The Great Atlantic and Pacific Tea Company Part 2

See Part 1 first.

Capital Structure Arbitrage

In the 10-Q from July 29th, 2010,

http://www.sec.gov/Archives/edgar/data/43300/000004330010000037/0000043300-10-000037-index.htm

we see the following indebtedness table. The $150mm converts maturing in June 2011 presented a major liquidity challenge and a potential bankruptcy catalyst. They couldn’t just pay it off with the bank facility (I think), their main liquidity source.

5.125% Convertible Senior Notes, due June 15, 2011                                    $   157,677       $   155,333
Related Party Promissory Note, due August 18, 2011                                         10,000            10,000
9.125% Senior Notes, due December 15, 2011                                                 12,840            12,840
6.750% Convertible Senior Notes, due December 15, 2012                                    226,741           223,838
11.375% Senior Secured Notes, due August 4, 2015                                          253,928           253,668
9.375% Notes, due August 1, 2039                                                          200,000           200,000
Borrowings under Credit Agreement                                                         132,900           132,900
Other                                                                                       2,702             1,971
                                                                                      -----------       -----------

Now I wondered if there was cap structure mispricing. First, I was intrigued by the 9.375% Notes. They were an unusual instrument called QUIBS, securitized quarterly interest bonds traded under “GAJ” on the NYSE.

Looking up the prices, I saw that the 6.75% Dec 2012 Senior Converts were trading around $56 (56% of par) and that GAJ was trading around $18. 18?! I was excited by how cheap that was until discovering that the notional was $25, or 72% of par.

Structuring The Trade

The mispricing was not immediately clear to me. There were other securities to examine, and yield and cap structure positions to compare. Eventually, I worked out the trade: long the Senior Converts while shorting an equal notional amount of GAJ. You’d short 40 shares ($1000 notional) of GAJ, getting $720 in cash, while longing 1 Senior Convert ($1000 notional) and paying $560 in cash .

GAJ current yield was around 9.375/72 = 13% while Senior Converts current yield was around 6.75/56 = 12%, so you’d be paying north of 1% of N each year to put on this trade (quarterly vs. semi-ann). But if they had the same seniority, one of two things could happen.

  • GAP would somehow turn around and pay off the Senior Converts in Dec 2012 at 100. I would expect GAJ to rally to slightly north of $25, but not exceed 100% of par by much. Thus, you make the substantial 16% (=72-56) of N spread by Dec 2012, carrying the -1% of N until then.
  • GAP would go bankrupt sooner, the securities would be forced DOWN, and you’d make the 16% (=72-56) of N spread, carrying the -1% of N until then.

Basically, other than the carry and the Senior Convert conversion option (both negligible), we had the same security trading at 56% of par and 72%. They would be forced to meet in price either in bankruptcy (perhaps around 0?) or in solvency (near 100) in two years.

Considerations and Disappointment

I couldn’t believe such clean arbitrage existed, so I had to verify that GAJ and the Senior Converts were indeed pari passu. This meant diving into the original bond prospectuses. They were hard to understand, so I wasn’t fully confident, but it was clear enough to send an e-mail to my fund PM.

I wish the story had an ending where the PM put the trade on in size, but I was ignored. I was headed home anyway the next week anyway, so I didn’t have time to keep pestering. But I realized that GAJ, because it was securitized, could be shorted by retail brokers at no borrowing cost (besides the quarterly interest).

Executing the Trade

I put on the following series of trades for my personal account:

Symbol Shares Price Action Date
GAJ -200 17.9 Sell 8/12/2010
GAJ 200 13.5 Buy 8/20/2010
CB4AK9 5000 57.75 Buy 9/27/2010
GAJ -200 18.4 Sell 9/27/2010
GAJ -400 20.25 Sell 10/6/2010
GAJ 40 19.46 Buy 10/13/2010
GAJ 100 17 Buy 11/16/2010
GAJ 60 17 Buy 11/16/2010
GAJTQ 400 3.5 Buy 12/13/2010
CB4AK9 -5000 27.125 Sell 12/13/2010

In August, I shorted 200 sh GAJ (without longing the Senior Converts) to play my bankruptcy idea. I was lucky to cover at $13.5 because it came roaring back up in September, as GAP sold off a few stores and people responded to the extra liquidity enthusiastically.

In September, I put on the arbitrage trade, longing $5000 notional of the Senior Converts (CB4AK9) while shorting 200 shares (also $5000 notional) GAJ. As GAJ continued to climb into October, I put on a pure short of  400 shares of GAJ at $20.25/sh. At this point, I had serious doubts about my research and the trade, but luckily school and job-hunting distracted me from doing anything rash. Over November, the stock came back down, and I covered 200 sh of the pure short.

As you might guess, GAP announced bankruptcy on December 12, 2010. Notice that I covered GAJ at $3.5/sh or 14% of par, while I sold the Senior Converts at 27% of par! Ironically, the spread had swung the other way – GAJ was now underpriced relative to the Senior Converts. And of course, my 200 sh pure short of GAJ was still on and probably made the most money of all.

Advertisements

2 thoughts on “The Great Atlantic and Pacific Tea Company Part 2

  1. About Great Atlantic & Pacific
    Very nice analisis, so what you think are you Bullish on GAPTQ and GAJTQ? Im holding both for a possible merger or adquisition.

    1. Hi Federico,

      This post is mainly to review an opportunity that existed half a year to a year ago in GAJ and the Senior Converts. I haven’t followed Great Atlantic and Pacific since then and don’t have any holdings in it, so I can’t advise. My impression is that GAJ might be okay, but holding equity during a bankruptcy (i.e., GAP) is usually bad news.

      -Hank

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s