October 12, 2010 - 3:55pm EST by
2010 2011
Price: 20.85 EPS -$5.50 -$2.75
Shares Out. (in M): 8 P/E N/A N/A
Market Cap (in $M): 166 P/FCF N/A N/A
Net Debt (in $M): 927 EBIT -98 -30
TEV ($): 1,378 TEV/EBIT N/A N/A
Borrow Cost: NA

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Summary/Thesis - This is a capital structure arbitrage idea. I recommend investors:

Go long the 11.375% Senior Secured Notes, due August 4, 2015, of The Great Atlantic & Pacific Tea Company (GAP) at the current market price of about 76. These notes are semiannual, fixed-pay, second-lien obligations and are guaranteed by all domestic subsidiaries.

Simultaneously short an equal face amount of the company's 9.375% Exchange Traded Notes (QUIBS), due August 1, 2039. These notes trade on the NYSE under the ticker "GAJ" at a current price of $20.85/unit. Quoted prices include accrued interest similar to a dividend-paying stock. Par value is $25/unit and interest is paid quarterly. The QUIBS are unsecured obligations that are pari with the company's other unsecured debt and are not guaranteed by any subsidiaries.

This is a positive carry trade that should be profitable regardless of what happens to GAP's business fundamentals. Additionally there exists the possibility for a large payoff in the highly probable scenario that the company files BK or otherwise effectuates a distressed recapitalization.

Situation Overview

The Great Atlantic & Pacific Tea Company owns 429 supermarkets in the northeastern US. The company's primary brands are A&P, Pathmark, Food Emporium and Waldbaum's. European retail conglomerate Tengelmann owns 39% of the stock Ron Burkle owns 28% on a diluted basis. In July the company reported FQ1 earnings that fell dramatically short of expectations, with EBITDA coming in at $19M vs. Street estimates of $65M, and same-store sales falling -7.2%. This led the company to hire its fourth CEO in under a year when former Office Max COO Sam Martin took the job.

GAP is widely recognized as a distressed company. In July S&P downgraded the company to CCC, the stock costs 25%+ to borrow, and even the near-term maturities trade at a significant discount to par. With nearly $1B in debt, GAP is highly levered, and the company has almost $400M of debt due in the next two years. A breakdown of the company's capital structure is shown in Table 1 below:

Table 1: Capital Structure of The Great Atlantic & Pacific Tea Company ($M)

  Face Value Price Mkt Value
Term Loan 132.9   132.9
11.375% 2nd Lien Notes due 2015 253.9   76.0 193.0
5.125% Converts due 2011 157.7   70.0 110.4
6.75% Converts due 2012 226.7   54.0 122.4
9.375% Sr. Notes due 2039 (QUIBS) 200.0   83.0 166.0
Other debt 25.5   25.5
Total Debt 996.8   750.2
Preferred Stock  175.0   60.0 105.0
Common  206.4  $   4.00 206.4
Enterprise value 1,378.2    

The bull case is that the company's problems result from a bad economy, past management errors (notably poor merchandising at Pathmark and remaining integration issues) and a lag for recent price cuts to drive traffic. These operational issues will resolve over time. Furthermore, any interim liquidity needs can be met through asset sales (it has been rumored that Food Emporium is for sale for over $200M), continued investment from Yucaipa and Tengelmann, or concessions from the company's major labor union or wholesaler.

Conversely, bears believe that GAP's problems are inherently structural issues and the company will not be able to pay off the almost $400M of debt due in the next two years. Short investors see GAP's brands being squeezed from Whole Foods on the high end, and WMT and regional competitors with better costs structures (i.e. Shoprite) on the price-sensitive side. Liquidity will be a problem, as banks will be unlikely to extend more secured debt for fear it could be challenged as a fraudulent transfer in Ch. 11. Control-minded investors such as Yucaipa would be better off buying the company out of BK, given the debt level and off-balance-sheet liabilities (pensions, cost for prior restructurings). Based on consensus earnings estimates and a reasonable level of new money, I believe GAP will not be able to refinance its debt due in 2012. The model is shown in Table 2 below:

Table 2: Three-Year GAP Liquidity

FYE Feb F2010 (last 3Q) F2011 F2012
EBITDA (consensus) 121 206 225
 - Capex (60) (75) (75)
 - Interest (140) (195) (200)
 - Dark Store Costs (55) (50) (50)
 = Cash Flow (134) (114) (100)
Debt Maturity   (167) (232)
Ending liquidity (before new debt  or assets sale) 169 (112)  
New Debt Capacity / Asset Sales   300  
Ending liquidity (after new debt or asset sales)   188 (144)

Scenario Analysis

I tend to agree with the bears, but do not have high conviction in this view. So let's assume that the company is able to implement a full turnaround over the next several years and that GAP's bonds trade to par. In this case, you're paid about 4.5% to enter the transaction and have a positive carry of 2% per year. Clearly not a great return, but not terrible given that the trade ties up no capital. This hypothetical scenario is shown in Table 3 below.

Table 3: Trade Cash Flow If GAP's Recovery Is Successful (assume $100 trade size)


Buy $100 face of 2nd lien  $(76.00)        
Sell $100 face of QUIBS  $83.00   Assumptions:
Pay November 1 interest payment on QUIBS  (2.34)     Price Coupon
      2nd lien  76 11.375%
  Holding Period   QUIBS  $  20.75 9.375%
Positive carry for 3 years (receiving 11.375% and paying 9.375%)  $6.00        
  Exit at Par        
Sell $100 face of 2nd lien at par  $ 100.00        
Buy $100 face of QUIBS at par to cover  $(100.00)        
Net cash flow  $ 10.66        

Suppose GAP's turnaround is not successful and the company files. While it is unclear exactly what recoveries would be in BK, it is fairly obvious that recovery to the second lien would be greater than to the QUIBS due to the second lien's senior claim on GAP's assets and subsidiary guarantees. For simplicity, I have assumed that GAP will file either at either the date of the next debt maturity in June 2011 or at the following debt maturity in December 2012. I also assume a reorganization enterprise value of $750M to $1B, or about 4-5x forward EBITDA (based on peer multiples and/or WINN's reorganization multiple) and first-lien debt/value reduction for asset sales of $500M in the 2011 case and $700M in the 2012 instance. Admittedly, this is a somewhat simplistic analysis, but I believe it is close enough to capture most possible outcomes. As shown in Table 4 below, there is a possibility for a large return in a bankruptcy, with little risk of loss.

 Table 4: Trade Cash Flow in a Distressed Scenario (assume $100 trade size)

Buy $100 face of 2nd lien  $(76.00)            
Sell $100 face of QUIBS  $83.00            
Pay November 1 interest payment on QUIBS  $(2.34)            
  2011 Bankruptcy   2012 Bankruptcy
   Low     High    Low     High
Reorg Enterprise value ($ mm) 750   1000   750   1000
 - 1st lien / asset sales 400   400   700   700
 - 2nd lien 250   250   250   250
Recovery to 2nd lien 100%   100%   20%   100%
Value for unsecured 100   350   0   50
Unsecured Claims (debt + $100mm) 710.0   710.0   536.7   536.7
Unsecured recovery 14%   49%   0%   9%
Net Recovery (2nd lien - unsecured) 86%   51%   20%   91%
Positive carry (2%/yr)          $   2.00    $ 2.00
Total Cash Flow  $   90.57    $  55.36    $   26.66    $ 97.34

Of course, the outcome is not binary. GAP could recap out of court, which would likely involve a new investment and/or an exchange of the near-term maturities. Such an exchange would be unlikely to involve the second-lien or QUIBS since the company is currently more concerned about near-term maturities. In any scenario, however, it is difficult to see how you get hurt, given the shorter maturity and capital structure seniority of the second lien.


The biggest risk here is getting and keeping a short on GAJ. GAJ is a $200M issue with an average volume of over 50k shares/day on the NYSE. While a borrow is available, it requires a bit of hustle to get. As such, there is a risk the trade could temporarily move against you, and your borrow is pulled.

Why does this opportunity exist?

I'm not entirely sure, but I suspect it has something to do with the exchange-traded feature of GAJ. Since the QUIBS are exchange-traded securities these bonds can be purchased by investors who would normally not be able to trade individual fixed-income issues. A look at various investing message boards seems to support this idea.


Ch. 11
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