Guest Post - American Axle

Contributor Nathan, has penned an ex-post facto distressed debt analysis of American Axle. We had been working on the case study and all the big news hit - timing is a bitch sometimes. Hope you enjoy.

AMERICAN AXLE – DISTRESSED SCENARIO ANALYSIS

For this entry we will be doing an ex post facto analysis of the American Axle situation as it existed in early August. Those that have followed this situation know that it appears Axle has escaped bankruptcy (for now), which obviously takes a lot of the fun out of presenting this case study. However, we think this entry will provide a good example of some core distressed investing concepts, namely capital structure trading and scenario analysis. The remainder of this entry will refer to the Axle situation as it existed August 5th, which is when the author initiated his positions in the bonds (long) and stock (short) following the company’s 2Q earnings announcement. On that date Axle stock closed at $3.75, up some 43% on the day, while the unsecured bonds ended the day quoted 42-44 (w/o accrued).

American Axle (“Axle”)—along with the vast majority of its auto parts supplier peers—has reached the crossroads of default thanks to the unprecedented decline in new vehicle production. Axle’s acute bankruptcy risk manifested itself in the form of a credit agreement covenant violation for the period ended June 30th. Shortly after quarter-end the company announced via an 8-K (July 7th 8-K) that it had entered an agreement with its bank lenders to waive the covenant violations through July 30th, in exchange for a security interest in its cash collateral, among other things. The waiver was subsequently extended to August 20th.

So unlike a case where bankruptcy is either existing or unavoidable, it is necessary to determine both the probability of bankruptcy and the approximate security prices in both survival and bankruptcy scenarios. Starting with the probability estimate, it is important to note some of the offsetting factors unique to the Axle situation that gave conflicting signals as to whether or not the banks would ultimately push the company into bankruptcy.

The reasons not to accelerate are fairly straight forward. First and foremost banks generally do not want to force bankruptcies if there are any feasible alternatives. Also, Axle’s secured leverage is reasonable relative to industry multiples, implying decent asset coverage for the bank lenders. Assuming a fully drawn revolver, Axle’s secured leverage is approximately 3.0x the 2010E consensus EBITDA estimate compared to the standard industry multiple of 4.0x-5.0x.

On the other hand there are other reasons that make a filing a real possibility. For starters, last November Axle and most of its revolving credit lenders agreed to extend $370 mln of its $475 mln revolving credit commitments to December 2011 from April 2010. This created a fairly unique dynamic whereby the non-extending creditors will mature before their extending peers. This is a big problem for Axle because there is nothing the banks despise more than pari passu or junior creditors getting paid before them. Along the same lines, Axle is expected to burn cash in 2H09 due to working capital outflows and a $40 mln buy-down payment to its remaining UAW employees. Obviously, the worst case scenario for the banks would see Axle narrowly redeem the April 2010 revolver and then file shortly after, avoidable preference notwithstanding.

So after examining the most prominent pros and cons of a bankruptcy filing (from the bank’s perspective) we assign a “highly scientific” near-term probability of default of 50%. Now we will estimate Axle’s security prices under the two scenarios. Starting with the non-bankruptcy scenario we estimate that the bonds would rally to $68 (with accrued), which with a 15% YTM would leave Axle’s bonds a little cheap to similarly rated issues of TRW and ArvinMeritor. With regard to the stock I assumed the market would assign Axle an enterprise value of approximately $1.5 bln ($300 mln 2011E EBITDA * 5.0x multiple). I further assumed net debt would increase by $50 mln to $1.1 bln, leaving $420 mln of equity value divided by 55.4 mln shares for a $7.50 price.

For the bankruptcy scenario we will assume that the stock goes to $0.75 and did a recovery analysis for the bonds (Appendix 1). Based on a base case unsecured recovery value of 47%, discounted at 25% for 1.5 years, we think the bonds will fall to 34% (32/34 bid/offer) if Axle is forced to file. So with the final piece of the puzzle in place we can now take a look at what a cap structure trade would look like.

Based on my assumptions Axle’s bonds and stocks are clearly mispriced relative to each other. By putting this trade on in the above sizes, I have an expected value of over $200K per $1 mln of capital. Now, you might be asking, if you really think the probability of a bankruptcy is 50/50, why wouldn’t you size the positions to maximize profitability in each scenario? The short answer is that I thought the probability of a bankruptcy was lower than 50%, with the unseen scenario of Axle pulling off some form of dilutive equity deal (probably involving GM). This scenario would obviously be good for our bond position and “less good” for the stock.

Fast forwarding a week to August 12th, Axle made the coupon payment on their 5.25% ’14 Notes, which sparked a huge rally in the bonds, while the equity really didn’t budge. The next day we sold our bonds (7.875% ’17) at $60.50 ($57+165 days of accrued) and covered the stock at $3.48 for a nice 75% return on capital, less the borrowing costs on the stock (L+350 for five trading days). Not bad for a week’s work.

Admittedly, this type of analysis is more art than science. I’ve taken a dynamic situation with several potential outcomes and (over)simplified it into a binary framework. I’ve also made highly subjective estimates about forward security prices. The very fact that I made a 75% return on a trade where my “best case” scenario targeted only a 30% return shows how imprecise these exercises can be. However, I believe I used reasonable judgment in shading the inputs to the conservative side for each scenario and firmly believe the risk of a permanent loss of capital was very low given the attractive entry prices. And as a doctor friend of mine once remarked, “Everything is more art than science, even science.”

	AMERICAN AXLE & MANUFACTURING, INC.
	Bankruptcy assumptions:				Duration	1.5 yrs
	Company files on Sept 30, 2009				Exit lev	3.0x
	New money DIP				DIP amt	250.0
	Trade payables, Pension and OPEB rolled				DIP rate	10.0%
	Intercompany payable pledged to secured creditors
	RECOVERY WATERFALL			Base
	2011E EBITDA	225	250	275	300	325
	Multiple	4.00x	4.00x	4.00x	4.00x	4.00x
	Asset Value	900	1,000	1,100	1,200	1,300
	Cash at filing	280	280	280	280	280
	+ New money DIP	250	250	250	250	250
	+/- Op cash burn	-160	-160	-160	-160	-160
	- Admin fees (5% of base EV)	-55	-55	-55	-55	-55
	- Less DIP interest	-38	-38	-38	-38	-38
	Net cash build / (burn)	-253	-253	-253	-253	-253
	Minimum cash	150	150	150	150	150
	Excess cash	128	128	128	128	128
	Distributable value	1,028	1,128	1,228	1,328	1,428
	DIP Facility	250	250	250	250	250
	Remaining value	778	878	978	1,078	1,178
	Domestic ops (33% of value)	257	290	323	356	389
	Foreign ops (67% of value)	521	588	655	722	789
	Intercompany notes	308	308	308	308	308
	Equity	213	280	347	414	481
	Equity value of foreign ops at 66%	141	185	229	273	317
	Domestic ops	257	290	323	356	389
	Total value to secured claims	705	782	860	937	1,014
	Pre-petition secured creditors	720	720	720	720	720
	Secured creditor recovery %	98%	100%	100%	100%	100%
	Residual value to unsecured	0	62	140	217	294
	Value of ops not pledged	72	95	118	141	164
	Total distributable value to unsecured	72	158	258	358	458
	Senior unsecured bonds	550	550	550	550	550
	Recovery %	13%	29%	47%	65%	83%
	Discounted recovery at 25%	9%	20%	34%	47%	60%
	TRADE P&L
8/6/2009	Buy 7.875% (flat)	-44	-44	-44	-44	-44
9/30/2009	Company files	0.00	0.00	0.00	0.00	0.00
3/31/2011	New Co. Emerges	13.16	28.64	46.82	65.00	83.18
	IRR %	(51.9%)	(22.9%)	3.8%	26.7%	47.1%