ARBITRAGE OPPORTUNITY – LONG THE BONDS, SHORT THE STOCK EQUALLY
- I suggest going long the bonds and short the stock
- OWENQ is in bankruptcy and for the stock, with a current MV of $230mm, to have any value, the bonds (currently trading around 80) must not be “impaired”, which means receiving 100 cents on the dollar plus accrued interest of about 30 cents, a 62.5% increase.
- The equity should be worthless, unless asbestos liabilities are limited, most likely through Congress passing legislation, plus the judge must apply an above market valuation multiple to the company. I believe the realistic potential liability ranges from $1.6 billion to $6.0 billion based on legitimate claims. (see discussion below).
- There is no equity committee that has been able to obtain standing in the bankruptcy proceeding and it is not likely that there ever will be.
BACKGROUND – SOLID COMPANY DRIVEN TO BANKRUPTCY FROM ASBESTOUS LIABILITIES.
OWENQ is a building materials systems and glass fiber manufacturing company which supplies the home improvement, new construction, commercial and industrials markets. Historically, the company had used asbestos in its products.
OWENQ is currently in bankruptcy due to pending asbestos litigation. Approximately 25,000 proofs of claims totaling $16.5 billion were filed. OWENQ identified 16,000 of these claims, totaling $8.6 billion, which it believes should be disallowed by the bankruptcy court. Of these objectionable claims, 6,200 claims ( $5.3 billion ) were either withdrawn or disallowed by the court and other claims were reduced by $1.7 billion. Of the remaining 9,000 claims, 1,000 were withdrawn or disallowed by the court. The other 8,000 claims total $7.5 billion. Thus, 17,800 claims remain totaling $9.1 billion.
The latest Plan of Reorganization called for the bond holders to receive 32 cents on the dollar and for the shareholders to receive nothing. Further, the company has already booked a non-cash reserve of $3.6 billion related to the above claims.
Two recent events have caused the stock to increase 644% since November 2nd. Not coincidentally, one of the events is the re-election of the Bush administration and the Republican’s increased power in Congress. The second is the appointment of a new bankruptcy judge who is considered to be less pro-plaintiff than his predecessor.
Let’s look at the second event first. In November, the judge presiding over the OWENQ case ruled that further examination of medical claims would not be required in this case. He went on to say, that existence of claims by individuals who had suffered no ill effects from asbestos exposure was well documented. Shareholders have taken this to mean that a sizable portion of the $16 billion in claims, already chiseled down to $9.1 billion, will be rejected when the judge rules on the matter in January. Analysts that I have spoken with estimate that claims could be reduced to as little as $6 billion. It is also possible that these liabilities will be structured to be paid out over time and have standing pari pasu with the bond holders.
The Republican victory has rekindled hopes that the Fairness in Asbestos Injury Resolution Act (“FAIR” act) will have a chance to be passed next. The last version of the FAIR act would cap asbestos exposure for OWENQ at 1.5184% of 2002 revenues or $1.7 billion, close to a 90% reduction from the currently liability. The Diane Feinstein form of the bill is to cap asbestos liabilities at $90 billion with payment over 30 years, but does not assign company level payemnts. The first five years would be higher than the remaining 25. If you use OWENQ’s estimated share of the original payment pool at 3%, then OWENQ would owe $2.7 billion. I have present valued this amount to $1.6 billion for the purpose of this analysis.
SCENARIO ANALYSIS/ VALUATION
It is clear that OWENQ needs judicial and/or legislative events to have its asbestos liabilities cut significantly. What is less clear is whether it is enough to matter to the stockholders. Below is summary table of OWENQ’s balance sheet. I have assumed that all non-asbestos claims are pari pasu and can be netted against cash with the remainder becoming net debt.
Trade Claims 213
Back Taxes 183
Accrued interest (if bonds are not impaired) 979
Other bankruptcy claims 700
Net Debt -4,211
Net Debt if bonds are impaired -3,232
Asbestos claims – Case 1* -9,100
Asbestos claims – Case 2* -6,000
Asbestos claims – Case 3* -1,600
Case 1: All claims are accepted by the bankruptcy court.
Case 2: Most claims are rejected by the court; no asbestos legislation
Case 3: FAIR act passed in current form; court ruling irrelevant
As discussed above the asbestos claims could range from $9.1 billion to $1.6 billion.
Due to the cyclical nature of the business, construction materials companies are typically valued at a multiple of mid-cycle EBITDA. On 7/15/2004 Thomas Lee acquired Nortek for about 8.2x LTM EBITDA. Euramax bought Berger Holdings for 7.9x LTM EBITDA in August 2003. Both of these transactions took place roughly in the middle of the current cycle, which we expect to peak in 2005.
In 2002 and LTM 2004 OWENQ had EBITDA of $383mm and $678mm, respectively. If we assume mid-cycle EBITDA of $600mm and exit multiples at the going private transactions of 8.0x EBITDA, then we get a valuation of $4,800mm for OWENS.
In Case 1, the debtors are very impaired and we are back to the terms of the last plan of reorganization and the bonds get 32 cents on the dollar. You lose 60% on the bond long, but still make 100% on the stock. The net gain assuming zero margin is 20%.
In Case 2, the debtors are quite impaired and receive only about 50% of the claims. You lose 38% on the bonds but the equity is still worthless and you make 100% on the short. The net gain is 31%.
In a case 3 scenario for the company the present value of asbestos claims would be $1,600mm for total claims of $4,832mm. The debtors would receive about 100% of their claim value; the equity would be worthless. You make 25% on the bonds and 100% on the short. The net gain is 62.5%.
Assuming that the judge allows the shareholders to have a voice, the only case I can think of where the equity is worth anything, is if the stock holders can persuade him that the company should receive a higher EBITDA multiple. At 10x EBITDA there is still nothing for the equity. It is only over an 11x EBITDA valuation that the equity (under Case 3) has any value. At these higher multiples, value does accrue to the equity. However, this is a very high premium to recent transactions and the shareholders will have a difficult time convincing the judge to let them participate in the restucturing.
There are other valuation scenarios that return more to bond holders. However, for the equity holders to receive anything they will need the perfect storm of continued strength in new home construction, passage of the FAIR Act substantially in its last form, high equity market multiples for building material companies and a judge who is willing to let the shareholders have a voice in the restructuring.
Shorting the stock and buying the bonds of OWENQ in equal proportions results in a gain in every scenario, except one where the FAIR act is passed and the judge accepts a valuation of the company that is 50% higher than recent comps. I believe that betting on what congress will or won’t pass is risky and I don’t think that a bankruptcy judge is easily convinced of hockey-stick valuations.
- When the company emerges from its chapter 11 bankruptcy, bondholders should be paid and the equity declared worthless.
- Passage of the FAIR act or similar asbestos liability legislation by congress will give investors a clearer picture of asbestos liabilities.
- Awards by Judge should defend my investment case, by adding credibility to the magnitude of liabilities amassed, but not yet ruled on.