I am back. So is SGH, page-360

Please feel free to point out any of my assumptions that you believe are incorrect. That's why I post them. They are up for discussion.

While you're at it, you may like to discuss how you have arrived at your $800M revenue and 15% margin figures you keep using as myself and several other posters have already pointed out that these are very heroic to the point they would appear to be unattainable. You have been asked multiple times and keep avoiding the question.

For reference - here is Grant's analysis based on SGH's figures and trying to make it work with your $800M revenue figure: https://hotcopper.com.au/posts/23916264/single - closest he can get is 10% margin - and that's assuming some lawyers are working for free and cost-of-sales remains flat!

I am not interested in talking down SGH. I am simply trying to keep the discussion grounded in reality. It's an investment forum. When you post fanciful projections and don't justify your assumptions you invite responses. Nobody has responded to any of my posts to point out incorrect facts, unjustifiable assumptions or unreasonable conclusions. They may find them uncomfortable, or not necessarily like or agree with them - however no-one has so far pointed out where they are wrong.

Now I know you would prefer that we all sat around waiting for the "experts" to come up with the answer for us... but while we wait I believe it is a worthwhile exercise to try to come up with our own reasonable model for what they may be thinking...

Here are my calculations and I again invite comment and discussion from anyone who is interested in improving this model...

When I say "Anchorage" here - it is shorthand for "all senior lenders" - i.e. the debt-holders.

Anchorage are owed $738M + $72M = $810M.

The $72M is likely split as $32M added to “old” debt (at existing 5% rate) and $40M as a new loan likely done at a more commercial rate (e.g. 8%) to reflect greater risk.

Anchorage acquired this debt for around $240M (~$200M they paid initially, plus $40M in fresh working capital. They also capitalised $32M in interest payments they should have otherwise received - adding this to the original $738M owing).

SGH is a valuable company (as you like to keep reminding us) - so one option for the senior lender to recover their investment with a return is to push the company into receivership and convert this asset value into cash.

OPTION 1. RECEIVERSHIP
In a receivership scenario, as senior lender Anchorage rank ahead of pretty much everything except statutory employee entitlements. They can push to recover all receivables owing and rank ahead of trade creditors (Payables). They can sell assets and keep the proceeds until the full face value of their debt is extinguished. Then, trade creditors (a.k.a. Payables) would collect what they could (at cents on the dollar) from remaining asset sales. Current Shareholders under this scenario would receive zero. There would be nothing left.

In this scenario - Anchorage receive back the full amount of their $810M debt - an impressive 330% return on their investment.

This is important to know as for any other scenario to be considered, it must produce a greater return than this.

Now - SGH board claim that Anchorage are committed to a turnaround - by putting the company back on a solvent footing through some debt-for-equity arrangement - so let’s assume that they do NOT go with OPTION 1 for now.

How will Debt For Equity work?

There have been several posts here where people seem to lack understanding / experience of how debt-for-equity works, and are working on assumptions that lenders will take into account things like acquiring the debt for less than face value (doesn’t mean they will share any discount with you), significantly improved revenue coming from previously poorly performing sections of the business (NIHL) and/or windfall moneys from future cases that are yet to be litigated (Watchstone / VW / Manus Island / etc.), or will be using a discounted cash flow based on heroic assumptions for future revenue and margin (looking at your here SWC).

Unfortunately, none of these will markedly affect the outcome of the debt-for-equity negotiations.

Here’s why...

Whilst a discounted cash flow analysis based on REASONABLE assumptions for future revenue and margin will form the basis for calculating a potential valuation for the company (and mostly to convince the lenders that there IS a viable business worth saving), and future windfall money may be considered in this, with some (considerable!) level of discounting applied for risk - the lenders will in reality be performing a far simpler calculation.

For lenders, it is about keeping their risk low and maximising their returns.

So let’s look at the options available to the lenders… remembering that receivership still remains on the table at this point.

NOTE: To keep the maths simple here - I will treat debt as $800M @ 5% - so $40M interest payable per year. It's actually a little higher, but that's immaterial at this point.

OPTION 2. KEEP THE DEBT - COLLECT INTEREST AND PRINCIPAL REPAYMENTS
Lenders have the option of converting ZERO debt, simply letting the business run and collecting $40M per year in interest - plus eventually repayment of the $800M in principal they are owed. A very good return on their $240M investment!

Of course, this option is unviable for SGH - the business simply does not generate enough profits or cashflow to service the interest on their debt (hence the recent capitalisation of $32M in interest due) - let alone make any sort of repayment towards principal.

To keep the business going, SGH and Anchorage need to reduce debt.

Which leads us to…

OPTION 3. DEBT FOR EQUITY
Here, lenders will exchange some or all of the debt for equity in the company.

The only reason Anchorage will do this, is if they are convinced that they can make MORE money through holding equity (dividends + capital growth) than they will through debt (interest and principal repayments).

Any debt for equity swap needs to take into account the additional risk that the lenders are taking on - as they sacrifice a top-ranked senior debt holder position (no risk) for bottom ranked equity holder position (maximum risk).

It is likely that the lenders won’t convert ALL of the debt - they will retain enough to protect their position as top-ranked creditors to at least recover their investment with some return. So probably the MAXIMUM debt they would convert would be $500M - retaining $300M. More likely they will convert a lower amount - around $200M to $300M, so they retain a certainty of getting back $500M in any receivership outcome that may still eventuate in future (i.e. if turnaround fails).

Remember - Anchorage aren’t interested in running a law firm. They are interested in maximising return on (and protecting) their investment.

So - let’s say that Anchorage decide to swap $300M of debt for equity.

They are giving up $15M p.a. in interest payments and $300M in future principal repayments. So they will want a better return on this investment than the 5% (more likely 8%) that they could get by simply keeping the debt. PLUS, they are sacrificing $300M in senior ranked debt - so they need an increased return to justify the risk they are taking.

The best way for them to maximise their return is to push for debt for equity to be done at the lowest possible share price.

SGH and the board will of course be painting rosy projections of future revenue and margins and suggesting a “true” value in the $1B+ range.

Anchorage need only point to the current market valuation (~$50M) to mount a convincing argument that the company as it currently stands is not worth anywhere near that today - plus they are the ones taking on the risk - they need to be the ones getting the reward.

This is why any deal is going to be done far closer to today’s price than any future projected value of $X per share.

Remember - Anchorage can push for receivership and collect the full $800M today. If they give up $300M in D4E, they need to be sure they will collect MORE than $300M in future to justify the risk.

If they work through from company's current financials and reduce debt to $500M @5%, finance costs drop from $40M to $25M. If revenue can be improved to $800M (which will take a couple of years from current levels), and margins can hit 10% (which would be a very good result for them) - then the company would be generating $80M in normalised profit. (At 15% margin, it would be $120M - but this is demonstrably unachievable).

Let’s say that to compensate for the risk they take on in giving up their $15M in guaranteed interest payments through swapping their debt, Anchorage are looking for a 5x better rate of return (conservatively). They would be looking to “own” a $75M share of that profit.

To collect $75M of an $80M profit, they need to own 93.75% of the company (75M/80M = 93.75%).

To own 93.75% of the company, they would need to increase shares on issue from 375M to 5.55B - an additional 5,180M shares.

This suggests debt for equity would be done at a share price of $0.058 ($300M debt divided into 5180M shares).

In a more (very!) optimistic scenario, Anchorage may only look for 3x return on the risked portion of their debt - so would want to “collect" $45M of that $80M profit - or 56.25%.

To do this, they would need to increase shares on issue from 375M to 857M - an additional 482M shares.

This very optimistic scenario would suggest debt for equity being done at $0.62 - nearly 5x current market price - and this alone makes this an extremely unlikely scenario.

And remember - this is based on increased revenues and margins that only occur after a couple of years. So - Anchorage would be far more likely looking for a higher rate of return than just 3x to compensate for the increased risk and time factor. But even at just a 3x expected return - if it takes just two years to hit those revenue and margin numbers, they would need to collect 6x to meet their expected rate of return over time - for which they would need to own more than 100% of the company!

@Successwillcome, if you think Anchorage would be happy to swap debt for equity as though both carry equal risk, then you are free to perform your own calculations as to what that might mean in terms of mythical SP. Just remember that performing the calculation doesn't make it real.

Now - after considering all of this, the far more realistic and least risky (for Anchorage) scenario, is that Anchorage works from CURRENT financials.

In this scenario - i.e. reality - the company is making $680M revenue (not $800M) and negative margins (not +15%) - so NO profit. The shares are quite literally worth nothing (zero SH equity and no return). Even if they remove all of the interest payments, the company is still not making profit.

Short version - current shareholders money is gone thanks to board and management of SGH.

To achieve any future returns depends entirely on Anchorage putting up their money. They put up the money, they take the risk - means they get the reward. That is how investing works.
Now - Anchorage probably can turn this around with some fairly ruthless cost-cutting and efficiency improvements - and possibly selling off some assets. But they are going to want/need to pretty much take full ownership of the company in order to hit anything approaching an acceptable rate of return for taking on this level of risk. And given the current situation, it is highly unlikely this would be done on terms favourable to current shareholders.


OPTION 4. MORE FANCY DEBT-FOR-EQUITY (e.g. WARRANTS etc.)
Any more fancy method of exchanging or amortising debt, or pushing around repayments etc. will be considered against the very simple question:
Does doing X (e.g. taking a 3-year warrant to buy shares at a 20% discount to a future share price) deliver a BETTER return to Anchorage than any of the other options above?
If the answer if no - then why would they do this?


Further reading / research:
For anyone interested in how debt-for-equity firms typically carry out their modelling:
http://buysidefocus.com/value-distressed-debt-practical-guide/

It’s US-focused, but the fundamental concepts are the same.

Note that they do reference in this article how they come up with a risk-weighted valuation for a company based on best ("top dollar"), baseline and worst-case scenarios, which is I realise something that SuccessWillCome has previously categorically stated is NOT how company valuations are arrived at - however I invite you to consider that he/she may perhaps not have a full handle on how all this works and may in this instance be wrong.

This book is also a good overview on Debt-for-Equity swaps:

Little expensive for a kindle book at USD$125 - arguably a far better investment than an extra 1269 SGH shares.


Again - happy to be have any of my assumptions or conclusions challenged here.



Steve