Will Emmis Communications be Allowed to Strip Its Preferred Stock of Voting Rights and Dividends?

I saw this outrageous story "Taking the Preferences Out of Preferred Stock" in the New York Times. Emmis Communications has a 6.25% cumulative preferred (EMMSP) that was issued in 1999. In December 2008, the company suspended the quarterly dividend on the preferred stock, which by its terms continued to accrue. The preferred was also putable at par ($50) plus accrued  in the event of a takeover.

By this summer, the preferred had accrued about $12 per share in dividends, for a total of $178.6 million in par plus accrued that would be due in the event of a takeover. The preferred holders were preventing management from taking over the company - they refused a 2010 offer of $30 in debt in lieu of the $50 plus accrued interest that they were owed.

So, the company borrowed money to do derivatives transactions with some of the preferred holders, such that the company had economic interest and voting interest in the shares but the shares were still "outstanding". (If they had simply been bought by the company, the company would not have been able to vote them, since company securities that are repurchased are considered cancelled and can never be voted.) It also established an employee retention plan and issued 400,000 shares of preferred stock to it so that it could "vote" those too.

With these votes, the company had the 2/3 majority needed to amend the terms of the preferred shares. Last week, after winning an initial Indiana court battle, the company voted its shares and amended the shares to eliminate the cumulative provision, the right of preferred shareholders to appoint two directors, and to redeem the preferreds in the event of an acquisition. The value of the preferred immediately dropped by 40 percent.

The reasoning in the ORDER DENYING PLAINTIFFS’ MOTION FOR PRELIMINARY INJUNCTION by federal judge Sarah Evans Barker (Reagan appointee!) is appalling. One of the key issues is whether or not shares of preferred stock were still "outstanding" after the company synthetically acquired all economic and voting interest in them.

The court’s task here is [to determine whether], regardless of the label given to the transaction, the manner in which Defendants structured the transactions to ensure the shares remain outstanding is permissible under Indiana law. [...A]lthough we concede that it is difficult to articulate what concrete value remains with mere record ownership, it is not meaningless under Indiana law.

I think that if you tried to do a transaction like this with the purpose of minimizing taxes, a court would call it a sham transaction. In fact, rather than selling securities and realizing capital gains, why don't people simply do swap transactions that transfer all of their economic and voting interest? By this reasoning, capital gains could be deferred forever by everyone!

The outcome would be perverse, just as it is in this case. How can a company be allowed to behave this way (assuming the account is true)?:

"[A] portfolio manager with Corre who was not one of the ten Preferred Shareholders approached by Defendants, but who contacted Emmis in November 2011, after learning that Defendants were acquiring shares from some of the Preferred Shareholders [testified] that he spoke with Pat Walsh, Emmis’s Vice-President, COO/CFO, who advised him that Corre should sell its Preferred Stock because Emmis was trying to acquire two-thirds of the Preferred Stock in order to amend the terms and 'if that happened, [Corre] didn’t want to be in the preferred.' [He] further testified that Mr. Walsh had said to him 'you’re in a prisoner’s dilemma' and 'you don’t want to be the last guy to act because there might not be room for [Emmis] to buy your shares.'

I can't believe that this will be allowed to stand. Ben Graham writes at length about preferred stocks in Security Analysis, with special emphasis on the necessity of cumulative provisions.

Should a company ever be allowed to remove the cumulative feature from a preferred over the objections of a holder? Ben Graham wrote that the lack of a cumulative feature is "so patently inequitable that new security buyers (who will stand for almost anything) object to noncumulative issues, and for many years new offerings of straight preferred stocks have almost invariably had the cumulative feature."

Arbitraging Their Own Capital Structure

Just saw this press release from Genie Energy Ltd., (GNE) which announced

"[a]n offer to exchange outstanding shares of Class B Common Stock for a new series of Preferred Stock. The offer will cover approximately one-third of the outstanding common stock, and Howard Jonas will not be exchanging any shares of common stock he owns or controls. The exchange will be on a one for one basis, and the preferred stock will have a liquidation preference currently anticipated to be $8.50 per share, and dividend right that is senior to dividends on the common stock, providing an annual yield in the 7-8% range. Genie anticipates that, following the current quarter, dividends on the common stock will be suspended for an indefinite time. The preferred stock will be redeemable by Genie after a certain period.

Claude Pupkin, Chief Executive Officer of Genie, said 'Genie is a unique combination of our retail energy business, which generates good cash flow, even while investing in steady growth, and Genie Oil and Gas, which requires substantial investment, but offers the potential for fantastic future growth and value. In the nine months since the spin-off of Genie from IDT, we have learned that stockholders have varying investment preferences and objectives. The exchange offer will provide our stockholders with the opportunity to own a security meeting their preferences, while allowing us to continue to benefit from the synergies of having the two operations in one corporate family.'

Ira Greenstein, President of Genie, added 'Our oil and gas projects are long term plays, with risks both known and unforeseen. We are bullish on the long-term prospects of our GOGAS business, but that risk profile and horizon may not be comfortable for all our stockholders. The exchange offer is intended to ensure that a broader range of investors have the opportunity to partner with Genie and reap the rewards of our performance.'"

This is an example of something I've been talking about for a while: firms arbitraging their own capital structures.

Something Else Important From the EMH-Busting Paper

This is another gem from the paper we just wrote about, "Low Risk Stocks Outperform within All Observable Markets of the World"

"In considering the costs of raising internal capital, managers should employ state-of-the-art inductive technology (supplemented with their own information) to forecast the expected returns to their firm’s menu of prospective securities and portfolios of their securities. Forecasts of the expected returns to these securities, and portfolios of securities, should be based on statistical models that explain and forecast the behavior of stock market prices. In financing, managers should determine the least-expensive portfolio of securities that can be issued. As long as the firm’s assets are over or undervalued by the market, management should be able to create financing portfolios that are overvalued."

Another way of describing something I have long advocated: firms should arbitrage their own capital structures. It's amazing that so many firms are either indifferent to their capital structures (net nets) or actively mismanage them (poorly timed buybacks).

Any company that isn't issuing as much long term, low rate debt as possible right now is mismanaging its capital structure. Why aren't the oil majors issuing 4% long term paper and buying up E&P companies like CHK selling for less than half of NAV?

There's a short list of people and firms that have been really arbitraging their own capital structures. The two classic examples that come to mind are James Ling / LTV and Henry Singleton / Teledyne. Singleton famously bought back a huge portion of outstanding Teledyne stock during the early 70s bear market, reducing outstanding shares by 64% in four years. [Singleton was also a fantastic manager, emphasizing that all capital projects needed to have high returns on assets and equity in order to be approved.] Similarly, Ling was good about issuing securities that were overvalued and buying or trading new securities for what was undervalued.

When Teledyne stock was expensive, Singleton used it to make accretive acquisitions. This is something I thought that Netflix should have done back when its stock was insanely overpriced. As I wrote last year, the rents from the streaming entertainment business are going to go to the content owners. The smart play would have been to sell stock and acquire content, either by buying libraries or by generating new content.I'll bet that during the height of the NFLX mania, they could have bought film libraries with stock and their multiples would have expanded. With their peak market cap of $15 billion they could have easily absorbed DreamWorks and LGF, for example.

The latest own-firm capital structure arbitrage idea is David Einhorn's Greenlight Opportunistic Use of Preferreds (GO-UP) strategy. The idea would be to issue prefs at low yields and use the funds to buy back stock trading at low multiples. These could unlock value by converting low multiple net income into low yielding (high multiple) preferred stock.

Chesapeake Energy and Aubrey McClendon are pursuing the same essential strategy as the GO-UP arbitrage, by the way. As the company describes it, they like to raise capital through VPPs, royalty trusts, and asset level preferred stock transactions because they

"recognize the world is 'short yield' and [want to] provide various investment opportunities to yield-hungry investors who are willing to pay more for select assets than core E&P investors are willing to do."

In other words, investors will buy an MLP that owns midstream assets at a 5% yield, but they would never value them that highly as part of an E&P.So, the arbitrage opportunity exists because it takes advantage of an irrational investor preference for fixed coupons.

Is the preference for fixed coupons really that irrational? I think it might be "quasi-rational" in that investors have no confidence that managements will return earnings to them anymore, primarily because of a lack of capital allocation discipline.

Capital Structure Arbitrage Note: KV Pharmaceutical

KV Pharmaceutical Company is a pharmaceutical company that is currently marketing two approved products: Makena and Evamist, and expects to launch two previously approved products, Gynazole and Clindesse, in 2012.

There are two classes of common stock. The A class has a higher dividend but much smaller voting rights than the B class. The fully dilluted A+B share count is ~90 million, giving the company a $90 million market capitalization. Meanwhile, there are $225 million of senior secured notes due 2015 trading at 60 (market value $135mm) and $200 million of convertible notes due 2033 trading at 16 (market value $32mm). [In addition to various other obligations including payments owed to the previous owner of Makena.]

Importantly, the 2033 notes are putable next May (less than a year) at par. The specifics are that "holders may require us to repurchase all or a portion of their 2033 Notes on May 16, 2013, 2018, 2023 and 2028, or upon a change in control, as defined in the indenture governing the 2033 Notes, at 100% of the principal amount of the 2033 Notes, plus accrued and unpaid interest (including contingent interest, if any) to the date of repurchase, payable in cash."

Obviously, these notes which are trading at 16 and due next year are both the fulcrum and most exciting security. According to a recent holders list, ~25% of the issue is owned by Susquehanna, 15% by Lazard, 15% by SAC, 13% by Whitebox, and the rest by a variety of other distressed debt and convert arb funds.

They gave an investor presentation on Apr 12 which has the longest safe harbor statement I've ever seen. Besides the notes, their material financial obligations are $95 million in milestone payments to Hologic for Makena, and $35 million in various government settlements. They had roughly $60 million cash at the end of March.

Makena is a once a week injection (given for approximately 15 weeks) for women who have already had a prior pre‐term pregnancy and are once again pregnant. It was shown to reduce the chance of the mother having a preterm birth. In optimistic sell side research that shows substantial enterprise value, almost all of the value is in Makena.

The problem with Makena is that it is an "orphan drug" and doctors had been using the active ingredient in Makena (a progesterone called 17p) for years, made by compounding pharmacies. Apparently the cost of 17p from a compounding pharmacy was in the $10/shot range. However, KV initially priced the drug at $1,500 per injection. Doctors and health care payers like insurance companies were not impressed, and as a result many potential customers have continued to use compounded product rather than Makena.KV needed the FDA to prevent the compounding pharmacies from undercutting them on price by a factor of 100x. Unfortunately for KV, the FDA did not exactly come to the rescue with this statement:

"FDA approved Makena (hydroxyprogesterone caproate) in February 2011 for the reduction of the risk of certain preterm births in women who have had at least one prior preterm birth. For many years before Makena was approved, a version of the active ingredient of Makena has been available to patients whose physicians requested the drug from a pharmacist who compounded the drug. In March 2011, after learning that the owner of Makena, K-V Pharmaceuticals, had sent letters to pharmacists indicating that FDA will no longer exercise enforcement discretion with regard to compounded versions of Makena, FDA issued a statement about compounded hydroxyprogesterone caproate to clarify the agency's enforcement priorities. In the March 2011 statement, FDA explained that the agency prioritizes enforcement actions related to compounded drugs using a risk-based approach, giving the highest enforcement priority to pharmacies that compound products that are causing harm or that amount to health fraud. The agency also stated: 'In order to support access to this important drug, at this time and under this unique situation, FDA does not intend to take enforcement action against pharmacies that compound hydroxyprogesterone caproate based on a valid prescription for an individually identified patient unless the compounded products are unsafe, of substandard quality, or are not being compounded in accordance with appropriate standards for compounding sterile products."

Essentially meaning that the FDA is not going to stop the compounding pharmacies from undercutting KV on their wildly overpriced drug. The American Congress of Obstetricians and Gynecologists (ACOG), which was not pleased with the pricing of Makena, had previously said,

"[While]… there are clear benefits to having an FDA-approved version of 17P, there is no evidence that Makena is more effective or safer than the currently used compounded version. In fact, the evidence used to obtain FDA approval for Makena relied primarily on data obtained using the compounded product."

I found a UnitedHealthcare document describing their reimbursement policies for 17p/Makena:

"UnitedHealthcare requires prior authorization for Makena, whether administered in the office or by a home health service, for the following Commercial plans and products..."

It seemed as though they would prefer that people use/doctors prescribe the cheaper compounded version (surprise).

Anyway, the bonds are cheap enough that there is a pretty clear long bonds / short stock opportunity here. And it is helpful to know that the company's assets are probably insufficient to cover the bonds, meaning that the stock is most likely worthless.

Companies with Distressed Bonds and Non-Zero Market Caps

Name	Ticker	Market Cap	Coupon	Maturity	Dollar Price	YTM
NETWORK EQUIP TECHNOLOGIES	NWK	32	7.250s	May 2014	35	73
K-V PHARMACEUTICAL	KV-A	68	12s	March 2015	60	35
K-V PHARMACEUTICAL	KV-A	68	2.5s	May 2033	18	16
ATP OIL & GAS CORP	ATPG	378	11.875s	May 2015	75	24
JAMES RIVER COAL CO	JRCC	148	4.5s	Dec 2015	50	27
JAMES RIVER COAL CO	JRCC	148	3.125s	Mar 2018	36.5	23

Pretty similar to the last list. Leaving GMXR and AONE off because we are already talking about those.

Latest Updated GMX Resources (GMXR) Cap Table

Here's the latest according to what I have:

Shares Outstanding	71,987
	Face Amount	Price	Market Value	Interest Exp
Cash, as of 3/31/11	-71,079	1.00	-71,079
4.5% Senior Note due 2015	86,520	0.49	42,395	3,893
5% Senior Note due 2013	54,672	0.77	42,097	2,734
11.375% Senior Note due 2019	1,970	0.50	985	224
11% Senior Secured Note due 2017	288,620	0.80	230,896	40,407
Total Debt	360,703		245,294	47,258
9.25% Series B Cumulative Preferred	79,418	0.52	41,297	7,346
Enterprise Value through Preferreds	440,121		286,592	54,604
Common Stock	103,661	1.44	103,661
Enterprise Value	543,782		390,252

The senior secured interest expense assumes that they continue to PIK those notes. The EV I come up with is on the low side, as I don't subtract for working capital. 

Barron's Article on Hovnanian: "Hammered and Nailed" ($HOV)

This was a great Barron's article on Hovnanian that I meant to post earlier.

Vicki Bryan, an analyst at research outfit Gimme Credit, points out that the company hasn't generated enough cash to cover interest costs since 2006, the result of weak demand and stepped-up land acquisitions considered vital for its future.

[...]That's why Bryan thinks a bruising recapitalization is inevitable, perhaps within a few months. The maneuver could involve converting outstanding bonds into equity, heavily diluting existing shareholders. Bryan goes so far as to call Hovnanian's stock "worthless."

The article's "bottom line" has been prescient: "Hovnanian may have to ask bondholders to swap debt for equity, diluting stockholders."

I've already written a few posts about Hovnanian. I view the debt as cheap relative to the stock, and you'll notice that they are undergoing a slow motion restructuring.

Updated GMX Resources (GMXR) Cap Table

Latest estimate; this updates the bond prices and reflects the increase in senior secured debt that will occur as a result of the PIK election for the interest payment due June 1, 2012.

Also, adjusting the interest expense in the table for the secured notes to reflect that they will most likely continue to chose the PIK election, which is at a higher interest rate. (I haven't seen a trade on the secureds recently; but I am estimating them to trade at 80.)

Shares Outstanding	69,272
	Face Amount	Price	Market Value	Interest Exp
Cash, as of 12/31/11	-102,493	1.00	-102,493
4.5% Senior Note due 2015	86,520	0.49	42,395	3,893
5% Senior Note due 2013	59,372	0.77	45,716	2,969
11.375% Senior Note due 2019	1,970	0.50	985	224
11% Senior Secured Note due 2017	288,620	0.80	230,896	40,407
Total Debt	333,989		217,499	47,493
9.25% Series B Cumulative Preferred	79,418	0.52	41,297	7,346
Enterprise Value through Preferreds	413,407		258,797	54,839
Common Stock	99,752	1.44	99,752
Enterprise Value	513,159		358,549

Once again, we see a disparity between the enterprise value implied by the debt and what is implied by the common stock. Buyers of the unsecured debt create the company at a valuation of around $220 million and buyers of the common stock create the company at a valuation of around $510 million.

Capital Structure Table for A123 (AONE) Shows Big Disparity in Market-Implied Enterprise Valuations

This is roughly what the cap table looked like according to the 10-K (for the period ended 12/31/11).

	Face Value	Market Value
Cash	-186,000	-186,000
Revolving Credit Lines	38,000	38,000
EV through Senior Debt	-148,000	-148,000
Convertible Notes	140,000	43,400
EV through Notes	-8,000	-104,600
Common Stock	142,454	142,454
EV through Common	134,454	37,854

Notice the huge disparity between the enterprise value implied by the convertible notes and what is implied by the common stock. Buyers of the notes create the company at a negative valuation and buyers of the stock pay an enterprise valuation that is around $240 million higher.

The one hazard of this cap table is that the balance sheet we have is now over three months out of date and does not reflect any subsequent cash burn or equity issuance since the beginning of the year. We know that there was one share issuance:

"In January 2012, we completed a registered direct offering of 12,500,000 units at a negotiated price of $2.034 per unit, with each unit consisting of (i) one share of our common stock and (ii) one warrant to purchase a share of our common stock for net proceeds of approximately $23.5 million."

So I have another cap table that tries to take this transaction into account:

	Face Value	Market Value
Cash	-209,500	-209,500
Revolving Credit Lines	38,000	38,000
EV through Senior Debt	-171,500	-171,500
Convertible Notes	140,000	43,400
EV through Notes	-31,500	-128,100
Common Stock	154,579	154,579
EV through Common	123,079	26,479

So, with the new share issuance, the gap between the note-EV and the stock-EV is a bit higher actually: $250 million!

Hovnanian (HOV) Using Proceeds From Share Issuance to Repurchase Notes

Hovnanian had recently announced that they would be issuing and selling up to 28,750,000 shares - which is almost a 30 percent increase in shares outstanding. Today they announced that the

"net proceeds from the issuance of the Shares, along with cash on hand, will be used to fund the purchase of approximately $15.3 million principal amount of 6 1/4% Senior Notes due 2016, approximately $22.8 million principal amount of 7 1/2% Senior Notes due 2016 and approximately $37.4 million principal amount of 8 5/8% Senior Notes due 2017 in a private transaction."

The 6.25s trade at 72, the 7.5s trade at about 60, and the 8.625s trade at 60 as well. There's actually only about $175 million of the 8.625s remaining, so they are buying back more than 20 percent of that issue. Another slow motion restructuring. The stock appears to be roughly half owned by retail; and most of the institutional holders are index funds.

More About A123 Systems (AONE)

Greentech Media has a good post about the troubles at AONE.

This is an even more extreme enterprise value disparity than what we saw in ENER. The market value of the debt is about $40 million, but the company has ~$200 million in cash, meaning that the bond market implied enterprise value is negative $100 million or even less. Meanwhile the market capitalization is like $130 million! That is a huge disparity!

This is a clear restructuring candidate. It's hard to sell enterprise products when your bonds are trading at 30; people wonder whether you are going to be around, etc. It's hugely distracting. I don't know why they haven't already announced an exchange offer?

Capital Structure Note: A123 Systems ($AONE)

A123 Systems (AONE) designs, develops, manufactures and sells advanced rechargeable lithium-ion batteries and energy storage systems and provides R&D services to government agencies and commercial customers.

The company has a market cap of $120 million. There is also $140 million face amount of convertible notes outstanding, which are trading at 30 cents for a market value of $42 million.

The notes bear interest at 3.75% and mature on April 15, 2016. The initial conversion rate of 138.8889 shares of common stock per $1,000 aggregate principal amount of notes is equivalent to a conversion price of approximately $7.20 per share.

The company has had a negative gross margin each of the past three years. Also, its operating expenses (not including COGS) are nearly 100 percent of sales.

On January 25, the Company raised $23.5 million from an institutional investor in a registered direct offering. They are also taking actions to improve cash flow by reducing manufacturing costs and operating expenses, as well as by managing inventory levels. The company mentioned in its annual report that if it "is unable to raise enough capital and improve operating performance, the Company's growth potential may be adversely affected and the Company will have to modify its growth plans to conserve available cash. Management believes that the available cash and cash equivalents should be sufficient to fund operations for the next twelve months."

Interestingly, the company had close to $200 million cash at the end of 2011. This looks a lot like another ENER situation with a negative enterprise value through the bonds.

Another Blogger Writes About GMXR

"At 90% gas production, 98% gas reserves, a cash cost structure of around $3.00/Mcfe - about even with spot prices pre-basis, and no remaining hedges, GMXR is in a world of pain. I understand it gives them more time to attempt a liquids conversion by doing the exchange, but with the variability of results in the Niobrara, recent cost pressures in the Bakken and my expectations of continued pressure on the gas curve, the company may just be whistling past the graveyard."

GMX Resources (GMXR) - Capital Structure Arbitrage Idea

Summary
GMX Resources (GMXR) is an Oklahoma City-based, independent oil and natural gas exploration and production company. They have interests in the Bakken in North Dakota, the Niobrara in Wyoming, and the Haynesville/Bossier and Cotton Valley Sands in East Texas. You might have noticed that GMXR was on last Friday's list of "Cheap Debt, Upcoming Maturities, and Big Market Caps." Once again, we seem to have an energy company where pieces of capital structure have mutually inconsistent prices.

The market capitalization is almost $100 million, even though the preferred stock trades at 50 cents, the unsecured debt (due 2013 and 2015) trades at similarly deep discounts, and with an inverted yield curve), and the senior secured notes (due 2017) are trading at a YTM of ~17%. The market prices of the debt securities imply that the common stock is out of the money by over $150 million.

Shares Outstanding	69,272
	Face Amount	Price	Market Value	Interest Expense
Cash, as of 12/31/11	-102,493	1.00	-102,493
4.5% Senior Note due 2015	86,520	0.45	38,934	3,893
5% Senior Note due 2013	59,372	0.69	40,967	2,969
11.375% Senior Note due 2019	1,970	0.50	985	224
11% Senior Secured Note due 2017	283,520	0.80	226,816	31,187
Total Debt	328,889		205,209	38,273
9.25% Series B Cumulative Preferred	79,418	0.52	40,948	7,346
Enterprise Value through Preferreds	408,307		246,157	45,619
Common Stock	96,289	1.39	96,289
Enterprise Value	504,596		342,445
Valuation Gap Implied by Debt/Preferred			162,150

Catalysts
One immediate and ongoing catalysts is that the company is actively deleveraging by issuing shares in exchange of its notes due 2013, which are the nearest and most pressing maturity. After three exchanges YTD, shares outstanding have grown by 10 percent and the face amount of 2013 notes has been reduced by $13.4 million.

Even more deleveraging will be necessary. Ongoing interest expense and preferred coupons are $45.6 million annually. Given the ambitious capital spending plans (more about the IRR of those later), our bet is on continued equitization of the capital structure.

The company has no problem issuing stock. Shares outstanding nearly doubled during 2011, as their oil-play acreage in the Bakken and Niobrara were both purchased using some stock as currency.

Another ongoing catalyst is the Bakken well results, which have been disappointing but may improve after workovers (on multiple new wells). Our fingers are crossed.

Capital Structure Mispricing
The senior secured notes with a face amount of $284 million trade at 80 cents for a yield to maturity of ~%17. These have a nominal 11% coupon; it is actually an option for 11% cash or 9% cash and 4% PIK.

The unsecureds are trading with an inverted yield curve: ~60% YTM for the 2013s and ~35% YTM for the 2015s. Total unsecured debt at face is $146 million. There is also a preferred, trading at roughly 50, with face amount of $79 million. Total liabilities through the preferreds are $408 million. [And it is hard to identify any assets that sum to this amount.]

The valuation gap (roughly $160 million) between face value and market value of unsecureds and preferred stock imply that the equity is significantly out of the money. In our view, the real debate is whether the fulcrum security is the senior secured or the unsecureds.

The company seems to need need a distressed debt exchange, which it has already started by way of the periodic debt for equity swaps. (No public exchange offer has been made yet.)

CapEx Plan for 2012 Implies Restructuring this Year
The company has an ambitious plan to drill 7.1 net wells in the Bakken in 2012, which they say will cost $68 million (and not counting other capex). Their interest expense and preferred coupons should be $46 million, and they project SG&A for 2012 to be $31 million.

Their own projection is for 373k bbl oil in 2012 which we guess is roughly $30 million in revenue, and the company had $100 million in cash at the end of 2011. In theory, the company would need to actually be building cash to meet the upcoming unsecured maturities. In reality, it is likely that some kind of deleveraging transaction will take place to clear the unsecured maturities and allow the company to spend more money drilling wells and buying acreage.

Sum of Parts Valuation
Keep in mind that the current enterprise value through the preferreds is $410 million and the total enterprise value is $500 million (and this assumes nothing for working capital). Sell side research that we have seen puts a value of $350 million on the company's assets, which covers the secureds but results in impairment for the unsecureds and leaves the preferred stock and common stock with nothing in a liquidation.

We actually struggle to come up with a value as high as the sell side research. The company has a few key assets: producing wells and acreage in the Haynesville (much of the production has been VPP'd), the Cotton Valley, acreage in the Niobrara, acreage in the Bakken, and a few producing wells in the Bakken.

The company wrote down the Cotton Valley Sands inventory at the beginning of 2011: "Due to the Company's focus on developing the new acreage in the Bakken and Niobrara oil resource plays, and the prolific nature of the Haynesville/Bossier gas resource, we do not currently expect to reactivate a Cotton Valley Sand vertical drilling program within the next five years."

The way that the company came to acquire the Niobrara and Bakken acreage is noteworthy. First of all, most of the purchases were made at the beginning of 2011. This was roughly two to three years into the Bakken play - making them a late arrival. [The EIA has an excellent animation of producing wells in the Bakken. For fun, and something I may do in a followup post, compare the locations of good wells to the location of GMXR acreage.] Anyhow, the company acquired acreage in a series of transactions that involved a large proportion (in some cases, 90%) of consideration paid in common stock of GMXR.

Bakken Acquisitions
From a company filing:
"GMXR's 26,087 total net acre leasehold for these acquisitions is primarily in five distinct areas, all of which are within the Bakken 'thermal maturity window'. The consideration to be paid by us for the three Bakken transactions includes the issuance of shares of the Company's common stock. Two of the transactions, totaling 8,290 net acres (including 1,629 acres under the LOI), reflect an average purchase price of $4,665 per acre, with approximately 67% paid in common stock [...].
"The third transaction, previously announced January 20, 2011, totals 17,797 net acres for a purchase price of $1,000 per acre. Approximately 90% of the consideration will be paid in common stock [...]."

Niobrara Acquisitions
From the previous filing:
"GMXR's entry into the Niobrara involves two transactions for approximately 41,637 net acres in southwestern Goshen, southeastern Platte and north central Laramie Counties in Wyoming, with a 80% net revenue interest. One of the sellers has retained a 90-day option to reacquire a 50% working interest in approximately 16,000 acres, at our initial cost."

Trade Ideas
The stock is optionable so no there is no borrowing concern. You can get negative delta synthetically by buying puts or shorting deep-in-the money calls. There is fairly high implied volatility, which means that you can create the company at a higher price in the options market by selling calls.

The obvious play is to short equity and buy the 2015 notes, which have the lowest dollar price. Another obvious opportunity would be to try to tender the 2013 notes for stock back to the company, at a transaction premium. These transactions, which are already taking place, amount to a slow motion restructuring and help the debt recovery (by reducing amount outstanding), dilute the existing common stock, and most notably decrease expected future volatility and therefore reduce the value of call options, because of the deleveraging.

As always, do your own research, but it seems to me that the bonds are drastically underpriced relative to the stock. 

Major Holders
Insiders own roughly 5 percent and institutions another 36 percent. So the company is 59% owned by retail. It doesn't look like there is much actively managed ownership - mostly index funds.

Weird Behavior
On the most recent quarterly conference call, an analyst asked about the company's Niobrara acreage. One of the company executives said "we'll tell you about it when we've got a - when we have a great story to tell at the site".

The preferred stock is putable back to the company if CEO Ken Kenworthy ever leaves the company, voluntarily or involuntarily. As company filings state,

“We depend to a large extent on the efforts and continued employment of Ken L. Kenworthy, Jr., our [CEO]. The loss of his services could adversely affect our business. In addition, if Mr. Kenworthy resigns or we terminate him as our [CEO], we would be required to offer to repurchase all of our outstanding Series B Preferred Stock. The indenture governing our Senior Secured Notes will restrict our ability to repurchase our outstanding Series B Preferred Stock, and we may be required to issue other preferred or common stock in order to raise cash for such required repurchases.”

Keep in mind that the preferred stock is trading at roughly 50 cents, with a face value of almost $80 million. It would not be good if the company was forced to buy it back at par. What do you think boardroom discussions are like with a CEO whose departure would cause that kind of a liquidity drain?

Partial Conclusion
I'm going to publish this post now and update on the sum of parts analysis, waterfall recovery analysis, well results, and acreage details later. 

Hovnanian (HOV) Swaps Shares for Debt

Pursuant to agreements with bondholders, each dated March 26, 2012, Hovnanian Enterprises, Inc. issued an aggregate of 981,302 shares of the Company's Class A common stock, par value $0.01 per share, in exchange for an aggregate of approximately $4.1 million aggregate principal amount of the Company's outstanding 8.625% Senior Notes due 2017.

This bond has recently been trading at around 60.

GMX Resources (GMXR) Hedges Oil and Gas Production

From the press release:

"GMX RESOURCES INC today announces that the Company has entered into agreements with two hedge providers to protect its cash flow on oil and natural gas production."

I would probably hedge oil production here, too. But not natural gas. Here are the prices they have locked in:

2012: April -- December: $2.60 Swap for 4.0 Bcf
2013: January -- December: $3.50 Swap for 4.2 Bcf

These swaps cover "a significant portion of [their] estimated production". Remember that Chesapeake, which is really probably the smartest player in the natural gas market, covered its hedges back in November. I don't think that going short natural gas (which is what a swap is) is the smart play when natural gas is at a record low and the oil/natural gas equivalent BTU spread is at a record high.

Ironically, the scariest part about being short GMXR equity as part of a capital structure arb was that there was some optionality on a natural gas recovery. By shorting natural gas, they have basically taken that possibility off the table.