OVERVIEW

An investment in the Advanta 8.99% Trust Preferreds due 2026 offers investors the opportunity to earn multiples on their investment with minimal downside risk.  A recent settlement with the FDIC greatly reduces the downside for the Trups, shortens the duration of the reorganization, and reduces professional fees.

For those familiar with the defunct bank holding company reorganization (Washington Mutual, Fremont, etc) the facts in Advanta will sound familiar.  The key assets include cash, receivables, securities, tax refunds, and litigation recoveries.  The key claimants are bondholders, trade creditors and the FDIC.  At the outset, the key risk for unsecured creditors was an adverse outcome in litigation with the FDIC, but this risk has now been eliminated.

BACKGROUND

Advanta., a subprime credit card issuer catering to small businesses, entered Chapter 11 following a severe increase in delinquencies and charge offs as the economic downturn impacted its customer base.  Incorporated in 1974 as Teachers Service Organization, Advanta's most recent business model took hold in the mid 1990s.  Advanta issued credit cards to small business owners unable to receive credit from more traditional lenders like American Express.  Advanta's advanced credit and sourced funds from its wholly-owned sub, Advanta Bank Corp., a Utah-based industrial bank. As an industrial bank, ABC did not take deposits and funded its balance sheet with high-cost brokered CDs.  As the economic downturn accelerated, charge offs and delinquencies increased.  As these credit problems ramped, Advanta's cash burn increased and its capitalization at ABC rapidly deteriorated.  Soon, ABC was subject to a cease and desist order from the FDIC and was restricted from issuing new credit. With limited options for additional liquidity, Advanta Corp filed for Chapter 11 on November 8, 2009.

FDIC LITIGATION & SETTLEMENT

Despite Advanta's November 2009 bankruptcy filing, Advanta Bank Corp was not seized until March 19, 2010.  By this time, Advanta Corp had already completed numerous tasks within its reorganization, including the filing of its 2009 and amended 2008 tax returns.  Of note, Advanta structured its tax filings in a way that reduced the aggregate refund, but also limited the size of FDIC's claim for the portion of the refund owed to ABC.   (Advanta Corp and all of its subsidiaries, including ABC, operated under a tax sharing agreement which specified that each subsidiary pay/receive taxes as if the sub had filed a tax return on its own.)  The FDIC strongly opposed Advanta's tax strategy, and sought permission to file its own tax returns.  The FDIC argued that Advanta should have filed to receive a larger aggregate refund (based on ABC's losses).  However, if this strategy was accepted, Advanta countered, the FDIC would receive a large unsecured claim, to the detriment of all of Advanta's other creditors.  This set the stage for a protracted fight between the FDIC and Advanta.

However, as the preliminary hearings began last week, Advanta and the FDIC reached a settlement that resolved the tax dispute and included a mutual release of any additional litigation between the two.  The settlement agreement specifies:

• The FDIC receives permission to file its own tax returns, which request the larger refund based on ABC's losses in 2009
• If the IRS accepts the amended returns, 90% of the incremental refund will go directly to the FDIC and 10% will go to Advanta Corp.
• If the IRS rejects the amended returns, the FDIC will receive an unsecured claim for $50 million.
• Both Advanta and the FDIC agree to mutually release each other from any further claims going forward.

RECOVERY ANALYSIS

Resolution of the litigation with the FDIC provides increased clarity into the potential recovery for Advanta's unsecured creditors.  Details of our assumptions for assets and claims are described below in more detail.

ASSETS

Cash:  $108 million of cash and equivalents.

Tax refund:  $3 - 6 million incremental recovery expected.  (Final outcome determined by whether the IRS accepts the FDIC return).

Credit card receivables:  $31 million of credit card receivables outstanding.  Almost all of the outstanding receivables are current pay.  Given that these receivables are currently amortizing a year after Advanta ceased advancing funds, we view the receivables to be very high quality. Our estimated recovery from receivables assumes:

• 5% charge off rate for current pay receivables ($27.4 million balance)
• 25% charge off for all balances 30 - 60 days delinquent ($1.6 million balance)
• 50% charge off for all balances 61 - 90 days delinquent ($1.1 million balance)
• 100% charge off for all balances 90+ days delinquent ($0.9 million balance)

Visa B shares:  Advanta owns 497,000 Visa B shares, a specific share class issued to participants in the interchange network. B shares currently convert to 0.55 Visa A shares, but are restricted from conversion until the latter of March 2011 or the settlement of specific litigation.  In the interim, Visa B shares can transfer to other Visa B holders.  There are two primary inputs to determine the value of this asset:  potential increase in value of Visa A shares over time and the time value of money determined by the duration of the lock up.  Visa shares are trading about 5% above their 52-week low and about 40% below their 52-week high.  To keep it simple, we assume a 10 - 30% discount of the current value of converted B shares based on the current price of Visa.  This valuation assumes no increase in Visa's share price and a roughly 1 - 3 year duration of the lock up (discounted at a 10% rate).  Obviously, an increase in the value of Visa A shares, a shortened duration of the lock up, and a lower discount rate are all accretive to the recovery of the Trups.

Fleet Services:  Advanta owns 1.3% of Fleet Credit Card Services, L.P., (FCCS) which is a carryover from its exit of the consumer credit business.  Advanta sold the consumer business to Fleet in 1998 and received a 4.99% ownership stake in this entity as part of the transaction.  Advanta's stake was diluted to 1.3% of FCCS in 2004 when Bank of America entered the picture.  As of Advanta's last 10-Q, in Q309, Advanta carried the ownership stake on the books at $31 million.  To give a sense of the earnings power of FCCS, Advanta received the following dividend payments during 2004 - 2008:

Our low, mid and high estimates value the ownership stake at 33%, 50% and 67% of book value or 5x, 8x and 10x the average cash flow received over the past 5 years.

3^rd party litigation and D&O insurance:  The total amount of coverage is unknown, but Advanta holds over 30 D&O and umbrella insurance policies.  We estimate $5 - 35 million recovery.  This assumes about $50 million in D&O insurance and 10 - 70% is recovery via litigation.  Former CEO Dennis Alter was known for his extravagant spending and holds substantial personal assets (see http://www.phillymag.com/articles/dennis_alter_and_the_tragedy_of_advanta/)  Recovery from other third parties, such as auditors (KPMG was the auditor and the Big 4 typically carry around $100 million of coverage) presents an opportunity for additional recovery.

Company-owned life insurance policies:  $8.5 million stated value for company-owned life insurance policies.  Additional policy premiums undisclosed, thus additional upside is possible.

Artwork:  Numerous pieces of art, books and other collectibles are valued at the purchase price of $4 million, giving no credit for potential appreciation.  For example, the most valuable piece, Morris Louis's "SAF" was purchased by Advanta for almost $1 million in 2004 and may have appreciated in value.  But to be conservative, we assume the art is liquidated at 50% of original purchase price, or slightly over $2 million of recovered value.

NOL carry forward:  Assuming the FDIC return is accepted, Advanta should retain an approximate $400 million NOL.  We assign no value to this asset, but believe monetization of the NOL is possible and could offer substantial upside.

CLAIMS

The claims within the estate consist of approximately $137 million of senior notes (inclusive of pre-petition accrued interest), $96 million of trust preferred securities (including accrued interest), and about $5.5 million of other general unsecured claims (trade claims, leases, etc.)

• Senior notes: $137 million of senior notes outstanding. These notes, primarily "Advanta Investment Notes" with varying maturities and coupon rates, were advertised in newspapers (often resembling higher rate CDs) and sold directly to retail investors.
• TRUPs: $96 million of 8.99% trust preferred securities outstanding. These notes were originally issued in 1996 and are subordinate to the senior notes.
• Trade claims: $5.5 million of assorted trade creditor claims.
• FDIC claim: The FDIC claims will total either $0 or $50 million depending on whether the IRS accepts the FDIC's amended return. We think there is little chance that the IRS rejects the FDIC amended return given the mutual agreement between the FDIC and Advanta. We believe the 20% probability assigned to this outcome in our expected value calc to be conservative.

SUMMARY

• Worst case (5%): Haircuts the Visa B shares by 30%, Fleet Services by 67%, artwork by 50% and assigns $5 million to recovery from D&O insurance. Assumes IRS rejects the FDIC's amended return. Implies 7% recovery for the Trups.
• Low case (15%): Haircuts the Visa B shares by 20%, Fleet Services by 50%, artwork by 50% and assigns $20 million to recovery from D&O litigation. Assumes IRS rejects the FDIC's amended return. Implies 28% recovery for the Trups.
• Base case (50%): Haircuts the Visa B shares by 20%, Fleet Services by 50%, artwork by 50% and assigns $20 million to recovery from D&O litigation. Assumes IRS accepts the FDIC's amended return. Implies 69% recovery for the Trups.
• Best case (30%): Haircuts the Visa B shares by 10%, Fleet Services by 33%, artwork by 50% and assigns $35 million to recovery from D&O litigation. Assumes IRS accepts the FDIC's amended return. Implies 93% recovery for the Trups.
• Expected Value = 67% recovery or ~5x current price of 14.

CATALYSTS / UPSIDE

• IRS acceptance of FDIC tax returns
• Sale of Fleet Credit Card Services, LP
• D&O insurance recoveries and other third-party litigation
• Increase in the market price of Visa shares
• Other unknown sources

RISKS

• IRS denies FDIC tax return
• Rapid deterioration in credit card receivables
• Decline in value of Visa shares

Disclosure: We and our affiliates are long Advanta.  We may buy or sell securities in the future.  This is not a recommendation to buy or sell securities.