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Heavily levered situations

Anyone have experience in investing in crappy firms with excessive debt…but who are rapidly paying down their debt? In theory once they pay down their debt, there should be rapid multiple expansion due to the heavy leverage….but that’s in theory. Anybody have insight into this?

The particular stock that came up (I stole this from a blog), is ALJ Regional Holdings. (ALJJ). The company has negative equity (not sure how exactly to assess that), but has been steadily restructuring the firm…

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Paying down debt does not necessarily result in rapid multiple expansion. If they are paying down debt because ferrous scrap prices are lower and customer demand is higher, then they have the option for rapid multiple expansion. However, expansion without matching customer demand will cripple the company.

You’re going to have to analyze a few factors that will maximize the future value:
- lower ferrous scrap prices
- stronger USD
- lower foreign scrap demand
- higher customer demand

“Your beliefs become your thoughts,
Your thoughts become your words,
Your words become your actions,
Your actions become your habits,
Your habits become your values,
Your values become your destiny.” - Gandhi

Thanks for the response. Why do you say that the firm will need increased customer demand to realize value? Even if demand (and the other variables you mentioned) stay constant, wouldn’t debt levels coming down be enough to create expansion?

I’m not quite as good at this sort of stuff, but it seems to me that when a company pays down debt, its ROE falls, becauase earnings rise only by the amount of interest payments no longer needed, but the BV of equity rises by the amount of the paydown.  Falling ROE is not so good for companies future growth prospects, so even though the P/BV of the stock may go up, the component of the stock price that is captured by future growth falls, and that can be a substantial part of the market value.

In order to keep the PVFE (present value of future earnings) up, the company needs to grow.  In theory, this could also be done through cost cutting, but cost cutting ultimately runs into difficulties.

I sense that this explanation may be overly convoluted, though, and maybe there’s a simpler one.

You want a quote?  Haven’t I written enough already???

book value does not go up by the amount of debt paid off, the amount of debt does not change your book value (you can leverage up 100x and it won’t change your book value 1 bit)…..ROE falls because because the amount of leverage is lower (lower invested capital ~lower returns on equity all else equal).

No?  I figured that book value was Assets - Liabilities.  Pay off debt reduces liabilities.  Oh wait, the cash paid to reduce debt reduces total assets too.  Yeah, you’re right.  As a macro guy, it’s been a while since I looked at corporate actions on this stuff and missed that.  Embarassing: that’s an L1-type question too.

Though if debt is paid down through issuing new stock, there’d be dilution of earnings, which isn’t good.

You want a quote?  Haven’t I written enough already???

Palantir wrote:

Anyone have experience in investing in crappy firms with excessive debt…but who are rapidly paying down their debt? In theory once they pay down their debt, there should be rapid multiple expansion due to the heavy leverage….but that’s in theory. Anybody have insight into this?

The particular stock that came up (I stole this from a blog), is ALJ Regional Holdings. (ALJJ). The company has negative equity (not sure how exactly to assess that), but has been steadily restructuring the firm…

“Anyone have experience in investing in crappy firms with excessive debt” = “Anyone have experience lying down in traffic on the freeway and getting lucky and not dying?”

I have a lot of experience with leveraged equity. My best leveraged stock pick of all time was up 1800%. I have seen some do better than that. I have very little experience with crappy leveraged equities. Those are extremely dangerous. You’re basically buying a terminally ill late-stage cancer patient with AIDS who might be coming down with a case of ebola.

As you said, the attraction is multiple expansion as the market realizes the equity is not about to be vaporized. To catch a bid, this basically requires three things: Enduring business model of at least respectable quality, some kind of refi package or “event” that triggers this realization, and enough liquidity and business size to justify institutional interest (is it buyable and does it have the potential to be a well valued business?).

I have never looked at ALJJ before. But immediately I notice this company hasn’t broken a dollar in its stock price since at least 2007, sells for 24m market cap (not sure on the debt since that isn’t coming up on any of the sources I usually look at), has a sketchy name (regional holdings? ugh), and is probably one of the highest cost mini mills in a bad industry. Within 30 seconds I have the impression this sounds like toxic waste.

I could be totally wrong, maybe there is an awesome case to be made here, but it sounds like playing with fire.

Basically, even if they pay down debt, you are very unlikely to get a multiple on this. It’s bad and it’s small. The stock might as well be invisible to your average institutional investor. “Value” (if any, and I would be skeptical there is any) is irrelevant – all that matters is what someone else is willing to pay. Mr. Market only serves you if there IS a market, and there is no market for this stock. It shouldn’t even be public.

I would systematically pass on this regardless of whatever “case” you can come up with as to why it is cheap. I have seen people get absolutely raped on stocks like this by convincing themselves they have some angle. Look at PNCLQ sometime. I have a really smart friend who had a case on that stock around 0.75-1.00. It sounded amazing. It’s now worthless. I couldn’t convince him not to own the stock.

In my own experience with these, I almost got destroyed on AGUNF. There was a great “case” as to why it should be worth a lot more than it’s single digit penny stock price. It was a good business, they shouldn’t go bankrupt, etc. It went bankrupt. Fortunately for me, I was correct in my assessment of the value and it got bought out of bankruptcy, including payments to the equity, and I ultimately sold for more than 0.20. But it took over a year and was brutal in the process. The only reason the equity didn’t get wiped out is because there was an equity steering committee (which I knew before getting involved).

Moral of the story is, fish where there are fish. You will lose much more often with dog **** stocks like this unless you can take a control position and create real change, most likely a liquidation or sale of the company.

The sweet spot is $500mm of cap in good businesses that are currently out of favor. Sub $50mm stocks are usually a disaster.

Thanks for a great response. That really was very informative. Normally when you invest in these really leveraged firms, do you prefer to buyt debt or equity?

bromion wrote:

I have a lot of experience with leveraged equity. My best leveraged stock pick of all time was up 1800%. I have seen some do better than that. I have very little experience with crappy leveraged equities. Those are extremely dangerous. You’re basically buying a terminally ill late-stage cancer patient with AIDS who might be coming down with a case of ebola.

On a sidenote, may I ask which firm this was?

I don’t want to give the name because it’s currently selling for less than 50% of its long-term intrinsic value – the question is timing because it’s macro sensitive and they still have some debt. It’s a manufacturing company most people have never heard of.

Debt vs. equity – it depends on your view of the ultimate outcome of the leverage. Obviously if it’s not going away, the equity is the way to go. If you think it’s toast, then maybe buying the senior debt at a discount makes sense.

On a different, somewhat philosophical note, I’m coming around to the idea that I should generally avoid leveraged companies outside of market panics such as right after Lehman. Not because debt is inherently dangerous, but because a highly levered balance sheet often seems to imply that the company is destroying value. You have companies that roll up and may be overpaying for acquisitions. Other companies have such low returns in mature industries that the only way for them to grow is via debt, which basically means the company is enslaving itself and creating a situation where the equity will be permanently stuck in the mud or worse if there is a down turn and the company has high fixed costs (needing to grow via debt – that math doesn’t work most of the time unless they can buy competitors very cheaply).

I’m not saying debt is bad. It just seems to me that there aren’t too many cases where a firm can economically justify taking on a lot of debt capital relative to its normalized cash flow – it usually ends poorly for shareholders.

The other issue with debt-laden companies is they lie all the time, even more than your average public company. If you think about it, this makes complete sense. Lying to equity holders is a call option for management. If they don’t go bankrupt, they look heroes. If they do go bankrupt, the equity gets wiped out anyway and the shareholder base turns over, so they never have to see or talk to those equityholders again. Lawsuits? Probably not, anyone can plainly see the company had a lot of debt, right? Point is, there is always a “story” – I have yet to ever hear a company come and say, yeah, we’re ****ed, you should sell our stock. There is always a plan and projections that show the company gradually digging its way out of the debt hole based on some miraculous turn around, synergies, revenue pipeline or whatever.

In the case of the one stock I recommended that went through the roof, I almost didn’t care what the numbers said. It was 50/50 to me on the math. The reason I liked it is because I met the CFO of the company. He was an ******* who hated Wall Street. He wouldn’t tell me anything about the company. Nothing. Not even answering basic questions. Like he enjoyed verbally pissing on me when I asked questions. At the very end of the meeting, right before I walked out of the room, I said to him with a straight face, yeah, it looks like you guys are hosed, if you need DIP financing for the bankruptcy, give me a call. He sat up in his chair and got super excited, and said ARE YOU KIDDING? HAVE YOU SEEN OUR AGREEMENT? WE ARE HEAVILY INCENTIVIZED TO GET A REFINANCING, WE MEET WITH OUR BANKERS ALL THE TIME – BUT I CAN’T TELL YOU ABOUT THAT. So basically he was highly confident they would get it but wouldn’t tell me that until I verbally kicked him in the balls (which is an effective interview technique) and pride kicked in. They got the refi a couple of weeks later and the stock went ballistic.

Quote:
 it looks like you guys are hosed, if you need DIP financing for the bankruptcy, give me a call. He sat up in his chair and got super excited, and said ARE YOU KIDDING? HAVE YOU SEEN OUR AGREEMENT? WE ARE HEAVILY INCENTIVIZED TO GET A REFINANCING, WE MEET WITH OUR BANKERS ALL THE TIME – BUT I CAN’T TELL YOU ABOUT THAT. So basically he was highly confident they would get it but wouldn’t tell me that until I verbally kicked him in the balls (which is an effective interview technique) and pride kicked in. They got the refi a couple of weeks later and the stock went ballistic.

That’s an epic DYKWIA moment.  

Curious - what do you guys consider “excessive debt”? Multiple of book value or multiple of earnings or multiple of FCF or interest coverage or … ?

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One Rec Ho

bromion wrote:
On a different, somewhat philosophical note, I’m coming around to the idea that I should generally avoid leveraged companies outside of market panics such as right after Lehman. Not because debt is inherently dangerous, but because a highly levered balance sheet often seems to imply that the company is destroying value. You have companies that roll up and may be overpaying for acquisitions. Other companies have such low returns in mature industries that the only way for them to grow is via debt, which basically means the company is enslaving itself and creating a situation where the equity will be permanently stuck in the mud or worse if there is a down turn and the company has high fixed costs (needing to grow via debt – that math doesn’t work most of the time unless they can buy competitors very cheaply).

I’m not saying debt is bad. It just seems to me that there aren’t too many cases where a firm can economically justify taking on a lot of debt capital relative to its normalized cash flow – it usually ends poorly for shareholders.

The other issue with debt-laden companies is they lie all the time, even more than your average public company. If you think about it, this makes complete sense. Lying to equity holders is a call option for management. If they don’t go bankrupt, they look heroes. If they do go bankrupt, the equity gets wiped out anyway and the shareholder base turns over, so they never have to see or talk to those equityholders again. Lawsuits? Probably not, anyone can plainly see the company had a lot of debt, right? Point is, there is always a “story” – I have yet to ever hear a company come and say, yeah, we’re ****ed, you should sell our stock. There is always a plan and projections that show the company gradually digging its way out of the debt hole based on some miraculous turn around, synergies, revenue pipeline or whatever.

This is great, I feel like I just walked away with a better perspective on debt structure. Thanks for sharing.