Distressed Debt Case Study

Contributor Mark has been working diligently on our next distressed debt example. We hope you enjoy:

Introduction:

One of the reasons that distressed debt investing has the propensity for generating significant alpha is the fact that the distressed market is less efficient than other markets such as equity markets. Imperfect information and access to this information results in inefficiencies where astute investors can take advantage of market pricing anomalies and thereby earn substantial returns.

To take things a step further, illiquid or small cap issuers can result in even greater inefficiencies, and thus even greater alpha. Take, for instance, a small cap company that issues a term loan which subsequently trades in the secondary market with an 8 point bid/ask spread. There are two important things here to note:

1.) The small size of the issuer will likely result in many funds not being able to invest based on their policy statements (IE they may not be permitted to delve into issuers with market caps of say, less than $100 mm), and also based on the fact that small size loans and issuers are just plain overlooked by larger funds that need to put more money to work.

2.) The wide bid/ask spread means the issue doesn’t trade often. Although a bank might quote you 80/88, you likely could lowball it closer to the bid size and get a bite, thus creating a lower entry point than you would if the issue traded like water at a bid ask of 87/88. This is particularly advantageous if you plan to hold the security until maturity since you won’t have to deal with the heartburn of trying to sell an illiquid security when it’s time to take profits.

There are funds out there that specifically deal with odd lot small size deals specifically because of the opportunities the inefficiencies create. Generally larger funds chase larger deals, and view the effort and due diligence needed on small issues as a waste of time. This foregone investment can be a golden opportunity for others, and with this in mind, I would like to present a term loan issued by Interstate FiberNet, a subsidiary of ITC Deltacom (ITCD).

Structure:

The first thing we will do is address the structure of the deal, for those of us who don’t recall the lesson on structural subordination, this will be a brief refresher. Interstate FiberNet is the main operating subsidiary of ITCD, and thus is where the assets are held. Since the term loan was issued at the opco level, and is secured by all the assets & guaranteed by such opco, we know that structural subordination is not an issue. Additionally there is what we call an ‘upstream guarantee’, where the parent (ITCD), provides a full guarantee with respect to the loan. ITCD also provided a pledge of all of it’s assets to secure the term loan.

Business:

ITCD is a Competitive Local Exchange Carrier (CLEC) providing voice, data, and internet services strictly to business customers over it’s fiber backbone spanning across the southeastern United States. CLECS compete with Incumbent Local Exchange Carriers (ILECS), which are the more dominant larger companies that have been in existence providing telephone service in their given markets since the time of the Telecommunications Act of 1996. In this particularly deal we are analyzing today, AT&T would be the primary ILEC with whom ITCD competes with.

ILECS are required to offer collocation of facilities with other carriers, where such carriers can use network elements of the ILEC to provide their own facilities. The rates at which these Unbundled Network Equipment Platform (UNE-P) lines that ILECS must provide are set ‘reasonably and commercially in good faith’, and regulated by the FCC.

Investment Considerations:

To illustrate the purpose of such an agreement, think of a CLEC who does not have many of their own facilities, in order to even reach certain markets, they would need to effectively ‘piggy back’, on the network of the ILEC at the UNE-P rates. Another example is the final local loops or “last mile” copper lines. It would be economically unfeasible for a small carrier to outlay the funds needed in order to replicate such a structure, thus it must rely on one already in existence. ITCD is a facilities-based provider, and as such provides the majority of its services over its owned and operated network. It costs ITCD less to operate over its own lines than to pay the UNE-P rates, and as such ITCD has been effectively reducing its cost structure and increasing margins by increasing the lines offered on it’s own network versus through the more expensive commercially negotiated lines. Specifically as of Q1 2009 the company had 428,800 voice lines in service of which 86.2% were provided through its own network, up from 82.5% in Q1 2008. ITCD has also been reducing headcount, down 3.5% from FYE 2008. The following cost reductions along with a few others were able to increase margins enough that despite a decline in overall voice lines and drop in revenue of 2.25% from Q1 2008, EBITDA actually increased to $22.4 mm in Q1 09 from $20.8 mm in Q1 08, or 7.3%.

In my analysis I assume that revenue further declines due to an extended recession, resulting in a decrease of approximately 4% of annualized Q1 numbers for FYE 2009, and EBITDA margins contract 16% (the same as FYE 2008, down 2% from Q1 2009). This would result in FYE 2009 EBITDA of around $75 mm, which is probably a bit on the conservative side. At this level I expect levered free cash flow to be relatively flat or ever so slightly down, say between $0 mm and -$5 mm, as CAPEX should be down to more historical levels of around $45 mm after the company’s network investment in 2008 and Q1 2009. ITCD also has a ‘plain vanilla’ interest rate swap on it’s term loan with a notional amount of $210 mm, in which it has locked LIBOR in at 4.995%. When this hedge rolls off I expect the company to negotiate a new hedge at more economical rates, which will likely save a couple $mm of interest expense for the year.

With an assumed forward EBITDA for FYE 2009 of $75 mm, and applying an extremely conservative 2x multiple, we arrive at the following valuation and recovery prospects:


Enterprise Value @ 2.5x EBITDA¹ $ 187,500,000

Amount available to Pre-Petition Claims $ 187,500,000

Term Loan ($230 mm at issuance) $ 224,585,000
Revolver $ 10,000,000
Capital Leases $ 19,000,000
Total 1st Lien Secured Claims $ 253,585,000

Amount available to Second Lien Claims $ 0

Second Lien Credit Facility $ 75,000,000

Recovery
Forecasted 1st Lien Recovery 74%
Forecasted Second Lien Recovery 0%

Recovery @ different EBITDA multiples Recovery
@3.0x 89%
@3.5x 104%
@4.0x 118%

¹ S&P assumes 2 X Multiple and a 30% decline in EBITDA, which is how they arrived at their 5 recovery rating. Most recent comparables indicate 5 X is average for the industry, 2 X is a very bearish implication. A transaction for a similar network 9 months before the recovery report was issued traded at 11 X.

*RCL currently has 8.5M Drawn and 10M is total size

What the above analysis shows us is that at $75 mm EBITDA and applying only a 2.5 multiple, we are at 74% recovery. The term loan is currently pricing 73/78 so if we were to invest today our cost basis would be just about fully recovered as the loan is fairly valued. The above set of conditions is what I would consider to be a worst-case scenario, indicating that this pricing level would be the bottom for the loan. Several months ago the loan was actually pricing in the mid – high 50’s, and I commend any investors who snagged it at those levels. Now in reality I believe the appropriate multiple for this company to be closer to 4x-5x, and as you can see above the recovery prospects are well north of 100% resulting in an IRR of 13.4% and a current yield of 6.03% at current LIBOR of 0.51%.

In the analysis above is a footnote referencing S&P’s recovery ratings, a 5 recovery rating translates to 10-30% recovery prospects, the assumptions S&P used to outline their ranking are described in the footnote. To illustrate why I disagree with the assumptions provided by S&P, a brief synopsis of how their recovery rankings are produced is worth discussing.

S&P’s Recovery Analysis:

S&P recovery rankings are designed to show the prospects of recovery in a default situation, in order to arrive at a default, S&P almost always (with certain exceptions) stresses EBITDA to a level where covenants break. The next step is routinely to put a DIP Loan in front of the debt stack based on liquidity that will be needed to emerge from this simulated bankruptcy, this DIP primes all the other debt, and thus dilutes recovery. Additionally, after already stressing EBITDA down to low levels, S&P uses what I would consider to be ultra-conservative multiples.

There are two issues I have with this approach. First off, stressed EBITDA is not always the reason that a company may face default. Say for instance, a company was producing $100 mm in EBITDA, had $30 mm in interest expense, and $50 mm CAPEX, and thus generated $20 mm Free Cash Flow annualy. Now lets say there are no signs indicating a catastrophic dropoff in revenue, however there are several large maturities amounting to $200 mm total over the next two years. The reason for default here is likely the maturities if the company cannot refinance them as their FCF only allows them to pay down $40 mm leaving $160 to account for. However, the EBITDA and overall cash generating prospects of the company have not changed. Now if we were looking at a recovery ranking, they may have squashed EBITDA down by 30% to produce a default, and then apply a lowball multiple to an already unnecessarily stressed EBITDA. Doing this will produce an artificially low Enterprise Value. Secondarily, mathematically speaking, EBITDA multiples represent the relation between the discount rate and growth rate of a company, just like P/E multiples for equity. The higher the growth rate of cash flows, the higher the dollar amount an investor will pay for each dollar of earnings, similarly the more these cash flows are discounted, or the higher the discount rate, the lower amount an investor will pay for each dollar of cash flows as the present value is worth less. The above statement can be illustrated by analyzing the following formula for a cash flow multiple:

∑ [CF * (1+g)ⁿ / (1+k)ⁿ] ÷ CF

where “CF” is the initial cash flow, “g” is growth rate, “k” is the discount rate, and “n” is the number of periods. Now if you are already flexing EBITDA down to create a simulated default, you have already taken care of the low growth rate, so why would you take it a step further and apply an uncharacteristically low multiple (compared to industry trading averages)? I know this may seem like a lot of detail to explain a simple rating, but in this particular case study, I feel it is worth discussing due to the fact that the only real wall street coverage on this credit is from S&P, and their rating is pretty dismal. The fact that the only analysis out there is very negative is, in my opinion, a likely reason the debt is still trading at distressed levels.

Skin in the Game:

This deal is the product of a recapitalization that took place in 2007, where the company exchanged equity and used the proceeds of new debt to refinance and retire substantially all of their then outstanding debt. At the of the recap the company had a First Lien and Second Lien Facility outstanding, as well as Third Lien notes and various classes of Preferred Stock. The First and Second Lien Facilities were fully repaid with the proceeds of the new debt that was issued (the new debt refers to the $230 mm Term Loan we are analyzing in this case study, as well as the $10 mm Revolver secured and guaranteed equally and ratably with the Term Loan, and the $75 mm Second Lien Facility), and the third lien notes were paid off mostly with the residual proceeds from the new debt as well as a small portion of equity for the balance. Preferred’s got equity.

The original First Lien and Second Lien Facility were provided by funds affiliated with Tennenbaum Capital Partners (“TCP”), who also held a portion of the Third Lien Notes and Series D Warrants. Prior to the recap TCP held no equity interest in ITCD, but post-exchange TCP had approximately 20% of the equity in the company, as well as the ability to appoint 2 board members, which they have. Even further, the entire new $75 mm Second Lien Facility was issued by TCP and subsequent to issuance of the First Lien Term Loan TCP received a syndication interest in a portion of the Term Loan. Additionally after the syndication TCP purchased some of the First Lien Term Loan in the open market, and has recently been purchasing equity in the open market (to be exact 1,070,569 shares at a weighted average price of $0.55 for total cash consideration of $612,404.40) from November 28, 2008 until as recent as June 10, 2008. While in absolute dollar amount this may not appear a large position, it did increase their stake by about 10% as they currently hold 11.6 million shares, and with only 80 million shares outstanding, this is a 15% stake in the company.

The point of all of this is to show that the TCP funds have what I would consider to be considerable “skin in the game”. If you were a fund who provided credit to an issuer which later went through a recap, would you be willing to participate in their subsequent refinancing and recapitalization unless you were pretty confident in the future of the company? There is a very big aversion in the investment industry to “throw good money after bad”, IE continue to escalate a position that is likely to ultimately fail in hopes that it will turn around. Most companies will only keep throwing money in an investment if they are fairly certain of a profitable outcome, and the folks at TCP are no dummies. To me the fact that they went through one recap, provided funding to refinance their loans they made the first time around, and continue to purchase the equity in the open market says to me that they believe in this company, and you better believe with the amount of capital they have invested that they have done substantial due diligence. It is also probably worth mentioning that Welsh Carlson beneficially owned the majority of ITCD’s equity pre recap, and due to their position in some of the Third Lien Notes as well as various series of Preferred Stock, they received even more equity during the recap. Currently they hold about 48% of the equity and thus are the controlling holder. They have 3 board seats, TCP funds as mentioned earlier have 2, and the board as a whole has 9 seats. This company is essentially being run by two funds both with a lot at stake, and a lot of financial savvy to help move this company in the right direction. Additionally one of the funds is still throwing cash into the company.

Conclusion:

There are a couple of factors that play into this deal. Given the complete lack of coverage by all but S&P’s draconian Recovery Analyses, and the small-cap status of the Issuer, I feel the deal has likely been under the radar to most investors. The lack of eyes reviewing the security and thus the relative illiquidity evidenced by the bid/ask spread has resulted in a price that is what I believe to be below intrinsic value. Assuming a price of 75 which is around the midpoint of the bid/ask spread, and with a coupon of L+400 at current LIBOR of 51 BPS, the IRR on this Term Loan is 13.4% with a CY of 6.03%. Given the recent run-up in the high yield markets I feel this is an attractive yield given the improving credit metrics for the company. The most restrictive of the Company’s covenants is it’s 1st Lien Leverage Covenant, which is 3.00:1.00 until the end of 2009, then stepping down to 2.75:1.00 for the period 1/1/2010-9/30/2010, and finally 2.50:1.00 for the period 10/1/2010 and thereafter. The company is currently in compliance and I anticipate they will be able to maintain compliance due to their substantial liquidity ($65.8 million cash on the balance sheet for Q1 2009), and estimated flat to mildly decreasing FCF position over the course of the next year.

Questions / Comments / Thoughts always welcome here at Distressed Debt Investing