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.
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.