Description

I recommend the purchase of Associated Material’s (“SIDE”) 9.125% Senior Notes ($830MM), which I believe presents a compelling risk / reward proposition + a near-term event / maturity date is less than 18-mths away, with a realistic 6-mth return profile of ~30%.  SIDE is a $1.2Bln revenue building products manufacturer largely focused on windows and vinyl siding with 11 manufacturing facilities.  ~75% of sales goes through its own 122 company-owned supply centers and the remaining ~25% goes through 260 independent dealers.  The unit economics of SIDE’s biz very much mimic PGEM (written up multiple times in the past) but for the fact that SIDE also captures downstream margins with its own distribution ntwk – accordingly, I believe a “normalized” margin profile for SIDE should be north of PGEM but have conservatively assumed ~11.5% EBITDA-capex margin in the out years.  70% of biz is R&R and ~30% new construction.  SIDE was purchased by Hellman & Friedman in 2010 for ~$1.3Bln with >$500MM of equity poured into the buyout.  6-years later given some operational hic-cups that are being fixed (1-yr+ of evidence supporting a healthy turnaround), the “creation value” of SIDE through the 9.125% note is less than $850MM or -35% discount to the buyout purchase price.  More importantly, the maturity date for the security is November 2017 and given improved trends in the business with a pathway to >$130MM in EBITDA in 2016E (and less than $12MM of capex), a refinancing is highly likely in the next 6 to 12-months providing a ~30% return profile.  Over the longer-term, I view $175MM+ as a realistic “normalized” EBITDA figure and >$160MM of EBITDA-capex equating to a ~5 – 5.5x EBITDA-capex multiple at the current ~90 price.

SIDE is in the middle-stages of a turnaround and the 9.125% security offers an attractive current yield of ~10% in a very defensive / covenant-light capital structure with adequate liquidity and a highly supportive private equity sponsor (recently liquidity loan provided by H&F in February 2016 is a material signal and highlights their views that the equity is in-the-$).  As highlighted below, SIDE has a unique capital structure as it’s effectively a single security: $830MM 9.125% is leveraged from less than 1x EBITDA - capex through 7x EBITDA-capex using my 2016 estimate.  I view EBITDA-capex as the proper unleveraged FCF valuation proxy given capital-light biz model.  Additionally, creating SIDE for less than 0.7x sales (a -30% discount multiple relative to PGEM, its closest peer).  I believe a 6-mth to 1-year refinancing of the Snr Notes is highly likely (esp given recent momentum in the biz turnaround) providing a ~30% return profile.  In the scenario of a bankruptcy filing, I believe the upside is even greater and think a “normalized value” for the biz is at least in-line with what H&F paid 6-years ago ($1.3Bln versus current $850MM creation value). 

Investment merits:

1.      Collecting a ~10% CY, >20% yield-to-1yr par, and >17% YTM (November 2017); an attractive return profile for a business that benefits from US housing recovery

a.      Downside to the trade is ~20% assuming the sponsor refinances the security by mid-2017.  I view this as a ~80%+ probability

b.      Upside is that the sponsor walks away from the biz (highly unlikely) and the 9.125% gain control of the business.  Assuming a conservative approach, I get to a FV that is >60% (~30% IRR) assuming a 2-yr hold.  I view this as a <20% probability

2.      SIDE’s creation value is effectively a -35% discount to the purchase price that Hellman & Friedman paid 6-years ago

3.      Hellman & Friedman committed to the investment as witnessed via the recent “sponsor loan” of $27.5MM contributed in February 2016.  Currently,  H&F is >$450MM out-of-the-$ ($850MM creation value through bonds versus $1.3Bln purchase price)

4.      Greater evidence of SIDE “turning” around its operations post the installment of a new management team – EBITDA has improved from its 2014 lows of ~$60MM to current LTM Q1 2016 of $101MM and my expectation is for 2016E EBITDA of $130 - $140MM

5.      Mgmt will ultimately provide greater clarity on a normalized runway to >$175MM EBITDA (assumes ~5% top-line growth and ~12.5% EBITDA margins or ~11.5% EBITDA-capex) in the out years

6.      Valuation is attractive: through the 9.125% Snr Note, creating for less than 10x EBITDA – capex on LTM Q1 2016 results and less than 7x EBITDA – capex on 2016E estimate.  Given asset-light business model, EBITDA-capex (unleveraged FCF) is the appropriate metric to focus on IMO

a.      PGEM in comparison trades at ~10x EBITDA-capex on 2016E figures

7.       Trigger date in less than 14-months where Hellman & Friedman needs to put up or shut up (maturity date for the ABL springs forward in August 2017)

Risk / reward profile:

Base case: 6-mth refinancing = >30% return profile (~50% probability)

Upside case: H&F passes along the keys and the 9.125% holders own the equity.  Using conservative assumptions, I get to a very realistic >30% 2-yr IRR (>60% all-in return profile)

Downside case: 12-mth refinancing = >20% return profile (~30% probability) … in the scenario where the biz turnaround fails (unlikely), housing tailwinds turn into headwinds (unlikely in the n-term) and H&F walks away from the biz, there could be mark-to-mkt pressure on the bonds but would view this as an attractive opportunity to increase the position

Catalyst

Refinancing of the notes in the next 6 - 12 months on the back of improved results 

Mgmt to provide clarity on a pathway to >$175MM in EBITDA in 18E