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.

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.

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.