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  1. 1. REVLON As Jack Nicklaus said of Tiger Woods, "There isn't a flaw in his golf or his make-up." I didn't know Tiger wore make-up but I bet it's Revlon. Recent economic news has been less than encouraging, to wit:  GDP declined 6.2% in 4Q08, the biggest drop in 25 years  continuing claims for unemployment are 5.1mm, the highest since 1967 (the lousy 1967 job market wasn't a distraction for Bob Gibson, who incredibly allowed only three earned runs and 14 hits over three complete game World Series victories that year - I wonder what he'd think of the Joba Rules)  consumer confidence hit 25, the lowest in four decades when the good people at the Conference Board starting confabulating about confidence  a proposed budget featuring a deficit of $1.7 trillion, a whopping 12% of GDP, the highest ratio since 1942, proving that the new president is determined to throw money around like the New York Cosmos at Studio 54 circa 1975 In such a bleak environment, some high yield credits are less dodgy than others, and Ellen Barkin's ex-husband runs one of them, Revlon. Revlon's 4Q sales dropped 10.5% yoy, lower than the 7.5% decline expected by our analyst, the adroit Kevin Ziets (fx was 3/5 of the drop). The revenue drop was worsened by returns, which are netted against revenues. When the company introduces new products (Jan & September typically), the existing products get either returned to REV or are heavily discounted at retailers (both of which wind up depressing Revlon's revenues). On a positive note, according to ACNielsen, the US mass retail color cosmetics category grew 3.6% yoy in January, while Revlon brand color cosmetics dollar volume grew 9.7%, so Revlon's retail market share expanded to 13.3%, up 70 basis points. With fx a headwind (40% of intl sales are sourced in US; intl sales were 42% of FY08's total sales), pension expense up, and the economy as unreliable as a mid-bender sot, somewhat offset by cost savings and the implied price increases of new products, the company will probably produce positive yet bantam free cash flow. FY08 adjusted EBITDA was about $250mm; on its conference call, the company said that 2009 taxes would be about $15mm (I'm assuming that's cash taxes, rather than wading into the death spiral of deferred vs cash taxes, avoided completely by Obama's current trade rep nominee, Ron Kirk, who owes about $10,000 in back taxes; it's now like Groundhog Day The Movie comes to Connecticut Avenue), that the cash flow effect of working capital and higher pension expense would be another $15mm, and that total capex (capex plus display expenditures) would be $70mm. If you assume interest expense is $115mm, then free cash flow would be about $35mm, but that's too neat so let's assume fx trumps cost savings and say REV is about free cash flow neutral, for year- end leverage through the notes of about 5.5x, on estimated FY09 EBITDA of $218mm, up from 4.7x right now. So I admit that leverage is going up, but 33% is a bumper yield for a seller of products that should prove somewhat defensive (an account as crafty as Madoff's wife says she thinks consumers will give up hair products before they'll jettison make-up), especially when one considers that Sally Beauty subs are levered 5.4x and trade in the mid 80's to yield about 13.5% and shouldn't show much deleveraging over the next 12 months, so the difference in yield is more than the ytw of the Merrill Lynch High Yield Index. I concede that some of my accounts get nervous when I mention Ron Perelman (about as nervous as I do when A-Rod comes to bat with runners in scoring position late in the game), but as Kevin has explained to me and as I think I understood him, Perelman's actions in the past few years have been supportive of the company and bondholders (and he hasn't taken money out since the 90's):  he and a large financial institution bought about $500mm of debt and converted it to equity  he contributed his pro rata share of about $200mm in new equity
  2. 2.  he provided financing in the form of the M&F loan, which is behind the 9.5s in the cap structure, and has committed to his pro rata share of new equity to address the M&F loan's maturity Louis Cowell, CFA
  3. 3. WESTMORELAND Despite the lousy recent performance of the coal sector, the 10.75% senior secured notes due 2/1/18 of Westmoreland Coal (WLB) are worth a long look. Our analyst, the Delphic Phil Wirtz, drew the following conclusions about Westmoreland Coal after his conversation with management yesterday:  WLB wants net leverage to drop toward 2.5x over 3-4 years. Phil thinks this will happen even quicker.  Pro-forma for the company’s Kemmerer acquisition in January, about 80% of coal will be shipped mine mouth (conveyor belt), making delivery cost to customers extremely low. It’s Phil’s belief that these mine mouth deliveries provide customers with average energy costs below (in some cases significantly below) the cost of front month gas (currently around $2.33/mmbtu); consequently, utility switching should not be a large concern.  For the 20% or so tons that are trucked or shipped, the company has a freight advantage (400 mile rail advantage) by being located north of the Powder River Basin. Customers for this coal are also receiving a freight cost advantage.  ROVA (the company’s two coal-fired power-generating units with total capacity of 230MW) is a very competitive asset, and it’s environmentally compliant with state-of-the- art pollution control equipment. Phil believes it will be monetized between now and 2014, with sale proceeds in the $100 -$150 million range. At a price of 92, the 10.75% notes’ ytm is 12.77%. Not only are the notes backed by the assets of the parent, the Absaloka Mine, and the Kemmerer Mine, but they are also secured by ROVA. The company issued $125mm of add-on notes to finance the Kemmerer mine acquisition, which should provide $28-34mm of incremental EBITDA (WLB’s FY11 EBITDA was $57mm). Cap structure as of 3/31/12: $50mm cash, unfunded revolver ($25mm total, $23mm available), $114mm term loan, $275mm sr secured notes (original issue of 10.75% was $150mm), $18mm capital leases, and $2mm of other debt. For FY12, Phil believes the company will produce EBITDA of $90-105mm, ending the year with leverage around 3.5x. ROVA’s two units sell electricity to Dominion North Carolina Power under long-term power purchase agreements. ROVA is an exempt wholesale generator (EWG) and was recognized in 2002 by Electric Light & Power magazine as one of the top twenty power generating plants in the country based on utilization. Power assets can often sell at relatively high EBITDA multiples (6x+ is not uncommon) due to stable cash flow and low capex burdens. Below are the most recent five complete years of EBITDA, capex, capacity factors, and revenue at ROVA: What does Westmoreland say about potentially monetizing this asset? The story on ROVA really, in my mind, hasn't changed a whole heck of a lot. It's not a core asset. It'd be our preference to monetize it. There are some complications with monetizing it, specifically the fact that it's under a long-term power purchase agreement with Dominion. We've been in conversations over the last several years here. It's a good plant. Its technology is current. It's -- regulation-wise, it's in great shape. We think it's an asset that makes sense in the hands of somebody else, but we have to navigate through the
  4. 4. complexities of the contractual relationships we're under. I would hope, certainly, over the next 12 to 18 months, we'd have a solution for this in terms of monetization. There's no guarantee that that would occur. But I find it hard to believe that three years from now, we'd be operating this in the manner that we are today. I think the climate is better now than it has ever been to have these conversations. We're dealing with large organizations, utilities, that move on a different timeframe and have a different agenda than we do. But we remain ready, willing and able to look at anything that makes sense along the terms of monetization there -- or mitigating our coal costs longer-term because of current market conditions . Keith Alessi - Westmoreland Coal Company - President and CEO Westmoreland Q1 2012 conference call Louis Cowell, CFA
  5. 5. SKYLIN 1Q12 Skylink (ticker SKYLIN) reported lackluster 1Q12 results this morning. The company recorded revenues of $77.3mm, down 16.8% y-o-y as gross margin dropped to 11.2% from 16.4%. Among operating expenses y-o-y, project administration dollars were almost unchanged ($4.2mm vs $4.5mm) and SG&A dollars were higher despite the drop in revenues (+16.9% to $3.3mm). EBITDA was $1.1mm down from $8.1mm y-o-y. Cash from operations less capex, while negative was better y-o-y: -$7.2mm up from -$16.7mm on less working capital use. The company drew $8.8mm from its $25mm revolver during the quarter (it was undrawn at year end); it did draw a similar amount in 1Q11 ($7.3mm). As of 3/31/12, the company was in compliance with the revolver’s covenants and its cash balance was $3.2mm. Supposedly the bonds were offered at 50 today. At that price, assuming a fully drawn revolver and LTM EBITDA of $34mm, market leverage is 2.3x. When the notes were marketed in the March of 2011, 62% of revenues were in Afghanistan and 11% were in Iraq (disclosure is a problem with this company, so I’m unsure of current geographic concentration), so 73% between the two regions. If that held in FY11 when total revenues were about $500mm, then those two regions would have produced about $365mm of revenues. Let’s assume sales to that region drop 40% but that the company wins some new business (global peace will probably not break out) so 30% of revenue is lost. So total revenue would drop to $350mm. The company claims it can cancel its aircraft operating leases on 30 days notice, so let’s say its cost structure is almost all variable and a 30% drop in revenues results in a 40% drop in EBITDA. FY11 EBITDA was $42mm (the company’s “adjusted” number was higher), so reduce that to about $25mm. For comparison, FY08 revenues were $263mm and adjusted EBITDA was $25.8mm. If the company is worth a 4x multiple (capex is very low, $2mm in FY11), that’s $100mm EV less let’s say a full revolver draw of $25mm to be conservative, leaving $75mm to cover $110mm of notes for 68 cents on the dollar recovery. These notes are worth a look at 50. Louis Cowell, CFA
  6. 6. HERE ARE FOUR INTERESTING SITUATIONS: 1) Xerium (XRM) 8.875% sr notes due 2018. At 79, ytw is 14%. Company makes consumable products used in the production of paper. Cap structure as of 3/31/12: $38mm cash, unfunded revolver ($30mm total, $16mm available), $216mm of term loans, $240mm of the sr notes. Using LTM EBITDA of $98mm, gross leverage is 4.7x, and net market leverage is 3.8x. Comps Albany Intl (AIN) and Metso Corp (MEO1V FH) trade at 5.5x and 6.2x, respectively, on an EV/EBITDA basis. Our analyst, Phil Wirtz, knows the sector very well- before making a clearly ill-advised move to the financial sell- side, he was a senior analyst for Corporacion Durango (now bio-pappel) in the areas of raw materials procurement, paper manufacturing, and containerboard converting. He thinks there’s a good chance that the company will announce a rationalization program before its 2Q financial report to address overcapacity in its roll cover segment (roll covers and clothing are the company’s two segments). The recent concern has been weak European demand (represented 33% of FY11’s sales), which Phil thinks should improve during the remainder of the year. 2) Westmoreland Coal (WLB) 10.75% sr secured notes due 2018. At 95.5, ytw is 11.9%. The company’s business model is cost plus with long-term supply agreements, so it is more stable than some of its peers. Back in January, the company issued $125mm of add-on notes to finance a mine acquisition. Cap structure as of 3/31/12: $50mm cash, unfunded revolver ($25mm total, $23mm available), $114mm term loan, $275mm sr secured notes (original issue of 10.75% was $150mm), $18mm capital leases, and $2mm of other debt. FY11 EBITDA was $57mm, and the company expects $28-34mm of incremental EBITDA from the January acquisition; so for FY12, our analyst believes the company will produce EBITDA of $90-105mm, ending the year with net leverage well below 4x. 3) Affinion (AFFINI) 11.5% sr sub notes due 2015. At 89, ytw is 15.8%. The company sells credit monitoring services, identity theft protection, accidental death & dismemberment insurance, loyalty programs, and enhanced checking and credit/debit card services (Wells Fargo is largest customer at 14% of sales). Apollo is the sponsor. Cap structure as of 3/31/12: $117mm cash (+ $30mm restricted), unfunded revolver ($165mm total, $158mm avail), $1.1 billion term loan due October 2016 (but stipulated to mature 91 days prior to 11.5s if still outstanding), $475mm 7.875% sr notes due 2018, $355mm 11.5% sr sub notes, $325mm 11.625% holdco notes due 2015, and $1.8mm cap leases. Gross leverage through the 11.5% notes is 5.3x using “Adjusted” EBITDA of $366mm (unadjusted EBITDA is about $292mm for 6.6x leverage). The company has guided to modest EBITDA growth this year, so free cash flow could be about $60mm ($300mm unadjusted EBITDA - $170mm interest - $50mm capex - $20mm working capital (a guess) – no cash taxes). The account who gave me this idea thinks that the bonds sold off in March over concerns about how Dodd/Frank-type regulation would affect Affinion’s business with financial customers. Additional legislation will probably target things like draft fees and finance charges, not Affinion’s products. He thinks Affinion’s financial sector customers will need its services all the more now because as the banks lose some sources of revenue (exorbitant late fees and card usage charges), they'll turn to Affinion’s fee-based loyalty and "enhanced" checking products (car rental discounts, grocery coupon packages, movie ticket discounts, cell phone protection, etc) to compensate. With Affinion’s products, the banks can argue that they're providing "value-added" services, not fleecing individual depositors. 4) Not for the faint of heart: THQ Inc (THQI) 5% cvt notes due 2014. Bonds are in the mid 50’s, and the stock trades at 65 cents. The company makes video game software. Cap structure as of 3/31/12: $76mm cash, unfunded revolver ($50mm total), and $100mm
  7. 7. converts. The company has exited the children's games business, in the process drastically cutting its cost structure, so it should have enough liquidity to get to the end of the year, when it has a number of promising releases. Company guidance seems extremely conservative (and why not? No one would believe this management team otherwise). If this is of interest, I attached a competitor’s report, where a title-by-title revenue estimate (an artistic not scientific undertaking) shows how the company’s revamped cost structure gives it operating leverage to beat guidance on even modest outperformance from one release. Louis Cowell, CFA
  8. 8. JIVE Expiration of insider lockups has recently produced good short candidates, especially among tech/internet IPOs. Jive Software (JIVE) is a good short candidate (see first chart). The company furnishes social business software products and services; it provides a combination of community, collaboration, and social networking software, as well as social media monitoring platforms. For the backbenchers, it aspires to be the Facebook of the “enterprise.” JIVE’s IPO was in December 2011. Its stock has been weak since hitting a high on April 3 (it was off 10.3% to $20.34 today but was up after-hours in response to its earnings release, so it could trade higher tomorrow). It’s important to note that its lockup expires on June 9. Sequoia and Kleiner Perkins own a combined 23.6mm shares, more than the 18.0mm float and 38% of the 61.4mm fully diluted shares outstanding. It’s a decent bet that its chart will look like those of ZNGA, GRPN, BVSN, and LNKD (the latter for the period before and after the expiration of its lockup). JIVE reported 1Q12 earnings today in press release form that, when printed from the company’s website, features font microscopic enough to be considered illegible (it might be an additional sell indicator that a company in the technology sector, or “space” for those who embrace the hideous argot of bankerspeak, produces such a printer-unfriendly document; I practically had to get behind it to read it). “Non-GAAP” EPS (sadly, a favorite “metric” among money-losers and cash-flow burners; here it’s adjusted for stock-based comp, acquisition amortization, and 1Q11’s fair value change in warrant liability) checked in at a net loss of $0.09 vs a consensus net loss of $0.13 (1Q11 non-GAAP EPS was negative $0.36). The company is without question a fast grower as sales increased 57.6% to $25.3mm and gross margin expanded 200 basis points to 58.1%, while opex increased by a much smaller 21.9% to $23.5mm (92.9% of sales vs 120.1% yoy) for a smaller unadjusted loss from operations of $8.8mm vs $10.3mm yoy. The company’s guidance for 2Q12 is as follows:  Sales of $26mm to $27mm (vs $17.9mm in 2Q11, a 48.2% increase, but slower than 1Q12’s yoy rate)  Non-GAAP loss from operations of $6.5 mm to $7.5mm (sequentially worse than 1Q’s $5.1mm loss)  Non-GAAP loss per share of $0.11 to $0.12 (sequentially worse)  Full year guidance includes a revenue expectation of $110.0mm to $113.5mm. At the midpoint this would be annual growth of 44.6%, slower than the 2010/2011 growth rate of 67.0%. It also includes a non-GAAP loss from operations of $22 to $24mm, down from a $32.2mm loss in 2011. Despite its good performance vs expectations, the company has a beastly insider overhang and trades at 12.7x EV/LTM sales vs 8.5x for competitor Salesforce.com (CRM), a company that has had an encounter with positive net income and whose stock has been on a tear. Moreover, it’s a bit worrisome that JIVE has been touted by the infamous National Inflation Association- one of its recent picks was Broadvision (BVSN), which is discussed below.
  9. 9. ZNGA’s IPO was in December 2011; it sold 100mm shares. Three months later the company priced a secondary offering of a whopping 49.4mm shares to allow insiders to sell a portion of their shares in exchange for later-dated lockups on their remaining shares. The company narrowly beat estimates when it reported 1Q earnings on April 26. Lately, the stock has been atrocious: GRPN’s IPO was in November 2011. It’s had its share of problems since its debut, to wit: it missed estimates on its first earnings release, which had been effectively restated; the restatement triggered an SEC investigation and led the company to replace two-thirds of its audit committee. Adding insult to injury, it had to endure the inanity of its CEO/founder admonishing his troops to grow up while he pounded down a coldy. Hard as it is to believe, this company probably has characteristics of both Ponzi and pyramid schemes. The company’s lockup was extended to June 1 from May 2 supposedly to accommodate its planned May 14 reporting date (management must have know the approximate date for its 1Q release back in November, so this explanation seems a bit weak). The stock has had a recent rank run:
  10. 10. BVSN’s IPO was back in 1996 so there’s no overhang. The company develops, markets, and supports application software solutions that personalize e-business, a description which sounds a bit like JIVE, notwithstanding the 10-K-speak. It reported lackluster quarterly numbers on April 25. Ironically, its stock drop may have been helped by the exhortations of the aforementioned NIA. On its call, the company was even asked whether it had paid NIA a promotional fee (but who knows?...maybe the questioner was a short seller- these internet stock stories quickly become as convoluted as the plot to Gravity’s Rainbow). Of late, the stock has been on the cusp of verticality:
  11. 11. LNKD’s IPO was in May 2011. The stock has been a pleasant trip this year (1st chart) but didn’t do that well leading up to and shortly after its lockup expiration on November 20, 2011 (2nd chart, from 11/01/11 to 12/30/11). The company has the solitary distinction among those charted here of being net income positive (what a novel concept). Louis Cowell, CFA
  12. 12. LTACH LifeCare Holdings (LTACH), an operator of 27 long-term acute care hospitals with 1,431 beds, is a comp to much larger Select Medical (ticker SEM, 110 hospitals) and Kindred Healthcare (ticker KND, 121 hospitals). The term loan, L+1,325 and quoted mid 80s for an 18% yield, seems interesting (there’s also the chance for covenant waiver fees). For FY11, revenues were $415mm with EBITDA of $47mm. Driven by an acquisition of 375 beds late in 2011, our analyst, the intrepid Joe Phillips, believes the company will produce revenue of $488mm and EBITDA of $54mm in FY12. The company’s capital structure is as follows: $12mm cash, $30mm unfunded revolver due 2/1/16, $313mm term loan also due 2/1/16, and $119mm 9.25% sr sub notes due 8/15/13. If the sr sub notes aren’t refinanced by May 2013, then the term loan and revolver are due on that date. Using the $54mm EBITDA projection, leverage through the term loan is 5.8x at face, 4.9x at market (6.7x face, 5.7x market using $47mm). Select Medical (SEM) and Kindred Healthcare (KND) trade at 6.7x and 6.1x, respectively, on an EV/EBITDA basis. Louis Cowell, CFA
  13. 13. UA Under Armour (UA) reports tomorrow and the stock trades at 41x consensus FY12 EPS estimate of $2.33/share, rich compared with footwear comps of adidas (ADDYY) 16x, NKE 22x, PUMA 16x, Wolverine (WWW) 14x and apparel comps of Quicksilver (ZQK) 22x, Columbia (COLM) 16x, VF Corp (VFC) 16x. Although the company has been a fast grower (FY11’s sales and EPS both up 38%) and its future growth prospects warrant a premium valuation, there’s a very good chance that 1Q12 (ends 3/31) will see gross margin pressure from 1) product cost inflation in synthetics, cottons, labor, and shipping; 2) need to work off recent inventory build-up (4Q inventory up 51% vs 4Q sales increase of 34%; 4Q’s days inventory increased to 151 from 135 y-o-y); and 3) warm weather. Comp NKE reported its 3Q12 (ended 2/29) on 3/22- EPS was $1.20 vs consensus of $1.17 as sales increased 15% to $5.8 billion but gross margin was down 200 bps to 43.8% as price hikes didn’t offset higher costs (the fifth consecutive quarterly gross margin drop on y-o-y basis). Moreover, the company guided 4Q gross margin down again y-o- y, this time about 100 bps. NKE’s inventory increased 32% (2/3 of the increase was from higher costs, not units), but with inventory turnover for the year ended 5/31/11 of 4.2x vs UA’s 2.3x for the year ended 12/31/11 as well as better margins (13.5% vs 11.1% for same FYs), NKE appears to be a more efficient inventory manager despite its size (inventory of $3.4 billion on 2/29 vs UA’s $324 million on 12/31/11). NKE reported after the close on 3/22; that day, the stock closed up $0.55 to $110.99 but closed the next day at $107.42 (it had hit a 52-week high of $112.13 on 3/19). Despite its attractive growth prospects in its footwear, international, and direct-to-consumer businesses, UA could very easily disappoint when it reports 1Q12 numbers tomorrow. Louis Cowell, CFA
  14. 14. MEG Do you work at an event-driven hedge fund? Do you ask your salespeople, “What’s the catalyst?” on every idea they try to give you? If you answered yes to these questions, you need to look at Media General (MEG).  MEG has a L+700, 150L floor term loan that matures in March 2013, unless the company can raise $225mm in new notes by May 25, 2012 (if the notes are issued, then $190mm of the term would be paid off and the balance’s maturity would be extended to March 2015).  The company has $300mm of 11.375% senior secured notes due 2/15/17 that are offered at 92 and are pari passu with the term loan.  The company is also exploring the sale of its newspaper business (asset sale proceeds must be used on a pro rata basis to retire bank debt and bonds). The value of the 18 TV stations that MEG owns (8 NBC, 8 CBS and 2 others) should be more than sufficient to provide all debt holders with a par recovery. The newspapers aren’t worthless, but the value is a fraction of the television stations (say, $25mm of EBITDA x 4), to wit: The New York Times supposedly sold its Regional Media Group to Halifax for about 4x EBITDA while television station comps look as follows on an EV/EBITDA basis:  Belo (BLC) 8.3x  Grey (GTN) 9.6x  Nexstar (NXST) 8.8x  Sinclair (SBGI) 7.2x  Lin (TVL) 9.1x My colleague Dave Marsh follows this company and can walk you through a $/household value of the company’s TV stations if you’d like to discuss his thought process. Louis Cowell, CFA
  15. 15. SKYLIN FY11 If you claim that you are a value investor when your oleaginous salesman calls with "ideas, situations, and opportunities" of the humdrum momentum-driven or cap-structure-arb ilk, then you should look at Skylink Aviation (SKYLIN). At a market price of 75, leverage through the bonds is a whopping 2x with a good free cash flow profile, given FY11 EBITDA of $42mm (up 30% yoy), $15mm of projected cash interest (company's revolver balance is now $0) and small capex ($2mm in FY11, $5mm in FY10). The company is a provider of global aviation transportation and logistics services, primarily fixed-wing and rotary-wing air transport and related activities. In practical terms, ie, patois the lawyers wouldn't "bless," it flies people and cargo to and within hot spots. 3Q revenue and EBITDA all but doubled, while 4Q revenue and EBITDA increased 32% and 27% respectively. The cap structure is simple- unfunded $30mm revolver, 12.25% 2nd lien notes due 2016 with Apollo as the equity. The bonds appear to have gapped down to the 80s on light volume when the high yield market weakened in August and never really recovered despite the company's subsequent good performance. News of the Global Aviation (ticker GLAH) bankruptcy didn't help these bonds, but the companies' cost structures are dramatically different in important ways (SKYLIN's aircraft leases are cancellable with 30 days' notice, GLAH's are long-term). My colleague, the estimable Dave Marsh, knows the credit well and is happy to talk about what is certainly no shopworn, prosaic "idea, situation, or opportunity." The year-end conference call just ended. Louis Cowell, CFA
  16. 16. EXIDE See chart below (and attached) and then dust off that scintillating reading from the BCI (yes, that's the Battery Council International, the inevitable trade association- there's a trade association for everything, including for trade associations) because XIDE sr sec 8.625% are worth a look. Lead prices, 45-50% of COGS, have been falling and should produce upward pressure on gross margins. In the attached chart, which shows average lead price by quarter and the company’s quarterly gross margin, you can see that gross margin lags average price by a quarter or so. When lead averaged $1,993 per metric ton in calendar 2Q10, gross margin was 20% the following quarter. Gross margin last quarter was 16% (when the prior quarter’s average lead price was $2,458) on effete aftermarket sales, lower fixed cost coverage because of lower production, and lower lead market sales (and spot selling prices) in the company’s lead recycling business. 4Q average lead prices fell 18% to $2,016. In the "circ"-filled (some oh-so- cool investment banking patois for the cheap seats, and some more parentheses (or would it be -is?) for fans of Infinite Jest, a footnote perhaps?) model that I have, a 100 bps change in gross margin increases EBITDA by about $7.5mm. The company was free cash flow positive last quarter to the tune of $14mm and guided to a higher number for the current quarter. Leverage through the notes is 3.7x gross and 3.1x net. At a price of 79, net market leverage is so low that it's begging you to pick up the BCI weekly for some weekend reading and think about buying some XIDE bonds. Louis Cowell, CFA
  17. 17. MARKET COMMENTARY Like Manny Ramirez confronted by a roomful of reporters, baby formula hucksters, and bra salesmen; distressed and high yield investors (the former in particular) should be looking for an expeditious exit from what I’ll at least currently call the markets (I’m not sure what we’ll soon call them in United Socialist North American Republic). Selling into the recent strength seems as smart a move as Calvin Borel’s demarche along the rail in Kentucky two Saturday afternoons ago. Starting from the March 9 lows, the S&P is up 31% as of yesterday. And, as David Rosenberg so sagaciously points out in one of his last pieces for that two-headed hydra ML/BofA, if one looks at a graph of that index’s performance year-to-date, it’s a V, not Thomas Pynchon’s V, but our very own V. So we’ve basically retraced the decline from the January 6 peak of 945. But the erudite Mr. Rosenberg contents that there’s even more risk in the market now than back in January because many professional investors have probably covered shorts and gone at least modestly long, so there’s less technical support beneath; and, meanwhile, unless you believe all the wacky horticultural drivel about green shoots, the economy doesn’t look much better. I figure there are at least five good reasons to flee: 1) A beyond-lousy economy, dragged down by a supine consumer and a still frightening housing sector (not to mention the worsening commercial real estate picture, etc); 2) A banking system shakier than stress pop quizzes revealed (back in grammar school, I wasn’t given the answers beforehand and a chance to dispute my performance afterward); 3) The likely and growth-stifling prospect of a new regime compliments of our current administration: i) higher income taxes; ii) a cap & trade energy policy (in other words higher taxes, see “little one in the hole” as the drafters of credit agreements say); and iii) expensive universal healthcare (in other words higher taxes…there’s a sad theme here); 4) A Federal Reserve forced to tighten just when real green shoots start to appear; and 5) Much related to #3, an environment about as friendly to business as Hank Paulson is to big, non-Goldman Sachs bank CEOs; to wit- the Obama administration’s trampling of the absolute priority rule, not to mention the Contracts Clause of Article V of the Constitution (and this from an erstwhile constitutional law school “lecturer”), in the Chrysler bankruptcy, all with a nod to one of its favorite constituents, the unions. The Economy As that country bumpkin who stumbled upon the White House and who never turned down a speaking engagement or an admirer once said, “It’s the economy, stupid.” I’m not really sure how or why last week’s jobs number was so celebrated. From a Rosenberg piece, 539K jobs got knocked off; included in that comely number was the addition of 72K jobs from the government (60K census workers- a Democratic redistricting plot if ever there was one; but look there on the grassy knoll, it’s umbrella man) and another 60K from the Bureau of Lying Statistics “birth/death adjustment”- a concept so stupid only an intellectual could accept it, adjusting for both gets a closer-to-reality job loss number of 670K, not too great. And toss onto the turd pile
  18. 18. that the workweek was 33.2 hours, an all-time record low. Today’s jobless claims data weren’t exactly reassuring, with continued claims now at an all-time record high of 6.56 million. And yesterday’s economic nonsense wasn’t much rosier: April retail sales off 0.4% sequentially (March’s number revised slightly downward to -1.3%) and off 11.4% yoy. I’m not so sure that housing is doing much better; here’s a nice chart from that genius at zerohedgeblogspot.com (who is that guy???) that shows the number of foreclosures over time as disclosed by RealityTrac (April’s number out yesterday) ; we are at an all time high: Zerohedge man then provides a nice quote from Reality Trac: “Total foreclosure activity in April ended up slightly above the previous month, once again hitting a record-high level,” said James J. Saccacio, chief executive officer of RealtyTrac. “Much of this activity is at the initial stages of foreclosure – the default and auction stages – while bank repossessions, or REOs, were down on a monthly and annual basis to their lowest level since March 2008. This suggests that many lenders and servicers are beginning foreclosure proceedings on delinquent loans that had been delayed by legislative and industry moratoria. It’s likely that we’ll see a corresponding
  19. 19. spike in REOs as these loans move through the foreclosure process over the next few months.” I probably don’t need to add anything here. Also on the topic of housing, apparently Alan Greenspan addressed The National Association of Realtors on Tuesday, and, amazingly, had this to say: “We are finally beginning to see the seeds of a bottoming…" in the housing industry. I’m not sure what else The Maestro, whose speaking style confuses me about as much as Jose Reyes trying to stretch a double into a single, said, but if he thinks we’re near the bottom, it’s a good bet we’re about half-way there. That AG is still willing to perform his hot air artistry in exchange for a speaker’s fee is about as surprising to me as news of a Wells notice directed to the tanned man of real estate, Angelo Mozilo. I’ve read that the consumer spending before the meltdown was a bit more than 70% of GDP (and the savings rate was just about negative as consumers got spending money from mortgage refi’s) but was as low as possibly, say, 62% back in the early 1980’s when the saving rate was in the mid to high single digits. Let’s face it, “going forward” (as equity analysts in particular like to say; strange, I’ve never heard anyone say, “Going backward” except a driver’s ed instructor) we have a better chance of seeing Ian Kennedy pitch a complete game shutout (in the majors) than we do of seeing the average consumer refi his mortgage for spending money, which means the savings rate is going to keep going up, maybe back to early 80’s levels and it’s going to have to stay there because the easy refi route is gone for years to come and, in the meantime, people need to save some money if they ever want to retire (unless they work for the UAW and then they can probably stay in the guest bedroom at the White House). Clearly, this inevitable and possibly long consumer pullback isn’t good for growth, which both stocks and distressed bonds need. The Banking System In a recent piece, Pali’s very own strategist, the incisive James Ferguson, provides a nice perspective on why the banking system might need a lot more than the $75 billion suggested by the government. Sparing you lots of detail and accounting ratios and calculations (something Geithner probably suggested sidestepping as well), James concludes: “For sector analysts to take the US authorities' $74.6bn capital requirement figure as a done- and-dusted solution to the banking crisis, given the fact that it seems impossible to reconcile the loss ratio assumptions with the asset base and the capital required and given that the macro assumptions are almost ludicrously benign, seems dangerously complacent. Market sentiment may want to believe these "reassuring" figures but we can't comply.” Notwithstanding James use of such hideous tropes as “done-and-dusted,” he discusses how the assumed loss ratio behind the stress test (I believe 11% on a straight line basis; but remember, as James points out, “Japan’s slow burn cumulative loss ratio after more than a decade stands at about 20%”) clearly isn’t being applied to all risk assets of about $15.7 billion; it’s being applied to a much smaller asset base and the answer that pops out at the end of the stress test, $75 billion, is suspiciously close to the amount of remaining TARP funds. I believe that the IMF has forecast that the US banking system needs about $275 billion of capital, and there are a lot of ways to get there: housing related losses, commercial real estate-related losses, credit card-related losses, etc.
  20. 20. A New Regime Let’s face it, next year, right around the time that maybe, quite possibly, the economy is showing signs of life, Obamanomics, for better or worse, should be kicking in. For starters, higher taxes on income for those making over, say, $250K, which will probably hurt small businesses- the biggest “driver” of new employment. Then there’s healthcare; supposedly the plan will insure more people but cost less; that trade-off sounds almost too good to be true. I worry that the only thing missing from the promises on universal healthcare is a used car dealership in the background, but wait, I see one, because car dealerships are owned by the government now. It will supposedly cost an extra $150 billion/year and there’s a good chance that at least some of that will be paid for with new taxes. The cap and trade idea is problematic for the economy too. Energy Secretary Steven Chu has suggested that if other countries don’t adopt similar plans, we’ll impose tariffs on their incoming goods. But China and India, in their attempts to continue to grow and move more of their citizens into the middle class, aren’t going to stop using oil and coal as their cheap sources of energy. As far as starting a trade war indirectly over our current administration’s global warming fears, I don’t buy that the Smoot Hawley tariffs turned a bad recession into the Great Depression, but they sure didn’t help. The Fed Quantitative easing sounds like a three card monte game: As the country borrows more and more money (assuming we can continue to cajole China to buy our bonds), the Fed will be printing money and buying some of those bonds, in the process increasing the money supply. At some point, when the economy is picking up, the Fed will have to begin to take money out of the system; this is never an easy fine-tuning process (and could threaten the recovery but the alternative could be massive inflation) and this time it will have to be done on an unprecedented scale. And for you supernatural history buffs out there, break out the Ouija board and ask the ghost of Nixon’s Fed Chairman, Arthur Burns, about the political pressure that will be applied to whoever is lucky enough to be Fed Head next year. The Overall Business Environment The environment is getting less friendly toward business. Using the Chrysler bankruptcy debacle as a springboard, Todd Zywicki, professor of law at George Mason University, does a nice job of discussing the souring business environment in this article: http://online.wsj.com/article/SB124217356836613091.html One final note: Adam Smalley of Straits LLC is one of the savviest high yield investors I know; I used to torture him with accounting questions at an old job; he handled all incoming with élan. He reminded me yesterday that high yield investors don’t necessarily need growth if the capital structure is manageable; they just need to get their coupons and then their principal. I think he makes a great point. So I’d hold onto bonds of decent companies with workable capitalizations, names like Revlon and Amscan and Burlington Coat Factory, but as far as companies that need to “grow” into their capital structures, race the Dodger with the dreadlocks for the nearest exit or you might wind up in the poor house with the formerly tanned man of real estate. Louis Cowell, CFA
  21. 21. SALLY BEAUTY Sally Beauty (debt and equity ticker SBH) subs are worth a look as a short. The company distributes products directly to salons and retails beauty products through a chain of cash and carry stores. Cap structure as of 12/31/08: Cash $113mm, $75mm funded ABL revolver ($400mm total), $130mm TLA, $900mm TLB, $430mm 9.25% sr notes, and $280mm 10.5% sr sub notes. LTM EBITDA is $336mm for leverage of 5.4x (6.3x on a lease-adjusted basis).  bonds traded mid 50's in the third week of November and are now 89 area  4Q was not a total disaster, and bonds rallied on short covering and the general market  comps remain positive but have been declining and are currently about flat  average ticket is down  on the plus side, customer count is up (salon professionals are stocking less inventory so are visiting stores more often; retail customers are visiting salons less frequently (opting for do-it-yourself) so are also visiting stores more often)  maintaining customer count requires more SG&A spending (more direct mailing, etc) versus comps:  at 89 (ytw 12.77%), subs trade on top of Dollar General's 11.875% sr subs (at 97, ytw 12.45%), which have a turn less leverage; in addition, DG has been outperforming with 3Q08 adjusted EBITDA up 60% and comps up 10.6% (in SBH's most recent quarter, EBITDA was down about 6.4%)  Revlon (REV) is levered 4.7x through its 9.5% sr notes, which yield about 30% at a price of 70, and could be modestly free cash flow positive in FY09  a reasonable level for the SBH subs seems to be ~15%, about 10 points lower than current levels Have a good weekend. Lou Louis Cowell, CFA
  22. 22. HANESBRANDS Just as most now realize that there was no beating Sean Penn for best actor (given the role, his political weltanschauung, and that of the academy - the latter an exemplar of political neutrality), we might look back on Hanesbrands floaters (debt and equity ticker HBI) in the 60's as a great buying opportunity. The bonds traded as high as 82.25 back in the middle of January but are now in the mid 60's. The bond's performance was not helped by a 10.5% drop in 4Q08 revenues (not great for a business thought of as defensive; EBITDA did better...$119mm vs $127mm yoy, a 6.4% drop), the company's observation of recent double- digit volume declines in some sub-segments, and the announcement that it was discussing an amendment with its first lien lenders, especially considering it had spoken confidently in the past about its ability to remain in compliance. Leverage for the quarter, as defined by the credit agreement, was 3.3x vs a 3.75x covenant. The problem is that the covenant dips to 3x at the end of FY09. The credit facility EBITDA calculation and add-backs are about as clear as a first read of Neuromancer (leading me to wonder "What's the website number?") and with no amendment it might be close. Nonetheless, a few factors should support the credit in 2H09 and provide reason to think about this "in the context" (to use some provocative trading-floor lingo) of a long. Cap structure as of 12/31/08 as follows: $67mm cash, $242mm A/R facility, $139mm TLA, $850mm TLB, $450mm 2nd lien, $494mm FRN, $62mm other debt, and $650mm of equity market cap. LTM EBITDA is $507mm for leverage of 4.4x; EV/LTM EBITDA = 5.6x. For FY09, our analyst, the perspicacious Kevin Ziets, projects revenues down 5.7% and EBITDA off 5.3% to $480mm. The company should produce good free cash flow at this level: $480mm - $120mm cash interest - $130mm capex - $50mm cash taxes + $45mm working capital benefit (company carried excess inventory in 2008 while it was relocating production facilities in lower cost areas) = $225mm. Assuming this filthy lucre is used for debt reduction, then leverage would stand at 4.2x at year's end, down a half turn. As Kevin has explained to me with the patience of a 1st grade teacher, 1H09 will no doubt be tough, but the 1st lien lenders should go along with the amendment and by 2H09 the company will benefit from lower cotton as well as cost and working capital reductions. Eventually people need underwear as badly as they'll need a wheelbarrow to take their money to the supermarket to buy a loaf of bread, and HBI has some of the best basic brands in Hanes, Champion, and Playtex. Lou Louis Cowell, CFA
  23. 23. HIGH YIELD MARKET Not unlike the current administration, many fixed income types think they're smarter than everyone else (including their equity coevals). So it's odd that the high yield market, as measured by the Merrill Lynch High Yield Index (to be replaced in future pieces by the Pali High Yield Index), is up about 2.5% ytd while the Dow is down about 18% as I write (and this curiously despite most thinking that default rates will hit the teens by year end). Here's a theory propounded by one of my accounts: the money that's been flowing into mutual funds has provided a strong but ultimately ephemeral technical bid to the market (how else does Aramark stay in the 90's with 5.8x leverage, Sally Beauty subs climb from the 50s in November to upper 80's while levered 5.5x, or Pinnacle Foods subs trade in the low 70's with a whopping 7.5x leverage (granted seasonal peak)). However, the tidal wave of inflows came to a halt this week with an outflow of about $250mm. This outflow coincided with a serious drop in high yield volume; to see this check out NBBHVOINDEX HP go. (You can see the components of that index by typing NBBHTR INDEX MEMB go.) Look at the difference in volume between the left and right columns on the HP page; hy volume is drying up. This shrinking volume has come during a stretch where the market has felt weak on most days. My equity colleagues, who love recondite technical concepts such as head-and-shoulders patterns, tell me that stretches of low volume, down days are bad omens - they prefer large drops on big volume, which show "capitulation." The lousy tone and scant volume suggest to my cagey account that the high yield and equity markets will finally start heading in the same direction as Freddie Prinze Jr's acting career...due south. Lou Louis Cowell, CFA

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