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Friday, June 10, 2011

Capital Structure Arbitrage Trade Idea

Came across an interesting capital structure arbitrage trade idea and thought I would share it with the group. If anyone has any feedback, feel free to leave a comment:

The opportunity consists of two capital/arbitrage trades within the Claire’s capital structure:
1. Long Sr Notes due 2015 – Short Sr Subordinated Notes due 2017; and
2. Long Sr Notes due 2015 – Short Second Lien Notes due 2019.

There are a number of headwinds facing retailers entering the second half of 2011. These include:
1. Higher commodity (input) costs;
2. Higher labor costs in China; and
3. Depressed discretionary consumer spending due to higher gas and other

Weaker retail credits should show greater volatility than stronger credits. Furthermore, logically one would expect the mid-to lower end to be more volatile than the luxury area. Claire’s is highly leveraged retailer of fashion accessories and jewelry to tweeners and teenagers. Claire's debt stack can be seen below:

In 2007 Claire's was LBO'd by Apollo for $3.1 billion. Most of the Claire’s products are discretionary in nature. Claire's merchandise inventory to debt ratio is among the lowest in the high yield retail universe. Sales and operating performance would likely underperform in a more difficult economy. Moreover, most of Claire's merchandise comes from Asia – primarily from China. Given that it is one of the most highly leveraged retailers, one would expect the note prices to come under pressure in the event of a downturn in either the high yield market or in operating performance.

Long Sr Notes due 2015 – Short Sr Subordinated Notes due 2017 The Sr Notes are the first notes in the capital structure that mature. The company has been using some of its free cash flow to purchase its Sr Notes in the open market. In the past, the company has also purchased some of its Sr Subordinated Notes in the open market as well. However, the company has nearly exhausted its ability to do so, as only $6.0 million of availability remains under its restrictive payment basket.

For nearly an even dollar, an investor can go long Claire’s Sr Notes and short its Sr Subordinated Notes. The Sr Notes are 1 turn less leveraged, and mature two years before the Sr Subordinated Notes. Some Wall Street analysts believe that the Sr Notes will be supported by continued open market purchases by management. In addition, the notes could be refinanced with proceeds from a new bank loan facility, second lien notes or other sr notes. So suffice it to say the senior notes have some interesting aspects to them that the junior lack.

Long Sr Notes due 2015 – Short Second Lien Notes due 2019. The YTW for this trade is about the same, given the shorter duration of the Sr Notes, the STW is 120 bps greater.

Moreover, Claire’s may increase its bank loan or issue an add-on to its 2nd Liens in order to refinance its Sr Notes. Given the limited hard assets associated with Claire’s and the substantial amount of debt ahead of the 2nd Lien Notes, the security attached to the 2nd Lien Notes probably won't be that valuable in a distressed situation.

The chart below shows the liquidation stack:

I think this trade has potential merit. I am a believer in the thesis of potential threats from a slowing economy and it is clear that the junior more levered pieces is definitely more subject to volatility. I think this does a good job of getting the lure in the water - if interested the next step is to truly understand the cash flow nature of the business in order to ensure that your senior is truly worth something in a potential distressed scenario (which given the leverage ratios present may not be all that unlikely).

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