Wednesday, April 1, 2009

The 3-to-1 GM Digital Option

At this point nobody doubts what the final outcome for GM will be, the only question is how the company will get there, or specifically whether it will occur in court via a prepackaged bankruptcy, or out of court, through a debt-for-equity exchange, and as Obama's flip flopping on the matter over the past 3 days has demonstrated, there is a lot of political capital resting on either outcome. Another question is why did Obama limit the new extension to 60 days. The answer to the second question also presents an alternative way to play the possible outcome to the first, via a potentially lucrative trade.

GM has $1 billion in 1.5% Series D contingent convertible debentures that mature June 1 (some pretty extensive discussion of this issue in the company's 10-K risk factors section), just inside of the 60 day grace period Obama granted GM on March 31. The notes which last traded in the 40s present two possible payoff scenarios depending on what the ultimate outcome for GM ends up being along the two presented alternatives. What are the target prices:

- In a prepack scenario, the converts will be treated pari with all unsecured debt, and projected recoveries on the unsecured class range from 10 to 20 cents on the dollar. Therefore there is a 50% downside in case the company ends up, contrary to Obama's wishes, in court with a lengthy bankruptcy and potential liquidation as a consequence.

- In a debt-to-equity, or distressed exchange, GM will likely pursue preferential treatment to the nearest maturing class of debt, likely to buy itself even more time beyond the 60 day "grace" period. This is because GM will be unable to get another grace extension from Obama, despite his desires, without contractually entering bankruptcy due to the probable breach of the maturity date. In such an outcome, the Series D will likely be given notably preferential terms to induce their participation, possibly up to par, which may consist of cash or cash and stock. The upside would imply over 100% return within 2 months.

Based on a price in the 40s, and assuming these are the realistic outcomes, the market is projecting roughly 3-to-1 odds of an in court bankruptcy. However, sticklers who believe Obama will do anything he can not to antagonize his core constituency by throwing the company to the lions, or in this case the bankruptcy judge, this risking outright liquidation, could take a stake in the converts. Either way, to silence critics who say GM will get another 60 day extension, and then another, the Series D maturity presents a final deadline by which things have to be made clear for GM: it will be impossible to keep the company out of bankruptcy post June 1 without reneging on the convert indenture (thus the need to pay them off).


The convert closed today at 25, meaning the option now presents a 15-to-1 upside/downside assuming a 20 cent recovery value on the unsecured pool. Alternatively, the unsecured recovery could be assumed to be a conservative 10 cent, which still implies a juicy 5 x 1. Nonetheless, the probability of a bankruptcy based on the two scenarios is either 94% or 83%, respectively. Caveat emptor. Sphere: Related Content
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In Debt We Trust said...

So in the end GM faces massive equity dilution and a slow downward drift to the pink sheets?

Matthew said...

Depending on what you mean by slow....I'm gonna go out on a limb here....

Yes and no.

Anonymous said...

If Obama wants GM to produce fuel-efficient cars, why is he allowing them to save Cadillac which isn't exactly known for being fuel-efficient.