Yellow Media (TSE:YLO) is a small Canadian company that is recapitalizing. YLO hopes to exchange $1.8B worth of debt for new debt, cash, and 82.5% of New Common Shares (NCS). The existing convertible debentures, preferred shares and common shares will be exchanged for 17.5% of NCS and warrants (representing in the aggregate 10% of NCS). They have holders of 30.0% of medium term notes and 23.7% of Senior Unsecured Debt supporting the Recap.
If this goes through the company will be significantly less levered (Net debt of $794M) and save approximately $45M a year in interest alone.
Conversion Rates:
From the Q&A document common shares will be treated as follows:
"Each holder of 100 existing common shares will receive 0.50000 New Common Shares and 0.28571 Warrants that are exchangeable into New Common Shares."
So right now every 100 common shares that are bought will cost $7 and in exchange you'll get 1/2 share and 0.28571 warrant which will exercise at $31.67 (and expire 10 years from the closing of the Recap). Ignoring the value of the warrants, NCS are valued at $14 right now.
The company also had existing preferred shares. Preferred shares 1,2,3 and 5 will receive the following:
"Each holder of 100 existing preferred shares, other than Series 7 preferred shares, will receive 6.25000 New Common Shares and 3.57143 Warrants that are exchangeable into New Common Shares." Cumulative dividends on the existing preferred shares won't be paid."
Today the series 3 (TSE: YLO.C) will cost you $53 to buy 100 shares. After the recap you will receive 6.25 NCS and 3.57143 warrants. YLO.C is pricing the NCS at $8.48 a share($53/6.25), assuming that the warrants are worthless.
Game Theory
There are two scenarios that could play out in my eyes. The recapitalization goes through (1) or it doesn't(2).
(1) If the recap goes through the logical argument is to go long the preferred. Right now the shares of the preferred are priced at a 39% discount to the existing common shares. While it is unknown whether or not the deal will go through it seems likely in my opinion.
As stated previously, management has commitments from note holders of the medium term notes (30%) and Senior Unsecured Debt (23.7%). If this does go through a holder of $1,000 face value medium term notes will get Senior Secured notes($423), subordinated Unsecured Exchangeable Debentures($56 exchangeable at a conversion price of $21.95), NCS (12.001 shares) and cash ($141). The new Senior Secured notes will pay 9% and will be redeemed with 70% of consolidated excess cash flow at par on a pro rata basis. Ignoring the value of the common shares, existing bond holders are getting 62 cents on the dollar.
(2) If the recap doesn't go through it's a whole new ballgame. The worst case scenario is they file for bankruptcy and the common goes to zero. I have no ability to predict what residual value (if any) will exist in the common or preferred so I won't try. The preferred, being higher up in the capital structure, will have more residual value.
So the question is: how do you play the upside potential that this recap has while drastically reducing the downside of a bankruptcy filing?
Go long the preferred and short the common.
While the upside is less, the downside is also capped. By shorting the common you negate the bankruptcy risks and by going long the preferred you get a play on the upside if the recap goes through. The image below shows what we believe will happen if the recap goes through, you buy a 1000 share slug in the preferred and short an equal dollar amount of common.(This has changed obviously due to price fluctuations)
The downside is the borrowing costs (~3% annual borrow cost currently) and transaction costs. It is hard to imagine a scenario where the preferred get totally screwed but the common survive. Currently convertible debentures holders are crying foul over the recap but they seem to be the only ones left in the dark.
"However, during a conference call on Monday, Yellow Media’s restructuring advisers, BMO Nesbitt Burns and Canaccord Genuity, explained the rationale for treating convertible holders in this manner.
They said that Yellow Media assumed that convertible debenture holders would convert their bonds to common shares, despite an $8 conversion price when the stock was trading around eight cents.
According to lawyers not involved in the deal, the presiding court for this restructuring will likely rely on case law to approve the deal, and case law dictates that debt holders and shareholders must vote on the transaction as separate classes of owners. To make sure shareholders approve, the company must give them reason to vote, and that could be why they’re getting something extra.
Convertible debenture holders, however, have been grouped with holders of the senior debt. Their $200-million pales in comparison to the $1.8-billion owed to senior holders and the banks, so their votes are not going to sway the result."
The convertible holders appear to be retail holders. A significant portion of senior holders have already agreed to the restructuring. Holders who appear to be more sophisticated investors (Bloomberg screen shots). To sum it up...I don't see how holders of convertibles can sway the vote enough.
The convertible holders appear to be retail holders. A significant portion of senior holders have already agreed to the restructuring. Holders who appear to be more sophisticated investors (Bloomberg screen shots). To sum it up...I don't see how holders of convertibles can sway the vote enough.
What could the NCS be worth?
I believe the downside from this trade is defined. If the recap does not go through I would expect the common to drop for fear of bankruptcy and the preferred to drop but less than the common given the discount already present and the higher residual value in bankruptcy. I anticipate a mark to market downside could be much greater than stated but patience should take care of that.
Net debt/LTM EBITDA will be 1.3X, Net Debt is $794M which means EBITDA is $610M. LTM cash interest was $132.7M and taxes were $134.8M(YLO financial filings). The press release for the recap stated that interest expense would be reduced by $45M. So post recap earnings before CapEx are $387.5M. For the past four years CapEx has averaged $52.4M. I'll round up to $60M, so earnings would be $327.5M. Since YLO is a dying business lets say that it's only $300M.
There are going to be 26M shares after the recap plus 3M warrants which are ITM at $31.67. If the NCS are priced 2X earnings or $600M, with 26M shares that's $23/share. Above $21.97/share the Unsecured Exchange Debentures are ITM.
Conclusion:
On the other side of this arbitrage there appears to be plenty of upside if the recap goes through. Ultimately it is hoped the recap goes through, the shares shorted are covered and the owner of preferred has a significant stake in a company that has little debt and significant upside, even in a business that is dying. Long YLO.PR.C, Short YLO.
Update 9/11/2012
The recapitalization went through. I covered 3/4 of my short leaving only a little remaining in case the court order goes against them. I didn't really think the change in the recap made much of a difference. It basically dilutes NCS by ~8%. Nothing really significant.
Thus far this has been a profitable trade as I've been able to take advantage of an arbitrage several times. Still long YLO.PR.C and short YLO.
I like this kind of play. Is the gameplan to dump the shorts as soon as the recap goes through?
ReplyDeleteSometime before or right around recap would be the goal. It will depend on relative trade levels, if one is out of synch with the other etc.
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