Energy Conversion Devices ($ENER) - What Are the Notes Worth?

It is sort of absurd that we are going to talk about the recovery value of Energy Conversion devices debt on a day that the common stock was up thirty percent. In a sane world, that increase would imply some sort of good news or rational basis for optimism.

However, this is the world of capital structure arbitrage. Our research into the worthless stock inefficiency shows that a group of mostly retail investors buys these stocks because they behave like lottery tickets. From the time we have been paying attention to ENER, it looks like institutional investors have continued to sell out, and are now down to around a quarter instead of a third.

Anyway, back to the liquidation analysis. The most recent balance sheet we have is for September 30, 2001 from this 8-K filing. The first part of the analysis is to look at the assets. [Note that the company has not announced any plans to liquidate - I am just considering where bondholders and stockholders would likely turn out if that was the case. There is a wide margin of error because the numbers we have are now four months old.]

I'm assuming that the company burned $5 million cash during the fourth quarter of 2011. We really don't know, but we are certainly assuming that the quarter did not go well, given that the company suspended operations and laid off 70 percent of their workforce on November 8.

I'm assuming that accounts receivable would take a 20 percent haircut and inventory a 25 percent haircut - both seemingly reasonable given the lack of detail about these items. Other assets (e.g. prepaid expenses) I assume are worthless. I actually assume that the Ovonics subsidiary is worth ten million dollars more than the carrying value.

In the long-term asset category, I assume a 75 percent loss on property, plant and equipment. I assume 20 percent haircuts on the restricted cash and lease receivables. And a total haircut on the other long-term assets.

	As of 09/30/2011		Haircut	Value
Cash & Short Term Investments	119,876		-5,000	114,876
Accounts Receivable	21,621		20%	17,297
Inventory	68,012		25%	51,009
Other	13,957		100%	0
Ovonics	4,253		10,000	14,253
Total Current Assets	227,719			197,435
PP&E	59,064		75%	14,766
Restricted Cash	10,365		20%	8,292
Lease Receivable	11,428		20%	9,142
Other	9,857		100%	0
Total Assets	318,433			229,635

That results in a liquidation value of the assets of $229.6 million versus the current carrying value of $318 million.

Meanwhile, I value all of the liabilities at the amounts on the balance sheet, and I assume that the notes would share equally with the other unsecured creditors in the recovery value of the company.

	As of 09/30/2011		Haircut	Value
A/P	31,200		0%	31,200
Warranty – current	14,284		0%	14,284
Other	11,082		0%	11,082
Senior Notes	235,781		0%	235,781
Lease Obligations	21,134		0%	21,134
Other	16,916		0%	16,916
Total Liabilities	330,397			330,397

The result is $330 million in total liabilities, which exceed the liquidation value given above by $100 million! If my analysis is correct, buyers of the common stock are paying $60 million for a claim that is out of the money by $100 million.

Anyway, if all of the corporate liabilities share equally in our estimated liquidation value, that means that the unsecured claims are worth 70 cents (~70=230/330). Interestingly, this is 77 percent higher than the current trading value of the notes. So, given this initial set of assumptions, the common stock is worthless in a liquidation, but the notes are worth nearly twice as much.

I've put together a stress test analysis below, which uses the assumptions made above but shows the unsecured recovery percentage given different assumptions regarding what the property, plant, and equipment is worth, and also how much more cash (in thousands) the company burns before it liquidates.

		Continued Cash Burn
		-15000	-25000	-35000	-45000	-55000
Writedown of PP&E	100.00%	0.60	0.57	0.54	0.51	0.48
	80.00%	0.64	0.61	0.58	0.55	0.52
	60.00%	0.68	0.65	0.62	0.59	0.56
	40.00%	0.71	0.68	0.65	0.62	0.59
	20.00%	0.75	0.72	0.69	0.66	0.63
	0.00%	0.78	0.75	0.72	0.69	0.66

It is interesting that for all these assumptions, the notes are still worth more than the current trading price of around 40. Yet, under none of the assumptions does the equity come close to being in the money. [Note that the assumptions where PP&E are worth the balance sheet carrying value are presented for completeness and are not necessarily realistic. It would be basically unheard of for a liquidating manufacturer to be able to sell its plant without taking a loss.]

This painted an awfully optimistic recovery scenario for the notes. Let's do it again with a slightly different set of assumptions for the other balance sheet items.

We will assume that in Q4 2011, the company lost ten million in cash instead of five. We will assume an accounts receivable write down of 25% instead of 20%, and an inventory writedown of 33% instead of 25%. We keep the value of Ovonics the same, but assume that all the restricted cash is burned.

		Continued Cash Burn
		-15000	-25000	-35000	-45000	-55000
Writedown of PP&E	100.00%	0.54	0.51	0.48	0.45	0.42
	80.00%	0.58	0.55	0.52	0.49	0.46
	60.00%	0.62	0.59	0.56	0.53	0.50
	40.00%	0.65	0.62	0.59	0.56	0.53
	20.00%	0.69	0.66	0.63	0.60	0.57
	0.00%	0.72	0.69	0.66	0.63	0.60

I end up thinking that the notes are worth about 50, which would be a fair return for the opportunity cost and risk in owning them. I also do not see any reason to be enthusiastic about the stock.

FT: "Conoco to cut North American gas output"

Improving supply fundamentals.

Why We Give Buffett A Hard Time on Credit Bubble Stocks

Consider the following 2x2 matrix of possibilities:

Buffett is either right or wrong about an investment, and we either agree or disagree with him (and act accordingly). Note that "Buffett" can be a shorthand or placeholder for conventional wisdom in general.

	Buffett is right	Buffett is wrong
We agree	Make no money	Lose money
We disagree	Lose money	Make money!!

If Buffett is right and we agree, we make "no money" in the economic sense, i.e. no abnormal returns, because it is conventional wisdom and therefore priced in to the market. 

If we agree with a wrong idea, or disagree with a correct idea, we will obviously lose money in those cases.

Our only way to make (significant, abnormal) money is to focus on areas where we are right and Buffett is wrong. That is, we need the Buffetts of the world - conventional wisdom - to create opportunities for us, either through indifference or actively making a mistake.

So, no wonder I focus my thoughts and research on areas where the market exhibits groupthink that I think is incorrect! That is the quadrant of opportunity!

[Afterthought: you could have a "fifth quadrant," with cases where Buffett is indifferent and we are right, which would also be profitable.]

Tuesday Links. 2011 Was "Just Buy The Dip." 2012 is "Buy the Rumor, Buy the News."

• The 24 hour economy. Nearly 40 percent of McDonalds stores are open 24 hours. Great news for drunks.
• Niederhoffer: "The Blow-Up Artist" and "On Being Wrong".
• Hmm. Mohegan Tribal Gaming Authority is asking bondholders to refinance.
• There is an enormous bubble in U.S. farmland. I can't wait to bail out all these idiot farmers in five years.
• Typical Wall Street attitude: "Baruch is not an American and the decline of the middle class there is not his uppermost concern; in fact he cares as much about the Chinese factory workers toiling away at Foxconn."
• Manufacturing in the U.S. "The combination of skilled labor and complex machines gives American factories a big advantage in manufacturing not only precision products, but also those that are made in small batches..."
• The economics of domain names.
• Bullish thesis on manufacturing in the U.S.: "it takes about 25 years for the latest 'super-cheap-let’s-go-build-it-there' emerging industrial economy to lose its effective labor cost advantage over the U.S."

German Solar Firm Q-Cells to Restructure ($QCEG)

From a press release by Q-Cells today:

Q-Cells SE plans a restructuring of its financial liabilities in two steps. After intensive negotiations with different creditor groups, the Company initially aims to come to an agreement with the holders of the convertible bond due at the end of February 2012. This agreement will provide among others for a partial repayment of the outstanding bond volume in tranches over a period of time. In a second step, and in due course, the convertible bonds due in 2014 and 2015 shall be restructured via a debt-to-equity swap.

"Partial repayment in tranches" would mean that those bondholders are getting a haircut, and getting paid in new debt with later maturities. And it sounds like the 2014 and 2015 bonds are getting only shares. The company has yet to publicly announce the details, but you would expect the shareholders to be basically wiped out in this restructuring.

In the same press release, the company mentions that it does not expect to achieve operating profit until 2014. In my experience, when someone projects that something will happen more than six months away, it either means never or "I don't know".

They will apparently be cutting manufacturing operations in Germany by 50% (more excess capacity in PV solar!).

Anyway, this is all good news for the short solar trade. Tons of excess capacity, and other firms that will emerge more competitive after restructuring. 

Undifferentiated Trading in Solar Stocks

This is a chart of Evergreen Solar common and Energy Conversion common over the past month.

Notice the very high correlation. Basically, every highly shorted stock spiked sharply last week (which of course meant the solar stocks did too).

It's funny because there is very little uncertainty about the value of ESLR stock: the company is in bankruptcy, the secured debt is taking a big haircut, the unsecured debt is getting virtually nothing (trading at less than a cent). Clearly, there is no good news or reason to buy the ESLR shares.

That allows us to test the hypothesis that there was no information content in the rally; just undifferentiated buying of highly shorted stocks.

What we see in the ESLR/ENER chart is consistent with that hypothesis.

Review of The Rise and Decline of Nations by Mancur Olson

In his book “The Rise and Decline of Nations,” Mancur Olson suggests a theory for why the Great Depression was so long lasting. (And why the current depression has been, too.)

He thinks of the economy as having "fixed price" and "flexprice" sectors. The fixed price sector has monopoly or oligopoly prices set by either government, union, or collusive/cartel combinations. Fixed price also applies to raw materials with prices set by world markets. As with any collusive scheme, the cartel members in the fixed price sector benefit from abnormal profit while society suffers from below-equilibrium output. The flexprice sector is where prices are set by the free market, i.e. industries and sectors that are not just a racket being perpetrated.

Macroeconomic discussions usually posit a free market with prices that adjust dynamically according to demand. But during deflationary episodes, the fixed prices in collusive sectors do not adjust downward and consequently become absurdly high, resulting in falling demand and then falling production.

This explains why we see a clamor for inflation, because it brings the market price closer to the fixed price in the collusive sectors.

The health care sector is a cartel. The financial services sector uses taxpayer money to maintain their bonuses when they embarrass themselves. Most importantly: the amount of capital that is being raked off by these interest groups is going to end up leaving less for investing in productive enterprise.

4/5