NOT AN ANALYST

Company Overview Chemtura Corp is a manufacturer and marketer of specialty chemical products, most of which sold to industrial manufacturing customers for use as additives, ingredients or intermediates that add value to their end products. The Company operates on a global scale with 52% of last year sales coming from outside the United States.

Path to Bankruptcy In the 4Q of 2008, Chemtura experienced an unprecedented reduction in orders as the global recession deepened. Liquidity also deteriorated as the availability of financing under the European Receivable Facility decreased significantly due to the Company’s weak financial performance and it was eventually terminated in the 2Q of 2009. On January 2009, the US Facility was formed for the purpose of selling receivables and restoring most of the liquidity that was available in the previous quarter. However, sales and the overall financial performance deteriorated further in the first part of 2009, resulting in the company’s inability to be in compliance with two maintenance covenants under its Amended and Restated 2007 Credit Facility. On December 2008, the Company obtained a 90-day waiver of compliance with the covenants from the lenders under the 2007 Credit Facility. When Chemtura realized that it wasn’t able to refinance its 370 mm notes due in July 15, it filed for bankruptcy on March 18 2009. Foreign subsidiaries and certain US subsidiaries were not included in the filings. The Company is expected to file a plan of reorganization by February 15 2010, after the court already granted two extensions.

Capital Structure As of petition date, there are 1,020 mm of unsecured debt and 199 mm of secured debt, for a total of 1,229 mm.

Advances under the 2007 Credit Facility were originally set to 300 mm, but after it was amended on December 30 2008, the maximum allowed was reduced to 190 mm. The 2009 Notes (GLK.GA) are obligations of Great Lakes Chemical Corp, a wholly owned subsidiary of Chemtura Corp. The 2016 Notes (HTRA.GA) are obligations of certain domestic subsidiaries of Chemtura Corp, but may be released from their subsidiary guarantees under certain circumstances (exhibit 10.1 10Q filing on May 10 2006). The 2026 Debentures (CK.GE) are obligations of Chemtura Corp, the parent company, and therefore junior compared to the other notes.  The 2009 US Facility was terminated on March 23 as a condition of the debtor entering into 400 mm DIP Lending Agreement.  All receivables were sold back to the Company by purchasers for the amount of 117 mm. The CFO for 2009 already contains that charge.

Valuation For the nine months ending in September 30, the Company accumulated 169 mm in EBITDA and it will earn approximately 210 mm for the entire year. During Chemtura’s peak cycle 2005-2007, EBITDA ranged from 350 mm to 400 mm, which is not possible in this environment as demand remains weak, therefore I expect EBITDA for 2010 to be 210 mm on the conservative side, and 20% higher to 250 mm on the aggressive side. EV is calculated with a 4.5 multiple, which is conservative considering that the company never traded around these levels, but rivals like DOW and DD, traded around 5.2 and 6.2 during their peak cycles in 2005-2007. For the nine months ending in September 2009, CFO was 26 mm and it will be approximately 50 mm for the year with 60 mm in capex. For 2010, I expect the company to generate 60 mm in CFO with 90 mm in capex. Historically, capex has been around 110 mm a year with a CFO of 150 mm in 2007 and 250 mm in 2006. Keep in mind that results before 2005 are not directly comparable to more recent results due to the inclusion of operating results of Great Lakes, subsequent to the merger on July 2005.

Recovery Analysis Unsecured debt holders, excluding the 2026 Debentures, are getting 100 cents on the dollar if EV is higher then 1,035 mm in 2010. In fact, the 2009 and 2016 Notes are now trading around 107 cents on the dollar and 2026 Debentures are trading around 78 cents on the dollar, which implies that investors are expecting an EV on the high end of my valuation, around 245-250 mm. There seems to be no equity value left after restructuring at this moment, but if the company earns more then 210 mm in EBITDA for 2009 and expects to earn mote then 270 mm in EBITDA for 2010, I would be a buyer of the 2026 Debentures and the equity as well, which is now trading at 70 cents under CEMJQ.

General Growth Properties Overview General Growth Property’s primary business is the ownership and management of over 200 malls and shopping centers. Operations are divided in two segments: retail, the primary source of income, which includes management of shopping centers, and Master Planned Communication, which includes the development and sale of land.

GGP Structure GGP Group is organized as a REIT and is the general partner of GGP Limited Partnership (GGP LP) which is the entity through which operations are conducted. In turn, GGP LP owns and control GGP LP LLC, The Rouse Company LP and General Growth Management Inc (GGMI) which is excluded from the filing.

GGP Bankruptcy  The Company wasn’t able to refinance its mortgage debt in the second half of 2008 because credit markets were locked and sought protection under Chapter 11 on April 2009 to restructure its debt. Pershing Square provided 375 mm DIP financing at LIBOR + 12% for 18 months from filing date. GGP has until April 2010 to submit a reorganization plan but it has an extension until October 2010. What’s very interesting about GGP is that the NOI has been rising over time, which means that malls and shopping centers are generating significant profits despite challenges in the CRE market and Bankruptcy. I am under the impression that GGP still has a lot of value and if the Company can defer maturities and reduce its debt levels, it’s going to be in good shape again as operating performance has been strong. As of December 31 2008, there are 24,850 mm of consolidated par debt outstanding, which includes 18,270 mm of secured debt and 6,580 mm of unsecured debt. Total liabilities account to 27,300 mm and total assets are 29,600 mm. Net Operating performance (NOI) for 2008 was reported at 2,590mm a 4.5% increase from the previous year. In the next few weeks I am going to post a more detailed analysis on the bankruptcy and I will try to unlock the Company’s equity value, which I think it’s substantial.

Recent News There has been a couple of significant articles lately and the stock started to soar. The Company announced on November 19 that it reached an agreement with lenders to postpone loan maturities  and it expects to emerge from bankruptcy by the end of the calendar year. Also there are rumors that Simon Properties Group might put some capital into the company.

CIT Group Bankruptcy Overview On Nov 02, CIT Group and CIT Group Funding Company of Delaware LLC filed for chapter 11 Bankruptcy protection under the pre-packaged plan of reorganization. The conditions for the debt exchange offer were not met. CIT Bank was not part of the filing and will continue to operate regularly. Court proceedings should not take long and CIT Group is expected to emerge from bankruptcy by the end of the year or early next year. The firm is now trading under CITGQ.PK. I am skeptical about CIT Group’s ability to return to profitability even if the company is reducing its debt level and postponing maturities, since leverage remains elevated. In 2006, the company’s leverage was 12x operating earnings (EBITDA), in 2007 and 2008 it was 15x. Assuming operating earnings remain constant post re-org in 2010 at 4,260 mm; the company will be leveraged 9x, which it is still a high number.  The credit rating that will be assigned after the company emerges from bankruptcy and the evolving of ongoing regulatory issues, the “cease and desist order” imposed by FDIC on CIT Bank, will be a key factor for the firm’s capacity to raise short term funds.

CIT Preferred Class Z While I was looking up and down the capital structure, I found out that a mandatory convertible preferred stock, CITEQ which was formally CIT-PZ, trades around $16, surprising for a preferred stock. The interesting part is that the security is actually benefiting from bankruptcy filing. Let’s take a closer look at it.

Corporate Units On October 17 2007, CIT Group issued 24,000 m of mandatory convertible preferred shares called “Corporate Units”. Each unit represents a 1/40 or 2.5% ownership interest in $1,000 principal amount senior note maturing on November 15, 2015 issued by CIT Group and is composed of a purchase contract which obligates the holder to purchase, no later than November 17, 2010, for a price of $25 in cash, a certain number of common shares.

Treasury Units Holders of a Corporate Units have the right to substitute, anytime before November 1^st 2010 in integral multiples of 40, for Treasury Units which consist of an ownership interest in a $1,000 principal zero-coupon U.S. Treasury security (CUSIP No. 912820MJ3) maturing November 15, 2010. Each Treasury Unit is composed of a purchase contract which obligates you to purchase common shares under the same terms of a Corporate Unit Holder. More specifically, when the treasury security matures on Nov 15 2010, the proceeds are used to purchase common shares on Nov 17 2010.  

Bankruptcy Clause The offering states that in the event of Bankruptcy, the obligation under the purchase agreement is terminated. You are no longer obligated to purchase common shares on Nov 17 2010, which could cause a huge loss at the current price, and can no longer create Treasury Units from Corporate Units either, because that was contingent to satisfying your obligation under the purchase contract.

Conclusion CIT-PZ is trading at $16, slightly below what holders are expected to receive from Bankruptcy, which is 70 cents on the dollar plus some unspecified equity interest like. If you are looking to buy senior unsecured bonds and participate in the restructuring, you should buy CIT-PZ because it has the same recovery rate as a Class 9 Senior Unsecured bond but it offers higher liquidity and better price.

Related posts on this Blog:

CIT Debt Exchange Set to Fail

Introduction A leveraged ETF is designed to replicate X times the daily investment return of an index or asset class before fees and expenses. A swap based leveraged ETF is a leveraged ETF that utilizes swaps transactions to reproduce the desired leveraged return. Due to the basic nature of these funds, increasing fees and risks, swap based leveraged ETFs are going to experience a significantly fall in value. Let’s take a closer look.

How it works In a leveraged ETF swap transaction, the fund enters in an agreement with a counterparty where the latter delivers the performance of the index to the fund and the fund delivers the performance of a basket of securities it holds which can be completely unrelated to the index it’s tracking. Prospectuses from Proshares and Direxion indicate the use of swaps to replicate the desired return and alert investors about several risks (counterparty, credit) involved but there are other factors to consider.

Counterparties The names and credit rating of the counterparties it’s not disclosed. If a counterparty defaults on the swap, the fund NAV will be significantly reduced regardless of the performance of the index.

Collateral The liquidity and quality of the collateral or the basket of securities used to back the ETF in the swap transaction have to be considered. Direxion and Proshares disclose the holding of each ETF daily but it is unknown which securities are used as collateral.

Fund Manager The name of the fund manager for ProShare Funds (Proshare Advisor) and for Direxion Funds (Rafferty Asset Management LLC) is disclosed but the fund manager track record, its ability to monitor counterparty exposure and performing fiduciary duties are unknown.

Fees Transaction fees are a fixed cost. The desired leveraged return is replicated before fees and expenses, therefore higher fees will significantly impact performance. Counterparties will start charging higher fees to enter in a swap transaction with ETF issuers due to increasing credit risk. In June, FINRA issued a regulatory notice alerting brokerage firms that suitability and sales material have to be updated for investors looking to buy a leveraged ETF.

Leveraged ETF Trading Pattern Holding a leveraged fund for more then a day can cause unintended consequences. Some factors become evident after analyzing returns for a period that is longer than one day. We look at returns of FAZ and FAS that follow an asset class, the Russell 1000 Financial Services Index.

Tracking Error The actual performance of a leveraged ETF significantly deviates from the predicted performance when we look at a time frame longer that one day, especially for volatile funds that track an asset class (FAS and FAZ) rather than a large cap index. This demonstrates that a buy and hold strategy can result in a significant reduction of value over time as the funds tend to largely under perform the predicted performance.

Confidence Interval of Errors It indicates what the upper and lower levels are for the tracking error of monthly returns with a 95% confidence. For example, looking at the data below, we observe that there is a 95% possibility to have a tracking error between -1.66% and -15.40% from its mean for FAS and between -5.01% and -38.69% from its mean for FAZ. The upper and lower limits are significantly wide, especially for FAZ, indicating a high deviation of  the tracking error when we look at monthly returns.

 Mean= Average of the tracking errors

SEE (Standard Error of Estimate) =Standard deviation of the tracking errors

Confidence Interval= Mean+/-1.96*(SEE/square root of Mean)

Tracking error= ETF Return – Leverage Factor*(Index Return)

Prices for FAS and FAZ  are adjusted for a reverse stock split

Rebalancing Most funds rebalance their holdings at 15:00 EST or right before the close in order to maintain their target debt/equity. The rebalancing effect is magnified by the presence of a trend and volatility of returns. The highest returns are obtained in trend markets with low volatility. The lowest returns are in volatile and non trending markets.

Negative Bias There is a natural negative bias embedded in leveraged ETFs. We can calculate the return needed to bring the value of an asset to par as R=1/ (1-R)-1 which means that if the asset declines 10%, we would need a return of 11.1% to bring the value back to one. Given Ru=2[(1+Rd)/1]-1 the predicted return on a index and Rd= [(1/1+Rd)-1] the return on the leveraged ETF based on that index, the first equation will always be larger than the second one when the return is negative and will always be larger when the return is positive. The equation will hold for short term trades and in absence of a trend. An investor who wants to capitalize on the fall of a particular index is better off shorting the long bull leveraged fund rather then go long the bear leveraged fund for that same index.

Conclusion   Swap based leveraged ETF like FAS, FAZ, DIG and DUG that track a certain asset class (financials, oil and gas) rather then a large/small cap index, are the most likely to fall first because of higher volatitlity of returns and the nature of the funds.

I have been browsing the market for the last two weeks in search of a stock to short when I came across Realty Income Corp (ticker “O”) on Distressed Debt Investing.com, one of my favorite blogs, where the author reported some notes from the “Best Ideas Symposium” on October 11 in Dallas. The Company was presented as a short play and it seemed like an interesting idea, so I did my due diligence and here is what I have found.

Business Model The Company’s primary objective is to generate a dependable monthly dividend to shareholders supported by cash flow income from a portfolio of properties leased to regional and national retail chains. The firm doesn’t really have any other type of operation, their only source of revenue is rent and it’s highly dependable on the lessees’ capacity to pay.

Free Cash Flows The firm generates all the operating cash flow from rental income and it’s all used to pay dividends to common and preferred shareholders and obligations. Note that FCFE is cash available before common shareholders are paid.

Table 1

The dividend has been raised every year since 1994 and has now reached a level where the amount is more then what the company can pay with cash on hand. In fact, in 2003 the Company started to explore other ways to raise capital such as issuing equity and debt. There is nothing wrong with raising funds though offerings but if you don’t reinvest the proceeds at a higher rate, eventually you will be forced to rollover debt continuously, and then burn all of your cash.

Capital Structure The capital structure changed dramatically in 2003, when the company started to issue unsecured notes to finance its dividend payments, and that’s when solvency and liquidity ratios deteriorated, we will look at that later.

Table 2

In September 2008, the company issued shares of common stock (at a price of $26, which is almost record high, an indication of the stock being overvalued) and used the proceeds, about 75mm, to repay of 120mm in notes outstanding at par.

Table 3

Covenants On the 2008 10K report, the Company reported to be “in compliance” with the bond covenants for the Senior Unsecured Notes outstanding, but after a closer look, it doesn’t seem the case. The issue lies with the way assets are recorded. Land and commercial properties are reported at book value, which can be significantly different then fair value, especially in a real estate downturn. If assets are reduced by 15% to 20%, the debt to asset ratio would rise to 65%, which is above 60% limit imposed by the bond covenants.

Liquidity Cash levels are on average 1% or less of total assets, which is very low and that raises some liquidity concerns. Also the current ratio, except for 2007, has been historically around 0.7 or less and this doesn’t account the 355 mm credit facility originated in 2008 which has no outstanding balance now, but if used could significantly increase short-term liabilities and further deteriorate liquidity.

Lessees I wasn’t able to find any information about the lessees but few names are identifiable if you read the 10K report or the Company website. There is Office Max, rated “B” at S&P, Wawa Convenience Store, Jiffy Lube, basically unknown local stores, it’s a joke! Because all of the firm’s revenue is generated from lease payments, it’s important to know who the lessees are and the capacity to meet their obligations. Poor financial performances of a lessee, solvency issues or failure to make payments on time, could result in material losses. For example, on January 22, 2008, Buffets Holdings Inc filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code and Realty Income owned 116 properties.

Conclusion The Company will have to cut the dividend of $1.71/share because it doesn’t have cash on hand to pay for it and is using proceeds from stock or debt offerings. The Company might be forced to sell assets at a loss to generate cash but that would deteriorate debt to asset ratios, which could cause a default on the terms of the debt covenants set in the indenture. The names and financial conditions of the lessees are a key ingredient to firm’s profitability but are a big unknown. This seems to be easy money, I don’t see the stock going higher, but there is one downside: when you are short, you PAY the dividend, a big one in this case. Target price $12 within 6 months. I will provide discount cash flow analysis in future posts. Have a good day.