NOT AN ANALYST

Background One of the most discussed topics in HY is Harrah Operating Company, one of the largest casino entertainment providers in the world. The enterprise has been taken private in January 2008 by a group of investors (Apollo, TPG and Paulson & Co. Inc) through an LBO and since then it has been cutting expenditures, reducing costs and initiating several debt-to-equity exchanges to avoid Chapter 11 filing. Despite those actions, Harrah continues to be a highly leveraged Company with a 10.3x Net Debt/Projected 2010 EBITDA and a 1.1 Projected 2010 EBITDA/Interest Expense.

Valuation and Leverage Harrah’s EBITDA has decreased in recent years, dropping to a projected 2 billion in 2010 from a peak of 2.8 billion in 2007. Despite debt exchanges, which have eliminated about 5 billion of debt, and substantial cost reductions, which have helped offset some of the decline in EBITDA, Harrah’s leverage in 2010 will be at 10.3x EBITDA and EBITDA coverage will be barely above 1. However, in 2011 the story is going to be a different. In June the equity sponsors announced a debt-to-equity swap that will cut about 1.118 billion in debt. Hence, in 2011 Harrah will have approximately 19.5 billion in net debt outstanding, assuming cash on hand remains constant. EBITDA will have to rise up to 2.4 billion or 20% (assuming 2010 EBITDA will be 2 billion) to reduce the multiple to 8.1x. At that level, Harrah’s debt is certainly something worth looking at, especially the second lien notes. Don’t get me wrong, this is still a leveraged capital structure, but certainly manageable giving the ample liquidity and an EBITDA at 2.4 billion/year. Although I expect the gaming industry to rebound next year, I don’t expect Harrah to reach its 2007 peak levels anytime soon. 

Public Offering and Implied Valuation A few weeks ago, Harrah Entertainment announced a plan to raise 575 million through an IPO for 9.75% of the Company to finance projects in Las Vegas and Ohio. The decision to invest capital rather than use it to reduce the already high debt level underlined the confidence of management in the turnaround of the business. Management probably expected to earn an IRR on the incremental capital that far exceeded the 13-15% pre-tax yield on the bonds if they were bought in the open market. However, the deal fell apart shortly after its announcement as market conditions were deemed hostile for private-equity backed IPOs but this scenario opened up a whole new valuation for Harrah. Let’s take a look. The IPO would have raised 575 million for a 9.75% stake in the Company, giving an implied equity value of 6.183 billion and an implied enterprise value of 25.63 billion after the 1.118 billion debt-to-equity exchange planned for next year. Considering that EBITDA for 2011 will probably be around 2.2 billion the implied EV/EBITDA multiple is 11.7x. Management is obviously extremely optimistic abut the outlook of the gaming industry but I think their projections and valuation are too generous and that the IPO is a bit pricy. However, I expect Harrah to launch another equity offering attempt next year, which will give us more information about the value of the enterprise.

What looks good? The first lien debt seems to be well covered in case of bankruptcy (see below) even if EBITDA will be 1.6 billion, which is very conservative. The second lien debt will experience above par recovery only if EV will be between 17.6 to 20.8 billion, the high end of the valuation. If you believe in the rebound of the gaming industry, the 10% Senior Secured Noted due 2018 are a good investment. They are currently trading at 89, with a CY of 12% and an YTM of 12.8%. All the Unsecured Notes trade at a significant discount to par, ranging from 60 cents to 90 cents on the dollar, but I don’t expect any meaningful recovery since Harrah has been exchanging them for equity at rates significantly below par.

Risks Harrah is a highly levered company; hence it would take a less significant decline in EBITDA to generate a payment default compared to a less levered company. S&P uses multiples of 5x to 8x EBITDA to value gaming companies, with an average multiple of 6.7x. This compares with the 5x to 7x used for most industrial sectors.

Bondholders will be pushed down the capital structure if the Revolver gets fully drawn (1,500 in available borrowing at the moment)

The presence of junior debt in the capital structures has resulted in higher recoveries for the loans senior to these obligations because senior lenders would have a priority claim to the total enterprise value of a firm. Harrah’s capital structure doesn’t contain many junior or subordinate notes.

Conclusion Although I don’t expect the economic recovery to allow the company to grow back to its 2007 peak, Harrah’ credit profile will get stronger in the next years. Looking at the capital structure, the best investment is to own the 10% Senior Secured Notes due 2018. Based on my calculations, above par recovery is possible if we apply a multiple of 8 to 2.4 billion in EBITDA, a plausible scenario in 2011 or 2012.

For all the loyal readers out there, this is why it pays off reading this Blog. One of my earliest posts was about a value opportunity that was hiding behind a technicality on certain Citigroup non-cum equity preferred shares (CprP, CprM and CprI). Here is a link to my post in case you don’t remember:

http://www.notananalyst.com/2009/10/17/citigroup-preferred-shares/

Background In February 2009, Citigroup announced the suspension of dividends on certain non-cum equity preferred (CprP, CprM and CprI) as the securities were converted into equity in an effort to raise tangible common equity and capital requirements. In theory, preferred shares that don’t pay a dividend are worthless based on the Gordon Growth Model but those preferred continued to trade despite the suspension of the dividend due to a technicality. That’s when the value opportunity became evident.

Technicality As I described in my original post, holders of the non-cum equity preferred shares were required to vote on a series of amendments and the most important among them was the dividend blocker. That amendment was designed to eliminate the legal obligation of the issuer or Citigroup to pay dividends on the non-cum equity preferred even if some investors elected not to exchange their shares. However, the dividend blocker didn’t pass and Citigroup became legally obligated to pay a dividend on the outstanding non-cum equity preferred shares before it could pay a dividend on common shares. As a result, the equity preferreds that were trading ex-dividend continued to rise, on speculation of a possible dividend payment in the future.

IRR In my original post, I proposed a scenario in which Citigroup would defer the dividend for six quarters and resume it afterwards. Now, after only four quarters, Citigroup has announced the reinstatement of the non-cum equity preferred dividend. The trade idea yielded an IRR of about 49.5% for each security, significantly higher that the 20% IRR I expected.  Here is the press release:

NEW YORK – The Board of Directors of Citigroup (NYSE:C) today declared dividends on preferred stock as follows:

6.5% Non-Cumulative Convertible Preferred Stock, Series T, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full convertible preferred share, will be paid $.8125 for each receipt held.

8.125% Non-Cumulative Preferred Stock, Series AA, payable November 15, 2010, to holders of record on November 5, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.5078125 for each receipt held.

8.40% Fixed Rate / Floating Rate Non-Cumulative Preferred Stock, Series E, payable November 1, 2010, to holders of record on October 20, 2010. Holders of depositary receipts, each representing one-twenty-fifth of a full preferred share, will be paid $42.00 for each receipt held.

8.50% Non-Cumulative Preferred Stock, Series F, payable December 15, 2010, to holders of record on December 3, 2010. Holders of depositary receipts, each representing one-thousandth of a full preferred share, will be paid $.53125 for each receipt held.

On February 27, 2009, at the time of the announcement of its public and private exchange offers, Citi announced the suspension of dividends on its Preferred Stock. Pursuant to the exchange offers, Citi offered to exchange up to $14,923,650,000 of its outstanding publicly-held Preferred Securities for Common Stock at a price per share of $3.25; 98% of the Preferred Stock elected to participate in the exchange offers. Dividends declared today will be paid on the Series AA, T, E and F Preferred Stock that remains outstanding.

Common Dividend The dividend reinstatement on those outstanding non-cum equity preferred is a hint to investors. Citigroup should be in no rush to reinstate the dividend on the non-cum equity preferred unless the Company is getting ready to repay a common dividend.  In my opinion, Citigroup will announce the payment of a $0.05 quarterly common dividend in the 1Q of 2011. Stay tuned.

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.

The initiation of coverage is probably more meaningful than the information contained in the research itself. It’s a beginning of a process that will open GGP to a completely new clientele and that will make GGP a “must” not only among mutual funds REITs but also among major REIT indexes.

The target price assigned by Credit Suisse is $16.50, a cautious estimate; however the timeframe for price appreciation is not disclosed. I hate sell-side research; it’s so vague and so long at the same time. That’s why my blog is called the way it is called.

However, there is some important information on the report, some regarding “Spinco” assets and its valuation, which I think it is worth a look:

• Several catalysts are mentioned for the price to reach $16.50; however I believe that it’s just a matter of when, rather than how, the company will reach its fair value value, which should be around $25, excluding Spinco, by the of 2011.
• After the recapitalization, GGP will remain a fairly leveraged company, with a LTD/EBITDA of 8.2x by the end of 2012, a multiple that should be below 7x. Post bankruptcy, additional deleveraging will have to occur, which can be a catalyst for equity appreciation over the long-term but it will depress the dividend yield.
• An interesting breakdown of “Spinco” assets and a highly subjective $4 price for “Spinco”.

Enjoy the reading!

Credit Suisse Report

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.

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.