NOT AN ANALYST

Here you can find the Pershing Square Q1 and Q2 letter to investors. The Q3 letter highlights the possible consolidation of the retail book industry, which increases the probability that BGP is included in that potential merger activity. The Q1 letter, talks about the $20 bid from Simon Properties and why the GGP board wisely turned it down. Enjoy the reading.

Pershing-Q1-2010-Investor-Letter

Pershing-Square-Q2-10-Investor-Letter

A high return on capital should outweigh a low return of capital in the case of Domtar Corp (UFS) at current prices. In 2006, Domtar completed the acquisition of the Weyerhaeuser Fine Paper Business, which gave the company the #1 market share in North America for uncoated free sheet paper; this was a very important transaction for the company (and industry) as it turned the industry into an oligopoly.  Domtar is currently operating 10 paper mills with uncoated free sheet capacity of about 3.9mm tons and has the #1 market share in North America with about a 35% share; International Paper is #2 with about 25% share and Boise is #3 with about 10% share.

Business:

Domtar has three segments: (i.) Paper, which includes the uncoated free sheet manufacturing and pulp businesses, (ii.) Paper Merchant, which runs warehouses and distributes both Domtar paper and that of competitors, and (iii.) Wood, which the company has an agreement to sell and should close in the coming months.  The Wood business has been a money loser (even from an EBITDA perspective) over the past few years and the company will realize about $95mm in net cash proceeds from the sale.  The Paper Merchant business is not a meaningful cash flow perspective, but is noteworthy because sales of Domtar paper are much higher through this channel than with other distributors.

Positives/Negatives:

The biggest negative for the business overall is the structural industry decline of units of uncoated free sheet paper, which is due to increased use of computers, email, ipad, etc.  The management team pegs the decline in units at about 4% per annum, which we think is a reasonable estimate.  On the other hand, the consolidation of the industry has provided pricing power to the remaining players in the industry.  In fact, in one of the most difficult business environments in recent history (2008-2009) prices actually went up, which is shocking to anyone following the industry over time.

Pulp:

While the pure uncoated free sheet business has remained steady at about $200mm of EBITDA per quarter, the pulp business has been wildly volatile.  The pulp business lost about $75mm per quarter in the first half of 2009 and was positive by about $30mm in the 3/10Q.  The decline was primarily due to one of the sharpest declines in pricing ever in that industry.  The company has about 1.7mm ADMT per year of pulp in excess of the company’s internal requirements, which causes the swings in profitability.

Balance Sheet:

Net debt peaked in 2007 at about $2.4 billion following the Weyerhaeuser transaction and has steadily declined to about $1.3 billion at the end of the 3/10Q.  This can partially be attributed to strong cash flow from operations over that time frame, but also partially due to black liquor tax credits that the company received as a nice gift from the government.  I won’t get into the mechanics of the credit (Google it), but it basically provided the company with about $500mm in cash, of which the company will receive $350mm in the 6/10Q.  (Also noteworthy, the company is getting about $75mm from the Canadian government in tax credits to use to upgrade facilities.)  The company is using this cash initially to pay down debt; following a recently completed debt tender, the company should have ~$950mm of debt that is all senior notes (no bank debt) with most of the maturities after 2013.

Cash Flow:

Current sell-side estimates for EBITDA for 2010 and 2011 are about $1.0 billion and $900mm respectively.  We think the normalized over the next few years is about $775mm less $175mm main capex gets you to our normalized pretax unleveraged cash flow of about $600mm.  If you assume interest expense is $100mm and taxes of $125, the real free cash flow is about $375mm or about $8.75/share.  What are they going to do with all this cash if their debt is fixed for several years (and at their target leverage)?  Return it to shareholders.  The company reinstated its’ dividend at $1.00/share annually and has a $150mm authorization to buy back stock, which we think will be utilized in the near future (and probably increased).

Valuation:

Less than 6x after-tax normalized free cash flow in a relatively unleveraged company even for a paper company with declining units is cheap.

It’s in the best interest of every investor to know the exact value of their investments. However, more often than not, business value cannot be precisely determined. Any attempt to precisely value an enterprise, will yield values that are precisely inaccurate because business value changes over time, fluctuating along numerous variables such as macroeconomic and microeconomic factors. This is the beauty of valuation. It’s more an art than a science. How can you precisely value a business that, unlike debt instruments, may not have a constant stream of cash flows? Thus, the value of a business is never a single number, but a range of values where the highest estimate is sometimes twice as much as the lowest one. For example, we all experienced the difficulties or impossibility to value an enterprise such as General Growth Properties. I remember that at the beginning of the bankruptcy process, valuation ranged from $5 per shares to more than $20. That’s where opportunities arise. If securities could be valued precisely, there would be few differences in opinion, market prices would fluctuate less frequently, and trading would diminish significantly, making our job useless. Discrepancies over the value of a business result from differences among the assumptions used, especially discount rates, projected cash flows, differences among the valuation methods used. I consider three different valuation methods that can be used to value en enterprise.

Absolute value

When futures cash flows are reasonably predictable and an appropriate discount rate can be chosen, the absolute value represents the most reliable source of information. However, cash flows are usually uncertain and the choice of the appropriate discount rate is usually an area of debate, hence we have to be careful when we use this valuation method. In the context of absolute valuation, cash flow, which comprises of dividends, free cash flow or residual income, is discounted at the required rate of return to find the PV of such cash flows.

Dividends

Generally, using dividends as cash flows is most suitable when the company is dividend paying, the board of directors has established a dividend policy that bears an understandable and consistent relationship with profitability and the investor takes a non-controlling ownership, because shareholders do not have control over the dividend policy.

Free cash flow

Valuation using free cash flow to the firm (FCFF) or to equity (FCFE) is most suitable when a company is dividend-paying but dividends significantly fall short or exceed FCFE, the company doesn’t pay dividends at all and the investor takes the ownership prospective. However, applying the free cash flow approach posts problems in some cases.  Some companies have intense capital demands and, as a result, have negative expected free cash flows far into the future. A profitable enterprise that is expanding may have a negative free cash flow indefinitely because of the level of capital expenditures. The present value of a series of negative cash flows is a negative number, therefore the use of a free cash flow model entails a long forecast horizon to capture the point at which expected free cash flow turns positive. The uncertainty associated with such forecasts may be considerable.

Residual value

Conceptually, residual income is the book value per share plus the present value of expected future earnings reduced by the equity charge.  Because the record of residual income can always be calculated, a residual income model can be used for both dividend-paying and non-dividend-paying companies, and for companies with negative expected free cash flow with reasonable forecast horizon. However, the application of the residual income model requires a detailed knowledge of accrual accounting. In some cases, the degree of distortion and the quality of accounting disclosure can be such that the application of the residual income model is error-prone.

Relative value

A valuation method relies on price multiples that sophisticated and prudent investors have recently paid to purchase similar businesses. For example, multiplying a benchmark value of the price-to-earnings (P/E) by an estimate of a company’s EPS provides a quick estimate of the value of a company’s stock. The concept behind price multiples is that a stock’s price cannot be valued in isolation (absolute value). Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net assets, or some other measure of value. The economic rationale behind the method of comparables is the “Law of one price”, which is the economic principle that two identical assets should sell at the same price. But what can constitute the benchmark? Generally, it’s the mean/median multiple of the company’s peer group within a certain industry, or the mean/median multiple of the company’s whole industry sector or the company’s own past multiples. However, this valuation method is not without shortcomings. The method of comparables argues that a firm with multiples below the benchmark is undervalued, and with multiples above the benchmark is overvalued. In this case, the fundamental of the stock have to be similar to the fundamental of the benchmark before we make any direct comparison and draw conclusions whether the stock is overvalued or undervalued. Let’s suppose that, after hours of research, you determine that the P/E of the stock you are trying to value is less than the benchmark. There are at least three possible explanations for this:

• The stock is undervalued
• The stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower P/E
• The stock is properly valued, but it has a higher expected return (higher risk or required rate of return) than then benchmark, which leads to a lower P/E.

In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to the benchmark, it should have similar expected growth and similar risk/return.

Liquidation value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment opportunity. The assets of a company are generally worth more as a part of a going concern than in liquidation, hence liquidation value is generally a worst-case scenario assessment. When no crisis is at hand, liquidation proceeds are maximized through an orderly winding up of a business. Cash is worth one hundred cents on the dollar. Investment securities are valued at market prices, less any transaction cost. Accounts receivable are appraised at close to their face amount. The value of inventories is not easily determined and it depends on whether or not the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is the risk of technological obsolescence. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flow and their next best use. Emulating Benjamin Graham, the approximation of the liquidation value of a company can be calculated as “net-net working capital”, which is net working capital minus all long term liabilities. As long as working capital is not overstated and operations are not rapidly consuming cash, if a company could liquidate its assets, extinguish all liabilities and still distribute proceeds in excess of the market price to investors, it represents an attractive opportunity.

Investment Thesis Lodge Net (NASDAQ:LNET) might be a candidate for bankruptcy filing probably for mid-2012. The current balance sheet deleveraging efforts are putting a cap on expenditures, which are vital element for a tech Company. These efforts cannot last long because technology rapidly changes and the Company will eventually be forced to spend again or profitability will be eroded and margins will start to decline. Lodge Net also records on its balance sheet a large amount of goodwill and intangibles, which will eventually have to be written down as a rapid shift in technology will cause these intangible assets to be worthless.

Company description Lodge Net is a dominant provider of interactive television and media solutions solution to the hospitality industry in the US. The Company is divided in four main segments: Guest Entertainment, which provides a wide range of guest-paid entertainment options including movies, games, music and other interactive services delivered through the televisions, the Hotel Services segment, which provides services to hotels at a monthly fee, the System Sales segment, which delivers advertisement and TV commercials, and the Healthcare segment, which sells entertainment solutions to hospitals.

The levering up period For the last couple of years, Lodge Net has been trying to deleverage its balance sheet. In 2007, Lode Net acquired two competitors through a debt offering, creating a highly leveraged Company. The deleveraging efforts have been successful so far, mainly due to reduced capital expenditures. However, this trend is not sustainable because rapid technological changes, which are inevitable, will force Lodge Net to upgrade its systems, increasing capital expenditures and decreasing free cash flow significantly. At that point, Lodge Net will be force to stop pay down debt, affecting the compliance with debt covenants under its Credit Facility.

Misconception For the past 12 months, the company has shifted focus from increasing operating performance to optimizing its free cash flow, which has grown from 15mm in early 2009 to 23mm in Q110. The FCF is being used to reduce its long term debt which is currently at 417mm. Management is forced to undertake this strategy otherwise high leverage will cause non compliance with debt covenants in the near future. However, there is a flaw in the Management’s decision. Positive FCF is generated from reduction in capital expenditures and not from earning growth. Once Lodge Net will need to spend to keep up with new technology, capital expenditures will rise again, putting a dent on FCF and on the deleveraging efforts. The technology shift process is already in place. Lodge Net provides HD television system solutions, but its customers will eventually shift their taste, prefering 3D over HD TV for example, forcing Lodge Net to upgrade it system and write down intangibles.

Scenarios A shift in technology and consumer taste, which I assume will occur in the next 2 years, will put the company at a crossroad. If the Company does nothing and continues to keep cap ex low and use FCF to reduce leverage, profitability will be eroded.  If the Company starts spending, it will be able to keep up with demand, but at the expense of leverage, which will remain high. Either scenario doesn’t look too good. I am working on crunching some numbers to show how the two scenarios will affect the Company.

Goodwill and Intangibles Lodge Net has a significant amount of Goodwill and Intangibles on its balance sheet, approximately 206mm or 42% of all the assets. Considering tangible book value alone, the Company is highly overvalued at these levels.  Impairment of goodwill or intangibles will be warranted if technology or customer taste shift rapidly.

Company vs. Peers It’s not easy to find a true comparable in the industry as the Company provides a unique product not offered by competitors. Relative valuation is not meaningful in this case.

Conclusion Deleveraging is coming at the expense of profitability as the Company will not be able to increase its capital expenditures for some time. However, for a tech Company, R&D is vital as the industry shifts quickly. Not being able to adapt to new technologies, it will put a dent on profitability. In the next post I will get into more details and work the valuation.

Adjustment Error On the previous post, I introduced a capital structure trade on Town Sports International, recommending to sell short the equity and to buy the 11% Senior Note. However, it was brought to my attention by an alert follower that the adjustment for off-balance sheet liabilities was a little off. The correct adjustment for operating leases is to capitalize them, adding the PV of minimum lease payments to assets and liabilities and adding rent expense or calculating EBITDAR. For Town Sports Intl, the adjustment creates an EV/EBIDTAR multiple of 7.1 and EBITDAR/Interest Expense of 1.93, a slight improvement from my previous calculations but the fundamental idea remains intact. Now I want to take some time to go over few key aspects of investing: warning signs of earning s manipulation and balance sheet adjustments.  

Skeptical When you are valuing a company, as an investor, it is important to look at financial statements and management projections with skepticism. Sometimes management has an incentive to increase earnings or increase sales rather than maximize shareholders value. Sometimes financial statements need to be adjusted for valuation purposes, changing the picture of the overall company.

Manipulation When financial information is reported to capital markets, security prices move. This creates a clear incentive for management to report financial performance that meets or exceeds current expectations. The target that a Company is trying to achieve is a moving benchmark: the consensus sell –side analyst forecast. Investors need to be particularly skeptical about reporting earnings when: top management has a significant portion of vested options in the money, the company is trying to maintain a track record of successively meeting analyst forecasts and is looking to raise additional financing. The presence of these risk factors can provide an incentive to accelerate recognition of earnings or report aggressive earnings, which are transitory and non-persistent. A good example is Microstrategy. Between the end of 1999 and early 2000, the stock price of Microstrategy rose from $25 to above $300. But in March 2000, they announced a restatement of earnings because they accelerated the recognition of revenue by booking legitimate future sales orders in the current fiscal period. At a first glance, this doesn’t seem particularly egregious: after all, these would have been legitimate sales. But placed in the context of significant capital market pressures, where analysts and investors were looking for exponential sales growth to support very lofty stock prices, the front loading of revenues allowed Microstrategy to report very large revenue increases over the 1998-1999 period. When investors learned that this run up in sales was the result of front loading future sales, there was a quick correction in price. Did management knowingly accelerated earnings recognition? We will probably never know that but it’s beyond our point. A skeptical view on earnings report will help you identify potential manipulations.

Adjustments I will now introduce a brief discussion on two balance sheet issues, off-balance sheet debt and goodwill. Off-balance sheet debt includes items not reported in the body of the balance sheet but that might be associated with an obligation for future payments. The classic example is leases. US GAAP recognizes two types of leases (operating and capital) and provides different accounting rules for each. The treatment of operating leases relative to capital leases is dramatically different. An operating lease treats the cash outflow associated with the lease as a rental expense, which will be recorded on the income statement. With a capital lease, the PV of minimum lease payments is recognized on both assets and liabilities at the inception of the lease, and amortized over the life of the lease. Companies have a strong preference for operating leases, as this keeps the lease obligation off the balance sheet. The use of operating leases is pervasive in the retail sector with companies such as Walgreen, Wal-Mart, CVS and others having very large off-balance sheet operating leases obligations. The consequence of bringing these leases onto the balance sheet will be to increase leverage ratios; and depending on how these companies amortize the value of their assets, there could also be significant impact on reported earnings.

When a company acquires another company and records part of the acquisition price as goodwill, the goodwill is capitalized as an asset and no periodic amortization charges are taken against it. Instead, companies evaluate goodwill and other acquired intangible assets for impairment annually or whenever circumstances indicate that the value of such an asset is impaired. Disclosures for goodwill can be found in the supplemental information to the financial statements. Investors should look carefully at changes (or the absence of an impairment given overall economic conditions) in reported goodwill. Companies that continue to report goodwill on their balance sheet, but they have a market capitalization less than book value of equity, are certainly worth an examination to understand why an impairment charge was not taken.

Investment Thesis Short Town Sports International (NASDAQ:CLUB) common stock and buy the Company’s 11% Senior Discount Notes. The amount of off-balance sheet liabilities adds a significant risk to equity holders, as the Company could face Bankruptcy (small chance but tangible). On the other hand, the Notes are undervalued with strong multiple and coverage ratios.

Intro Town is the second largest owner and operator of fitness clubs in the Northeast and Mid-Atlantic regions of the United States and the fifth largest fitness club owner and operator in the United States. The Company operates 161 fitness clubs under four key regional brand names; “New York Sports Clubs” (NYSC), “Boston Sports Clubs” (BSC), “Philadelphia Sports Clubs” (PSC) and “Washington Sports Clubs” (WSC).

Industry Description The US fitness club industry is a growth industry and in the last decade has experienced a moderated growth with a CAGR of 6.8%, higher than the overall economy. According to the most recent information released by the International Health, Racquet and Sports club Association, or IHRSA, the industry grew from $10.6 billion in 1999 to $19.1 billion in 2008. During the economic recession of the last two years, attendance at health clubs has increased nearly 7%.

Competition The level of competition comes on the basis of price, level of service and convenience of location. Primary competitors include Equinox Holdings, Inc., Lifetime Fitness (NASDAQ:LTM), Inc., Crunch, New York Health and Racquet, LA Fitness International LLC, 24 Hour Fitness Worldwide, Inc., Bally Total Fitness Holding Corporation and other YMCA/small privately held clubs. Town is in the mid-range of the value/service ratio as prices are affordable and designed to appeal to a large portion of the population who utilize fitness facilities.

Capital Structure As of March 31 2010, Consolidated Debt amounts to $317,900M and it’s comprised of $185,000M TL Facility (almost fully drawn), $75,000M Revolver and $138,500M of 11% Senior Discount Notes. The Notes (Hold Co Notes) are unsecured, structurally subordinated and ranked junior to the Bank Debt. Cash on hand is 25,000M and equity (shares outstanding) amounts to 60,356M. The Company has significant amount of operating leases from rentals (PV of minimum lease payments amounts to $844,911M), which represent off-balance sheet liabilities that need to be capitalized.

Valuation Based on estimated 2010 EBITDA of $84,700M , Town  trades at an adjusted multiple of EBITDA of 9.43, which is much higher compared to the only true publicly traded company, Life Time Fitness (NASDAQ:LTM), which trades at multiple of 7.6. Town’s equity is overvalued on a relative bases, considering that the Company has a lower growth rate and higher required rate of return Life Time Fitness. For this reasons, Town should be trading at a multiple of 5-6 after adjustment for off-balance sheet liabilities. In this scenario, the equity should be zero. On the other hand, the 11% Hold Co notes are undervalued because of a low leverage and high coverage ratios. The Notes are subordinated to bank debt but they are well covered from a valuation prospective and can enjoy a significant recovery in a reorganization scenario.  

Catalysts Refinancing and improving fundamentals (higher EBITDA from increasing membership revenue) will be the two major catalysts for an appreciation of the Notes up to par. The Company expects to refinance the Notes prior to their maturity date in 2014. If they are refinanced before August 2013, which is the last day to keep the TL in place, the annualized return is 16%.

Risks There is a small but tangible chance of Bankruptcy. Deterioration in memberships due to a decrease in consumer spending and increasing competition could severely affect the Company’s fundamentals and force bankruptcy. A deterioration in the Company’s credit rating could impair the ability to access capital markets.

This represents the latest piece of the puzzle on the GGP story. Ackman sees GGP priced around $15 and GGO at around $5 upon emergency from Bankruptcy. Currently, the market is valuing GGO at -$1, obviously a mispricing according to Ackman. Enjoy.

GGP-Ackman-Presentation-at-Ira-Sohn-Monference-May-2010

Last week, legendary value investing fund manager Seth Klarman made some rare public comments at the CFA Institute in Boston. Here are some notes from the conference, reported originally on Distressed Debt Investing.  

Seth Klarman Discussion with Jason Zweig of The Wall St. Journal

Additional-Seth-Klarman-Notes

Investment Thesis BGP carries an intrinsic value of $6.5 based on the relative valuation of comparable multiples. The stock is expected to reach its fair value by the end of 2010, giving an annualized IRR of 77% from current levels. BGP represents a value opportunity in a mature industry. The Company’s shares have been pushed lower over the last year due to significant price competition among book retailers and unfunded bankruptcy rumors. Now the scenario has shifted; the implementation of a new business strategy and the commitment of fresh capital from a group of lenders, are clear signs that BGP can effectively manage through its troubles and focus on regaining market share.

General BGP is an operator of book, music, movie superstores and mall-based bookstores. The business is organized three main segments: Borders Superstores, which includes Borders.com launched in May 2008, Waldenbooks Specialty Retail Stores, which operates small boutiques located in malls, airports and outlet malls, and International Stores.

Restructuring Efforts In the last three years, BGP has suffered a significant price competition from online book retailers such as AMZN, which has squeezed Borders’s margins and profitability. However, due to a conservative capital structure, consistently positive FCFF and cost cutting initiatives, the Company was able to survive. In the beginning 2008, Borders launched a turnaround effort designed to return to profitability. These efforts included store closings, staff reductions, advertising cuts and reduction in inventory for stagnant segments like music and movies. The efforts are ongoing and are expected to continue through 2010. BGP is also planning to gradually exit the Waldenbooks Specialty Retail Stores segment because it has not delivered the amount of growth expected, given the capital invested. The international Stores segment accounts only for a very small fraction of the overall revenue.

New Business Strategy The U.S. book retailing industry is a mature industry, which experienced little or no growth in recent years. In the beginning of 2010, Borders have developed a new strategy designed to grow certain segments, increase revenue in the long-run and drive traffic into stores. There are three main points of the new strategy:

1-Leverage Boarders.com and the power of social media –Grow the online sales business on Borders.com and introduce new technologies. A new shop zone will be introduced called “Area-e”, where multiple e-Readers will be available for sale.

2-Become a community gathering place –Host customer events including author and celebrity signings, local events, educator appreciation weekends, which are expected to drive traffic into stores and sales.

2-Improve in-store experience – Retain customers through reward and coupon programs.

Availability of Capital The ability to refinance its debt and to obtain credit are key ingredients for the Company’s recovery.  On March 31, 2010, the Company entered into a Third Amended and Restated Revolving Credit Agreement, which replaces the prior Senior Revolving Credit Agreement. The commitments are divided into a $270.5 mm existing tranche maturing in 2011 and a $700 mm extended tranche maturing in 2014. Also, on March 31, 2010 BGP entered into a Term Loan Agreement under which the lenders committed to provide $80 mm in capital maturing in 2014. The commitments by the lenders are subject to which include borrowing base and availability restrictions, which are pretty “lax” and should not trigger a credit event in any circumstance.

Unfunded Bankruptcy rumors In late 2009, rumors that the Company was close to file for Bankruptcy skunked the shares below $1. However, when we look at the historical current ratio and various capitalization rations, we can clearly see that liquidity and solvency have never been an issue for BGP. The capital structure has always been conservative and compliance with financial covenants was always maintained. The new financing received on March 31^st, which provides capital for the next four years, confirms that investors are confident about Border’s ability to repay its obligations over time and the risk of bankruptcy is now remote.  However, the share price still doesn’t reflect that.

Valuation BGP trades at multiples that are significantly lower than its direct competitors. Comparison with the book retail industry is not meaningful, because multiples of the industries include online retailers such as AMZN, which have a much higher growth rate than BGP. Applying these multiples to BGP would overstate its value. The most meaningful comparison can be made with Barnes and Noble (BKS) because it has a very similar business model, it operates in the same geographical areas and it has similar fundamental characteristics. However, a relative comparison based on multiples of EPS, EBITDA and FCFF is not meaningful.  BGP is experiencing negative earnings and BKS had high capital expenditures in the last twelve months, generating a negative FCFF. A valuation based on Adjusted CFO, which is CFO plus after-tax interest, Total Revenue and Book Value seems more accurate. When we apply multiples to BGP fundamental, we find an average price of $6.50, which equates to an IRR of 133% over 8 months or represents an annualized IRR of 77%.

Potential Dilution Resulting from Equity Offering In connection with the term loan made by Pershing Square, which was repaid in the 1^st Quarter of 2010, BGP issued warrants to Pershing Square to acquire 14.7 million shares of our common stock, which currently represent approximately 19.7% of the outstanding shares.

Synopsis Chemtura Corp is among the largest publicly traded chemical Companies in the United States, dedicated to the manufacturing and marketing of specialty chemical products. The Company filed for bankruptcy protection on March 18, 2009, as a result of a sharp decline in demand for its products and restricted access to credit. The Debtor has until June 2010 to file a plan of reorganization and it estimates to emerge from bankruptcy by the 3^rd Q of 2010.

Investment Thesis Buy the 7% 2009 notes as they provide an attractive risk/reward ratio compared to other debt in the capital structure. The notes trade around 107 cents on the dollar and have virtually no downside and have significant upside potential if converted into equity.

Valuation The Company is worth around $2,000 mm, which should cover all the unsecured debt and existing liabilities, including a large diacetyl claim. The valuation is based on 2009 EBITDA growth of 10% to 18% and a multiple of 7.72 derived from comparable Companies.

EBITDA In 2010, EBITDA will range between $285 and $300 mm, which represents a growth of 10% to 18% from 2009 levels. The growth is justified by a stronger demand for the Company’s products and emergence from bankruptcy. Peak cycle EBITDA was recorded around $400-450 mm during 2005-2007, but these level will be probably be attainable after 2015.

Multiple The 6.78 multiple represents an average of the EV/2010E EBITDA multiple extracted from Companies in the industry with similar fundamentals like market capitalization and debt (Albermale-ALB, Ashland-ASH and Lubrizol-LZ). I applied a 10% growth rate to the 2009 EBITDA level of the Companies analyzed. For reference, Chemtura’s market capitalization in 2007 was $1,050 and total debt to capital was 38.2%.

Capital Structure The DIP loan was refinanced at a lower rate on February 12 and increased by $50 mm to $450 mm to fund bankruptcy charges and ongoing capital requirements. The Term Loan, which constitutes part of DIP financing, has been fully drawn as of February 12. Borrowing under the 2007 Credit Facility were $154 mm as of January 31^st 2010, however this amount can increase following the drawing of certain letters of credit issued under the Facility. The 2009 notes and the 2016 notes are senior unsecured and guaranteed by certain subsidiaries. The 2026 notes senior unsecured parent Company notes and are not guaranteed by any subsidiary.  

2009 Notes Senior unsecured and guaranteed by Great Lakes Chemical, a subsidiary of the Debtor, which merged with Crompton Corp. to form Chemtura Corp. in 2005. In virtue of their maturity, the notes cannot be reinstated. In the worst case scenario, they’ll be repaid out at par plus post-petition interest. In the best case scenario, they’ll be converted to equity and participate in an upside potential materially above par.  

Other Liabilities The Debtor is subject to various other legacy liabilities, including environmental liabilities, estimated to be around $146 mm over 10 years, pension and OPEB (other-post-retirement-obligations) of about $172 mm. The Company, primarily through its non-Debtor subsidiary, Chemtura Canada, is also exposed to diacetyl litigation, estimated around $300 mm. Claims have been filed arguing that exposure to diacetyl, a chemical used to enhance and mimic food flavorings, caused workers to develop a disease that affected their lungs.

Risks The 2009 notes have virtually no downside risk. However, the risk of reinstatement for the 2016 and 2026 notes, will force repayment for the 2009 notes. The negative pledge clause in the notes would be triggered, so the notes would need to be reinstated as secured debt. In case of a debt to equity conversion, the creditors will have a lower claim on the Company’s assets if the Equity Committee will push for a high valuation above $2,500 mm.