Advanced Distressed Debt Lesson: Implied Valuations

Last week, Sbarro filed its disclosure statement and bankruptcy plan in the Southern District of New York. For reference, here is the bankruptcy docket for Sbarro:

Sbarro Bankruptcy Docket

While this case has had its back and forth, the background of the case and the developments of the plan started with an April 2011 Chapter 11 filing by Sbarro with an agreement with junior creditors (second lien and 70% of note holders) to own the equity of the company by backstopping a rights offering while giving first lien lenders a new term loan. This term loan was supposed to be ~$173M which would lever the company between 5-6x, depending on your estimates of cash flow. When I first saw this, I had two concerns:

1. The agreement did not include first lien lenders. While the argument can be made they would be paid in full (with the new term loan), not including them felt like poking a hornets net with a pointy stick.
2. This would be awfully high leverage for a company experiencing hefty operational difficulties. Well run QSRs were being levered 3-4x through the bank debt, adding 2 turns to this seemed excessive.

In May, Sbarro terminated this pre-petition plan to explore other strategic options, including a possible sale of the company. I would assume, from news reports, that this decision was partly driven by first lien lenders that shared my aforementioned concerns.

In July, it was announced that the Sbarro had received a plan from the first lien steering committee. Last week the details of that plan emerged and was filed with the court. The essentials:

• Assuming the company can not find a bidder for its assets, the DIP and 43% of the first lien facility will be converted to a $110M exit facility
• The remaining 57% of first lien claim will be converted into equity, with first lien lenders owning the entire company
• Certain first lien lenders have agreed to also place a $18.6M new money term loan to provide the company with liquidity
• The second liens and unsecured notes will be canceled

This is in essence the stalking horse bid for the company, and indeed the second liens, unsecured note holders, or a third party could offer more for the asset.

As of this morning, Wells Fargo was making the Term Loan B at 92-93. The question then becomes: What does this imply about the valuation of Sbarro?

While the financial projections were not filed with this most recent disclosure statement, there is a statement in the disclosure statement that reads (in the discussion of potential business improvement):

"The Debtors expect to realize the full benefits from these initiatives and anticipated capital expenditures over their five-year business plan horizon, which forecasts an

improvement in adjusted EBITDA from approximately $28 million in 2011 to more than $45 million by 2015"

We know that the contemplated plan will have $110M of debt as a baseline. In addition, there is a possible $18.6M in additional debt, but this debt, should, in theory, bring a similar amount of cash on the balance sheet. So at a price of 92, what equity value is the market implying for Sbarro?

According to the disclosure statement there is: "approximately $176.2 million outstanding under the Prepetition First Lien Credit Facility (including accrued and unpaid interest and approximately $3.5 million in issued and outstanding letters of credit)". Because L/Cs will surely roll, I assume the claim for the first lien $172.7M. From here:

1. Using the average of 2011 EV/EBITDA comp of 6.5x and our $28M in 2011 EBITDA, we come up with a TEV of $182M
2. The implied equity value is then $182M less the $110M of pro forma debt on the balance sheet or $72M
3. First lien lenders are thus receiving 100% of the $72M + $75M of the exit term loan or $147M of value divided by their $172.7M claim for a market price of 85 cents on the dollar

To me though, a better way to think about the problem is what multiple is being implied by the current 1st lien price. To do this, you just work backwards:

1. The current price of 92% * total claim of $172.7M = ~$159M of "market value"
2. You then subtract the $75M exit term loan first lien lenders are receiving to determine the value of the equity award. This gets us to $84M of value. (Note: You do not add $110M of total exit debt as first lien lenders are only receiving $75M of the exit term loan - remember we are determining the value they receive relative to their claim)
3. You then add $84M to the total contemplated exit debt of $110M and divide by the 2011 EBITDA forecast ($28M) for a value of 6.9x to get an implied cash flow multiple.

Here are some other forward looking comps (FY+1 EV/EBITDA)

• CRBL: 5.7x
• BOBE: 4.8x
• RT: 5.7x
• DENN: 6.7x
• BAGL; 6.1x
• KONA: 6.5x

Seems like 6.9x is high relative to these comps. Of course, you could forecast EBITDA moving substantially higher. The average of the subset above is 5.9x. Using our implied valuation technique again, this would mean Sbarro would need to do $33M of EBITDA to justify today's first lien price of 92. Given the history of Sbarro (which used to do upwards of $50M of EBITDA) this seems achievable given the right management team in place to turn the operation around.

There is definitely a bit of optionality in the bank debt with a cash buyer coming in and taking the bank debt out at par + accrued and this may be one of the reasons the bank debt is trading at a higher implied multiple than comps. I think a purchase at 80-85 cents on the dollar makes sense here to allow for more margin of safety if a turnaround does not go as planned.