Description

Introduction

A fairly complex and apparently misunderstood restructuring of NCI Building Systems involving a Private Equity firm Clayton, Dubilier & Rice ("CD&R") has lead to a fat mispricing of their convertible bonds leading to a special situation arbitrage opportunity. There is the opportunity to get about a 33%, very low risk, return over the next 1-3 months, depending on how long the deal takes to close. The deadline for the conversion I am about to describe ends October 7 at 11:59p NYC time so time is running out quickly.

First some background: NCI Building Systems manufactures and markets metal products for smaller (typically <5 stories which is about 80% of the total market) commercial buildings in the US. Basically when new buildings go up or are significantly renovated, they get business for the metal workings (metal coils, roofs, doors, walls, etc.). There is a high correlation with the activity in the commercial real estate market as well as steel prices. I have a decent understanding of their business, but as this is not a straight long or short idea it is less important. Overall, they do seem to be a good business that throws off cash (as opposed to "profits" building up as more equipment in the yard as happens with many construction companies) and can re-scale themselves without a ton of fixed assets and capex. This is illustrated by their most recently profitable quarter where they threw off $30M of cash, despite revenue down 50% from a year ago. If I could buy this business cheaply, I would - but this situation is much better than simply buying the common equity. I'll touch on this more below, but I would be much more likely to short rather than long the common at $3.65 as there is a 93% dilution about to happen due to this restructuring that makes $3.65 imply a very optimistic enterprise value.

Background and timeline of the Restructuring:
NCI currently has 2 significant debt obligations, a $293M term loan with Wachovia, and $180M of the convertible notes I refer to here. NCI would have been forced into bankruptcy already (June 18, 2009) if they hadn't received extensions on their loan covenants for the term loan, hence the situation here. The restructuring plan is to pay down $143M of the term loan (to bring it to $150M) and pay off all the $180M of convertible notes with $90M cash and 70.2M common shares (390 per $1k face value). They are paying for this largely with an equity injection of $250M in the form of series B Preferred shares from CD&R. The convertible situation is particularly interesting when you look at the timeline.

Aug 14, 2009: CD&R announces they are injecting $250M in convertible preferred (convertible into 106M shares) and the convertible notes will get $500 + 125 shares of common (22.5M shares total). That gives CD&R a 72% overall stake, as there are 20M shares outstanding of common now. They need 95% of the note holders to agree to the terms to do the exchange... (no official notice released to SEC, just a press release - which is STILL the most recent press release on CD&R's website, likely leading to some of the confusion now)

...Clearly the note holders don't like that very much (*there is a complete account for the events leading up to this on p60 of the S4 filing), especially considering the notes have a put option at par Nov 15th.... Of course debt holders get more power than common equity holders in these kinds of situations, so preferences must go towards satisfying debt rather than worrying about dilution for common.
*Also - I was burned by a situation earlier this year where I was long the common and strongly believed that the company had the cash flow to deal with their debt but they decided to declare bankruptcy anyways and hurt the common equity holders severely. The management at that company did not own a substantial amount of stock, where I have seen other situations where management owns a large chunk of stock and they work out much more favorable deals to the common equity holders in a restructuring. My point: when directors do not own large amounts of common stock, the common equity holders typically get a worse deal in restructurings - so don't be long the equity, go higher in the capital structure with your money! In this case there is nobody on the NCI management who owns more stock value than 1 year salary, so I would say they are likely much more interested in keeping their jobs and running the company than they are bending over backwards and fighting for the equity holders to not be diluted. This is more reasoning for why this conversion deal WILL go through at stated terms below -> it is friendly to the bondholders (who are making the decision whether the deal happens) and it puts some level of safety in shorting the common, so in the unlikely event that the deal falls apart, it will not likely fall apart in the favor of the common equity (so the short position will be a favorable one).

Aug 27, 2009: CD&R and NCI release an amendment to the deal agreement - changing now that that note holders will get $500 + 390 shares of common (vs 125 before, now 70.2M total) - clearly much better for them. Also, the $250M preferred shares CD&R is getting is now convertible into 196M shares (vs 106M before) giving them only 68.5% of the total voting shares on a fully diluted basis (note this is a conversion price of $1.27 which they agreed to, based on a projected EV of $450M after the restructuring - details in the S4 filing). Clearly this is much more dilution for the current common equity holders, the market recognized this and the stock fell about 30% after this updated announcement.
Sept 10, 2009: CD&R releases Q3 numbers that they actually made a profit and threw off ~$30M of cash, the stock jumps back up to where it was a month ago with this optimism, but the numbers are not presented on a fully diluted basis given the imminent restructuring, leading to some irrational optimism on what this is worth.

***Just a short aside on why I don't think it makes sense to buy the stock long: The capital structure before and after: (also important as related to downside analysis below)
 Current cap structure After restructuring
Cash $100M $60M
Term loan $293M $150M
Convertible notes $180M ($260M with notes trading at $144 due to current conversion offer) $0
Preferred series B (CD&R) 0 $250M (convert to 196M shares)
  
Share price with EV unchanged at $446M           $3.65      $1.18
Total shares outstanding (fully diluted) 20M        286M (20M + 70M convertibles + 196M preferred series B)
Enterprise value (fully converted/diluted) =$293M + 180M + $73M - $100M = $446M         = $150M loan - $60M cash + (share price * 286M shares out)
= $90M + (286M * share price)
EV with share price @ current price of $3.65 $446M ($526M w/notes at $144) $1044M

I do not believe in financial maneuvering miracles - in that by simply restructuring the balance sheet, the EV can instantly go up $600M (135%) or so, so the common looks quite overpriced at $3.65 to me. Based on an optimistic normalized EBITDA of $150M and multiple of 8X, you could maybe justify a $1200M EV and $4.00 common stock, but I think that doesn't provide any margin of safety and significant upside requires a really V-shaped recovery, so I won't be buying the common at these prices. For $1.27/share that CD&R is paying I'd consider it (though they still have a much better deal with liquidity preference, 8% dividend paying convertible preferred!).

The special situation: details on the trade.
The arbitrage here is to buy their convertible notes due 2024 (which can currently be bought for about $144 according to FINRA and trade about $3-10MM/day while shorting 390 shares of NCS common stock per $1000 bond. On Oct 7th, the offer expires to exchange each $1000 of principal bond for $500 cash + 390 shares of common (currently at $3.65 as of sept 25 close).

The Trade:
So: Buy 1 bond (CUSIP: 628852AG0): -$1440; Short 390 shares of NCS = $3.65*390 = $1423
Net cost = $17
After conversion: receive $500 cash + 390 shares (use to cover the short)
Net holdings in the end: $500 - $17 = $483.

Profit $483 per bond which ties up about $1500 of your capital (depending on what your margin requirements are for buying bonds and shorting) = 33% return as soon as an Oct 8th distribution (potentially an extra ~2 months if they go through the courts for a prepack BK, more on that below)

Downside analysis and some key points:
This seems like an obviously good trade, why is the spread so fat? If the conversion goes through, there is no risk assuming you can buy the bonds at this price (you could on Friday Sept 25th) and assuming you can short the stock without an insanely high borrowing cost (you also could on Friday and the stock trades ~$3M/day so there is solid liquidity here).

Some factors to consider for evaluating the downside:
-As of Aug 31st (before the S4 was officially put out) - 79% of the convertible bond holders agreed to a lock-in for this conversion so this is largely set already. Plus it is clearly in their best interest to have this deal go through with the current stock price; nobody will oppose this newly sweetened deal.
-Management doesn't own much stock, so it's in their best interest to have this go through
-The alternative situation if they do not get 95% of the convertible notes offered is simply to run the EXACT SAME restructuring plan through the court as a prepackaged BK, so downside is minimal.
-This is all dependent on CD&R following through with their investment, but considering how good of a deal they are getting it seems silly for them to pull out now after all the negotiating.
- Why is this so mispriced? Another factor to consider the size and complexity of this: the most anyone could really put to work in this situation is say $5M. How many investment firms out there would dedicate resources to reading the 600 page S4 for a 30% return on only $5M? Only 2 analysts (sort of?) cover this company that only has a $75M market cap and haven't spoken up in the news at all about this deal.
It is clearly likely to be overlooked - hence the fat spread.

The current common equity holders are the real losers in all this, but the alternative: the deal all falls apart and they have to declare (non-prepackaged) bankruptcy and the common holders will likely get $0 per share in that case, so it's hardly a really bad deal for them.
Note, in the worst possible case scenario: The common goes to $0 (the short makes $1423 profit) - the bonds will likely still be worth something, possibly as high as $1000 which is their put option Nov 15, but at least say $500 - that's STILL $500 profit per bond!
How could this trade possibly lose money? Could the bond price go down while the stock price goes up? First of all: even if this does happen - say the stock goes to $50 and the bond goes to $500, as long as the conversion still happens at $500 + 390 shares, you are fine if you can meet your interim margin requirements and don't get the rug pulled out from under you.
So the only risky situation is if the stock goes up, the bond goes down AND the deal is off or renegotiated at adverse terms compared to the current one. This requires the balance of power to shift heavily towards the equity which would probably require some kind of last minute alternative takeover offer at terms much more favorable to the equity (and more expensive to the buyer). This seems extremely unlikely given the fact that JP Morgan did a buyer search during the first half of the year and found only CD&R, as well an industry member turned down an offer to buy them Aug 16th, so I don't think anyone is coming to rescue the common stock here.

This seems extremely unlikely - firstly it is an official S4 filed with the SEC now stating $500 + 390 shares, not just a press release. The S4 also states the conversion cannot be terminated or modified at any terms inferior to the bond holders - if anything changes it seems likely to be adverse to the common equity holders (as the aug 14 -> aug 27 changes were), which will not make the stock price go up. So could the bonds go down? Yes - but only likely if the stock goes down at least as much, so your short position covers that. There is a floor of $1000 on the bond due to a nov 15 put option, that would only get exercised if everything else here falls completely apart (which is in nobody's interest who has power in this situation) and EVEN if that happened, the stock would likely go way down so you are safe from the short position again.

A final note: I didn't mention details about the $125M term asset backed loan facility CD&R wants as part of completion to this deal as it doesn't seem critical to the deal - they do not mention it in their pro forma capitalization and they do not require it to refinance things. The details are in annex K of the S4 filing (p558) but it's basically just to finance working capital and hardly seems essential. I think they just want it in there from Wachovia as part of a sweetener to the deal for restricting the $293M term loan so favorably to the bank. Also - the risk of the $293M term loan not being refinanced to a $150M loan seems very minimal to me. Not confirmed yet officially, but I have heard there is some overlap of the convertible note holders and the term loan and they are all happy with the situation. The term loan holders (Wachovia) certainly have absolutely nothing to gain by blocking this restructuring and I'm sure are very happy CD&R was there with more equity to prop things up (nobody else was!). The company will be a much better credit after the restructuring than before.

Catalyst

1. Oct 7th deadline of conversion offer. If 95% accept (seems very likely, as 79% had locked in before the offer even went public), then you should receive $500 + 390 shares very shortly after.
2. Nov 6th extended term loan waiver expires which would accelerate the repayment immediately due to violated covenants.
3. Nov 15th put option at par for convertible notes.
After Oct 7th people finally realize how much dilution there really is with the deal and the stock goes down (protecting your downside, as this is a short - worst case would be stock blows up and you get in trouble with margin requirements)