Distressed Debt Case Study: ABH / Bowater

Every few months, I try to post a recent idea from the Distressed Debt Investors Club to give readers and potential applicants a sense of the quality of ideas on the site. With that I give you a recent submission by "shoreboy" on Bowater. Enjoy!

Synopsis

We recommend an investment in the AbitibiBowater “Bowater side” unsecured bonds at a price of 30.5, or 2.9x-3.4x run-rate EBITDA (depending on the outcome BOW Finco double dip dispute) offering near term upside in excess of 50% at an important turning point in the cycle. More importantly, we believe downside is supported by low financial leverage and extremely high free-cash flow generation (worst case scenario FCF yield of 15% assuming downside EBITDA of $500mm and a complete loss to the Bow Finco double dip).

Investment Write - Up

Recommendation:

Dramatically Restructured Operations: ABH significantly transformed its business while in bankruptcy, closing high cost mills, shifting focus to more attractive paper grades, and slashing operating costs. As an example, ABH closed in excess of 900k tons of newsprint capacity (representing 20% of ABH’s capacity and in excess of 10% of North American capacity) since January 2010. We anticipate only 35% of future EBITDA will be generated from Newsprint, with the other 65% coming from coated paper, specialty paper, pulp, and wood products. Additionally, the company reduced fixed costs by $900mm and will benefit from an agreement with the union upon confirmation of the plan of reorganization, which will further reduce COGS & SG&A by $95mm.

Overly Pessimistic Outlook for Newsprint & Under appreciated Sustainable Export Story: As a result of the secular decline in North American newsprint demand accompanied by the step-function loss of demand experienced during the financial crisis, much of the North American newsprint industry found itself in financial distress over the past couple of years. The industry responded by dramatically reducing North American capacity by in excess of 25% since 2009. This reduction of capacity has caused a spillover effect which has increased the cash costs for newsprint manufacturers outside of North America and thus, shifted the cost curve in favor of the North American producers (who are currently the low cost producers in the world). This dynamic stems from North American producer’s outsized reliance on virgin wood fiber as its key raw material, relative to Asian and European producers who rely much more heavily on recycled newspaper (ONP – old newsprint). Historically, ONP was in plentiful supply and thus, its cheap cost accompanied by a production process that was less energy intensive allowed ONP mills to produce newsprint on the lower end of the global cost curve. As a result, almost all of the European and Asian mills built over the past two decades have been ONP based and most do not have the equipment or the wood supply to produce newsprint using virgin wood fiber. ;This has come back to bite them, as ONP can only be recycled 4 times before the fibers breakdown and Asian producers must source ONP in North America (which they then have to ship back to Asia) because of its high virgin fiber content. Due to the rapid decline in North American production of newsprint, unsurprisingly recycled newsprint has become increasingly tight (and is expected to remain tight) – driving up the cost for ONP to in excess of $100 per ton relative to $50 two years ago. Additionally, the current low cost of natural gas in North America has reduced the energy cost advantage of the ONP production process.

As a result, North American producers currently have ~$150 cash cost per ton advantage over Asian producers. Meanwhile, European producers would not be competitive until the Euro was sub $1.20, a situation which seems less likely every day. All of the aforementioned factors have created a huge export story (ABH is currently exporting over 50% of its production and is turning down export orders) allowing North American producers to operate at 100% utilization ratios and thus, creating pricing momentum. Despite the continued secular decline in North American newsprint demand (which is expected to continue to decline at 5-6% per year), the rest of the world is actually growing - Asian demand is expected to increase in excess of 500k tons per year through 2014 (more than offsetting the decline in North American demand, as the base of North American demand is already extremely low) as literacy rates increase in emerging markets. Therefore, we expect ABH will maintain their ability to generate meaningful cash flow from newsprint operations into the foreseeable future, as it exports more of its production into the Asia and Latin America.

Near-term Upside in Coated & Super-Calendar Paper: ABH has in excess of 1mm tons of capacity of coated paper and super-calendar paper, representing in excess of 15% of North American production. Due to a dramatic reduction in capacity and inventories, accompanied by a second half recovery in magazine and catalog circulation, coated paper manufacturers have recently announced $100 per ton of price increases. Despite these price increases, we believe there is room for additional price increases, as prices remain near historic lows on a real basis. Additionally, the US ITC ruled on Friday that domestic coated paper makers are being harmed by low-cost imports from Indonesia and China. This was the last of 4 decisions that was necessary for tariffs to be imposed on imports and is expected to keep the Chinese out of the domestic market for the next 5-years, which should further support price stability.

Pulp – A long-term Secular Story: The recent run-up in pulp prices in 2010 to in excess of $1,000 highlights the long-term story for pulp, as consumption per-capita increases in the developed world, as more and more people in emerging market use tissues, toilet-paper, diapers, etc. and and areas of North America are the only place in the world that produce long-fiber NBSK pulp. While many of the industry forecasters expect short-term pulp prices to decline, recent industry pulp data has indicated a more gradual decline, as demand in China continues to support pricing. Regardless, current prices are in excess of the plan assumptions.

Option on Wood Products & Upside from Monetization of Other Ancillary Assets: I currently ascribe no value to the wood products division as well as a number of other ancillary assets, including timberlands and closed mills (which they have been selling to scrap steel companies for $15-20mm). While the wood products division is currently generating virtually no EBITDA, it has generated as high as $100mm of EBITDA in the past and I believe normalized EBITDA for this business is $75mm. Assuming 5x, this business could be worth $375mm alone (7.5 bond points, or 25% upside from today’s price).

Business Overview/Paper Grade Exposure:

• Newsprint: 3.3mm tons of capacity representing 9% of worldwide capacity and 37% of North American capacity
• Coated papers: 658k tons of capacity representing 15% of North American capacity
• Specialty papers: 1.8mm tons of capacity representing 36% of North American capacity (note: roughly 1/3 of this capacity is supercalendar capacity, which trades like coated, 1/3 trades like uncoated, and 1/3 trades like newsprint)
• Market pulp: 1.1mm tons representing 7% of North American capacity
• Wood products: the company operates 18 sawmills in Canada that produce construction grade lumber sold in North America.

Simplistic EBITDA Projections:

Key EBITDA Sensitivities

-/+ $25 newsprint = -/+ 80mm of EBITDA

-/+ $25 CPP = -/+ 55mm of EBITDA

-/+ $25 Pulp = -/+ 26mm of EBITDA

+/- .01 C$/US$ = -/+ 18mm of EBITDA

+ / - 10% natural gas = -/+ 11mm of EBITDA

Other Investment Considerations:

Bowater Finco Double Dip: The outcome of this inter-creditor dispute remains unknown, and appears to be trending in favor of the Finco. However, based on current prices on the Abitbi-side, the market is currently ascribing now value to the option associated with this claim. Said differently, the market is implying 100% probability the Finco wins. While I don’t have any special view towards the outcome of this case, assuming a 50/50 chance (or a settlement that splits the value down the middle), the bonds should be at 33.5 (3 points higher, or approximately 10%)

ACH Sale: ABH is in the regulatory process of selling its Canadian Power Assets. The assets have $239mm of debt associated with them, which is non-recourse. We expect the assets will be sold for in excess of $400mm ($200mm of equity value) by Q1 2011. The proceeds will be used to pay off the debt at ACH as well as pay off up to $100mm of the 850mm exit debt.

Pension: The company has an underfunded pension of ~$400mm (as indicated Plan Projections on the POR balance sheet), most of which resides in Canada. The company is in the process of finalizing a deal with the governments of Quebec and Ontario that will limit the cash contribution of the pension catch-up payments to $50mm annually. As a result, I add $424mm underfunded pension (the NPV of $50mm per year) to my gross debt.

NOL’s: ABH has retained significant NOL’s and we do not expect them to be a significant tax payer for an extensive period of time.

Emergence, Listing, & Technicals: We expect the judge will confirm the plan within the next two weeks and likely will not rule on the Finco double dip (expect a 17% holdback). We do not expect this company will experience a technical sell-off post-emergence (ala Lyondell & Smurfit). The investor base is strong and the stock will be tightly held – large holders include Avenue, Paulson, and Fairfax. Additionally, the company will be immediately listed (day 1) on the NYSE and will have a secondary listing on the TSX (Toronto Stock Exchange). Furthermore, we believe there is a possibility ABH will experience a strong technical bid from Canadian Pension Plans, who typically hold substantial positions in Canadian Companies that trade on the TSX, and may be flush with cash assuming the Potash deal goes through.

Upside/Downside Cases (click to enlarge)

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Warren Buffett's Successor

Many of you know I run a value investing blog side project. I also know many of you have asked my thoughts on Buffett's choice of Todd Combs to begin running some of BRK's capital. I wrote an extensive post that you can find here:

Value Investing: Warren Buffett’s Successor: Todd Combs of Castle Point Capital

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Trade Claims Primer

It gives me great pleasure to introduce a new contributor to Distressed Debt Investing, Joshua Nahas, principal of Wolf Capital Advisors. Wolf Capital is a Philadelphia based advisory firm focused on distressed debt, corporate restructuring, corporate finance advisory and capital raising services. Wolf provides advisory services to hedge funds and private equity funds on distressed investing and provides restructuring services to debtors as well as creditor committees. In his first post, Josh provides a primer on the sometimes esoteric field of trade claims trading and investing. This is a must read for all distressed debt investors. Enjoy!

Trade Claims Primer

Introduction

While bank lenders and bondholders generally represent the largest portion of debtor’s pre- petition claims, upon filing there is a large constituency of other creditors who also possess claims against the debtor at various levels of priority within the capital structure. Because the sale, assignment and transfer of ownership of these claims are not considered securities, securities trading laws do not apply. The lack of uniformity and active market for these claims makes the instruments less liquid and transparent, thereby providing an opportunity for outsize returns for those willing to perform the necessary due diligence and shoulder the liquidity risk.

Vendor claims generally trade at a 10-20% discount to other wise pari passu securities and therefore present a potential arbitrage opportunity for investors. The typical vendor does not wish, or may not be financially able, to wait months or possibly years to receive his money and is usually sufficiently motivated to sell his claim at a discount. A distressed investors may also purchase trade claims as a way to obtain strategic advantage in a restructuring. By gaining control of a larger share of a company’s General Unsecured Claims (“GUCs”), a sophisticated distressed investor can gain leverage to influence negotiations with the Debtor and other Creditors. By purchasing trade claims at a discount to the unsecured debt he already owns, the investor also lowers the effective cost basis of his investment (assuming trade and bonds will receive the same consideration in the reorganization). In addition, if the claims pool is large enough an investor can set up a capital structure arbitrage trade by going long a trade claim and short pari passu unsecured bonds of the same company.

In structuring such a trade, one must ensure that the bond and the claim are at the same entity and that the bond does not have any guarantees or claims on subsidiaries that might make it more valuable. For instance in the case of Nortel Networks, their North American bonds issued at Nortel Networks Inc (“NNI”) had guarantees from their Canadian parent which the trade claims of NNI did not. Thus, one had to segregate the value of the North American and Canadian operations to determine the value of an NNI claim. Fortunately in this case there were bonds issued at the Canadian parent Nortel Networks Corp (“NNC”) that did not have recourse to NNI, so one could subtract the value of an NNC bond from an NNI bond to find the implied value of an NNI claim. Many times this is not the case and one needs to try and apportion the value using information available in the company’s financial statements. If the company has subsidiaries that are not guarantors of its debt then it will segregate the financials of the guarantor and non-guarantor subs. Also, one may look to segment reporting of revenue and EBITDA and attempt estimate how much value may be attributable to the various entities. In a scenario where the investor faces a great deal of uncertainty over valuation and how it will be attributed amongst various entities, he must bid an appropriate discount to compensate for the risk.

Types of Claims

A “Claim” is a right to payment, whether that right is fixed, liquidated, potential or contingent (i.e., based on the outcome of litigation). Claims can fall into different categories: priority, secured, unsecured, contingent, liquidated, disputed or matured. The most common claim to arise out of a bankruptcy filing is a vendor claim or trade claim as they are more commonly known. These claims arise due to the fact that a company’s suppliers ship goods on credit ranging anywhere from 30-90 days. When a company files for bankruptcy it likely to be in arrears on its accounts payable, this increases the amount of debt on its balance sheet (AP), thereby increasing the tradeable instruments in the debtor’s obligations. While trade claims are the most common, there several other types of claims that arise from a bankruptcy filing which provide potential investment opportunities. These include:

• Contract Rejection Damage Claims: Damages resulting from the termination of contracts under Section 365 of the Bankruptcy Code.
• Deficiency Claims: Secured claims that are under collateralized result in a deficiency claim under Section 506 of the Bankruptcy Code for the portion of the claim where there is insufficient collateral securing the claim.
• Pension/OPEB Claims: Collective Bargaining Agreements (“CBAs”), Defined Benefit Pension Plans and other employee benefits that are terminated pursuant to Sections 1113 and 1114 of the Bankruptcy Code give rise to unsecured claims.
• Contingent Claims: Claims that may result from pending lawsuits, environmental damages or other contingent events. Some examples of cases where large contingent claims were involved include the asbestos cases such as Owens Corning, Grace and Armstrong and environmental claims include cases such as Asarco and Tronox.
• Priority Claims: Generally include back taxes and unpaid employee wages and benefits, however, can also include lease deposits up to $2,452 and “Gap Claims” which arise when the Debtor is targeted in an Involuntary Bankruptcy Petition filed by one of its Creditors. All trade debts incurred in the period between the filing of the Involuntary Bankruptcy Petition and potential Entry of the Order for Relief by the Bankruptcy Court will be deemed to have a priority status.
• 503(b)9 Claims: These are claims for goods shipped within 20 days of a company filing for bankruptcy. Unlike other trade claims, these claims are accorded administrative status and are paid in full as long as the estate is administratively solvent.
• Reclamation Claims: Reclamation claims allow for the Creditor to reclaim the goods shipped to the Debtor. These claims arise under state law, §2-702(2) of the Uniform Commercial Code (“UCC”). Once the Debtor files for bankruptcy protection, §546(c) of the Bankruptcy Code preserves a creditor’s state law reclamation rights, those rights are enhanced by the code and create additional requirements and defenses. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) expanded the reclamation period from 10 days to 45 days prior to a bankruptcy and to 20 days post-petition from 10 days previously. There are a number of requirements that must be met for these claims as well as potential defenses against such claims.

Proof of Claim

In order for the Creditor’s claim to be paid he must file a Proof of Claim (“POC”) with the court. This is done by filling out Official Form 10 within 90 days from the Section 341 meeting of creditors and filing it with the Bankruptcy Court. The date past which a claim can no longer be filed is known as the Claims Bar Date, and claims past this date generally will not be paid, although it is possible to appeal. The POC will have a Docket Stamp on it denoting the date of its filing. The POC must be signed by the creditor, include the amount of the claim, whether there is a perfected security interest and have attached to the POC documentation evidencing the claim such as invoices, purchase orders or contracts.

Sample of Proof of Claim Form 10

Sourcing Trade Claims

Upon filing of its petition for bankruptcy, or within 14 days of filing, the Debtor is required to file its Schedule of Assets and Liabilties and its Statement of Financial Affairs (“SOFA”). The Schedules are the primary source used to locate claim holders. In practice the Debtor routinely is granted extensions to the filing of schedules and it can take some time before a potential investor has the requisite information in order to bid on a claim. Nevertheless, upon petition the Debtor must file a list containing the name, address and claim of the creditors that hold the 20 largest unsecured claims, excluding insiders. For a sophisticated trade claims investor it is possible to begin negotiations to purchase a claim utilizing this information, albeit without knowing whether the debtor is disputing the claim or if the amount of the claim at petition will be the same as what is listed on the Schedules.

The Schedules also contain the name, address, amount of claim and whether that claim is, Contingent, Liquidated/Unliquidated or Disputed. Contingent claims are claims that may arise contingent upon an event taking place in the future, such as an adverse judgment in an ongoing lawsuit or claims related to remediation for environmental damages that are not fully know. A Liquidated Claim is a claim where the dollar amount is known. An Unliquidated Claim is one where the debtor has liability, but the exact monetary measure of that liability is unknown. A tort case where the Debtor has been found guilty, but where the amount of the liability has yet to be established would fall into this category. Disputed claims are claims where the Debtor is disputing the validity of the claim and intends to file an objection to the claim. This generally occurs later in the case in the form of an Omnibus Objection made by the debtor. Below is an example of a Debtor’s Schedule of Assets and Liabilities filed by Tronox Inc.

Purchasing a Trade Claim

In examining the schedules it best to bid on an Allowed Claim. Under Section 502(a), a claim for which a proof of claim has been filed is deemed “Allowed” unless a party of interest (e.g. Bankruptcy Trustee, or the Debtor) objects to the claim, in which case the Bankruptcy Court will conduct a hearing to determine whether, or to what extent, the claim should be allowed. There are instances where the Debtor marks every claim on the schedule as disputed or contingent. This increases the risk and will required extra due diligence as well as the willingness to litigate if need be.

Once a claim holder willing to sell has been located, the negotiation process for purchasing the claim begins. This process can take anywhere from a few days to several weeks depending on the complexity of the issues involved. Since the seller is not a capital markets participant, he may change his mind several times throughout the negotiation process and also increase his offer based on competing bids. Moreover, factors may come into play in the due diligence phase that require a re-pricing or cancellation of the trade altogether. If an investor is bidding on a disputed claim he will need to factor the risk that the claim might ultimately be disallowed into his bid price. In addition, he may want to reduce price of his bid to allow him to negotiate with the debtor for a reduction in claim size in exchange for a stipulation that the debtor will treat the claim as an Allowed Claim.

Due Diligence

Once an initial bid is agreed upon, the parties enter into a trade confirmation, subject to final due diligence. This phase again can take a few days to a few weeks depending on the issues involved. At this stage in the process the buyer will begin examining the documentation supporting the claim. This includes reviewing invoices, purchase orders, or other contracts in order to determine the validity of the claim. It is also necessary to reconcile the amounts on the invoices with what is filed on the POC and the Schedules. If the invoice is for less than what is listed on the POC or what is listed on the POC is less than on the schedules, the purchaser must reconcile these discrepancies before funding, or have the buyer agree to indemnification provisions should the claim be allowed at a lower amount. The purchaser must also confirm that the entity at which the claim he is purchasing is filed corresponds to the entity listed on the supporting invoices as well as have been filed prior to the Claims Bar Date.

The claims purchase will be executed via a custom tailored contract known as a Purchase Sale Agreement (“PSA”). The PSA will contain provisions governing the transfer of the claim, Representations and Warranties and Indemnification provisions. The PSA will required the seller to provide Reps and Warranties on the ownership, validity and lack of any encumbrances on the claim. In addition, the PSA will contain Indemnification provisions, should the claim be impaired or disallowed . This means that if for some reason the purchaser of the claim needs to seek recourse because the seller misrepresented his claim or it was disallowed as a result of actions taken by the seller, , the purchaser must be able to rely on the counter party to indemnify him for his losses. If the counter party is financially unstable, not a well established enterprise, or is itself at risk of bankruptcy, then there is risk that he will not be able to perform his duties under the PSA. When the counter party is a publicly traded company, has, publicly issued debt or has a credit rating, it is fairly easy to do counter party due diligence. However, if the counter party is a small, private business, then counter party risk assessment becomes more difficult. One source of information is Dun & Bradstreet which compiles credit and other financial information on private businesses. In addition, the purchaser can and should ask for financial statements, bank statements, summary of tax returns and other information as needed to gain comfort with the counter party’s credit worthiness. Should legal disputes arise the between the buyer and seller, the PSA should contain provisions for settling the disputes. It is common for the PSA to require disputes to be litigated under New York or Delaware law, courts which routinely handle complex commercial litigation. This also avoids being in the home town court of the seller of the claim. If the claim being purchased is from a foreign supplier whose country is a signatory to the NY Convention of the International Chamber of Commerce (“ICC”) arbitration, then the PSA should include provisions for disputes to be settled via arbitration as courts of signatory countries are required to enforce arbitration judgments conducted in accordance with ICC rules.

Legal Issues Affecting Trade Claims

There are several legal issues that can impact the value of a claim or cause the claim to be disallowed. The following is a brief summary of some of the major issues that need to be diligenced from a legal perspective before purchasing a claim.

Equitable Subordination. If the seller of the claim aided and abetted fraud, insider trading or breach of fiduciary duty his claim may be equitably subordinated causing the priority of the claim to be moved to the end of the priority chain. This has the effect of the claim being treated as equity, not debt. This risk is heightened when a claim is purchased from an insider and one must have strong reps and warranties from an insider that he has not aided and or abetted any malfeasance. The purchaser must also have indemnification provisions covering such breaches. It can be several months post closing of a trade that these issues are discovered and even longer until they are adjudicated. In order to minimize this risk seek to avoid purchasing claims of company, insiders or those where the relationship could be potentially deemed as “insider”.

Avoidance Actions. When a company files for bankruptcy all payments made in the 90 days prior to bankruptcy (1 year for payments to insiders) are investigated as potential Preference Payments. A Preference Payment is the payment of a debt to one creditor rather than dividing the assets equally among all those to whom he/she/it owes money, often by making a payment to a favored creditor just before filing a petition to be declared bankrupt. The Bankruptcy Trustee has the power to Avoid (unwind) any payments that are deemed to be a Preference This is known as an Avoidance Action and the money is reclaimed by the bankruptcy estate . There are several criteria that are used to evaluate whether a payment was a Preference:

1. The transfer was "to or for the benefit of a creditor."
2. The transfer was made for or on account of an "antecedent debt"—that is, a debt owed prior to the time of the transfer.
3. The debtor was insolvent at the time of the transfer. (Fraudulent Conveyance which has 2-year look-back pursuant to 11 U.S.C. § 548)
4. The transfer was made within 90 days before the date of the filing of the bankruptcy petition or was made between 90 days and one year before the date of the filing of the petition to an insider who had reasonable cause to believe that the debtor was insolvent at the time of the transfer.
5. The transfer has the effect of increasing the amount that the transferee would receive in a liquidation proceeding under chapter 7 of the bankruptcy law (11 U.S.C.A. § 701 et seq.). 11 U.S.C.A. § 547

However, Section 547(c) of the Bankruptcy Code contains exceptions for payments made in the ordinary course of business. The prior course of dealings between the parties, including the amount and timing of payments, and circumstances surrounding the payments, should be analyzed. Additionally, inquiries may be made into the collection activities or practices between the parties, whether the payments were designed to give the transferee an advantage over other creditors in bankruptcy, or whether there was any change in the status of the transferee such as the ability to obtain security in the event of nonpayment. If there has been any unusual pressure or collection activity by the creditor resulting in the payment, the payment would not be ordinary course of business. The transfer at issue is not required to be the type that occurs in every transaction between the parties. It is necessary only that the type of payment be somewhat consistent with prior dealings and transactions

Closing the Trade

Once the due diligence and legal review is complete, the PSA is finalized and the trade is executed via Delivery vs Payment (“DVP”) format. ). DVP occurs when, to complete a trade, there is a simultaneous exchange of securities, in this case they are not securities but the format is the same, for cash that ensures that delivery occurs if, and only if, payment occurs. To be true DVP, there must be an element of finality in the process, whereby neither side of the trade can unwind the transaction after settlement. The funds are then wired within one day of execution. Closing can occur anywhere from 10-30 days post initial confirmation of the trade. The standard practice is that once the trade has closed, the Transferee files a Notice of Transfer and Evidence of Transfer (supporting documentation to evidence the transfer of claim) with the Bankruptcy Court pursuant to Bankruptcy Rule 3001(e). Rule 3001(e) reads as follows:

• Transferees trading on the “scheduled amount” prior to the filing of a POC must file a POC with court, although “evidence of transfer” is not required it recommend. Rule 3001(e) 1
• Assignment of a claim after a POC has been filed requires both a Notice of Transfer and an Evidence of Transfer to be filed with court. 3001(e)2

The clerk of the court or claims agent has the duty to notify the Transferor. The Transferor has 20 days to object to the transfer. Within 15-30 days post closing buyer follows up with claims agent to ensure claims register properly reflects the new owner of the claims.

Conclusion

Investing in trade claims provides a unique opportunity set for distressed investors who already understand the bankruptcy process, are familiar with analyzing complicated capital structures and understand inter-creditor issues. While trade claims are an illiquid market, they are also highly uncorrelated to the stock and equity markets making them attractive to distressed and special situation funds. Furthermore, it is possible in many cases to bid on claims at a discount to an established plan recovery for the reasons: stated earlier: that many trade creditors do not wish, or are unable, to wait for the exit from bankruptcy for payment. With that said the market has grown more competitive and sophisticated in the last several years, so do you due diligence and invest wisely.

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Reminder: European Investing in Distressed Debt Forum 2010

Just wanted to remind my readers the the European Investing in Distressed Debt Forum is next week in London. There are a few free buy side spots available -if you are interested in the free spots, call Anastasia Guha on +44(0) 207 368 9581 or email anastasia.guha@iqpc.co.uk and mention you are a Distressed Debt Investing reader.you are interested contact.

We will have a report from the conference in the next week. Hope everyone makes it!

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Hedge Fund Letter: Greenstone Value Fund

A few months ago, we did an exclusive interview with hedge fund managers Chris White and Tim Stobaugh of the Greenstone Value Fund. See below for their 3rd quarter letter. My favorite quote:

Investors have flip-flopped dramatically, from a fearful and anxious little boy one minute (August) to an exuberant girl skipping through the fields without care the next minute (September). Even the financial press has coined a new phrase to describe the market action: risk on/risk off. In other words, like flipping a light switch, investors either want risky assets (stocks, risk on), or they don’t (fixed income, risk off).

Enjoy the letter! And for those with interesting hedge fund letters, please send them my way - Your identity will be never be revealed (coming from the Zorro of the blogosphere - that has to mean something right?)

Green Stone September 2010 Letter

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Harrah's Files for IPO (HET)

One of the most talked about names in the distressed debt / event driven land is Harrah's Operating Company. There is so many different securities in the structure that it would be a shame not to have a position (either long or short) in one of the bonds of the company. How have those bonds performed? Let's take the 10.75% senior notes due 2016:

Seems like a pretty good investment from early 2009. During 2010 though, it looks to be following the more liquid stressed / distressed names, giving back a lot of gains in may and then rallying the past few months.

The news today was surprising in that in addition to the shares being registered by Paulson & Co, the company also added an IPO of an additional $575M in stock ($475M net to Harrah's). These monies are going to development projects. Development projects? Isn't the company nearly 12x levered? Why not use the cash to pay down debt?

Well for one, the various bank agreements and indentures allow this sort of thing. More importantly, Harrah's has done an amazing job of managing their maturity structure in that very little of the debt actually matures before 2015. Yes, there is some bank amortization payments, but those are manageable. Their return on the incremental capital probably far exceeds the 13-15% pre-tax yield on the bonds if they bought them on the open market.

Paulson & Co is a large large investor here. Assuming all goes according to plan with regulatory commissions, they will own 9.9% of the company's stock. Using round numbers, the operating company is running at about $1.5B of EBITDA, and $17B of debt. That debt is at various levels (call it 6x through the bank debt and 1st lien, 10x through the second lien and 12x overall). The company has a massive runway of liquidity - cash + revolver availability will be approaching $5B.

So what do you have here? A company with massive financial leverage, an incredible amount of operating leverage, and a long long runway, whose prospects are tied to the consumer. These are one of those weird situations where I think the most attractive securities are the most senior and the most junior - I think the senior bonds are in a weird "no-man's land" If you want exposure to beta CCC credit, than these are your bonds. The parent company (Harrah's Entertainment) owns nearly a billion of these bonds so you'd be in pretty good company.

With that said, if the equity works here it's going to be a ridiculous home run. And the 11.125% 1st lien notes are fully covered in my opinion and offer an above market yield and spread given the limited downside risk. The bank debt is a bit trickier in my opinion because of the extension option - but again is covered in a distressed scenario. The senior bonds run the risk of getting primed to the near bottom of the heap if the company does draw down the revolver (a negotiating tactic maybe?) or further issuance of 1st lien notes.

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Distressed Debt Investors Club Update

I received a number of comments and congrats from readers on the Distressed Debt Investors Club mention in Institutional Investor. As always, I am humbled and very thankful for such a wonderful group of readers. With that said, I received a number of emails from potential applicants to the site and wanted to answer these, in more or less an essay format, to the larger audience versus responding to individual emails.

For reference, here is the Distressed Debt Investors Club home page.

I started planning the Distressed Debt Investors Club in late summer of last year. In my opinion, there was lacking a forum for credit / high yield / distressed investors to talk and pitch ideas. While there are two very well known sites for pitching equity / value ideas, the amount of ideas speaking to distressed investors was limited at best. So where are we now?

As most people know, I am capping membership at 250 members. In my opinion that number balances well a high quality membership base but also, with a requirement of investment ideas, brings in substantial flow of ideas to the site. Right now we sit at a little over 150 members and nearly 3000 guests. We could have been at 250 members right out of the gates, but I have done my best to be as judicious as possible with the application process.

The biggest question / concern I get from potential applicants is ones related to compliance. Many high profile hedge funds / investment shops strictly forbid pitching investment ideas in a forum similar to the DDIC. If you look at the guest list on the site, you will see 95% of the major distressed / event driven hedge funds on there. With that said, as all the members of the DDIC know, user's identities are only known by me and our privacy policy strictly states that user's identities will not be released.

The quality of ideas is spectacular. Would you want access to over 150 of the best distressed / event driven analyst's ideas on a weekly basis? That is what the DDIC provides. I need to make an actual study of it, but I would say 90% of the ideas (both long and short) have been winners. Some have been absolute home runs.

Right now, as most analyst, portfolio managers, and traders know, distressed is somewhat picked over. Unless you are playing something like LBHI's subcon claim, or Capmark's settlement play, there really are not a lot of non-confi distressed names out there (we have a strict policy of only non-confi names on the site). With that said, I encourage all those interested in applying to pitch an equity or credit short to the site - a market I feel that is RIPE for out performance right now.

Many people ask me why I do not post more on this site - I have a little over 200 posts on this blog, but have just as many posts on the DDIC forum. For one, I can actually post there from work and two, I find the discussion fascinating on the forum. For example, I can ask users what their thoughts are on XYZ situation and get a number of well thought out responses that can help shape my investment opinion.

Overall, I could not be happier with the progress of the site. The membership quality has exceeded my wildest expectations and I am very grateful to even be part of such a wonderful community.

I encourage all those interested in applying either as a member or as a guest to visit the site. If you have question, my email is hunter [at] distressed-debt-investing.com.

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Distressed Debt Investors Club in Institutional Investor

If you did not see it today, the Distressed Debt Investors Club was part of an article in Institutional Investor. Here are some pertinent quotes:

To manage what traders might call the high “signal-to-noise ratio” of public web sites, at least three private online communities now cater specifically to professional investors: Value Investors Club and Distressed Debt Investors Club, which were founded in 2000 and 2009, respectively, and each cap their membership at 250 investors, who are anonymous to fellow users; and SumZero, which launched in 2008, combines user-generated investment research with social networking features and now boasts a membership of more than 4,000 buy-side analysts and portfolio managers.

And...

Networking and information exchange may be especially valuable in niche areas of the market. A case in point is Distressed Debt Investors Club, the brainchild of a credit analyst who goes by the handle “Hunter” and has eight years of experience on the buy side. Hunter, who declines to reveal his real name or the name of his employer, says that about three quarters of the roughly 200 investment ideas on the web site are distressed-debt and event-driven plays, with the remainder split between equity and special-situations opportunities.

“A lot of people on the site have either formal credit training or a leveraged finance background, so people understand the bankruptcy and restructuring process,” explains Hunter, who says his site marries the best of Value Investors Club and SumZero. (He is a member of both.) “On other sites or in sell-side reports, you might not have people well versed enough to understand the implications of, say, a fraudulent conveyance ruling.”

Great stuff! I will write a lengthy article this weekend talking about how well the DDIC is doing and future plans for that site (as well as this one).

Here is the link to the full article:

Facebook for Finance

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Notes from the Ira Sohn West Research Conference

Last week, the Ira Sohn West Research Conference was held with a number of amazing speakers, including one of the most prominent names in distressed debt, Mitch Julis. Here are some notes complied by BTIG. Enjoy notes!

BTIG West

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Distressed Debt Investing Interviews Simon Davies

It gives me great pleasure to introduce Simon Davies, Managing Director of the Restructuring and Reorganization Group at Blackstone in London.

Mr. Davies’ restructuring transactions have included AES Drax, Basis Capital, Boxclever, Carron Energy, Convenience Food Systems, Cox Insurance, Eggborough, Esprit Telecom, Eurotunnel, Galvex, Golden Key, Jarvis, Klöckner Pentaplast, Lisheen Mine, Luxfer, Mauser, MyTravel, Northern Rock, Petroplus, Pressac, Treofan and Wheelabrator.

Before joining Blackstone in 2007, Mr. Davies was responsible for structuring and corporate development at SVG Capital, structuring and raising funds for the private equity industry. Prior to that, he was an Assistant Director within the European Special Situations Group at Close Brothers Corporate Finance in London. He is co-editor of the Economist Outlook section of The Corporate Rescue Journal and a regular contributor to the journal. Mr. Davies began his training as a lawyer at Linklaters and spent seven years in the legal profession working on a range of restructuring, acquisition finance and LBO transactions.

Simon will be speaking at the upcoming European Investing in Distressed Debt Forum, a conference we are encouraging all readers to attend. Remember, there are still a few free spots left for the buy side (contact anastasia.guha@iqpc.co.uk and mention you are a Distressed Debt Investing reader).

Enjoy the interview!

To start off with, could you please give the readers a quick introduction?

Yes, sure. I work on the restructuring advisory side of Blackstone as a managing director in Europe. Based in London, we provide corporate finance advice to companies, to their creditors and other stakeholders in situations of financial stress and distress. We tend to deal across the board of effectively capital structure advice, providing solutions to companies' balance sheets when they need some form of corporate change event.

We know the structured finance market, especially CLOs led to significant leveraging of a number of companies in Europe. Does Europe have the same issues as the ‘maturity wall’ in the United States? If so, how do you expect that to affect the restructuring business in the next few years?

That's a very interesting question. When we went through what was a very credit expansionary phase, I guess, in the early and mid-2000s, the availability of finance was a global phenomenon, not just a US phenomenon, and so yes, in Europe we do have the same form of maturity wall through what I would call the teenage years of the 2000s. It's been referred to as a shark's fin. If you look at the shape of it on a chart, it very much resembles a shark's fin at the moment, although it is being dealt with from time to time. The maturity wall is across the leverage loan space, the infrastructure loan space and the property loan space. Slightly different shapes in terms of where it is at its peak, but what is happening at the moment in the next few years is that there's refinancing currently ongoing, and especially at the moment in the high-yield capital markets, which have become very open for business through periods of this year.

Although the bankers of the world have talked about windows of opportunity, the volatility in the markets is still there. And what we have, effectively, is periods of time when there is excessively busy activity in the high-yield markets versus quieter periods. May of this year was a very good example of a quieter period. People, I think, got a little bit jittery again. The net result of that is that there will be a lower refinancing risk when we get to the maturity wall, 2014-2016 is kind of where we’ll see peak activity.

But what you do have at the moment, obviously, is adverse selection. So what's going on is that the better companies are finding themselves capable of refinancing their maturity issues, and those that are less well in terms of a credit rating are effectively finding themselves with difficulties. So the way in which that's likely to affect the restructuring business from a leverage loan perspective is that we expect there to be a steady stream of new business, steady but not massively busy.

If we look at the world as being flat to slightly down in the developed world for a period of time, the type of things we're getting from the leverage loan side is some second-time offenders and possibly third-time offenders, old covenant reset deals, and candidates that were part of the big ‘kick the can down the road’ experience that occurred in 2008 or late 2008 and through the period of 2009. Plus there will be some new offenders. Despite the fact that I think prospects have stabilised, business pipelines remain with a lack of visibility and so what we have, I think, is going to be some new offenders coming through.

From the property side, the CMBS market has lagged the restructuring cycle quite significantly. The CMBS, it's a securitisation vehicle, it's designed not to be unwound and not to fall apart. And it does create some complexity in the property markets. You've got loan maturities, but you also have CMBS structures which have been bolted on top of that, creating complexity. And that, I think, is going to be busy for restructuring and also a complicated arena in that you will find that you've got people who are unaccustomed to distress sitting in the capital structure, and it will make it more difficult to get deals done.

We know the European restructuring process can sometimes be challenging to investors given the various legal regimes across the continent. Do you foresee a move to better standardise the bankruptcy process in Europe? Will that open the market to more willing capital, if that happens?

I think it's unlikely that there'll be more standardisation, and why do I think that? If we look back at history through difficult phases following financial crisis, most of the steps lead towards disjointed behaviour rather than joined-up behaviour, and an awful lot of what goes on is that people talk very nicely about finding global solutions and then national pride takes hold and we end up with thoughts in the press around currency wars, and people trying to competitively devalue their currencies in order to make their economies more competitive on a relative basis. But what you end up with is protectionism and an inward looking point of view and perspective.

I think that probably talks against standardisation of bankruptcy regimes. However, what we are seeing is people seeking to provide more streamlined processes in different jurisdictions. What has not been popular, I think, in certain areas of Europe is the whole debate around centre of main interest (COMI) shifting, in order to take advantage of a different bankruptcy regime within Europe. And given the insolvency regulations and how that governs insolvency processes from an overarching perspective above the national legal frameworks that are in place, that has obviously led to the reports of the insolvency brothel being the UK with its prepacked administration process having been used on a number of occasions. And what you've seen is countries trying to help streamline their own bankruptcy processes to allow for a fast - rack process to prevent the business distress that attaches to a company being in an insolvent situation for a period of time. That's been seen most recently in France, where they are now looking to develop and put a track record in place for a streamlined safeguard process.

I think the second part of your question was: will that open up avenues for more willing capital? I think the capital is there. I think the opportunity is more difficult to take advantage of at the moment in that there aren't quite as many sellers as people had hoped there would be of loan assets in distress and/or lending opportunities to companies that are in a certain amount of business distress. The equity markets have supported public companies to an extent through their rights offerings and there has been some new lending done, but what we have found is a general unwillingness for companies that have borrowed too much money to seek and be successful in seeking outside capital, in that the people who are currently invested in their capital structure either find it a better ideal for them to do the deals themselves, or they will effectively resist change, which became the whole ‘kicking the can down the road’ problem.

And what we saw, I think, for the last couple of years, which is still fairly prevalent, is that if a business is not strictly just running out of money, but it does have financial distress attached to it, people attach less attention to that, and they have bigger problems to have to deal with, so it goes to the back of the queue.

The distressed debt market is definitely a crowded one in the United States. Is that the case in the UK and Europe? Can you talk about some of the important differences between the two markets?

Yes, sure. The market is not quite as crowded in Europe. Like any form of a capital market, we seem to have followed, rather than led, and so the distressed debt market is no different in that the hedge fund community has largely grown up and matured at an earlier stage in the US than in Europe and a lot of the participants in Europe are part of a larger US umbrella group. But it is a very different investing environment.

In the US, you have a wonderful track record, a tried and tested method for fundamental restructuring, using Chapter 11 bankruptcy. Its track record, the process that it drives, the fact that it's in court, people get good visibility on what is going to happen and when it's going to happen, it gives people certainty as to the process and likely outcome and the things they're going to have to prepare and the way in which they will be able to deal or not deal with the stress as the case may be. It is a very debtor-friendly regime, but it is fundamentally a very

good way for businesses to restructure.

In Europe there's no equivalent in almost every jurisdiction, so you have, within the EU, 27 different regimes. And the most important differences that that, I guess, brings along are within all those different regimes, many of them are in their infancy. There are very few that have quite as good a track record or are as well-developed as the US Chapter 11 process. Chapter 11 has been around for quite a long time. Safeguard is a fairly recent phenomenon and the first high profile one, I think, was Eurotunnel, which was still only a handful of years ago.

And the second important difference, I think, is that it creates process risk for an investor. And that process risk becomes a far more important part of the valuation debate and the value debate when you're looking to make an investment. What you need to do, I think, in Europe, is very different to the US. There's a lot of forensic analysis around process risk in the advance of making that investment decision. There's greater risk in the type of jurisdiction you're in and how that affects that bankruptcy process should it be required, the ability to lend to a company in distress, and the likely investment duration, how long you may have to be an investor, whether you're in part of the debt capital structure or not of a particular business.

And so the differences very much revolve around a lack of track record to process and the risk that that then creates for the investor.

We know you have participated in a number of very high-profile restructurings over the past few years. We would like to know which has been the most interesting to you? The most challenging? And why?

As restructuring goes, no two deals are the same. But interesting tends to come out of complexity and it being a little different. And I think I could probably answer the two parts, interesting and challenging, just with one transaction, and that was the restructuring of Northern Rock.

Northern Rock had, I think, probably a number of fascinating pieces to it. Obviously there was the drama that is created by a run on the bank, pictures in the press and probably more stories in newspapers than I have ever seen on any single deal that I've worked on. But people standing outside branches of Northern Rock talking about trying to get their money back. And then, obviously, the first forced government intervention.

And this came, obviously, at a time before the whole of Europe had had to guarantee its banking system in one fashion or another, and the scandal attached to the government treating Northern Rock with a different brush than that with which it painted the other banks was phenomenally complicated for them, in that the European Union had not reduced its criteria around giving state aid to companies in times of financial and systemic distress. So there was a far greater risk that actually the European Union was going to come in and try to outlaw what was going on, together with the whole government intervention, together with the fact, I think, the most important thing… and the most interesting thing about Northern Rock is that everybody could relate to it, because everyone's got a bank account. And so it touched the lives of every single person who lives in the UK. Not because they had a Northern Rock bank account, but because they were interested in something that was effectively an early indicator for the market activity to come in restructurings, and they got a perspective on what happens when things go wrong. But no, Northern Rock is definitely the most recent, most interesting, most challenging one for us.

What is your outlook for the restructuring and reorganisation market over the next few years? Do sovereign issues begin to spill into the outlook for private enterprises and their access to capital?

A difficult one to answer, because the pipeline lacks visibility at the moment. However, having said that, deals do keep coming out of the woodwork, and we're not quiet here. We are actually quite busy. What we've seen recently, I think, have been some fairly esoteric types of activity.

There's still a structured finance fallout going on, so people who have disputes in relation to structured deals that were put together, sometimes just between two parties, sometimes as a package deal basis. And across the structured finance market, I think there will continue to be activity. People will seek to exit the restructurings that they've already executed, so structured investment vehicles have restructured, but people haven't exited their investment. They've restructured it in order to create a stable position and then to choose when to exit. But the things that are coming down the structured finance pipeline, I think, are bilateral deals where people have got large exposures to each other in an argument, and the mortgage-backed securities market on a commercial basis, so the CMBS market. We think they'll be very active areas.

As we move through 11 into 12 and 13, I think that the restructuring market will continue to provide its fair share of leveraged loan workouts and infrastructure loan workouts, and then you will come to, obviously, the restructuring wall, the refinancing wall that we have coming in 13, 14, and then a little bit in 15 as well. That, I think, paints a fairly rosy picture from, I guess,

a non-sovereign perspective.

From a sovereign perspective, I think there will actually be sovereign activity to come, and that's not just around countries going bust, but every country has got the word austerity in its budget now, especially across southern Europe and we do in the UK. And one of the things that that will require, as well as the raising of taxes and the reduction of the size of the public sectors in order to bring budget deficits down, it's going to be the sale of part of the state's assets, whatever's left.

I think the Greeks have been very forthcoming in terms of publicising exactly what they're looking to privatise. And that list is fairly long and will need to be put together into packages that are valuable to investors. And there'll need to be a story told and advice given on how best to do that.

Equally, just looking at the second half of the question, you have the sovereign issues spilling into private enterprises, I think there is a risk that it does that, and there are a number of different fallout potentials from the sovereign issues that are being felt in Greece and also in Ireland and Portugal, and to an extent, in Spain and Italy, and then across the world, to an extent.

But if you look at the extreme cases, as a sovereign gets downgraded, it has knock-on effects in that obviously, if we look at what happened in Ireland, for instance. The Irish turned round, some couple of years ago now, and guaranteed all of the deposits in all of their bank accounts. Now while Ireland is still a favourably rated nation for the purposes of credit quality, that guarantee is worth something. But what happens when that guarantee is worth less, because the credit rating of Ireland is dropping, is that actually people attach less value to that guarantee and you may find, whether it's in the financial institution space or in the corporate space, government backing doesn't really count for that much anymore. And there are likely to be issues that do come out on a corporate basis and a financial institution basis from a continuing sovereign issue thing.

DDI: Thanks, Simon. You will be speaking at the IQPC European Investing in Distressed Debt Forum in October. Can you give us a preview of what you will be discussing?

S Davies: Certainly. I will be helping to, I guess, give direction to a panel, talking about the response of the banks and other lenders to financial crisis. That will cover a number of different points, in particular the way in which banks have either recognised or not recognised loss when assets have gone south, crisis management of those banks and institutions. Their new capital requirements, the impact potentially, of BASEL III on those capital requirements and whether that is a good tool for helping create confidence in the sustainability and stability of financial institutions, and the structural position of banks and other institutional funds that do general lending within the markets. We'll also talk a little bit about incentive structures and potential improvements that could be made to those.

One of the things, I think, that's interesting is that incentive structures have been somewhat skewed to the outside, and in downside scenarios as we found, in the last two or three years, they have created some slightly odd behavioural patterns, which have been difficult to deal with when doing restructurings. I'll talk a little bit about that in more detail at the forum.

What we'll also talk a little bit about is recovery, the recovery phase. So there are two aspects, I think, that are interesting there. One is lending volumes in the recovery of lending volumes and there has been an awful lot of press written about that, which will be interesting to discuss. But also the response of institutions to change in regulation. Change, usually, is met with resistance, whether it's somebody's own wage packet or the ability of an institution to do business on a regulated or unregulated basis. And hopefully the discussion there will be interesting also.

Thank you for your time today Simon

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European Distressed Debt Conference Special Offer

A quite note to all readers - a month or so ago I introduced the 2010 European Investing in Distressed Debt Conference, taking place at the end of October in London . This is going to be a fantastic event for all distressed debt and leveraged finance professionals in Europe. I've worked with the conference organizers on the schedule and speakers and I hope you will be happy with the agenda.

With that, we have a special offer to Distressed Debt Investing readers. For a limited time only, the conference organizers are offerings Free Attendance for a limited number of Buy Siders and 20% off when you use the discount code "EDD_HUNTER_WEB" for the sell side.

For buy side clients interested in the offer, call Anastasia Guha on +44(0) 207 368 9581 or email anastasia.guha@iqpc.co.uk and mention you are a Distressed Debt Investing reader.

Everyone should definitely check out the conference homepage and check out the agenda. It's going to be a great one. And don't forget - We did an interview with Jon Moulton - one of our favorite interviews on the site to date. Enjoy!

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Post Reorg Equity - Visteon Revisited (VSTOV)

A few months ago, we did an introductory post the distressed debt situation of Visteon. In the last paragraph of the post, we noted that we believed the company had equity value, but the "J Factor" was a serious concern to potential equity investors. It turns out that pre-reorg equity got the shaft here - why? Making a long story short, bond holders, by getting management on board, the senior lenders on board, and stepping up for a right offering, are stealing the company. Let's look at the post reorg equity of Visteon

In my 8 years on the buy side, in distressed and high yield land, I have never seen a more consensus long than Visteon's when issued equity. Simply put, Visteon's equity to distressed funds is like Apple to Long/Short funds. Many people I know are long it (including myself) - The only thing I can't figure out: who is selling?

All this being said, when everyone is on the same side of the trade, I start to get worried. But let's go back to my valuation analysis, and update for all the new information that has come out of the docket in the past few months. In my opinion, Visteon is quite easily to analyze. I'll do it in steps so it is easier to follow:

1. Visteon owns 70% of Halla: At the USD equivalent market cap of ~$2B, gives us $1.4B of value
2. Visteon owns 50% of Yanfeng: We will use a 10x multiple, ~$900M of value [note I am seeing analysts put a 12-15x multiple on this business]
3. Cash at Exit: $785M
4. Added Cash from Warrents: ~$100M

That gets us to $3.2B before adding any value to the US operations. From this we subtract:

1. Term Loan: $500m
2. Cash at Halla ~$150M (as to not double count)

Which nets us to $2.55B of equity value. Still before US operations. 54M shares outstanding translates to $47/share. Given the $56/share price today, there is a $9/delta or $500M. This is where the market is currently valuing Visteon's US operations.

And that's where we say: "You've got to be kidding me?"

Everyone in the market knows Visteon sandbagged their numbers. Why? Because management is getting a good deal of equity post emergence. But let's say they are right - the 2011 plan calls for $550M of EBITDA. You have to deduct Halla from this which nets you do approximately $300M.

Therefore the market is valuing the US operations at 1.7x. For a company with a net cash position...Here are some 2011E EV/EBITDA comps for your reference: TRW: 4.1x, LEA: 3.9x, Fed Mo: 5.0x, Dana: 3.9x, Tenneco: 4.9x. Let's be conservative and use 4.0x and see where the value gets us to: Add $1.2B to our sum of parts above, gets us to a $70/stock. And I will tell you, I am probably one of the more conservative estimates out there.

I want to know who is selling this stock? Is this side as one-sided as I believe it to be (at $55/share)?

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