Description

As a follow-up to sam12's write-up from July 2008 (recommending the 9% Subordinated Notes at approx 50 cents on the dollar - have since traded down to the 25 cents range), I am recommending a long credit position in the 11.75% Secured Notes ($700MM) which currently trades at approx 60 cents (these were trading at approx 90 cents at the time of prior posting).  The Secured Notes offer (i) an attractive / equity-like current yield of ~20% (and total return potential of 40 - 50% assuming a 2-yr yield-to-90 and 2-yr yield-to-par, respectively) that is (ii) backed by considerable collateral / net asset value + goodwill / "sweat equity" (discussed in more detail further below - w/ relevant haircuts) and (iii) and the Company has more-than-enough liquidity (~$171MM of cash + ABL availability as of Sep 08) that should provide the Secured Notes w/ performing interest payments through 2011 (even under draconian / downside / Depression-level assumptions).  Trading at 60 cents, the Secured Notes effectively create the business at less than $400MM ($700MM * 60% - $21MM cash balance which equates to less than 3.2x LTM EBITDA / or less than 4x on 09E EBITDA of $100MM - which compares to public building product comparables that trade for >9x 09E EBITDA) which is less than Caxton-Iseman (the financial sponsor) paid for the business in 2004 (approx $560MM - NOTABLE that Caxton / Company subsequently made 4 tuck-in acquisitions w/ total PP of approx $800MM) and effectively has a >25% FCF on "normalized" FCF of >$100MM per annum (2 - 3 years out). 

I think a new / updated posting on PLYGEM is warranted given: (i) the Secured Note trade opportunity is moving up in the capital structure (the additional seniority provides more downside protection especially if the Company were to restructure in 2011 - 2012E) versus the prior recommendation to buy the Subordinated Notes and YET (ii) offers equivalent / "equity-like" returns to the prior posting on the Subordinated Notes and (iii) effectively encapsulates the upside optionality if housing shows any semblance of bottoming in 2H09E - 1H10E (as the Secured Notes will likely trade up 20 - 30 pts to an equivalent mid-teens yield - which would be an all-in 1-year return of approx 40 - 50% for a low-risk / secured company).  More pragmatically (and why I think this opportunity is timely / actionable), while housing is still in a downward spiral (and in fact, all aspects of the US economy appear to be eroding faster than expected), I'm more confident that the new administration will use the "shock / awe" approach to housing as they understand how critical it is to the entire system (and stemming the deflation cycle we're currently in).  As a result, while there is a great deal of uncertainty around housing (and, in typical fashion, Mr. Market has over-reacted / and over-discounted), I think the (i) downside protection (net asset value and Secured Notes at market value are trading at a >5x EBITDA discount to public comps on 09E EBITDA) + (ii) equity-like returns + (iii) optionality on any housing bottom _ (iv) positive technicals (consensus sentiment around housing-related names continues to be at depressingly low levels) create a compelling / n-term trading opportunity w/ total return potential of >40% - 50%.     

As you recall, PLYGEM is a ~$1.5Bln revenue building products manufacturer largely focused on vinyl siding / windows (please refer to sam12's posting to get a fuller description of the business).  PLYGEM is a high-quality company w/ best-in-class management that operates in a rational industry / market structure on the siding side and has a highly variable cost structure which should help mitigate further volume pressure.  Trading at 60 cents on the dollar, PLYGEM's $700MM Secured Note effectively creates the business at $420MM (or less than 4x my 09E EBITDA of ~$105MM).  The downside to the trade is limited given : (i) paid-to-wait as the CY of ~20%, (ii) there is significant collateral value (>$210MM of Cash + Inventory + AR - AP as of Sep 08).  Its also worth noting that since Caxton-Iseman's (the sponsor) acquisition of PLYGEM in 2004 for $560MM, the Company has made 4 accretive acquisitions (average PP multiple taking cost savings into account was <5x EBITDA) that totaled $790MM (so approx $1.35Bln in the aggregate).  While some of the goodwill / "sweat equity" on the balance sheet will likely be impaired over time, the margin of safety to the Secured Note trade is that the >65% of the goodwill is impaired.  Said a different way, give the net asset value on the balance sheet (>$210MM), an investor would have to ascribe a value of less than $230MM to the future CF streams of the business (or less than 35% of the goodwill value - using goodwill value as a proxy for the $ an investor would pay for the ongoing future CF).  Given my views on the management team / acquisition integration / ongoing market share gains, I'm comfortable w/ this downside protection.  One other pt worth noting is that based on "normalized' earnings power of >$215MM in EBITDA, this implies "normalized" FCF (after interest / capex / taxes) of >$100MM per annum.  Based on the creation value through the Secured Notes (approx $400MM net of cash), "normalized" FCF of >$100MM implies a FCF yield of >25%.

CAPITAL STRUCTURE:

PLYGEM's capital structure consists of a $150 million ABL facility due 2013 (currently undrawn as of Sep 08), a $700 million Secured Notes due 2013 and a $360 million Subordinated Note due 2012.  The Secured Notes offer a coupon of 11.75% and currently trade at ~60 (leveraged from 0.0x - 4x at market price based on 09E EBITDA of $105MM) and the Subordinated Notes offer a coupon of 9% and currently trade at ~25 ( 6.7x - 7.6x at market price based on 09E EBITDA of $100MM).  This compares with public peers (Owens Corning, Masco, Fortune Brands and Mohawk) who currently trade at >9 - 10x 09E EBITDA (and ~8 - 8.5x EBITDA on 10-yr historical trading multiples).  Assuming normalized EBITDA of $225MM, the Secured Notes finance to ~3.2x EBITDA at book value (less than 2x at market) and ~3.4x EBITDA-Capex at book value. 

MARGIN OF SAFETY / DOWNSIDE CASE:

I've run a downside scenario below (we can debate the merits / probably of this occurring but it's safe to say that this scenario would equate to a housing situation that is arguably 2x+ as bad as the Great Depression in terms of the depth / velocity of the deflation spiral) in which we take (i) housing starts down significantly in 09E - 10E and (ii) take R&R spending down significantly (i.e. at levels way beyond the total aggregate fall-off during the Great Depression) and (iii) an increase in fixed / variable costs given the demand destruction.  The upshot from the analysis is that PLYGEM still has adequate liquidity to weather even this downside scenario (i.e. cash + ABL are still >$22.5MM at the end of 10E).  More pragmatically, from a Secured Note perspective, the CY of ~20% per annum effectively buys down the position to approx 20 cents (versus 60 cents entry) by the end of 2010E (and effectively creates a "free" call option on any recovery in the out years - given senior positioning)

1. Starts: assumes down -44.1% in 09E and flat in 10E (i.e. 200k single-family in both 09E and 10E)
   1. Equates to approx 14.7% of peak 2006 levels of 1.358MM (on a side note, and to put in historical perspective, the equiv auto SAAR would be 2.5MM cars per annum vs peak of ~16MM) and the "normalized" demand / supply of approx 1MM
   2. Compares to Zelman 09E of -16.1% (328k) and 10E of +40.2% (460k)
2. R&R: assumes down -30% in both 09E and 10E
   1. Compares to -10 to -12.5% in 08 and -30% for 09E and 10E implies deeper consumer contraction that Great Depression
3. Fixed / Variable Flow-Through: assumes 22.5% in 09E (vs mgmt guidance of 20%) - which gives credit to mgmt taking proactive actions managing down the cost structure and 25% in 10E

UPSIDE / DOWNSIDE (4 cases):

• - HOMERUN CASE: assuming 1-yr exit at 95 - 100 cents driven by housing bottoming and 2H 09E - performance that surprises to the upside given cost savings / market share gains (19.6% CY and 35 - 40% capital appreciation = ~55 - 60% upside)
• - UPSIDE: assuming 1-yr exit at 90 cents driven by housing bottoming in 2H 09E and company taking market share and showing YoY improvement in qtrly trends by Q3 - Q4 09E (19.6% CY and 30% capital appreciation = ~50% upside)
• - BASE: assuming 1.5-yr exit at 90 cents driven by housing bottoming in 1H 2010E - i.e. 09E is another challenging year for the full year (19.6% CY per annum and ~22.5% capital appreciation per annum = ~42.5% upside)
• - DOWNSIDE: assuming 2-yr exit at 90 cents driven by housing bottoming in 2H 2010E (19.6% CY per annum and 15% capital appreciation per annum = 35% upside)

NOTABLE UPDATES:

• - COMPETITORS: one of PLYGEM's competitors re: vinyl siding (Heartland - 5% of industry) recently filed for bankruptcy (but was subsequently purchased by a small / regional door company). Notably, Heartland's key customers (per channel checks) have moved to likes of PLYGEM / Associated Materials (i.e. those that survive will benefit from the shifts in the total pie)
• - SPONSOR SUPPORT: recall Caxton put in $30MM of fresh equity into PLYGEM in mid-2008 (sign of support and their belief that "normalized" earnings power for this business is >$225MM). Another notable update is that Caxton recently put in $20MM in a separate portfolio company (KIK Products) - which is a more highly leveraged / less optionality business ... reason for the notable cross-read
• - RATINGS / 09E CROSS-READ: Its also interesting to note that per a recent Fitch credit ratings report from early Dec, they hinted at the fact that PLYGEM management (per their 09E business plan) expects to be FCF neutral in 09E - which implies EBITDA is in the $115 - $120MM range (note that I have used a more conservative EBITDA estimate of $105MM in the analysis below).

CATALYSTS:

•-          N-TERM (15 - 30 days): new administration provides clarity around housing proposals

•-          N-TERM (15 - 30 days): mortgages go down further (sub 4 - 4.5%); more importantly, the key will be if homebuilders show any headway / traction w/ the tax credit bill ... this could be the real game-changer for PLYGEM given their exposure to new construction and starter homes in particular)

•-          L-TERM (3 - 9 mths): given inputs have moved down by >50%, this should provide a n-term benefit to PLYGEM margin dynamic in Q4 08E - Q2 09E period (as you recall, every 5% move in PVC pricing equates to approx $14MM of EBITDA benefit / 5% in aluminum equates to approx $9MM assuming full-year benefit)

•-          L-TERM (6 - 12 mths): once market uncertainty / fog clears up (in 09E - 10E around housing in particular, investors will re-focus on fundamental and will recognize the low leverage (~4x at market) and attractive yields; in addition, they will realize liquidity is more-than-adequate (>$171MM) and that the Company should generate >$100MM of FCF (after tax / interest / capex) based on "normalized" profitability (i.e. >25% FCF yield)

• - L-TERM (6 - 36 mths): This is a cycle play (2 - 3 years) in which you're paid to wait (~20% CY) and have senior secured positioning if things fall off further in 2011E (~30% YTM)

RISK:

• - Longer / deeper housing cycle: risk is if you view housing recovery as a 2012 - 2013 event

Mitigants: Two important items to note: (i) the CY is ~20% so you're paid to wait, (ii) the Company's collateral value (>$210MM of Cash + AR + Inventory - AP) provides downside support and (iii) the FCF of the biz (company is FCF neutral based on 09E EBITDA and >$100MM on "normalized") provides significant optionality and (iii) liquidity is more-than-adequate (>$170.5MM as of Sep 08) ... One additional mitigant (probably the biggest of them all) is that the worse housing gets, the more bold / creative the policy response will be around housing (as its pretty clear now that the new administration is focused on stemming the housing bleed as a way to turn around the "deflation" fear that currently)

FINAL PT:

Given the general market uncertainty (esp around housing), the safe bets w/ "real" margin of safety (in my mind) are looking at:  (i) credits that pay equity-like returns and that have downside / collateral protection in conjunction w/ (ii) short opportunities on selected companies that (are a bit outside of the financial guise - i.e. that have bankruptcy risk premiums already in place and create massive swings in volatility) have particular exposure (both direct and indirect) to the weakening consumer and that have significant downside optionality if the environment continues to weaken and policy responses continue to falter (WHR, MAS, CCL as examples that top my list).  Another third category that's worth mentioning (and that probably provides significant optionality to a portfolio) is to start dabbling in "casino" names (i.e. names w/ bankruptcy risk premium already burnt in) that have significant upside optionality (i.e. the heinous of the heinous banks, etc) and apply the reversion-to-mean philosophy given some names are arguably trading below "replacement value".  Net / net, I'd label the PLYGEM Secured Notes (trading at 60 cents on the dollar and providing a ~20% CY) as one of the top picks in the first category (long stable / well-collateralized credit opportunities that pay "equity-like" returns).     

Catalyst

•-          N-TERM (15 - 30 days): new administration provides clarity around housing proposals

•-          N-TERM (15 - 30 days): mortgages go down further (sub 4 - 4.5%); more importantly, the key will be if homebuilders show any headway / traction w/ the tax credit bill ... this could be the real game-changer for PLYGEM given their exposure to new construction and starter homes in particular)

•-          L-TERM (3 - 9 mths): given inputs have moved down by >50%, this should provide a n-term benefit to PLYGEM margin dynamic in Q4 08E - Q2 09E period (as you recall, every 5% move in PVC pricing equates to approx $14MM of EBITDA benefit / 5% in aluminum equates to approx $9MM assuming full-year benefit)

•-          L-TERM (6 - 12 mths): once market uncertainty / fog clears up (in 09E - 10E around housing in particular, investors will re-focus on fundamental and will recognize the low leverage (~4x at market) and attractive yields; in addition, they will realize liquidity is more-than-adequate (>$171MM) and that the Company should generate >$100MM of FCF (after tax / interest / capex) based on "normalized" profitability (i.e. >25% FCF yield)

• - L-TERM (6 - 36 mths): This is a cycle play (2 - 3 years) in which you're paid to wait (~20% CY) and have senior secured positioning if things fall off further in 2011E (~30% YTM)