Thursday, January 19, 2012

Time to Put the Energy Conversion Devices ($ENER) Capital Structure Trade Back On

You may recall that we previously had a capital structure arbitrage trade on in Energy Conversion Devices, which we closed out last year when the stock collapsed to a de minimis value. I think I am going to put the capital structure trade back on. That is actually the best trade idea I have right now.

The reason is that an incredible short squeeze has taken place in the ENER stock, catapulting it from 20 cents to a high of 1.50 today. Meanwhile, the bonds have hardly traded, and are yielding nearly 80 percent. The prices of the company's bonds and common stock are inconsistent and imply wildly different valuations for the company.

Solar Short Squeeze
ENER manufacturers photovoltaic solar materials. The first two weeks of January have seen incredible short squeezes, in almost inverse proportion to the underlying strength of the business, for example in Evergreen Solar which has demonstrably worthless stock.

The other argument for the ENER rally is a recovery in the photovoltaic solar industry. Yeah, right. You can get a good sense of that possibility by reading this paragraph from a recent First Solar filing:

"In connection with a continuing objective of balancing production capabilities with market demand, [First Solar] is evaluating various means to reduce 2012 annual manufacturing production by more than 400MW. The Company expects to produce approximately 2GW of modules in 2012, reflecting an approximately 80% manufacturing capacity utilization rate, compared to an expected manufacturing capacity of approximately 2.5GW by the end of 2012. The Company expects to strategically idle some manufacturing capacity in 2012 in order to implement upgraded process technologies across existing manufacturing lines as part of its accelerated conversion efficiency improvement initiatives, and to better align production with expected market demand. The Company also expects to qualify its Mesa, Arizona manufacturing plant in 2012, but does not expect to start commercial production at this facility until 2013."
If FSLR is idling capacity, there is not going to be profitable business to be had by the smaller marginal solar producers. Marginal firms only do well when there is so much demand that the big firms in an industry are turning down orders. Here is more color on the PV solar market, from a Credit Suisse report:
“We caution that policy news tends to be very volatile day to day, and there will be occasions when a piece of news is interpreted as positive. However we think there is risk now that Germany will act in a way that reins in the pace of installations, adding to the oversupply in 2012, just like Italy did last year, and Spain in 2008. Last week’s solar rally is vulnerable to news flow on policy risk.”
Actually, the last we heard from ENER, they were completely idling their manufacturing to save money. This was from a filing on November 8:
"On November 8, 2011, Energy Conversion Devices, Inc. (“ECD” or the “Company”) publicly announced the temporary suspension of all manufacturing operations as an inventory control measure. ECD will continue to serve its customers through its direct sales force and its global network of solar integrators and building materials suppliers. The company expects to resume production in its manufacturing facilities as soon as possible once the existing inventory has been sold and market conditions warrant.

As a result of the suspension, 368 manufacturing associates have been laid off, while another 400 have been temporarily furloughed. The affected associates are located across the company’s Michigan, Mexico and Ontario manufacturing facilities. In addition, the company will lay off 132 associates from its corporate overhead worldwide. The estimated annualized cash savings from these actions is approximately $12.7 million.

In connection with the implementation of this plan, ECD will incur restructuring and other related charges in the second and third quarters of fiscal year 2012 totaling approximately $1.6 million."
According to Yahoo Finance, the company only has 1300 employees - so 70 percent of them have been idled. They are in complete free fall! That is why the stock was at 20 cents! Yet, it got swept up with the early January short squeeze and the misguided enthusiasm for solar stocks. I haven't heard an announcement from ENER about how sales are going, or whether they are any closer to restarting operations.

To me, the PV solar market represents a bet on three things: (1) rational demand based on unsubsidized IRR; (2) irrational demand from European subsidies; (3) irrational demand from Chinese subsidies. The rational demand has completely evaporated with the decline in natural gas prices over the past quarter.

Europeans can no longer afford alternative energy boondoggles, which was the big reason for the PV solar crash last year. That has not changed. The total German PV installation surprised to the upside for 2011, but the bad news is that the German PV subsidy will be cut by 24 percent as a result of this.

China has said that it will install 3 GW of PV solar in 2012. Remember from above that First Solar has idled 0.5 GW of their capacity in 2012. Anyway, China favors Chinese firms for solar projects.

For a given PV solar firm, their ability to sell depends on (1)cost and (2) bankability. Cost is a function of scale and technology, both of which favor the larger firms like First Solar. Bankability, meaning whether banks that finance projects believe that you will honor your warranty, is a function of balance sheet strength. Obviously, there are concerns with ENER in this regard.

ENER Capital Structure
Energy Conversion Devices has one series of debt, the three percent convertible notes due June 2013. There is $260 million face value of outstanding notes, which trade at 37.5 percent of par, for a market value of $100 million.

However, the company has $120 million in cash and short-term investments as of September 30, 2011. If the company could buy back its debt at a discount in the market without affecting the price, it could theoretically retire all the debt and have cash left over.

The fact that the market value of the bonds is less than the amount of the company's cash and short term investments means that the bond market ascribes a negative value to the company's business and investments in alternative energy: the “enterprise”. This is probably correct, because it implies that the company will continue to burn cash before eventually being forced into restructuring.

Were this simply a case of bonds trading at under forty cents on the dollar when the company has perhaps fifty or sixty cents worth of liquidation value, it might be interesting but still troublesome because that liquidation value would continue to fall as the company lost money in its operations.

The exciting part is that the company's market capitalization – the market value of its common shares – is $70 million. In order for the common shares to be worth anything, the enterprise must be worth as much as the face value of the debt ($260 million) minus the cash and short term investments ($120 million), which is $140 million. And a market capitalization for the stock of $70 million implies that the enterprise is worth $210 million. What does it mean if the stock market implies a valuation of $210 million for the same enterprise that the credit markets give a negative value?

Clearly, the valuations are mutually exclusive, and so only one of them can be correct. Ultimately, it does not really matter whether the bond market or stock market is right, because we can bet that the inconsistency will converge. By buying the bonds and shorting the stock, we can simultaneously “create” the enterprise at a negative valuation and sell it at a positive one. In fact, this situation is the first one I have found where the interval of enterprise valuations implied by different securities includes both negative and positive valuations.

Part of my investment process is to form a plausible hypothesis for why a market inefficiency or opportunity might exist. In this case, I can think of two possible explanations. First, an arbitrage opportunity involving a market capitalization less than $100 million is so small that many sophisticated arbitrageurs will not even look at the situation. Second, close to three-quarters of the Energy Conversion Devices stock is held by retail investors. These types of investors are generally oblivious or indifferent to the company's bond price, yet they are the marginal buyers setting the price of the stock. If they were paying more attention, they would consider selling their stock in a company with bonds that yield 80% to maturity, and buying the bonds instead.

Actually, it would appear that many of the marginal buyers that have pushed the price up this week don't actually have an opinion about the value of the company - they just want to "rent" a stock that is going up. A great way to check this is the Yahoo "Market Pulse" for the stock, which aggregates tweets and whatnot. The retail crowd got excited because the stock went up.

Recent Developments
The other major disclosure recently, besides the fact that they idled all of their capacity, was that they have started down the restructuring path:
"We expect to continue to refine these restructuring efforts and align our resources as conditions warrant to better execute on the revised technology roadmap and Open Solar business model. Although we are not currently experiencing significant liquidity constraints, we believe that a successful repositioning of our United Solar Ovonic business will require additional investment and refinancing or restructuring of our outstanding Convertible Senior Notes (“Notes”). We intend to invest the proceeds of any sale of OBC in our United Solar Ovonic business to support funding of our technology roadmap and Open Solar™ initiatives. We are considering a range of strategies to attract additional needed investment and we have retained the financial advisory firm of AlixPartners to assist us in evaluating our strategies. These strategies may include additional asset sales, technology license agreements, joint venture arrangements, renegotiating existing obligations or other transactions.

In connection with the foregoing, we have begun discussions with representatives of an informal group of noteholders regarding our repositioning efforts and to explore the group’s interest in restructuring our obligations under the Notes. Our discussions are at a preliminary stage. If we are unable to reach an accord with the noteholders or execute sufficiently on one or more of the strategies that we are considering to attract required investment, we may choose to seek reorganization under the U.S. Bankruptcy Code."
They are planning to sell the non-solar research subsidiary, which does about a modest amount annually through royalty revenue. That might be good for a bit of recovery of bonds. It is telling, though, that they are going to sell it and "reinvest" the money in the money-losing solar business.

Here is an interesting fact that tells you about the company's debt levels: in the most recent quarter, interest expense was 26 percent of revenue. Earlier this week, the company made its "previously deferred semi-annual interest payment" on the notes. They had taken advantage of a 30 day grace period not to pay. Apparently, that is wildly bullish!

Potential Catalysts
If I were in their shoes, I would offer the noteholders a combination of cash, new notes, and stock. I could see a coercive offer that gave the notes, currently trading at ~35, perhaps 10 cents in cash, 50 cents in new senior secured notes, and a majority equity stake in the company.

The noteholders should hold out for a lot of stock, preferably a controlling interest in the company, maybe even all of it, depending on what else they are offered. In these situations, you will often see management given a big chunk of the company (5-10%) to turn the keys over to the bondholders.

P.S. Someone else apparently agrees with me. Someone shorted "about 3,800 January 1 calls for $0.50 to $0.69. Volume is more than 4 times open interest in the strike." Selling calls is attractive compared to shorting the stock.


Taylor Conant said...


I think this is a robust idea. One can buy puts, short calls, write calls or try shorting the stock itself to play the short side of the equity hedge. What is the easiest, most cost-efficient way for a small investor to get exposure to the long side of the credit hedge in your mind?

Apparently lightning does strike twice in one place!

WSM said...

I agree w/ Taylor - how does one (small investor) get involved with the long convertible notes?

Can you provide a link to a quote? I can't even seem to find a quote for the converts...

CP said...

The best way to get short equity exposure here is to short ITM calls. I don't think you can short the stock, and you'd be paying a premium to buy puts, vs receiving a premium when selling calls.

To do the arb there is no substitute for owning the bonds.

As a distant second, you could own something else solar, like FSLR. Or related is inverter maker PWER which is correlated and is super cheap assuming solar demand holds up.

What is astonishing is the volume in ENER. The entire company has changed hands this week.

CP said...

Traded a piece today at 41.5

Taylor Conant said...

Is there a better brokerage for small investors to trade corporate bonds than Interactive Brokers?

CP said...

I don't think so.

Are you not seeing this bond offered on the electronic markets there?

Taylor Conant said...

I need to open an account. None of the discount equity brokers offer the opportunity to trade these kind of corporate debt securities. I was asking to see if there was a better brokerage option for the small investor.

ECD Fan said...

Any idea why the bond holders haven't gone to court and forced the company into Chapter 11 yet? The current management obviously can't be taken seriously - for example, the new CEO is on record saying that only glass PV can be cost effective (ENER uses steel & plastic!) and that any PV business that relies on selling modules for $2/Watt or more is unsustainable (ENER's cost of manufacturing is above $3/W!!!). And the "Chief Restructuring Officer" hails from a fraud and most recently lied that the non-solar business would be sold within 6 months of 7/19, that is by today.

CP said...

Theoretically, creditors can file involuntary bankruptcy petitions, but in practice that never really happens.

For one thing, if the creditor contests the involuntary petition, the petitioning creditors have the burden of proving that the debtor is not paying its debts as they become due.

If a court dismisses an involuntary petition, the petitioning creditors can be liable for damage claims, such as attorneys' fees or compensatory damages due to trade disruption.

CP said...

Anyway, there is nothing really that a creditor of a money losing business can do until there is an event of default, e.g. failure to pay interest or principal as it becomes due.

That is why when you look at the recovery analysis on a distressed bond, you have to think about how long the company will keep losing money before they can be convinced to liquidate.

A common creditor tactic is to give management a stake in the reorganized company, which can be thought of as a bribe to get management to begin representing the creditors' interests rather than the shareholders.

That is why it is common to see restructuring plans where management gets 5-10% of the new equity.