School Specialty 3.75% Convertible Subordinated Debentures

This is my take on an idea suggested by Tbone Sam in the comments section of a previous post.

School Specialty sells classroom, janitorial and office supplies to schools. It’s a cyclical business that took on far too much debt to fund acquisitions of businesses that were worth far less than the price it paid for them. As a result, with large debt maturities due in 2014, it’s in a bit of a pickle, perhaps presenting us with an opportunity.

The capital structure:

I.                Secured debt:

SCHS has drawn on $54.8 million of a total $200 million LIBOR + 250bps, Wells Fargo-led asset based loan facility (“ABLF”) that is secured by a first priority interest in substantially all of SCHS’ current  assets and a second priority interest in all other assets.

It owes a further $67 million under a Term Loan facility (“TLCF”) that has first claim on all non-current assets of the company and has a second priority claim on the current assets. This loan is held by Bayside Capital Partners, costs 12.75%.

It owes $12 million under capital leases and a further $65 million under its operating leases (or only $10 million under a liquidation scenario).

II.             Unsecured debt:

The company has issued convertible subordinated debentures (“the convertibles”) with a book value of $157.5 million and a 3.75% coupon payable semiannually in May & November.

The Opportunity:

Scenario #1: Refinancing of the convertibles

What’s important for our purposes is that the holders of the convertibles have the right to require the company to repurchase them on November 30, 2014 for $115.9  (including accreted principal) – a hard put that values them at 2.4x their current market value.

The company says that it plans “to refinance the debentures prior to September 30, 2014 and to obtain the money to refinance the debentures from the issuance of new debt and/or additional equity.” And it may be able to do just that, in which case for the convertibles is a simple and clean one.

Scenario #2 Involuntary Chapter 11 Reorganization

If the company is unable to refinance the convertibles before that date – the credit markets stink; the company’s cash flow profile deteriorates – then the company will be in default on the terms of the secured loans, the ABL and TLCF creditors will call in their loans, and SCHS will enter the Chapter 11 process.

One can see from the above that the business is worth something like $455 million. After accounting for the $134 million in secured liabilities, the residual value is ~$320 million, meaning that the convertibles will receive at least what they are owed, i.e. $183 million, either in cash or stock.

Of course, the restructuring process being what it is, and creditors being what they are, it seems quite probable that a  valuation professional engaged by the court could slap a 5x multiple on current (or on average trailing 2 year) EBITDA which, if approved , would value the enterprise at $400 million and the leave the convertibles owning 85% of the business (183/(400-134).  In that eventuality, the convertibles will be worth $270 million (85% of the real value of $320 million).

Scenario #3 Prepackaged Chapter 11 Reorganization

This seems to me the most likely scenario: covenants have been breached, forbearances granted, and reorganization lawyers and bankers engaged by both the secured and unsecured creditors.

One imagines that Bayside Capital Partners’ TLCF credit line to SCHS was strategic, and that they will pay off the ABL creditors and come to an arrangement with both the holders of the convertibles and with the equity owners whereby the equity survives (but only just), and Bayside and the holders of the convertibles take ownership of the lions’ share of the remainder.

It is hard to pin down the exact value of the convertibles under this scenario, but we can, I think, be confident that is somewhere between the minimum value envisaged under Scenario #1 and the maximum value envisaged under Scenario #2 – i.e., somewhere north of $115.9, though much closer, I would have thought, to the lower end of that range: Bayside Capital Partners’ hand seems to me much stronger in a prepack than it would be under an involuntary Chapter 11 process.

I haven’t discussed Chapter 7 scenarios because I don’t think there’s even a small chance of a liquidation process: all parties would lose under that scenario.

The bonds haven’t traded for a month. I think they are attractively priced: a likely 130% recovery in 21 months. If and when they trade at under $55, I’ll try to establish a position.

Portfolio Update

I am out of GEA at 71.80, and have used the proceeds to establish a fresh position in Lamprell. 

Portfolio Review

Time for a half-year review of my holdings and, while I’m at it, a discussion of what I have and haven’t (yet) learned from 2012.

I.  Current Holdings

Hawaiian is still good value. I estimate its worth at about $25 and, in so valuing Hawaiian, I have on my side arithmetic and, I think, some modest insight: Most market participants, even those who like HA, no doubt perceive it to be “an airline” with all that implies; I see it as a toll road to a favored destination. Hawaiian has a lot more in common with Mattel than it does with United Continental: an effective low-cost firewall behind which is a premium offering for a branded product for which demand will rise in the future. 

Dunkerley and the board seem to see it my way and every strategic move that they’ve made since 2008 – a second hub in Maui, adding Asian destinations, etc. – can be understood in the light of this perspective, as can the structure of the executive compensation plan.

Hawaiian is yielding 40% on trailing earnings. It more than earns its cost of capital, and growth, therefore, will add value – whether fuel prices rise or fall. And grow it will, meaning that one doesn’t have to fret about how long it will take for the gap between price and value to close.

Relative price appreciation has promoted it from a 20% share of my portfolio when I bought in, in August 2011, to a 33% position as of January 10th. In the three months since my last portfolio review, the stock price has moved from $5.30 to $7.30 to now $6.60 –sizeable moves but nevertheless just noise. 

It reports 4^th Quarter, and therefore full year, results at the end of the month. I expect headline EPS of $2.55 and true earnings, excluding the after-tax cost of intangible amortization, of $2.82.

Northgate is a new addition premised on arithmetic rather than any particular insight. “Return on Invested Capital” is, at bottom, nothing more than the cash that is generated in return for the cash invested in the business. The fastest way to calculate that relationship also happens to be the literal and best way of doing so:

[EBITDA *(1-Operating Tax Rate)]/[Operating Working Capital + Gross PP&E + Capitalized Leases + Gross Value of Operating Intangibles]

Northgate returns 16.4%, on average. Apply that figure to the net value of its operating assets, subtract the net non-operating liabilities, and one arrives at a value of 732p per share for the equity, almost 3x its price at the time that I took a position in it. I wish I’d seen it when it was selling at 160p in June. Woulda coulda. I bought it with the proceeds from the sale of my stake in Cegid – a fair exchange. What I particularly like about it is that the valuation is indifferent to the macroeconomic environment: its vehicle fleet is, for all intents and purposes, working capital and an economic downturn sees it converted into cash. And there’s nowhere for that cash to go but to debt repayment and buybacks. 

Cybergun is this quarter’s winner of the William Ewart Gladstone Award. A "stern and unbending" follower of High Church traditions takes in a lowly, reviled stock, gives it a cuppa and sees it on its way, after which he self-flagellates for being tempted by such a wretched creature, draws little whips in his journal, and vows not to do it again – until the next time. Except that the wretched stock still here, skulking, stinking up the joint.

I added to my position in Cybergun and lowered the cost basis from €2.29 to €1.97.  Minimum upside is, I think, €4.00.

More notable – and shameful – is what I didn’t do: Cybergun’s 2016 8% bonds fell to €32 implying a yield to maturity of 51% … and I didn’t buy them. A truly inexplicable mistake; I remember seeing it, I remember thinking “that’s good value”, but I don’t remember deciding not to buy it. (Similarly, at the start of 2012, I watched, slack-jawed, as Trident Microsystems fell to 6 cents, and only bought in when it had rallied to just above 15 cents. An unrepeatable mistake, I thought then.)

Precia. Nothing to report. Good stock, good price, profitable growth.

XPO Logistics. Nothing interesting to say about this one. I think it’s likely worth $75, although most of that perceived value is in the form of unmapped future growth. My aim is to lighten up on this stock as its price appreciates in 20% increments. It's the opportunity cost that I'm thinking about. The UK market, for example, is still stocked with some obvious bargains – notably Dewhurst, MS International, Lamprell, Instem, Northbridge, Finsbury Food Group, DRS Data & Research, Cambria Auto, Chemring, and Air Partner, to name only the ones that are selling at well below half their demonstrable value – and it would be a shame to completely miss out on these bird-in-the-hand opportunities for the somewhat more speculative opportunity that XPO’s unmapped growth represents.

GEA. I’ll be out of this one soon.

II. Full Year 2012 performance.

The first half of the year predates the blog and therefore predates the tracking portfolio that mimics my holdings. Nevertheless, for what it’s worth, here’s my 2012 performance:

Not quite as bad as throwing darts at the stocks page of the newspaper but, given the wealth of deep value opportunities available in 2012, it is a disappointing showing. I try to balance patience, action, and cash and I got that balance all wrong this year. I turned over 35% of the portfolio in 2012, which is about normal.

III. The blog

This blog is intended to be a real-time demonstration of a particular approach to value investing as well as a journal recording my mistakes.

I have fallen way short of describing my overall approach to value investing; that is something I’ll be focusing more on in the future.  I have written about French stocks in English only; I'll correct that going forward. I don't like 98.3% of the stocks that I look at. You'd never know it from reading the blog. So, I'll occasionally weigh in on why I don't like particular stocks that other value investors do like.

In order to minimize the chance that I’ll write utter nonsense just for the sake of something to say, I’ve set up an “inventory” page to track the performance of stocks that I have said I think are good value. In general, try to highlight those stocks (and, occasionally, bonds) that seem to me to priced at below half their value; the average performance of the stocks in the inventory page should therefore outperform the S&P by 2x or by 10% per year in any subsequent two year period. I can tell you now that the one post that I repudiate, am embarrassed by, and regret having written, is the one on Lojack, no matter how well it does in the future.

Ironically, aside from the mundane performance of my portfolio, 2012 was a productive year for me. I have managed to conclude a process that I started in 2010 of mapping out a large patch of the small cap equity space in the UK, France, Greece, Australia and NZ, sorting out good companies from bad, getting a sense of how their stock prices behave, and so on. It has been very interesting and helped greatly by bloggers in those countries – thank you! No doubt this preparatory work will come in handy at some point in the future. This year and next I hope to do the same for Germany, the Nordics, Switzerland, Austria and Spain.

IV “the 2013 Picks”

I have lately been experimenting with various approaches to automating a value investing approach that makes sense. I’d be happy enough to design an approach that I can rely on to earn good returns without regular attention to the markets.  In that context, the 2013 picks for the UK, the Eurozone, and the USA are attempts to accelerate this experimental process by running concurrent paper “portfolios” that use the same approach but in different markets. A paper portfolio that uses a slightly different approach that I started in April is doing okay, but probably not well enough for me to have full confidence in it. 

In any case, thanks for reading and Happy 2013 and, if you're new to the blog, please bear in mind that I'm an idiot.

Disclosure: I am long HA, XPO, NTG, PREC, and GEA

Decoupling