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When it comes to foam manufacturing, DE Shaw is hoping that two wrongs can make a right.
The mega-fund wants to combine its troubled portfolio company, Foamex, with pillow and mattress maker Sleep Innovations (SI), but it needs to convince SI’s lenders that a tie-up is worth their while, several sources close to both companies told Debtwire. That’s because SI missed an interest payment on its loans in June and is currently in workout talks with a steering committee of lenders led by JPMorgan.
Foamex and SI’s dire financial straights trace back to the same macroeconomic trends squeezing many manufacturers; feeble consumer spending and volatile commodity prices. A combination could help the two companies weather the storm but the very different management styles of their primary stakeholders – DE Shaw and JPMorgan – stand in the way, said two of the sources.
DE Shaw’s offer would require Sleep Innovation’s loan holders to swap into unsecured debt below Foamex’s USD 400m of existing bank loans. The deal is unorthodox since most bank lenders look for cash payouts in restructurings, or, at the very least, re-instatement into new secured loans.
So far, the banks and CLOs that own SI’s secured debt aren’t biting, the sources said. An official at Capstone Advisory who is advising a steering committee of SI lenders declined to comment. Neither the banker covering SI for JPMorgan nor a spokesperson for the bank returned requests for comment.
“It’s the classic bank group mentality,” said one of the sources close to Foamex, claiming that a hedge fund would more quickly consolidate a position and forge a consensus among lenders. “Nobody knows what to do so they’re not doing anything. But without a sale [to Foamex], SI will liquidate.”
One SI lender outside the steering committee sees things a bit differently. “There’s no reason to exchange one piece of junk for another,” said the lender. “Why would I want [Foamex] junior debt when the first lien is trading at 80?”
Standard & Poor’s slashed Foamex’s credit rating to CCC+ yesterday, citing operational difficulties and the increased likelihood of a covenant breach.
The Linwood, Pennsylvania-based company’s debt didn’t always trade at a discount. Foamex makes foam for use in mattresses, auto interiors and specialty products like printer cartridges. Like most low margin commodity manufacturers, Foamex reaches the peak of its earnings cycle when it is operating at maximum capacity.
DE Shaw hit a home run in 2006 when it bought into Foamex’s stock and bonds just as the company entered the sweet spot in its market cycle. Even though the company was in bankruptcy, its shares ran from USD 0.60 to USD 23.00 that year while its bonds peaked at close to 120% of face value.
The New York-based fund gave that entire windfall back in 2007 when Foamex’s shares nosedived to USD 3.00 from USD 14.00, hammering its 20% stake in the company, the source said. The stock dipped below USD 1.00 this year as the macro environment worsened. Rather than backing away from the situation, DE Shaw doubled down.
The fund teamed up with several other legacy shareholders from the bankruptcy – Goldman Sachs, Sigma Capital and Chilton – to buy back USD 120m of second lien loans in April that they then swapped into common shares. Not only did the transaction slash leverage, it cut Foamex’s annual interest expense by over USD 10m.
DE Shaw bought USD 92m of the second liens itself at roughly 80% of face value and swapped them for new stock, according to SEC filings and one of the sources. The fund ponied up another USD 10m equity injection to keep the company from breaching first lien loan covenants, boosting its total stake to 78%.
Foamex missed performance requirements in its credit agreement by a mile in 2Q08, when EBITDA fell to USD 10.8m from USD 28.2m in the same quarter last year. In comparison, Foamex generated USD 42m of EBITDA in 2Q06 – USD 17m in March alone – when consumer spending was still robust and oil traded well below current levels.
Macroeconomics hit the business with a double-whammy starting in the summer of 2007 as declining home sales and weaker consumer spending sapped demand for its core end markets. Adding insult to injury, SI, formerly one of Foamex’s largest customers, bought its own foam manufacturing facility in early 2007. The two companies began arguing over their supply contract shortly thereafter, a dispute that escalated into litigation until the two sides settled in December and parted ways.
SI’s decision to bring production in-house didn’t exactly yield the desired results. Prices of the raw material feed stocks for foam skyrocketed this year but SI’s two largest customers – Costco and Sam’s Club – pushed back when the company tried to pass the price hikes up the supply chain, said two of the sources.
The company breached financial covenants in 1Q, recalled 120,000 pillows with metal fragments in 2Q, fell behind on debt payments in 3Q. It is now in restructuring talks with its lenders.
SI’s sponsor, Catterton Partners, and its steering committee of lenders hired Carl Marks Advisory for turnaround advice and Rothschild to sniff out any white knight buyers. Carl Marks’ mandate remains in place but Rothschild’s engagement expired after it failed to find any interested parties, said a source close to the matter.
Enter DE Shaw. After pouring close to USD 100m into Foamex and cleaning up its balance sheet, the hedge fund believes it has gotten the company barely cash flow positive. All the foam maker needs to cover in fixed costs is USD 33m of interest on the first lien and USD 10m - USD 15m of maintenance capital expenditure, said two of the sources.
Nevertheless, Foamex’s top line could continue to erode unless consumers start buying homes and big-ticket items, like mattresses, again. The common stock trades around USD 0.40 and DE Shaw’s stake is in the red on paper. Given that neither property markets nor consumer spending are expected to rebound until the back half of 2009 at the earliest, recapturing SI’s lost supply contracts could make a real difference.
DE Shaw’s proposal to JPMorgan and its co-lenders fell significantly short of the white knight bid they’d been looking for. The fund approached SI’s lenders in early July and sent them a formal offer shortly thereafter, said one of the sources. The two sides briefly discussed terms of a negotiation process but failed to reach an agreement, he added.
The steering committee subsequently engaged Alvarez & Marsal to pick up where Rothschild left off and launch an auction process for the company, said another of the sources. Attracting buyers at anything other than liquidation prices will be difficult, all the sources said.
Quotes on SI’s secured bank debt bear that out, as its USD 225m Libor+ 350bps first lien is offered in the low to mid 20s and bids for its USD 50m Libor+ 800bps second lien are below 10, according to Markit Loans. Those indicative levels imply an enterprise value in the USD 50m - USD 60m range should the company restructure on a standalone basis.
But a tie up with Foamex could yield USD 50m of synergies from the closure of SI’s foam facilities and corporate offices as well from improved pricing power and economies of scale, said one of the sources close to Foamex. What’s more two of the companies’ plants stand literally across the street from each other, cutting down drastically on transport costs, the source said.
“They are close to each other geographically and that part of a [merger] makes sense,” said a source close to SI. “There’s also a lot of capacity in the industry and a deal would address that.” But, he added, “Foamex has issues of its own.”
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