NOT AN ANALYST

Morgan Stanly Research Here is a research paper from MS highlighting the firestorm of news related to the “ mortgage mess” that hit the market in the past few days. The issues include “robo-signing”, the right of MER to foreclose, the assignment of mortgages to securitization trusts, and putback risk. Although some of these issue such as putbacks represent a real threat to the banking industry, the media has somewhat overestimated the extent of some of these issues and the respective costs to the industry.

Putback losses MS estimates that putback losses to the entire banking industry can account to 105 billion on a base case scenario over the course of the next two to four years, while, in another research report, JPM speculates that losses could add up 55 billion in a base case scenario over the course of the next five years. As you can see, the putback risk is real but it’s certainly “manageable” for banks.

Conflict of interest The recent lawsuit filed by PIMPCO, the New York Fed and Blackrock against Bank of America  is embedded with HUGE conflicts of interest that deserve some attention. First, BlackRock is the largest holder of Bank of America shares, owning about 5.35% of the outstanding BAC shares, for a total value of $6.6 billion. Second, PIMCO has the most to lose if the MBS crisis escalates and if all the MBS are unwound as they hold large positions. Third, the FRBNY’s effort to force the buyback of several billion of mortgages runs against the Fed’s goal of strengthening the banking system and will certainly defeat the purpose of the Fed.  I will let you be the judge of this.

MS-Putbacks

Investment Thesis I recommend readers to buy Solo Cup’s 8.5% Senior Subordinated notes due February 2014 for a price of 92.5 with YTM of 10.1% and CY of 7.8%. The bonds are well positioned in the capital structure and offer an attractive high yield opportunity with minimal risk in a market that is crowded with anemic yields. Additionally the fairly low price implies a lower risk in comparison to similar bonds from other competitors.

Company Description Solo Cup is a leading producer and manufacturer of products used to serve food companies and beverages in homes, restaurants and other food service settings. The Company manufactures and supplies a broad portfolio of single-use products including cups, lids, food containers, plates, bowls, portion cups, cutlery and straws. Products are available mostly in plastic and paper. Solo Cup has two main segments: the food service distributors and operators, and the retailers of consumer products.

Capital Structure Although the 8.5% Senior Subs are second lien notes and are junior to the 10.5% Senior Secured notes, they are well covered in case of bankruptcy because they are guaranteed by certain subsidiaries such as SF Holdings, SCOC and have an equity cushion of almost 300 million.

Net Operating Losses As of June 27 2010, Solo Cup accumulated 308 million of net operating losses carry forwards that will expire between 2018 and 2030. I can reasonably expect that tax liabilities will low in the future, therefore improving the bottom line of the income statement and FCF.

Valuation Although EBITDA and operating margins will not improve in the near future, I expect the Company to generate approximately 45 to 55 million of FCFE in each of the next three years as the lack of maturities will allow the company to accumulate a significant amount of cash. However, the FCFE generated will not be sufficient to repay the 8.5% Senior Subs, but it will reduce leverage ratios and improve the value and price of the bonds. Additionally, based on the last earnings report in August 2010, the borrowing capacity under the credit facility is 110 million.

Catalysts Improving fundamentals: because there are no maturities until July 2013, I expect Solo Cup to accumulate around 150 million in free cash flow by 2013 in a base case scenario.  

Refinancing: In July 2009, the worst time to raise capital, Solo Cup issued 325 million of 8.5% Senior Subordinate Notes due in 2014. I can reasonably expect that the Company will have access to credit markets in 2014 and be able to refinance 325 million coming due.

Potential IPO: Solo Cup is a privately held organization but sponsors would like to take the Company public. A public offering will be a deleveraging event.

Risks The power of buyers: approximately 81% of the 2009 annual sales comes from the food service operators and distributors. Customers of such segments are  well-known and include Starbucks, Dunkin’ Donuts and McDonald’s Corp; hence they can exercise significant price power.

Concentration risk: five customers and one customer account respectively for 30% and 9% of 2009 total sales. Not only the power of buyers is strong, but it is also concentrated in a small group

Rising raw material costs: raw material costs make up 40% of COGS and the Company has historically not hedged its exposure to fluctuations in raw material prices.

Summary Despite several headwinds along the value chain, I expect the bonds to experience a price appreciation above par in the next three to four years.