Under a reorganization scenario for Peabody Energy (NYSE:BTU), it would appear that the 2nd lien secured notes provide the best risk reward for investors if we exclude comparing the 1st lien debt. A reorganization situation has numerous possibilities in terms of the final decisions regarding assumption for forward EBITDA, the amount of debt to put onto the new corporate structures as well as the valuation multiple assigned to the new corporation. Furthermore, the capital structure between now and the actual reorganization could change dramatically depending on whether Peabody's management will exchange current debt for a new class of debt or introduce new 1st lien debt into the picture.
I've calculated several possibilities for the reorganization with EBITDA assumptions ranging from $420 million per year which would be pessimistic but not unreasonable to $720 million per year which would be optimistic in my opinion. If the reader's belief is that an evaluation for EBITDA is significantly over $720 million per year in reorganization, then there is no need to read any further since certain of Peabody's securities then become an obvious buy.
For brevity's sake, I've only posted the graphs for the worst and best scenarios that I've considered. Under a pessimistic assumption of $420 million per year in EBITDA, the unsecured notes will recover nothing under both a low (1x) and a moderate (3x) leverage plan with low valuation multiple of 4.5 times EBITDA for the enterprise value. Under the low leverage scenario, the term loan gets the most favorable deal, getting 51% of the new low leverage company's equity as well as recovering $420 million in 1st lien debt. The 2nd lien debt will receive 49% of the new equity which should provide a fairly good return considering current prices are around 22 cents on the dollar. If the final decision is to go with a moderate leverage (3x) company, the 2nd lien lenders will receive all of the new company's equity and $94 million in new senior debt. Considering that the almost half of the current market cost of the 2nd lien debt would be recovered through senior debt which will likely be priced at par under a reorganized company, the return under this scenario would be very healthy.
Source: Author's own work
Under a higher valuation scenario in which it was decided that the enterprise value of the company would be 5.5x EBITDA, unsecured note holders would see a recovery of 9% and 16% of equity for the new company under leverage scenarios of 1x and 3x, respectively. A higher leverage level taken by the reorganized company will tend to help the unsecured notes under the current capital structure due to the large size of the aggregate unsecured notes and the large portion of higher priority debt. A higher enterprise valuation, of course, will also aid unsecured notes in recovering a higher amount of the equity.
Under the most optimistic scenario I have calculated with assumed valuation EBITDA of $720 million per year and a high valuation multiple of 5.5x, unsecured note holders will recover 56% and 100% of the equity for the reorganized company with leverage ratios of 1x and 3x, respectively, with a marginal amount of new senior debt for the 3x leverage scenario. This is certainly a decent return considering the low market price of the current unsecured notes. Supposing we pay 10 cents on the dollar right now for a senior unsecured issue which would be roughly $377 million or so in total market value. Also, suppose that $1.8 billion is the actual approximate market value of an unsecured note holder's new equity stake; the returns could turn out to be quite excellent under this very optimistic scenario with a return of almost 4.8 times the original invested capital.
Source: Author's own work
Although unsecured notes could potentially provide for high returns under a very optimistic reorganization of the company, it could also be a disastrous investment if valuation EBITDA assumptions were lower and the leverage taken on for the new company was chosen to be low as well. However, under all the various assumptions I have used to calculate outcomes, I find that the 2nd lien secured notes provide for a much better risk-return profile for the conservative investor. A healthy equity portion will be recovered for the 2nd lien notes under some pretty pessimistic assumptions which would provide for a very respectable return at today's market price for the notes. Of course, the situation may change due to moves made by management with respect to taking on new 1st lien debt or drawing on their liquidity from their current 1st lien commitments. Management may also partake in a debt exchange or repurchase debt with cash. All of these moves may completely change the outcomes calculated above, and I think it would be better to continue to follow the situation before taking any large positions in any of the aforementioned securities.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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