|Shares Out. (in M):||555||P/E||NA||NA|
|Market Cap (in $M):||55,000||P/FCF||NA||NA|
|Net Debt (in $M):||0||EBIT||0||0|
Motors Liquidation Company (fka General Motors) Bond Arbitrage
Long position in Motors Liquidation Company 8.375% Senior Unsecured Notes due 7/5/33 (ISIN #XS0171943649, "Euro Notes") and short position in Motors Liquidation Company 8.375% Senior Unsecured Notes due 7/15/33 (ISIN #US370442BT17, "Dollar Notes") in equal claim amounts to create a gross cash return of 10%, or over 9% net of borrowing cost. This is expected to generate a total IRR of over 25% assuming a holding period of approximately four months.
The distressed market is often inefficient due to the complicated nature of the product, lack of information and illiquid trading. In some cases, this allows for significant arbitrage, and an investment in the bonds of Motors Liquidation Company ("MLC"), the former General Motors, allows for just such an opportunity. Understanding a couple of k ey distressed concepts - namely accrued interest and how foreign currency is treated in bankruptcy - reveals that one can generate a gross return of 10% (less borrowing cost) and an IRR of over 25% based on current market levels by establishing a long / short position in the bonds of MLC. Specifically, we advocate a long position in the Euro Notes and a short position in the Dollar Notes at a ratio of 1.000:1.112 in terms of capital invested, which results in a neutral position on a claim basis, and given that both the long and short sides of the trade involve the same claim in bankruptcy, we believe this return involves no real fundamental risk.
The former General Motors filed for bankruptcy in June 2009. The governments of the United States and Canada sponsored an asset sale of the company in bankruptcy under Section 363 of the bankruptcy code by capitalizing a new company to purchase most of the assets. This "new" General Motors is currently private, with the equity owned by the US and Canadian governments, an employee b enefit trust and MLC. When the 363 sale was completed, the "old" General Motors was renamed Motors Liquidation Company and is being wound down over time as part of the bankruptcy estate. The unsecured claims at MLC are set to receive common stock and warrants of the new General Motors, and it is this value of new GM equity that comprises the vast majority of MLC's value and will determine the price of the bonds. As per numerous press reports, the new GM is likely to file a registration statement in August and conduct an IPO in November, prior to elections.
Bond Valuation and Trade Details
The proposed trade requires the purchase of Euro Notes (offered at 33.63%) and the short sale of Dollar Notes (bid at 32.00%). Despite the optically higher price of the Euro Notes, they are cheaper than the Dollar Notes by 10% on a claim basis. The reason for this is two-fold:
Each Euro Note (face value of €1,000) is bought for $425 (€1,000 face value * 33.63% price * 1.2636 current USD / EUR exchange rate), and what is purchased is a claim of $1,523 (€1,000 face value * 1.0758 to account for pre-petition accrued interest * 1.4159 USD / EUR exchange rate at time of filing). Therefore, the claim-adjusted price is 27.9% via purchase of the Euro Note.
Each Dollar Note (face value of $1,000) is bought for $320 ($1,000 face value * 32.00% price), and what is purchased is a claim of $1,032 ($1,000 face value * 1.0316 to account for pre-petition accrued interest). Therefore, the claim-adjusted price is 31.0% via purchase of the Dollar Note.
By investing the amount of dollars required to be neutral on a claim basis (a capital invested ratio of short $1.112 in Dollar Notes for each $1.000 purchased of Euro Notes), one will collect the difference in spread when the bonds are cancelled and new securities are issued. As an example, in conducting a short sale of $1,000 worth of claim via the Dollar Note, $310 in proceeds would be collected ($1000 * 31.0% claim-adjusted price). In order to satisfy the $1,000 of claim being borrowed, an investment in the Euro Notes of $279 ($1000 * 27.9% claim-adjusted price) is required. The difference of $31 would then be left over once the borrowed position on the Dollar Notes is covered using the claim proceeds from the Euro Notes.
While we do not believe there is fundamental risk associated with this position, there are several risks to be aware of:
Alternative Trade - Creating New GM Shares for "Free"
Depending on the viewpoint one has on new GM stock, the trade can be set up in a different ratio to create "free" shares in the new GM when the long and short ends of the trade collapse and new securities are issued. This can be accomplished by investing the same amount of dollars on each side of the trade (a capital invested ratio of 1:1). As an example, investing $1,000 in Euro Notes buys $3,585 of claim value ($1,000 invested / 27.9% claim-adjusted price), while shorting $1,000 in Dollar Notes results in being short $3,224 of claim value ($1,000 invested / 31.0% claim-adjusted price). The difference, $361, is what would be kept in claim value once the trade closes and the GM stock is received, and at a market price of 28% (based on the price paid for the claim), is worth ~$100 against $1,000 invested in the long position.
While we believe that we are creating GM equity cheaply based on current bond prices, as we believe there is 50% upside from current levels, we acknowledge that the investment is speculative and may not be for everyone. The trade also requires significant capital to be put to work on a gross basis. However, investing in the equity theoretically removes the timing risk involved in the trade - to the extent that the trade takes longer than expected, the company should continue to accrue equity value as the operations are improving at a very fast rate. This is offset by the fundamental risks associated with owning the equity, rather than receiving cash. We have included a very brief valuation discussion on the new GM for those interested.
New GM Valuation
The main source of value at GM is its auto manufacturing operations. With a streamlined focus on four brands (Buick, Cadillac, Chevrolet and GMC), an improved cost structure and positive outlook on vehicle sales, we estimate GM will generate $13 billion of EBITDA in 2011. We gain comfort in this estimate not only from our top-down model but also based on projections from GM's financial advisor and recent performance. In May 2009, Evercore estimated that GM would be able to achieve $13 billion in EBITDA in 2012, but since that time, results have been much stronger than anticipated, so we do not consider achieving those results a year ahead of schedule to be significantly optimistic (disclosure statement projections, especially recently, have also historically proven to be conservative). Moreover, GM generated $3 billion of EBITDA in Q1 2010, so on a run-rate basis is already tracking close to our 2011 estimate a year ahead of schedule, and this was achieved with European operations being a drag on earnings.
We value GM on a sum-of-parts basis and use the valuation of Ford as a blueprint. While Ford is a better-run company with a stronger lineup over the next few years, we believe that GM has significant cost-cutting opportunities (particularly in Europe) and top-line projections also have more upside, so a similar multiple to Ford on our projections is warranted. Additionally, there will be some technical support for GM shares upon issuance, as it will likely be added to major indices.
We do not believe that General Motors will end up being liable for this entire amount, particularly with respect to some non-U.S. and/or OPEB liabilities. Additionally, were the amounts to be paid off, the company would generate a massive deferred tax asset. Our base case conservatively assumes the entire liability is paid and discounts both the U.S. and non-U.S. amounts by 35% to account for the value of the tax shield, resulting in a total liability of $24 billion. Based on recently enacted legislation, the company will be able to pay this amount over seven years (after a two year holiday) or 15 years, and so the net present value of the liability is much lower, but to be conservative we have assumed the liability is incurred immediately.
Adding up these numbers gets to a total equity value of $75.8 billion. Based on an estimated $37 billion in unsecured claims (this is the amount estimated in the company's SEC filings, although its monthly operating reports filed with the bankruptcy courts show liabilities subject to compromise of $32.2 billion), MLC is entitled to 52.9 million shares of new GM stock, as well as two series of warrants to purchase 45.5 million shares at implied equity values of $15 billion and $20 billion, respectively. Using the treasury method (the warrants are well in-the-money and so we ignore option value), MLC will own 115.9 million shares of new GM at an implied share price (based on total equity value of $75.8 billion) of $134, resulting in total value of $15.4 billion. Based on a total claims pool of $37 billion, this implies a recovery of 41.7%, against the current claim-adjusted price of the Euro Notes of 27.9%. In May 2009, Evercore estimated a recovery of 26.5% - however, they assumed cash at GM would be $15.3 billion, while the company has nearly $20 billion more than that. This would imply a recovery of 37.3%, holding all else equal, and performance has also been better than expected in the year since that analysis was done. While there is a wide range of opinions on what the ultimate recovery will be worth, we note that Street estimates have recovery values as high as 47 to 50%.
Note: The share price listed is based on the implied price based on where the bonds trade.