APP keeps investors hanging on

The US SEC may not have even begun reviewing Asia Pulp & Paper''s (APP) critical debt exchange, which is highly unlikely to go ahead this year, if at all.

The SEC filing of a global exchange and consent offering for $1.938 billion of debt took place on September 18. As a frequent borrower, APP felt confident that the review process would be as straightforward as it had been in the past. Keen to stem rampant speculation about its financial predicament, the company also opted for a public, rather than confidential, filing in the hope that bringing news about the transaction into the open would lead to a bounce in its bond prices.

The company and its three lead managers - JP Morgan, Credit Suisse First Boston and Goldman Sachs - fully expected an effective date for the deal within two weeks. Two months later and with no roadshows in sight this side of Christmas, investors have become increasingly nervous about the fate of what is regarded as a make-or-break deal for the world's largest emerging markets borrower.

"A problem has been identified and a solution put forward, but not put through," one observer notes. "Investors are naturally left wondering what's going on and by association, what the hell's going wrong?"

In its wisdom, the SEC follows a policy of never publicly commenting on transactions under review and likewise does not allow lead managers, or the company in question, to comment either. In APP's case this policy has caused such mass uncertainty and confusion that its outstanding securities have plummeted even further into distressed territory. As of last Friday, for example, the company's New York-listed shares were trading at only $1 and its debt averaging 30 to 40 cents on the dollar.

Why APP China has caused the delay

However, it is believed that the commission may not have even begun examining the exchange offering in detail because of problems relating to a transaction earlier in the year for APP China, which has not yet been made effective either. In early March, Morgan Stanley Dean Witter brought a $403 million high yield deal for the group's Chinese operations and structured it as a registered rights offering. 

Because it did not need an immediate SEC review, the structure enabled the company to come to the public debt markets under an accelerated time frame. Its lawyers then had a standard six months to complete the registration process, else find the company subject to a penalty fine of 0.5%.

In itself, what equates to a $2.015 million payment to investors for failing to complete the process by September is but a small drop in the ocean that comprises APP's debt servicing costs. What will rank as of greater importance is the reason why the company has failed to clear up what is said to be a minor accounting issue. 

Observers report that a large number of faxes have been passing to and from the SEC relating to the capital treatment of a roughly $2.5 million foreign exchange loss in APP China's financial statements. At the heart of the issue is the fact that while the loss is treated properly under the IAS standards employed by APP China on an unconsolidated basis, it does not fit within US GAAP standards the US SEC is used to dealing with.

That both sides have given every indication of digging their heels in and letting a minor technicality hold up one of the most critically important transactions for Asian financial markets, baffles many onlookers. Some report that APP CFO Hendrik Tee seems perfectly content to allow the accounting discussion to roll on to its natural conclusion.

Others say that although the accounting issue concerns a relatively minor bureaucratic point, correcting it would have wasted valuable time. "The question Hendrik Tee faced was whether he should try and fight it out with the SEC in the hope of resolving the issue in his favour quickly, or caving in and holding the exchange offering up while it was sorted out," says one market commentator. "Obviously the net result is that it has been delayed anyway and now it's too late to launch the deal this year, because it needs to be held open for 20 days and the momentum would be lost so close to Christmas."

One of the company's largest bondholders, requesting anonymity, has a slightly different spin. "It's completely ludicrous and if it's the case that the company is refusing to budge on such a minor issue, then it signals to me that APP is not serious about getting this exchange offering done at all. It's quite extraordinary behaviour and extremely surprising when you consider just how distressed the company's bonds and equity now are."

The US-based account holder adds, "One logical explanation is that the exchange has become less meaningful to the company because it is able to secure an injection of funds from elsewhere. Selling a strategic stake in APP China would make sense under this scenario. I estimate that a 49% holding in the company would be worth about $1.5 billion to $2 billion."

An even less charitable explanation harks back to APP's self-confident belief in its ability to ride out any crisis without having to sell itself short. In particular, the group has shown time and time again that it is not comfortable selling assets below book value in order to ease its massive debt load. For some, this belief derives from their view of the controlling Widjaja family's psychology.

Says an investor, "My own personal view is that as an Indonesian family of Chinese descent, they feel a constant need to prove themselves. It's also the case that we are dealing here with a company that has grown from almost nothing five years ago to one of the world's largest pulp and paper producers. Hendrik Tee has created a world class company and he feels that world class companies shouldn't have to sell assets below book value."

How APP became vulnerable to liquidity shocks

The issue of APP's $11.5 billion debt started to come to a head about a year ago when the company was generating significant free cash flow. "It was at a point in the paper cycle when APP should have been putting the funds to use de-leveraging the company," the investor continues. "Instead, it was all getting sucked up into working capital. It made everyone nervous that they weren't serious about solving the problem."

About six months ago, investors recall becoming increasingly concerned about the combined impact of a weakening in the paper cycle and the company's maturity schedule from 2001 onwards. With the continuation of the financial crisis making it difficult for an Indonesian company to fund itself, the market became increasingly dubious about APP's ability to re-finance roughly $2.3 billion of debt coming due before 2003.

The structural subordination of debt at APP, which is registered in Singapore, listed in New York and 67% owned by the Sinar Mas group, appeared to threaten a liquidity crunch. Virtually all of company's capital expenditure in China had been funded through the holding company (APP). Profits, on the other hand, are derived from operating subsidiaries - Indonesian-listed vehicles Indah Kiat and Tjiwi Kimia - which are legally constrained from upstreaming enough dividends to pay down the debt coming due for the parent.

A fixed price exchange and consent offering was put together in the hope of granting the company some much needed breathing space from a repayment schedule that current cash flows are unable to service. Investors were to be offered a combination of cash, new bonds and warrants, while the Widjaja family themselves pledged to convert some of their bond holdings into equity.

By extending the maturity profile of four dollar-denominated debt issues out to 2004 and 2005, the company would then have more time to upstream dividends and profits, make some asset sales without having to resort to fire-sale prices, and raise new cash through the flotation of APP China.

As one investor puts it, "We think the flotation of APP China would be incredibly well received on the Hong Kong Stock Exchange. It has been a fantastic year for Chinese equity in the international markets and as a counter cyclical stock, APP China would be lapped up by investors."

Why yields have spiked since filing

Bond investors and the rating agencies, therefore, viewed the exchange offering as credit positive. Standard & Poor's, for example, put the company's CCC+ rating on CreditWatch with positive implications. Equity investors, by contrast, immediately dumped a stock that appeared to have no upside.

"They took their cue from the dilutive effect of warrants attached to APP China," one investor comments. "They also saw that the company would have to generate huge returns to give the stock upside. However, when they saw what had happened to the stock price, a number of bond investors started panicking and tried to reduce their positions as well."

The problem was compounded by the fact that there is not a natural buyer base for APP debt. Although many accounts own a tiny piece of the company, most of its debt is concentrated in about 20 to 25 large institutions, none of which wants to increase its exposure.

They remain unconvinced that the company is really willing to take what are viewed as necessarily painful steps and investors' attitude appeared to harden in the weeks after the offering was announced. In late September, for example, news leaked out that APP was planning to raise $1 billion to fund a paper mill in Malaysia. The company also confirmed that it was still planning to go ahead with the purchase of a Canadian pulp mill.

"We just think that APP finds it very difficult to get out of a mental mode which sees the Asian financial crisis as a temporary phenomenon that shouldn't be allowed to set the company's growth plans back," an investor argues. "So instead of taking a breather and focusing on de-leveraging, they continue to look for opportunities to increase the income statement rather than restructure the balance sheet. The Canadian pulp mill, for example, would reduce the company's cost of pulp and the Malaysian financing would increase the top line and make the company even larger."

The net result was a small improvement in some of company's bond prices immediately after the exchange offering was announced, followed by a continuous decline since then.

Four bonds were put up for the exchange. An October 2001 (APP IX) was trading at a mid market yield of 71 cents on the dollar at filing. It rose to 78 and is now at 58 cents. The April 2002 subordinated preference share issue (APP III) was at 60.5 cents, rose to 62 and is now at 33.

Two equity-related issues put into the exchange showed no upswing, however, because of the sudden collapse in the company's share price. The November 2012 LYONS transaction (APP IV) was at 13.5 and is now at 10. The April 2003 convertible bond (APP VII) was at 64 cents and is now at 43 cents.

Observers now argue that the securities have been oversold. "The market always overreacts," says one high yield specialist. "Over the course of my career, I've seen many companies close to death come back screaming. At the end of the day, this is virtually the only Indonesian company that has remained current on its interest and principal re-payments. They should be given a lot of credit for that and it certainly shouldn't be forgotten. These securities have tremendous value."

Large bondholders also remain sanguine despite their evident frustrations. APP's recent moves to cancel the Canadian pulp mill and Malaysian financing have not gone unheeded, even if there has been no tangible improvement in secondary market prices.

Says one US-based bondholder, "Not many companies can survive having to finance themselves at the 25% mark for very long and APP is finally showing signs of facing up to the situation. But we are still confident that the exchange offering will get done, because at the end of the day investors don't have any other choice. Hendrik Tee is also a very adept financier. He always seems to figure out some way of getting the cash up to the parent."

Asian debt experts believe that the fate of the APP exchange will have a major impact on what 2001 looks like, both for the debt markets and for the region on a wider level. "This is a very large borrower and the market is looking for any and every opportunity to support it," says one. But as a credit, there is undoubtedly a bit of a 'prove it to me' attitude."

Fund managers agree. "Most investors have no idea what's going on and they certainly wouldn't be aware that the offering won't take place until next year," one concludes. "All we are looking for is some kind of signal that the company is still working on this exchange and is serious about de-leveraging itself."  


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