious manner. We are currently finalizing the information memorandum and plan to send materials to participants in the process by the beginning of March. We would expect to receive indications of interest within 4 weeks of the launch of the process. In order to expedite your participation and evaluation of due diligence information, we will be sending to you shortly a markup of the NDA you provided to us during our meeting in Chicago.

Again, we appreciate your interest and we recognize the potential value that Simon could bring as an option for the Company to emerge from Chapter 11. The Company intends to pursue the process described above and we look forward to your participation. However, we reserve the right to pursue any proposals that we receive prior to or after formally launching the process so that we can maximize value for all stakeholders of the Company, and we reserve the right to change the process at any time we determine appropriate and without notice.

We would be happy to discuss this response further. To that end, you should feel free to contact either UBS or Miller Buckfire.

Sincerely,
Adam Metz

AOL reported on February 3^rd its 4Q results for the first time as an independent entity. The report provided few positives but the overall picture remained extremely weak.

Positive notes Domestic display, which accounts for 30% of total revenue, grew 1% Y o Y and 25% Q o Q, indicating that AOL is participating in the cyclical recovery of online advertising.  

The balance sheet remains strong with 147 mm in cash on hand and 130 mm of FCF generated in the quarter. The stock currently trades around 3x 2010 EV/EBITDA based on an estimated EV of 2,468 mm and EBITDA of 823 mm for 2010.

Several negative notes Advertising revenue declined 8% Y o Y, impacted primarily by weaknesses in the international market, where display revenue decreased 22% Y o Y. AOL called for an accelerated decline and possible closing of its international properties in the recent future if the negative trend continues. Domestic AOL subscribers declined 27% Y o Y, affecting subscription revenue significantly. Overall, revenue declined 17% Y o Y, although this was “less worse” than the 23% experienced from Q1 to Q3, it remained very weak as expected.

It’s important to add that the management team is fairly new and unproved at AOL. At least four top level employees, including the CEO, have joined the firm less than a year ago (Tim Armstrong, Jeff Levick, Brad Garlinghouse and Jon Brod). They certainly bring a fresh prospective to the Company, but it will take some time before they will be able to make a turnaround at the firm. However, there is no guarantee that a turnaround can or will happen anytime in the future.

AOL outlook The Company remains on my watch list for the “stocks to short” for 2010. I guess the question that I would like to ask AOL management would be “What are you planning to do with cash on hand and how do you plan to capitalize on your strong balance sheet position?” AOL has certainly a lot of cash and could potentially use some more leverage to finance new projects like the acquisition of content sites or the purchase of new technologies to build platforms. As of now, I don’t see any initiative from the management team into that direction. Let’s wait and see.

New “TARP Tax” on Banks The Administration has proposed a “Financial Responsibility Fee” that would be levied on banks and other financial institutions with assets exceeding 50 billion. The goal would be to recover the losses and costs associated with the TARP program.

Fee to be based on liabilities The fee would be 15 bps based on the “covered liabilities”, which are assets minus Tier 1 capital, FDIC-insured deposits and insurance liabilities covered by state regulated funds. The logic is that Tier 2 and Tier 3 liabilities serve as a proxy for risk trading activity and that firms engaged in such activities should bear additional costs.

Support The proposal will strike a positive tone from a populist perspective and be politically popular. The Democratic leadership in the House has indicated support for the proposal and it’s too early to speculate where the Senate might stand.

In details The fee would go into effect on June 30 2010 and would last for 10 years. The fee collected would contribute to the overall reduction of the budget deficit. I believe that is the bottom line, the Administration will need to decrease the horrifying budget deficit by increasing taxes to someone, and financial institutions look like the perfect candidate.

Flaws and uncertainties About 50 institutions could be subject to the new tax, including US subsidiaries of foreign firms. The Administration has not yet decided if off-balance sheet liabilities would be eligible to be taxed. So here is what needs to be clarified: If the tax is on only domestic liabilities, then a financial institution could avoid the tax by allocating the liabilities to its foreign subsidiaries or to a foreign SPV (Special Purpose Vehicle).  An SPV is an off-balance-sheet liability that is usually created by the parent company for the purpose of selling asset backed securities and securitization purposes. If the tax is on consolidated liabilities, then the Administration has no authority to tax the consolidated liabilities of foreign institutions operating within the US, which means that foreign institutions can avoid the tax while their US competitors cannot. 

The reality While the behavior of many major financial institutions or their leaders was unjustifiable, the proposed tax is both designed incorrectly, irrelevant and it makes little economic sense.  Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that are exempted from the tax. There is no justification from the taxpayers’ perspective of excluding them from responsibilities for losses, as well. I guess it would make little sense for the Administration to tax itself. Finally, it should be noted that government support to financial institutions extends far beyond just the TARP. Subsidies have come in the form of access to low-cost funds, through borrowing at subsidized rates utilizing Federal Reserve special programs, from merger assistance, from FDIC deposit and debt guarantees, and from the implicit subsidy inherent in too-big-to fail.

Recent turmoil In the past few weeks, there have been a number of reports from different individuals trying to value GGP and unfold how much equity will be created through reorganization. There are a lot of uncertainties over how much GGP is worth and we might see a valuation battle between the creditors and the owners. It’s clear that the Committees representing each side have different views: the Unsecured Creditors will want a lower valuation so they can have a higher equity stake and the shareholders will want a higher valuation so they can retain a higher residual stake.

For those who have not been following the GGP bankruptcy story, I will offer a brief synopsis:

• As of January 25, the restructuring of 74 secured mortgage loans aggregating approximately 9.4 billion has been completed. As a result, 180 GGP subsidiary debtors owning 96 properties are no longer in bankruptcy.
• The restructuring of the remaining 16 loans aggregating approximately 2.1 billion was approved by the Bankruptcy Court in December 2009 and January 2010 and is expected to be completed in the next few weeks.
• GGP has recently engaged UBS Investment Bank to assist the Company with exit strategies and Miller Buckfire & Co., LLC as a financial advisor and investment banker.

Now it all boils down to a restructuring plan for the remaining 2,590 mm in Bank Debt and 4,000 mm in Unsecured Debt. Valuation is rarely litigated in court; usually the Creditors and Equity Committee will submit a plan of reorganization which implies a valuation of the Debtor they both agreed upon. But in the case of GGP, there might be large discrepancies between Creditors and Owner, and we might see a valuation battle between the two. The Company is contractually obligated to de-lever its balance sheet based on the loan extension agreements with the Secured Mortgage Loans. Also, the fact that all the 6,590 mm remaining liabilities could be potentially reinstated at par and still have substantial equity left, it doesn’t mean that the Bankruptcy Court will allow it, as the Judge has to make sure that the Debtor will be able to survive as a going concern through another financial downturn.

Key ingredients Let’s look at some key elements that will play a pivotal role in the valuation process:

Ownership: There is a strong bias towards generating a high equity value. The Company is held by insiders, the Bucksbaum family has a 25% ownership and William Ackman, which is Director and a member of the Board, has a 20% ownership.

Equity Committee: An honorable member is Luis A. Bucksbaum, ex-CEO of the Company, which will push for a high valuation, given the large equity interest by his family.

UBS compensation: The Investment Bank charges several fees, but the discretionary fee that caught my attention. There is a completion fee comprised of the greater of 17,500 mm and 0.33% on any amount by which the equity recovery exceeds 1,000 mm. UBS will be indifferent between the two if the residual equity is 5,300 mm or 16.6 dollars a share. This is an incentive for UBS to maximize shareholders’ value.

A Valuation Expert: If the creditors and owner cannot agree on a valuation, the Court will consider the opinion of a third party independent and credible expert. This could be good news for GGP as the positive report from William Ackman, which value the Debtor between 42 and 24 dollars a share, is highly valued and recognized by other institutions and Hedge Funds.

Hovde Capital: The Hedge Fund that highly criticized Pershing Square Capital valuation and rates the Company at 5 dollars a share will have no weight in Court. The Hedge Fund is not a member of any committee, doesn’t own any equity or debt and it’s not a valuation expert.

De-leveraging How will de-leveraging be achieved? Two of the Rouse Bonds were due in 2009, and the Company will probably repay them at par plus post petition accrued interest. The 1,990 mm Term Loan under the 2006 Credit Facility will be refinanced with an Exit Facility and the 590 mm Revolver will be repaid in full. Eurohypo AG is the only creditor under the 2006 Facility and it’s a member of the Creditor Committee. How will the Debtor come up with the cash to pay off the bonds and Revolver ? With proceeds from equity issuance. If the three remaining Rouse bonds and the GGP LP notes, amounting to 1,650 mm and 1,550 mm respectively, are converted into new common, leverage will significantly decrease and equity will increase by 3,200 mm. That would mean that shareholders will face substantial dilution, probably around 40%. Let’s assume that the residual equity is valued at 5,000 mm, an addition 3,200 mm in equity will mean a 39% dilution for shareholders.

This is an overview of the restructuring businesses discussed on the Blog, to update investors on recent developments. I would be glad to give my feedback, or receive yours, on the on any bankruptcy proceedings discussed here.

CIT Group – It emerged from Bankruptcy on December 10 and it’s now trading under “CIT” on the NYSE. As you remember, the Company cancelled the old equity and issued 200 mm of new common shares. The implementation of the Company’s strategy unfolds around CIT Banks; the subsidiary will be the focal point for the origination of middle market loans, bank deposits and other businesses like Vendor Finance (which provides leasing solutions) and Trade Finance (factoring and ABS). That is currently on hold; waiting regulatory approval from the FDIC. On July 2009, the FDIC imposed a “Cease and Desist Order” on CIT Bank, which prevents the subsidiary to grow deposits given the weakness of the institution at the time.

CIT_New_Business_Model

General Growth Properties – The Debtor is expecting to emerge from bankruptcy by the end of June 2010. There are still 3,000 mm in Secured Mortgage debt that need to be reorganized before a plan of reorganization for the Unsecured (Rouse Bonds, GGP LP Notes and TRUPS) and Secured Notes (2008 Credit Facility, 2006 Term Loan and Revolving Credit Facility) is implemented. Most likely maturities for the remaining Mortgage Debt will be postpones at higher rates and a debt-to-equity conversion will be implemented for all or part of the Unsecured Notes. Worth noting is the dividend of 0.19 dollars a share that the Bankruptcy Court authorized the Debtor to pay to common shareholders in order to maintain the REIT tax status and avoid tax penalties.

Chemtura Corp – The December MOR (Monthly Operating Report) reported EBITDA of 54 mm, which brings the 2009 EBITDA to 251 mm, well above my expectations of 220 mm. We might be able to see some equity value up to 2 dollars a share even before a POR is unfolded. The Equity Committee was appointed on December 29 and I am under the impression that the current shares will continue to trade post bankruptcy and reinstated on the NYSE, but shareholders will experience dilution (probably around 50%) due to debt-to-equity conversion and/or new offering. Read my last post on Chemtura Corp for more details on that.

Idearc Corp – The Restructuring process was completed on January 4 and the business emerged under the name of Supermedia Inc which symbolizes a new line of business that the Company launched.  The pre-emergence common stock of Idearc Inc. (which has traded under the symbol “IDARQ.PK “) was cancelled effective December 31, 2009 and the Company now trades on the NASDAQ under “SPMD”. The new name symbolizes the continuity of the old business and the implementation of new products. More details on the different business segments are highlighted in the presentation attached.

SuperMedia_New_Business_Model

Accuride Corp – A third amendment to the Plan of Reorganization was filed with the Bankruptcy Court on December 21. The last date to vote on the Plan is January 29 and the confirmation hearing is scheduled for February 10 2010. The Equity Committee has urged shareholders to strongly reject the plan, arguing that a 2% share of the reorganized Company (which will become 0.6% after dilution) is far too little. The Committee plans to object the Plan at the Confirmation Hearing, and might be able to get away with more, maybe 5% of the reorganized equity. The Committee is not wrong, given the fact that creditors are expected to get no more that 100% recovery plus accrued interest through bankruptcy, but because the proposed Plan offers a significant equity interest to creditors, the upside will be more that 100%. Look at my previous post on Accuride Corp on December 9 for more details about the POR and dilution.

Chemtura Corp is expected to come up with a plan of reorganization in the next three months and emerge from bankruptcy by the middle of 2010. I am proposing a potential plan of reorganization that sees part of the Unsecured Notes reinstated and a 550 mm Exit Facility. In my previous post, I highlighted how the Company needed to generate 2010 EBITDA>270 mm to have equity value. Now, I recognize that the 4.5x multiple used was probably too conservative, therefore with a multiple of 6.00x and with a lower 2010 EBITDA forecast, there can be some equity value.

2009 Developments

Term of the DIP Loan – 250 mm Term Loan, 64 mm Revolving Credit and 86 mm Revolver that will be converted in a Term Loan once the Company exits bankruptcy

DIP Fees – Around 10.5% for the 250 mm Term Loan and 64 mm Revolver; around 6.5% for the 86 mm Revolver. There is a 1.5% unused fee for the unused portion of the Revolving Credit average balance, a 2% exit fee on the 86 mm payable to the lenders and 3% exit fee on all other commitments. The DIP Loan matures in March 18 2010

DIP Term Balance – 165 mm of the Term Loan was used in March to fully terminate the US Receivable Facility and to fund working capital. The remaining 85 mm of the Term Loan was used in April to fund certain outstanding amounts owed to Secured Creditors under the amended 2007 Credit Facility.

Assumptions

Emergence from BK – Before the end of 2010, probably around the 3Q of 2010

PVC additive business – The transaction will generate 45 mm in cash, capital expenditures will be reduced by 18% or 13 mm, which is the percentage of PVC sales to the total segment sales, and EBITDA will be reduced by 10% or 21 mm, which is a percentage of the PVC sales to total sales.

Capital expenditures – The Debtor will incur 45 mm in capital expenditures in 2009 and 2010, which includes a reduction due to the PVC additive business sale. The 8K on February 29 indicated that the company wanted to keep cap ex below 60 mm for 2009.

Working Capital – The Debtor will generate 20 mm in cash from reduction of working capital in 2009 and 30 mm in 2010 due to continuing effort to reduce inventories and account receivables. In 2011 and 2012 working capital requirement will be 20 mm and 40 mm

Potential Plan of Reorganization

Exit Facility – A 550 mm Term Loan with 50 mm amortization schedule each year. The loan will be fully amortized in 11 years.

DIP Loan –The 250 mm Term Loan will be repaid with proceeds from the Exit Facility, cash on hands and cash generated from operations. The 86 mm Revolver will become available as a new line of credit

Credit Facility – The 151 mm balance of the 2007 Credit Facility will be repaid in full using proceeds from the Exit Facility, cash on hands and cash generated from operations.

370 mm Senior Unsecured due 2009 – The Debtor will repurchase them at par plus accrued interest using proceeds from the Exit Facility, cash on hands and cash generated from operations.

500 mm Senior Unsecured due 2016 – The Notes will be reinstated and accrued interest will be paid.

150 mm Debentures due 2026 – The Notes will be converted into a 1.50% coupon mandatory Convertible Note. I assume that 80 mm will be converted in 2011 and the remaining 70 mm in 2012

Capitalization Upon emergence, the Debtor will have a 1,200 mm in debt comprised of a 550 mm Exit Term Loan Facility with an amortization schedule, an 85 mm unused Revolver balance, 500 mm in Unsecured Debt and 150 mm Convertible Note. The latter will be converted into equity by the end of 2012, bringing the debt level down to 950 mm. The end cash level in 2010 will be 116 mm; debt/EBITDA will be 5.4 and 3.2 in 2010 and 2012 respectively. Financial covenants under the Exit Facility should contain a minimum EBITDA of 190 mm per year and a minimum cash balance of 80 mm each month. Now, I am under the impression that the 2016 and 2026 Notes can be reinstated, given the fact that default on these notes was triggered only by cross-default provision included in the indenture governing them, and not by breach of their financial covenants. In order words, the default on the 2016 and 2026 Notes was the result of non-compliance with the covenants under more Senior debt, the Amended Credit Facility. It was likely that the Company couldn’t repay or refinance the 370 mm 2009 Notes due in July; therefore I anticipate that they will be repurchased at par plus accrued interest. Under this scenario I see little equity value in 2010, but can potentially appreciate to 4 dollars a share within one or two years after emergence. I am also attaching a link to an interesting article that I found on another Blog regarding reinstating the Chemtura’s Unsecured debt. Enjoy and I would greatly appreciate your feedback.

http://chemturaresearch.blogspot.com/2010/01/could-chemtura-reinstate-certain-debt.html

What is a spin-off? The parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary, thereby creating a separate legal entity with its own management team and board of directors. The distribution is conducted pro-rata, such that each existing shareholder receives stock of the subsidiary in proportion to the amount of parent company stock already held. No cash changes hands, and the shareholders of the original parent company become the shareholders of the newly spun company (SpinCo).

Reasons for a spin-off Divesting a subsidiary can achieve a variety of strategic objectives, such as:

• Separate an unrelated business For example, a diversified company may have a fast growing software or Internet business that is largely ignored or not valued by the market because it is a small part of a large company. The fast growing division would likely garner a richer valuation as a stand-alone entity.
• Eliminating dissynergies Divest non-core businesses, reduce bureaucracy and give SpinCo management complete autonomy
• Unlocking hidden value Establish a public market valuation for undervalued assets and create a pure-play entity that is transparent and easier to value.
• Public currency Create a public currency for acquisitions and stock-based compensation programs
• Motivating management Improve performance by better aligning management incentives with SpinCo’s performance (using SpinCo, rather than ParentCo, stock-based awards), creating direct accountability to public shareholders, and increasing transparency into management performance
• Anti-trust Break up a business in response to anti-trust concerns
• Corporate defense Divest “crown jewel” assets to make a hostile takeover of ParentCo less attractive

Accounting for spin-offs The parent accounts for the disposition of its subsidiary in a single line item on its balance sheet called “Net Assets of Discontinued Operations”, or similar. The parent also segregates the net income attributable to the subsidiary on its income statement in an account called “Income from Discontinued Operations”, or similar.

Structure of a spin-off The parent company will often extract value from the subsidiary before spinning it off by levering up SpinCo and siphoning the cash proceeds as a special tax-free or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo’s inside basis in the subsidiary’s assets. If either exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debt ParentCo can push down to SpinCo is also limited by SpinCo’s ability to service the debt.

Let’s look at an example where a Company sought protection under the Bankruptcy code after a spin off: Verizon’s spin-off of Idearc, which I have talked about not long ago. The following is excerpted from Idearc 8-K filing detailing its spin-off from Verizon, and outlines how the spin off deal was structured

“On November 17, 2006, Verizon Communications Inc. (“Verizon”) spun off the companies that comprised its domestic print and Internet yellow pages directories publishing operations. In connection with the spin-off, Verizon transferred to Idearc Inc. (“Idearc”) all of its ownership interest in Idearc Information Services LLC and other assets, liabilities, businesses and employees primarily related to Verizon’s domestic print and Internet yellow pages directories publishing operations (the “Contribution”). The spin-off was completed by making a pro rata distribution to Verizon’s shareholders of all of the outstanding shares of common stock of Idearc.

In connection with the spin-off, on November 17, 2006, and in consideration for the Contribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issued to Verizon $2.85 billion aggregate principal amount of Idearc’s 8% senior notes due 2016 and $4.3 billion aggregate principal amount of loans under Idearc’s tranche B term loan facility (collectively, the “Idearc Debt Obligations”) and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc’s tranche A term loan facility and from the proceeds of the remaining portion of the loans under Idearc’s tranche B term loan facility.”

Often spinoffs are required to incur heavy debt loads, and FCFE can easily be eroded by high interest payment if growth prospects aren’t met, which makes the SpinCo a candidate for a short position.

Fraudulent Conveyance When SpinCo incurs a loan and distributes the proceeds to the ParentCo, as described above, creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy because it is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCo insolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are adequately capitalized following the spin-off.

Capital Markets implications The separate business entities created in a spin-off sometimes differ in many ways from the consolidated company, and may no longer be suitable investments for some original shareholders. Institutional investors committed to specific investment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictions may need to realign their holdings with their investment objectives following a spin-off by one of their portfolio companies. For example, index funds would be forced to indiscriminately sell SpinCo stock if SpinCo is not included in the particular index. Also, the lack of a dividend may push income-oriented investors out of the spun off stock.

So why invest in spin-offs? Companies that have been spun off usually trade at a significant premium or discount compared to their peers. The spin off world is littered with many dogs and horses. Also there is often an absence of adequate financial information when the SpinCo commence trading as a standalone entity and the stock it’s mispriced. This a good reason for coverage on the Blog because a well written valuation can take you a long way.

AOL Spin-off On December 10 2009, AOL started to operate as a standalone entity and began trading on NYSE under the ticker “AOL”.  The Company has been spun off from Time Warner, which AOL acquired for 164 billion a decade ago. I am not going to go over the reason of the separation, but it became evident how AOL has been losing market share since the consolidation with Time Warner in 2000.

Investment thesis It’s hard to see any potential price appreciation, given the continuing deteriorating fundamentals. The stock can trade lower on a series of catalysts: additional goodwill impairments, higher than expected deterioration in subscription and/or advertising revenue and a rise in price without any fundamental change. I will keep it under the “stocks to short” list for 2010.

Shift in Business Given the declining revenue base and negative EBITDA growth experienced in the last 5 years, mainly attributable to a steep decline in subscription based revenue, the Company decided in 2006 to shift its core operation from subscription to advertising. However, results have not been great as competition from other popular sites like Google and Yahoo and/or social networking sites like Facebook and Twitter has been very intense. AOL’s new business focuses on five core business segments:  

• Web content; create and publish new original web content through its various site categories.
• Local and Mapping; provide local content, platforms and services covering geographic levels ranging from neighborhoods to major metropolitan areas like MapQuest,  Local Entertainment Guides, Local Directories and Local Events.
• Communications; email and instant messaging products and services like AOL Mail, ICQ and AIM.
• Online Search; offered through AOL Search and AOL Media, currently outsourced to Google.
• AOL Ventures; the investment/acquisition arm of AOL

Valuation I expect advertising revenue to decline 5% in 2009 and continue to decrease at a 5% rate every year after. Subscription based revenue will be 1,350 mm in 2009 and continue to decline at a 30% rate each year after. EBITDA margin will be 30% in 2009 and shrink 1% each year after, as a result of the continuation of the historical trend that saw operating revenue decline more than COGS and operating expenses. The Company is expecting to receive 250 mm Credit Facility with a maximum consolidated leverage ratio (total debt to EBITDA) not greater than 1.5 to 1.0 and a minimum consolidated interest coverage ratio (EBITDA to consolidated cash interest expense) of at least 4.0 to 1.0. Under the financial covenants, the Company can use up to 100 mm a year for acquisitions. Other than that, AOL has almost no debt; total fixed obligations due before the end of 2014 total 622 mm and are comprised of property and other operating leases. Liquidity doesn’t seem to be an issue; FCF will be the positive but decline in the coming years due to deteriorating fundaments. Given 823 mm of EBITDA in 2010, the Company currently trades at 3x 2010 EV/EBITDA, a discount compared to the average 2010 EV/EBITDA multiple for the top Internet Advertising Companies (7.9x) and Media Companies (7.3x). Cash generated from working capital in 2009 was mainly driven by changes in accrued compensation as the Company decided not to pay annual bonuses to employees related to 2008 performance.

Catalysts for a short sale An advance in price to 30 dollars per share or higher due to overall market appreciation without any change in fundamentals is the signal for a potential short opportunity.

If the Company deems that 50% of the fair value of goodwill is lower than then its carrying value, therefore impaired, the share price should drop by 10 dollars. In accordance with FAS 142, goodwill is tested for impairment at least annually. The fair value of the reporting unit is calculated using a DCF approach and a market approach. For the 2008 goodwill impairment analysis, the Company increased the discount rates utilized in the DCF analysis to a range of 13% to 15% from 12% in 2007, while the terminal growth rates for the advertising revenues were decreased to a range of 2.5% to 3% from 4.5% in 2007. What does this mean? Higher discount rates and lower growth rates produce a lower current value. There is a good chance of further adjustment in growth rates and/or discount rates, therefore potential impairments charges, if subscription based and/or advertising revenue deteriorates further from current levels. As of September 30 2009, 50% of the total asset or 2,175 mm is comprised of goodwill.

Conclusion I am keeping AOL under my list of stocks to short as it faces many challenges: The market place where it operates is highly competitive especially from Companies like Google, Yahoo, Microsoft, Facebook and Twitter and fundamentals are deteriorating quickly, increasing the chance of further impairments. The shift is strategy implemented in 2006 is towards the right direction but the company doesn’t seem to do enough to win market shares, mostly due to negative user experience built during the past years poor search results and lack of innovation.