NOT AN ANALYST

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

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.

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

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.