Distressed Debt Case Study: Lear

Before we get to the Lear distressed debt case study, I want to let everyone know that I received their email regarding the Distressed Debt Investor Club. I am happy to say I have received approximately 50 emails already. Please, if you don't mind, spread the word! I will talk about the application process in the coming weeks.

Now on to the fun stuff: Lear. For reference, here is the docket: Lear Docket.

Lear, like many auto suppliers before it, filed for bankruptcy protection due to declining auto sales (SAAR from 15M in 2007 to projected 8M in 2009) and its higher debt load. Knowing that the writing was on the wall, Lear and its lenders/bondholders worked out a pre-packaged bankruptcy (pre-pack) to allow for emergence as soon as feasible. The longer in Chapter 11, the more the lawyers and advisors get paid. No one wants that.

Lear detailed its proposed restructuring via an 8K that can be found here: Lear Proposed Restructuring. This is by no means a final agreement. As the 8K states: "agreement in principle" so there could be changes in the future. Summarizing:

• Restructuring approximately $2.3B of bank debt and hedging claims and $1.3B of bonds.
• $500M DIP consisting of a Term Loan that matures in a year and has a 15 month extension (needed if the case goes awry). Proceeds will be used for W/C and other corporate needs. The DIP is convertible into a $500M exit facility (rolled into) that matures 3 years after a plan is approved.
• The new Lear would consist of: 1) This $500M exit facility 2) A $600M second lien 3) $500M of preferred stock 4) And stock with certain management incentives and warrants to unsecured and lenders.
• The pre-petition bank debt lenders will receive, on a pro-rata basis: i) $600M second lien, ii) $500M of preferred stock which is convertible into 26% of common stock (excluding management incentive dilution) iii) approximately 26% of common stock (excluding managment incentive dilution). Their unsecured claim would be treated in the unsecured bucket (as an aside, this is an interesting point we haven't talked about...a bank debt lender is only secured up to the point that the collateral merits. So for instance, if there is $100M of senior secured bank debt and $100M of bonds, and the company's value is only $50M...lenders would have a secured claim for $50M, and an unsecured claim for $50M which they would share with the $100M of bonds...for a total unsecured basket of $150M...confusing I know)
• In the case Lear has more than $1B of liquidity at plan confirmation, certain excess liquidity will be used to pay down preferred, second lien, and the exit (in that order, respectively)
• Trade will be paid in cash
• Senior notes and other unsecured claims are getting 46% of stock (again fully diluted outside management grants) and warrants to purchase 15% of stock.
• Equity getting wiped out.
• Management getting an incentive plan to possibly own 10% of the post-reorg stock. This is HUGE in my opinion.

The 8K also goes on to list the value of Lear at $3.054B. From Bloomberg, the median EBITDA estimate for 2010 and 2011 is $511M and $550M respectively. With $1.2B of cash on the balance sheet today, this implies an EBITDA multiple of 3.6x and 3.4x respectively. To put this in perspective, in the middle of 2008, the sell side was estimating Lear would do over $1B in EBITDA for both 2010 and 2011. Further, EBITDA in 2007 was over $1.1B Management projected to lenders that Lear would do $450M of EBITDAR in 2009.

But can we really believe them?

Let's think about this for a second. Actually better yet, let's think about the incentives for a second. You can find these incentives in the same 8K, almost all the way to the bottom.

• Number of shares: 10% of new common stock
• Upon emergence, 2.7% of new stock...SO JUST FOR EMERGING THEY ARE GETTING 2.7% of the company. The CEO gets 18.25% of this or nearly 50bps of the new company.
• The remaining incentives will be performance based...i.e. meeting certain hurdles.

Now if you are management, are you going to go out there and say "Yea. We are going to crush it in 2010" even if you are 95% certain you would? Of course not. Setting a low hurdle when equity options are at stake is par for the course. So I would wager than $450M of EBITDAR in 2010 might be a lowball. Now remember, the CEO gets 18.25% of equity awards, so at some point in the future, he could own 1.825% of Lear. As of 3/14/2009, he only owned 0.565% of Lear...a much worse Lear with a lot more leverage. I have to say he is getting a pretty sweet deal.

So, now that we have all the technicals out of the way...let's see if there is anywhere we can make money? The pre-petition bank debt is trading at 70 cents on the dollar (was as high at 78 right after the filing). Currently, Lear has $1.2B of cash on the balance sheet and $2.25B of senior secured bank debt. Now we all know this year is going to be bad. They are going to burn cash. No doubt about it. Let's just assume, for simplicity, that they burn cash to that $1B liquidity trigger...i.e. they would emerge with $500M of cash.

Before I jump into what I think the bank debt is worth, I want to point out a few interesting / salient points about Lear. Lear has been a darling of the value investment circles. I believe Monish Pabrai (at least his consensus alias) wrote it up in Value Investor Club a few years ago. Rich Pzena has talked about it at Joel Greenblatt's Columbia class as a good investment. Franlin Resource, some of the best opportunistic value investors out there, is the 3rd largest holder. What gives?

Lear's main business, seating, is a duopoly in North America (Lear #2 supplier behind Johnson Controls). Both Lear and Johnson Controls have played nice and not gone into any sort of price war and surprisingly, have pricing power with the OEMs. Same thing in Europe with Lear #3 behind JCI and Faurecia. Further, the seating business really is not that terribly capital intensive relative to some other auto supplier businesses. EBIT Margins are tight right now given auto sale volumes, but management has led a fantastic cost cutting effort, and I believe a conservative run rate would be approximately 5% with definitely lots of room for upside. 50% of business is domestic, 50% overseas. Lear's electronics business is a smaller portion of the business, about 1/5 of total revenue. I am going to value this entire business at 0. Again, let's be conservative here.

Seating revenue in the past 5 years has been:

2008: $10.7B

2007: $12.2B

2006: $11.6B

2005: $11.0B

2004: $11.3B

Remember, we said this business should do at least 5% EBIT margins. Using a low of $10B of seat sales and a high of $11B, gets us to EBIT of between $500M and $550M. D&A at seating is approximately $175M giving us EBITDA of $675-$725M. Corporate expenses should trend around $175M (run-rate) implying total EBITDA of $500-$550M, in line with the sell side, and meaningfully over management. A quick point here...look at the leverage this company has. A 1% increase in EBITDA margins = $100M incremental EBITDA. BOOYA.

Again, let's say for the sake of argument, that cash is zero at emergence. I think Lear is worth somewhere around 5.0x, given the dynamics of the business. Let's use 4.0x, 4.5x, and 5.0x on our $500 - $550M EBITDA forecasts

At 4.0x on the $500M we are coming up with $2.0B of value. At 5.0x on the $550M of EBITDA we are coming up with $2.75B of value. So for our intent and purpose, lets figure out where the range of $2.0B-$2.75B puts us.

Now, I am going to make an an assumption here that all warrants, preferred conversions, awards are granted. What I am coming up with, as mentioned before, gives management 10% of the equity, and bank debt lenders 58% of the equity. So, all in all, the bank debt lenders are getting a $600M second lien note and 58% of the equity of the company (once preferred is converted).

With our range of $2B-$2.75B we need to deduct the $500M DIP and $600M second lien, and add back $500M of cash, to get to equity value. This gives an equity range of $1.40B to $2.15B. 58% of that plus $600M of second liens gets us to a recovery value of $1.41B to $1.85B. This versus a claim of $2.25B for, wait for it, a recovery of 63 cents - 82 cents. As an aside, bond holders are getting 32% of the company, giving them a recovery of 32% of our calculated equity value of $1.4B-$2.15B or ~$450M to $688M. This versus a claim of $1.3B implying a value of 35-52 cents on the dollar (bonds are currently trading at 40).

A few things to point out. Remember, we used a conservative seating margin, gave 0 value to the electronics business, used fairly conservative multiples, burned a lot of cash, etc. We may have been too conservative. At say $700M of EBITDA at 5.0x, bank debt lenders would recover north of par (~110 to be exact). The bond holders at these levels would be bigger winners.

In all honesty, I kind of like both securities. But not just yet.

Looking at Exhibit 10.1 in the 8K Lear filed outlining its plan, we can get a sense of who the lenders are. It definitely is an interesting mix. One thing that sticks out: Lots of CLO names on that list. CLOs do not like to hold equity (no cash flow relative to their liabilities). CLOs like it when recovery is granted via other cash paying debt securities - not equity, like in Lear's case. So, what I think you will see, or are seeing now, are CLO's selling down their paper, knowing that a large portion of their recovery is coming from equity. So when would I buy this thing? I would buy the equity, after it emerges and after the CLO dump is finished. I'd then be getting a conservatively levered (~2x) autosupplier, with solid prospects, and massive operating leverage at the bottom of the cycle, at probably a better discount than I am getting today. Now if they bank debt got to say, the mid 50s, or the bonds in the low 30s, then I'd be buying this paper. When the equity is free to trade, I think I am going to put on a position (assuming the puke is done in an orderly fashion)

Of course, I may miss it if it never gets to that level. But there will be more opportunities in the future. Have to watch a lot of pitches go by before you take your swings. This will indeed be an interesting distressed debt case to follow.