When Equity's an Option

Sometimes, investing in special (read: potentially terrifying) situations requires you to look at a company from a different perspective. Rather than soberly evaluating the business's strengths, weaknesses, and opportunities, and assessing its industry positioning -- all of which are important! -- you may have to go a mite further, and do a little "faith-based" investing.

Residual what?
Dusty finance textbooks define a company's equity (stock) as a residual claim against the firm. This is just a fancy way of saying that shareholders are low on the totem pole if company firmly and finally takes a dirt nap. Debt providers and other claimants get satisfied first, and stockholders get the leftover scraps (usually zilch).

There's no better example than the airline industry. It requires big investments (usually lease or debt financing -- planes are expensive). It's subject to cutthroat competition. And its inventory (available seats) spoils every time a plane lifts off half-empty. Airline investors have been routinely pummeled with the old 'residual claim' reality in recent years, as shareholders of the former United Airlines (now UAL (Nasdaq: UAUA  ) ) and the current Delta Air Lines (OTC BB: DALPQ.PK) can attest.

But if you can find a high-quality distressed company (an oxymoron, perhaps?) whose main problem is its crushing debt load, a little faith in the people running the show can make for tidy profits.

Equity as call option
Discounted cash flow models and relative valuation techniques are generally useless when applied to distressed firms. This sort of analysis only reinforces that the company is in trouble.

Instead, investors should view the company's equity as either fading to black, or paying off big as its managers right their ship. That type of "either/or" scenario -- zero or bonanza -- sounds an awful like a call option. For such an occasion, we can use an option-pricing model to value the firm's equity. We consider the time-to-maturity of the debt as the option's life, and the value of the debt as the de-facto "strike price" of the option. (After all, if things didn't go well, the bondholders will end up owning the company.)

A Foolish case study
My favorite example of 'call option' valuation was Blount (NYSE: BLT  ) , which makes chainsaw chain, guide-bars, and timber-harvesting equipment for the forestry and construction industries. As it happens, Blount dominates many of its markets, particularly in the chain and guide-bar area, where its estimated market share tops 50%. It manufactures for nearly every major forestry toolmaker, and markets its own product line as well. It's a boring business with a dominant position. Does that sound promising?

Recapitalization for (no) fun and profit
In mid-1999, Blount was on the sales block. Majority shareholder Winton "Red" Blount (the Postmaster General under President Nixon) was seeking an exit. He found it by merging and recapitalizing the company with a division of Lehman Brothers (NYSE: LEH  ) . The transaction was financed with roughly $418 million of equity and $725 million in debt; nearly half of that carried a whopping 13% coupon. Lehman ended up owning 85% of the outstanding shares.

Following recapitalization, Blount sought to "right-size" the company with the scale of its interest payments. Its private aircraft was sold in 2000. In January 2001, Blount amended its credit facilities to avoid default, and (grudgingly) received an additional $20 million from Lehman. In December 2001, still flirting with debt covenant noncompliance, Blount sold its sporting-equipment segment, which produced small-arms ammunition, optical products, and other sport-shooting accessories, to Alliant Techsystems (NYSE: ATK  ) . The $196 million made in the sale was applied to Blount's debt. In 2002, its former corporate headquarters in Alabama was shuttered, and corporate functions were amalgamated with the head office for the largest remaining business segment in Portland, Ore.

How bad did it get? By 2001, the company couldn't afford to pay the interest it owed and still invest in its business:

($ in millions)

1998**

1999

2000

2001

2002

2003

EBITDA*

$144.9

$76.3

$93.0

$86.5

$91.9

$105.5

Interest
Expense

$14.3

$44.8

$99.7

$95.9

$72.2

$69.8

(EBITDA - CapEx)
/ Interest***

8.7x

1.5x

0.7x

0.8x

1.0x

1.3x

Shareholders'
Equity

$354.6

($321.7)

($312.2)

($349.9)

($368.9)

($393.7)

Total Debt

$162.3

$816.2

$833.0

$641.0

$627.5

$610.5

* EBITDA = Earnings Before Interest, Taxes, Depreciation & Amortization
** 1998 results include the results of the subsequently sold SEG division.
*** A rough cash-flow metric for evaluating a company's long-term solvency. The higher, the better. A number below one indicates a company that cannot finance itself as a going concern (i.e. presuming CapEx has been pruned to a 'maintenance' level); more drastic restructuring measures are necessary.

Blount's share price after recapitalization was $15. By summer 2001, the stock traded at $2.

Coming clean
I bought shares from $7 on down through the $2 mark (for an average price of $3 per share). Was I unaware of the dire financials? Did I not recognize the default potential, followed by the sweet embrace of bankruptcy? Of course, dear Fool! But I also saw a thriving business and a supermajority shareholder with a vested interest in seeing the share price turn around. Also, consider that financials higher up the income statement remained stable, and that the debt was not due for some years.

($ in millions)

1999

2000

2001

2002

Sales

$486.2

$513.9

$468.7

$479.5

Gross Margin

32.3%

33.9%

33.4%

33.6%

EBITDA Margin

15.7%

18.1%

18.5%

19.2%

In other words, yes, debt was a problem. But if management effected its turnaround plan, Blount's $2 stock could be that proverbial call option. Presuming the company avoided bankruptcy, there was little more that could happen to Blount's stock price, and even a little good news could see a potentially outstanding outcome.

At its $2 nadir, Blount was valued at around $62 million. At rock bottom, valuing Blount as an option suggested an equity worth $4 to $6 (depending on the model inputs). As things marginally improved, so did the equity value.

The Foolish bottom line
Our story has a happy ending. Blount managed a halfway decent (though not spectacular) turnaround. Sure, it's been unsatisfying for long-term shareholders, who've seen an annual "return" of just shy of negative 2% since the recapitalization. I sold my shares in late 2003 at around the $8 mark. Sure, I missed the subsequent run from $8 to $13, but I'm not sorry. My valuation on the stock at that point suggested $8 was a fine price.

Sometimes, merely changing the way we look at investments can open up a world of new possibilities.

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Jim Gillies, a member of the Hidden Gems team, often looks at things from a unique perspective. Maybe tat's why he loves a good special situation. To find out why our Hidden Gems newsletter is so unique, simply sign up today for a free 30-day test drive.

Jim owns no shares of any companies mentioned. The Fool has a disclosure policy.


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