Jamba Juice Should Bear Fruit by Mid-2009

Smoothie chain Jamba, Inc. (JMBA) lost $113 million in 2007 and an amazing $258 million for the twelve months ended October 7th, driving its market cap down to $36 million from over $500 million. Institutional investors have taken their losses and moved on.  Insiders and individual investors now own nearly 90% of the shares.  Mainstream sell-side analysts no longer cover the company because it is just too small – in terms of market cap – to matter to their clients.

Thus, it is likely that few people recognize that JMBA is profitable at the adjusted EBITDA level, and fewer still are likely to have gone through the exercise of translating management’s guidance into projections for 2008 and 2009.  This is just the sort of stock for a value investor who likes to do their own research and analysis.

The chart below shows adjusted EBITDA for 2007 and the latest 12 months ended October 2008, along with my forecasts for fiscal years 2008 and 2009 based on management’s publicly disclosed guidance.

jmba-numbers2jpg1

Q4 Forecast

In Q4 of this year, store revenue is forecast down 5% versus last year to reflect double-digit negative comps, offset somewhat by sales from new stores.  Cost of sales is 27% versus management’s target of 26% for next year, due in part to the launch of oatmeal.  Labor is down slightly versus last year to reflect closed stores, offset by higher hourly rates.  Occupancy and store operating costs are down slightly from last year to reflect closed stores.  The resulting adjusted EBITDA loss is not far from the $12.18 million loss realized in Q4 ’07.

2009 Forecast

The 2009 forecast is based on the assumption that comp store sales are down 10-12% in Q1, down 8-10% in Q2, and flat during the second half of the year.  Costs and expenses are based on management’s guidance on the last earnings call.  If management can hit their targets for 2009, the company will generate nearly $20 million of cash flow – more than enough to meet its capital expenditure requirements.  Given the company’s cash balance of $28 million (excluding restricted cash) as of September 30th, management will have some cushion in the event that actual results do not meet these projections (although I expect this cushion to be reduced by losses in Q4 ’08 and Q1 ’09).

Summary

JMBA has taken numerous actions to reduce costs, which should bear fruit next year.  In 2009, the main challenge will be revenue growth.  The projections do not reflect any significant changes to the status quo.  We will not have real visibility into management’s plans to grow the company until we hear from new CEO James White (probably on the Q4 earnings call).

Even if one discounts management’s guidance, the company should be cash flow positive next year.  However, as management said in the last earnings call, JMBA is not expected to turn the corner until mid-year.

Due to the seasonality of the business, the soft retail environment and generally compressed consumer spending, I expect that Q4 ’08 and Q1 ’09 will show significant operating losses, which will limit upside potential in the stock in the short term and may take the price down.  As seasonal growth and a lower cost base begin to drive cash flow in late Q2 of next year, the stock price should begin to improve.  My current price target is $1.30 per share, although this is somewhat in flux until JMBA’s new CEO provides insight into how he views the business and what his plans are to grow and improve it.

(Disclosure: The author is long JMBA)

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.
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AIG’s Bond Sale is No Cause to Celebrate

The latest installment of the American International Group (AIG) “Bailout” is not the good news that one might imagine from reading AIG’s press release.   It does not provide as much financing as originally anticipated. More importantly, it is a reminder that, so far, the U.S. government has done much more to minimize losses for AIG’s counterparties than to maximize value for AIG.

AIG and the Federal Reserve Bank of New York announced on Tuesday that Maiden Lane II, an entity owned and controlled by the NY Fed, has purchased nearly $40 billion of mortgage-backed securities (RMBS) from AIG subsidiaries.  This was part of the revised U.S. government bailout announced on November 10th.  I described these arrangements in my article last week entitled, “AIG’s Bailout Needs a Bailout: A $150 Billion Problem.”

Edward M. Liddy, AIG Chairman and Chief Executive Officer, said: “AIG’s highest priority is the full repayment of the federal loan facility with interest. The creation and launch of this financing entity will eliminate the liquidity issues associated with AIG’s U.S. securities lending program, which will facilitate our repayment plan. Although we have more work ahead of us, this is an important step forward. We appreciate the support of the Federal Reserve Bank of New York in implementing this transaction.”  This seems to imply that this ‘financing entity’ is a new development that frees up AIG capital that otherwise would have gone to satisfy securities lending payables.

While the transaction is a means of financing AIG’s securities lending payables, it is part of the bailout plan and does not provide any capital beyond that anticipated in the bailout.  In fact, it provides somewhat less.  The illustration in AIG’s November 10th 10-Q1 filing shows a purchase price of $23.5 billion, based on fair market values on September 30th.  The actual transaction was based on lower values as of October 31st, and the purchase price was $19.8 billion instead of $23.5 billion.

In my previous analysis, I assumed, based on the 10-Q disclosure, that $23.5 billion would cover substantially all of the securities lending payables, and the financing would provide $22.5 billion, leaving $1 billion to be paid by AIG.  In the final deal, these payables required $24.9 billion – the $19.8 billion of sale proceeds plus a $5.1 billion capital contribution from AIG.  In other words, the final deal required an additional $4.1 billion from AIG.

The real bad news here is not that the value of these RMBS securities fell by $3.7 billion, or 15.7%, in one month; nor is it that AIG had to contribute $4.1 billion more to wind down its securities lending business.  The bad news is that until the deal was finalized, the NY Fed had the ability to make it a more effective tool for saving AIG, and now that chance is gone.

The NY Fed has purchased a portfolio of mortgage-backed securities for 50 cents on the dollar.  This price is more reflective of the lack of liquidity in the market than default rates.  It is likely that a price of around 80% of par would have more closely approximated the ultimate recovery if the securities were held to maturity.2 The NY Fed’s agreement to share a small portion3 of the gains with AIG after its loan to Maiden Lane II is repaid does little to help things today.  This should turn out to be a nice investment for taxpayers.

While some of the legal details have yet to be ironed out, it is clear that the U.S. government controls AIG.  The U.S. government can choose to maximize the long-term value of AIG’s most important assets – its reputation and its people – or it can focus on the salvage value of its financial assets.  Its actions to date indicate that it is focused more on the latter than the former.

So far, the U.S. government has made sure that banks, investment banks and other parties to AIG’s credit default swaps and securities lending agreements are made whole, even though these parties do not have the most senior rights as creditors.  Now that a partial list of the beneficiaries of these transactions has been made public, it is becoming clear that if these institutions had been forced to bear some loss as part of a negotiated deal outside of bankruptcy, the financial system would not have buckled.  The U.S. government made a policy decision to help certain members of the financial system that had transacted business with AIG, and has handed the bill to AIG.  Whether or not the policy decison is justified, forcing AIG to bear the entire cost is not.

Nearly all of the $170+ billion bailout has gone to fund losses on securities that are no longer on AIG’s balance sheet and have nothing to do with AIG’s go-forward business, so nearly all of the bailout funding arguably should have been funded off-balance sheet.  Instead, only about $50 billion is being funded off-balance sheet through Maiden Lanes II and III.

As a result, AIG is saddled with over $270 billion of debt and high dividend preferred stock, compared to under $150 billion in 2006.  As I explained in my analysis last week, the $270 billion needs to come down to around $120 billion before AIG’s balance sheet will truly be stabilized, and deserving of its ratings.  The plan is to achieve this through asset sales, but this is fallacy.  The current value of the assets targeted for sale is probably less than half of the amount needed.  Besides, the operating income from the targeted businesses4 may represent nearly half of AIG’s total normalized operating income, so if they were sold, the amount of debt that the remaining businesses could support would be far less than $120 billion.

AIG can limp along on “life support” for several years, since interest and dividends on $100 billion of the financing can just accrue instead of being paid in cash, but this just adds to the bill down the road.

The industry and AIG’s employees know that AIG’s current situation is not sustainable, and it is starting to show.  AIG disclosed in its 10-Q that its business is being negatively impacted by its financial instability.  And the company’s loss of senior executive Kevin Kelly to a competitor last week is just one example of what will happen to AIG’s executive ranks if things are not stabilized soon.

It is not clear if the U.S. Government cares about this, or if the intent is to break up the business, run-off the assets, and hope to recover at least the debt portion of the bailout funds.  It is not too late to choose the growth strategy over the wind-down strategy, but if growth is indeed the goal, the current course must change quickly.

Footnotes:

1 Please see the “Subsequent Events” section of AIG’s Q3 form 10-Q filed on November 10, 2008 (page 45).
2 As of September 30th, AIG’s RMBS included $14 billion each of Alt-A and subprime loans (the bulk of the rest was Agency and Prime). In October, 18.2% of all U.S. subprime loans were in foreclosure or REO, and another 10.4% were 90+ days past due (download data). Of all Alt-A loans, 9.3% were in foreclosure or REO and 4.8% were 90+ days past due (download data). Assuming that all of these end up in default and that the net recovery is zero, the total loss averages 21.3% between the Alt-A and subprime. The bulk of the RMBS were rated AAA, so they probably had about 10% subordination below them. Thus, assuming the securities sold to the NY Fed were evenly divided between Alt-A and subprime, the loss would be roughly (21.3%-10%)/90%, or 12.6%. This implies that a price of about 85% of par, or perhaps as low as 80% to allow a cushion, would have been a reasonable figure for the NY Fed to pay if the goal were to maximize the support of AIG while minimizing the loss to taxpayers. Instead, the NY Fed took advantage of the current dysfunction in the capital markets to buy the RMBS at a low price (for a scholarly article on how current market prices for mortgage-backed securities are below fundamental values, click here).
3 After the NY Fed loan is repaid, the first $1 billion (plus interest) of gains is paid to AIG subsidiaries, then the remainder is split 5/6 to the NY Fed and 1/6 to AIG subsidiaries.
4 Please see “Segment Information” on page 149 of AIG’s 2007 form 10-K for the operating income of AIG’s Life and Retirement Services businesses and aircraft leasing business.

(Disclosure: The author has no positions in AIG.)

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

AIG’s Bailout Needs a Bailout: A $150 Billion Problem

AIG could hardly support its pre-bailout debt, let alone an additional $115 billion of debt and dividend-bearing preferred stock.  For AIG’s balance sheet to be healthy again, leverage needs to come down by approximately $150 billion.  It appears unlikely that this can be achieved through asset sales.  AIG needs more immediate attention, and the company’s franchise value erodes each day that a permanent fix is delayed.

The original “bailout” consisted of an $85 billion credit facility with the NY Fed, in connection with which a trust for the U.S. Treasury purchased a 79.9% equity stake in AIG for $0.5 million.  The deal has since been revised and now totals approximately $168 billion, comprised of:

  • $115 billion provided directly to AIG, including:
    • The Fed credit facility, which was reduced to $60 billion;
    • $40 billion of preferred stock; and
    • Access to the NY Fed commercial paper program, through which $15.2 billion had been borrowed as of November 5th; and
  • $52.5 billion of off-balance sheet loans, including:
    • $22.5 billion to facilitate the termination of AIG’s securities lending program, and
    • $30 billion to facilitate the termination of certain CDS contracts. 1

The analysis below shows that AIG’s balance sheet was over-leveraged before the bailout, so the additional debt and preferred stock just compounds the problem.  The leverage piled onto AIG’s balance sheet, primarily to satisfy parties to its CDS and securities lending agreements, needs to be restructured again.

Windfall for CDS Counterparties and CDO Holders

AIG’s liquidity crisis became critical when rating agencies lowered AIG’s ratings by several notches last September, which triggered collateral calls on certain CDS contracts.  If AIG did not post required collateral, counterparties to the CDS agreements could terminate them, requiring AIG to come up with the full “notional”2 amount of the CDSs.  Termination payments would have been nearly twice as large as the collateral requirements.  The Fed credit facility enabled AIG to meet its collateral calls and avoid terminations.  Through November 5th, AIG had posted or agreed to post collateral totaling $39.9 billion with respect to credit default swaps.

The problems stemmed primarily from the unique terms of a small segment of AIG’s CDS portfolio with a notional amount of $71.6 billion or 19% of the $377.3 billion total CDS portfolio as of 9/30/08.  This segment, CDS agreements written on the “super senior”3 tranches of multi-sector CDOs, is unique in that the “exposure” on these agreements is not calculated using default models.  Instead, it is based on the market value of the underlying securities.  This feature greatly magnified the volatility and mark-to-market losses for these CDSs.4

click to enlarge

click to enlarge

Prices of the underlying securities5 suddenly plummeted after the initial Fed/Treasury deal, as market spreads shot up, so something more had to be done.  With the revised Fed/Treasury deal came a plan to terminate the “super senior” CDS contracts after all, and purchase the underlying CDOs.  Of the $52.5 billion in off-balance sheet financing referenced above, $30 billion is a loan to Maiden Lane III LLC (ML III), an entity formed by the NY Fed and AIG to purchase (at market value) $64.7 billion face value of the “super senior” CDO tranches on which AIG had written CDS agreements (AIG invested $5 billion in ML III).  In connection with the purchase of the CDOs, the related CDS agreements are being terminated.6

This is a huge windfall for the holders of these CDOs,7 which go from owning extremely illiquid securities carried on their balance sheets at pennies on the dollar, to getting cashed out at or near par (through the combination of the market purchase of the CDOs and the CDS collateral and termination payments).  Prior to the initial Fed/Treasury bailout, these parties could have threatened to put AIG into bankruptcy if AIG did not post the required additional collateral, but in reality their negotiating leverage was limited.  The collateral they held was only a fraction of the amount owed to them if the CDS agreements were terminated, and their unique status in bankruptcy as parties to “financial transactions” only gave them the ability to keep the collateral they had.  Their additional claims would likely have been treated like any other prepetition unsecured claims.8 Despite their questionable seniority, they are being made whole.

There are probably some senior secured creditors of AIG that wish they got the same deal….

The $150 Billion Problem

While it is difficult to calculate precisely how much debt AIG’s operations can support, the analysis below provides an approximation.

One can get a sense of AIG’s potential normalized revenue and operating profits, and the debt that can be supported by those profits, by going back to 2006, when the performance of AIG’s Financial Products group had little impact on the business.  Below is a summary of relevant 2006 financial data.

click to enlarge

The table shows that 2006 was a banner year for AIG.  With low losses and high investment returns, earnings before interest, taxes and minority interest (EBITM) was 25% of revenue, and the company had a 15% return on adjusted equity.  Debt amounted to about 5x EBITM and interest coverage (EBITM/Interest) was about 4x.  Presumably this was the type of leverage multiple and interest coverage that was necessary to maintain its ratings.

The table below compares 2008 to 2006.  For 2008, the table shows actual results for the year-to-date ended 9/30/08, annualized YTD 2008 results, and pro forma normalized results with and without the bailout.  One can see in the third column that AIG was over-leveraged before the bailout, with debt of nearly 8x normalized EBITM.  More debt and preferred stock was the last thing AIG needed.  The bailout leaves AIG leveraged at over 13x normalized EBITM, with interest coverage of only 1.5x.  To bring its leverage and capital ratios back to 2006 levels, it appears that AIG needs to reduce its debt and preferred stock by $150 billion (the difference between what is shown in the fourth and fifth columns).

click to enlarge

click to enlarge

Asset Sales – Too Little Too Late

AIG and the architects of the bailout knew that the structure was not a permanent fix, but anticipated that sufficient assets could be sold to repay the U.S. government funding and achieve the deleveraging needed to stabilize the balance sheet.  The main assets identified for sale are the aircraft leasing business (ILFC) and the life insurance operations.  I estimate the book value of ILFC at approximately $10 billion.9 With approximately $1 billion in operating income, ILFC would probably sell for about 1x book value in a normal economic environment, but in the current environment, I would not be surprised if the number is half this amount.  I estimate the unlevered book value of the Life Insurance and Retirement Services business at roughly $135 billion.10 Given that operating income for this segment is in the range of $8-10 billion, it is hard to imagine even the most strategic buyers paying 1x book.  A more realistic figure today might be closer to $80 billion (about 1.5x revenue and a high single-digit multiple of operating income).

Whether these assets are sold in the near term, for proceeds perhaps in the range of $80-90 billion, or a few years from now for something closer to $150 billion, it will not be enough to fix AIG’s balance sheet.  While debt would be reduced, operating cash flow to service debt would be reduced as well, so the remaining business would still be over-leveraged.

One Potential Solution

AIG attempted to raise capital in the private sector, enlisting the help of Blackstone, J.P. Morgan, and Goldman Sachs.  The company spoke to private equity funds, sovereign wealth funds and other potential investors.  J.P. Morgan and Goldman tried to syndicate a $75 billion lending facility – but all of these attempts failed.  AIG summarizes this whole saga here.

Given the state of AIG’s balance sheet, the unknown (and perhaps unknowable) risks in its investment portfolio, litigation risks from disgruntled shareholders and others, and many other factors, it is likely that the private sector would have required AIG to reorganize through Chapter 11.  The company’s total obligations were just too big to be met from present or foreseeable cash flows of the business.

If it is in the best interest of the global financial system for AIG not to go through Chapter 11, then the U.S. government should help engineer an alternate way to remediate AIG’s balance sheet permanently, not just plug a short-term liquidity gap by adding even more debt and dividend-bearing preferred stock.

There are many ways in which AIG and the U.S. government could address this.  One possible approach would be:

  • The Fed or Treasury purchase AIG’s investment in ML III for $42 billion in debt reduction (the Fed and/or Treasury would then own the “super senior” CDOs at par);
  • Instead of the Fed lending $22.5 billion to Maiden Lane II to buy RMBS securities from AIG (in connection with the wind-down of AIG’s securities lending program), the Fed buy the securities from AIG for $22.5 billion in cash plus $17.5 billion of debt reduction (the Fed and/or Treasury would then own the RMBS at par);
  • The Treasury exchange its Series D Preferred Stock for a new series of convertible preferred stock that converts at a price based on the price of the common stock at some future date, and sell its Series C Preferred Stock and warrants back to AIG at cost; and
  • AIG sell (at net book value) businesses with expected net asset values of over $50 billion to an entity jointly owned by AIG and the NY Fed or Treasury in return for a cash payment to AIG of $50 billion.

The sum of these actions would reduce AIG’s net debt and dividend-bearing preferred stock by an aggregate of $150 billion; increase book equity by perhaps $30 billion; and enable the complete pay-down and termination of the Fed credit facility.  AIG would have a healthy balance sheet immediately and could refocus on building its businesses and shareholder value.  Taxpayers would ultimately be paid back through the CDO and RMBS pools, the orderly sale of business assets, and the eventual conversion and sale of the new preferred stock.

There are many other approaches one could use to achieve similar results, but one way or another, the current Fed/Treasury deals need to be restructured.

(Disclosure: The author does not own any interests in American International Group, except indirectly as a United States taxpayer.)

Footnotes:

1 Below is a more detailed summary of the revised agreements with the Fed and Treasury. For an even more complete description, please see footnote 11 to AIG’s Q3 financial statements (“Subsequent Events” – beginning on page 43).

  1. Certain AIG subsidiaries entered into a securities lending agreement with the NY Fed, through which the NY Fed provided liquidity to AIG by borrowing, and posting cash collateral for, $19.9 billion of securities.  Since then, AIG and the NY Fed have formed a special purpose entity, Maiden Lane II LLC, to buy $40 billion face amount of RMBS from AIG subsidiaries for $23.5 billion in connection with the termination of AIG’s U.S. securities lending operations.  The NY Fed will be repaid the $19.9 billion of collateral with a portion of the proceeds.
  2. The NY Fed agreed to lend up to $30 billion to a special purpose entity, Maiden Lane III LLC, formed to purchase (on market terms) the CDOs underlying most of the credit default swaps written on “super senior” multi-sector CDOs.
  3. Affiliates of AIG were given access to the NY Fed commercial paper program, through which $15.2 billion had been borrowed as of November 5th to enable AIG to pay down borrowings under the Fed credit facility to $61 billion from $77 billion.
  4. The U.S. Treasury invested $40 billion in Series D preferred stock with a 10% dividend rate.
  5. The U.S. Treasury was given warrants for 2% of AIG’s common equity.
  6. Terms of the Series C convertible preferred stock provided to the Treasury in connection with the Fed credit facility were modified so that it is convertible into 77.9% of the common shares instead of 79.9%.
  7. The Fed credit facility was reduced from $85 billion to $60 billion, and the interest rate was reduced to LIBOR plus 3%.

2The “notional amount” is the face amount of reference securities on which the credit default swap is written.
3The super senior tranche is one that is not exposed to default risk until the less senior tranches, including the AAA-rated slice just below the super senior slice, have been wiped out. As of 9/30/08, multi-sector CDOs on which AIGFP wrote protection on the super senior tranche had a gross notional amount of $108.5 billion, of which the super senior tranche was $71.6 billion, with the difference being the subordinated layers that would need to be exhausted before the super senior tranche would experience a loss. Below is a graphical representation from AIG’s Q3 10-Q:

4 Most of these agreements also require physical settlement, meaning that instead of a cash settlement equal to the difference between the notional amount of the CDS and the “exposure” on the settlement date, the agreements require AIG to deliver the full notional amount of the CDS in return for delivery of the underlying securities.
5 The multi-sector CDOs were comprised of prime RMBS (11.3%), Alt-A RMBS (15.8%), subprime RMBS (37.1%), CMBS (21.5%), CDOs (9.4%), and other (4.9%) [Note: CDO percentage corrected 1-6-09].
6 As of November 25th, $46.1 billion of CDOs had been purchased and a corresponding notional amount of CDS agreements terminated, with the remaining $18.6 billion in process (See Form 8-K for more details).
7These CDO/CDS holders include Société Générale, Goldman Sachs, Deutsche Bank, Crédit Agricole, and Merrill Lynch (Source: WSJ).
8 Changes to the Bankruptcy Code in 2005 and 2006 expanded the rights of CDS counterparties in a bankruptcy, but the main effect was to enable these parties to enforce termination provisions and collect collateral. Any claims not satisfied by the collateral are still treated as prepetition claims (11 U.S.C. § 502(g)(2)).
9 $45 billion of identifiable assets as of 9/30/08 less $35 billion of ILFC debt leaves $10 billion of net assets. There are probably other operating liabilities of ILFC, so the actual book value is likely to be lower.
10 Identifiable assets of $615 billion as of 12/31/07 per 10-K, less $30 billion change in invested assets as of 9/30/08, less $450 billion reserves, contract deposits, DAC/VOBA & SIA leaves $135 billion of net assets excluding debt.  As with ILFC, the actual book value is likely to be lower.

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.
www.aptacapital.com John Appel