Distressed Debt Analysis: Reader's Digest

On February 22nd, Reader's Digest emerged from bankruptcy. For those that are interested, the bankruptcy docket for Reader's Digest can be found here: Reader's Digest bankruptcy docket

Before I get to any analysis, I thought it would be interesting to note to readers that even though Reader's Digest has emerged from bankruptcy, there are still a number of things going on in the bankruptcy court. Some of these filings deal with advisor fees, or tax issues and sometimes things out of left field. For instance, according to docket 764:

Shortly after the occurrence of the Plan Effective Date, Canyon contacted counsel for the Reorganized Debtors regarding its distribution of New Warrants pursuant to the Plan because the Canyon Funds had not received any such distribution. Canyon timely submitted its Class 3 ballots and voted to accept the Plan and has advised the Reorganized Debtors that its funds holding Senior Subordinated Note Claims in the aggregate face amount of approximately $51.3 million intended to submit Class 6 ballots in favor of the Plan, but neither the Reorganized Debtors nor Canyon have evidence of such ballots being submitted prior to the Voting Deadline.

Based on their Class 6 claim amounts, the Canyon Funds are entitled to receive 163,567 New Warrants. Issuing the additional warrants will result in a total of 1,863,394 New Warrants being issued under the Plan (reflecting rights to acquire 6.3% of the New Common Stock issued as of the Effective Date, subject to the terms and conditions of the New Warrant Agreement).

Generally speaking, a lot of these post-confirmation proceedings will not help in our analysis. Sometimes, where there is litigation, there could be updates posted in the bankruptcy court that will update the court on the state of the litigation - but you can follow the litigation generally on its own docket (remember a lot of junior creditors these days are receiving funds from litigation as part of their recovery, so it is important to follow said cases).

Back to RDA. Reader's Digest's equity is traded off quite a few of the distressed desks. For example, JP Morgan was making a market 20.00-20.50 around the close on Friday. In addition to RDA's equity, they have a $525M Senior Secured Note that trades right around par (L+650, 3% Floor). The bond was initially priced at 97, so has done decently well in the high yield market. As of 3/31/2010, the company has $189M of cash on hand, and an a nearly unused $50M revolver. All this results in gross leverage and net leverage of 3.1x and 2.0x respectively.

One thing I like when analyzing a new credit like this is a sufficient amount of disclosure. Their first quarter announcement is incredibly detailed which gives us a good amount of information on their various businesses. In addition, the conference call transcript was quite informative. This tells me management does not have much to hide at this point and is doing its best to communicate with investors. As well they should, as management has warrants to receive 7.5% of the stock.

Management commented on the conference call that given current EBITDA levels ($167M) its low level of capex and cash taxes as well as moderate interest expense, the company "yields high free cash flow." With that said, if EBITDA materially declines, or the company needs to invest substantial amounts of fixed capital to stem revenue declines, the value proposition here might be less attractive.

Reader's Digest operates out of 4 segments: Reader's Digest United States, Reader's Digest International, Lifestyle and Entertainment Direct, and Other. Of the four groups, only Lifestyle and Entertainment Direct showed signs of increasing revenue in 1Q 2010. According to the company's website: "Lifestyle & Entertainment Direct is a global direct marketing business that sells an array of products, including Time Life products under license, primarily through DRTV." Despite revenues being down in 3 out of 4 segments, EBITDA margins expanded in the quarter by approximately 200bps.

For those that do not know what DRTV is - it stands for direct response television - TV advertisers put up a website or a 1-800 number and consumers respond - Reader's Digest Fitness Product has shown significant strength in this market. On the conference call, Mary Berner, the company's CEO stated: "We have an exceptional marketing channel in DRTV, and we intend to more aggressively exploit this robust channel by selling more of our own brands

through it, as well as continuing to work with partner brands."

Currently, RDA's comps trade on the order of 5-6.5x. With that in mind, and using the LTM EBITDA of $167M we can back into what valuation the market is implying for RDA:

Now there are two things we have to do to complete this analysis: 1) How much EBITDA is going to decline? and 2) How much cash flow will be generated in the interim period?

I am going to be conservative and use 3 cases: An annual 15% drop in EBITDA, a 7.5% EBITDA decrease, and a flat EBITDA over the next two years.

So using 5.5x, in 2 years, RDA is worth between 16 and 28 dollars a share. If you are confident that either EBITDA will be flat or that the resulting multiple is more than 5.5x (I am confident of neither), than you would be a buyer of this stock. At a trading level of 20.5, I find RDA as fairly valued here and would neither buy nor sell the stock.

That being said, given the situation above, cash levels at RDA will be near $300M (all else being equal). With debt outstanding of $525M, the debt looks pretty attractive here and probably trades at a discount to peers because of high yield investors typically being fearful of post reorg fixed income instruments.

Reader's Digest presents an interesting distressed debt opportunity and we will keep our reader's updated in the coming months.