Bankrupt and Distressed (BAD) Research and Due Diligence

[Madclown]

Book value might come into play in a chapter 7 liquidation but in a reorganization proceeding, the generation of cash and earnings, is king. The Supreme court has defined reorganization value to be "the expectation of income" from the reorganized debtor. In addition, another definiton used by the courts is "present value of future anticipated earnings".

There are a couple of methodologies that might be used, one is the comparable company analysis and the other is the discounted cash flow method. In some cases both methodologies would be employed and perhaps the entity value might be struck from a combination of the two. The comparable company analysis will give credence to what other similarly situated companies are valued at based on their performance and the DCF method is largely concerned with the ability of the reorganized company to generate cash to pay its obligations, reinvest back in the business, or return something to the equity holders.

In either event, the EV is largely derived from the cash flows (EBITDA or Free Cash Flows) of the business and not the balance sheet. The balance sheet reflecting positive equity may come into play if the company has significant cash on hand or if it has positive working capital because these can be used as sources of funds to reduce the debt. You can't assign value in this methodology to an asset that will not be liquidated into cash. Doing so reverts the valuation methodology to one that might be used in a chapter 7 liquidation. These restructurings are more appropriately viewed as one might value a buyout situation.

One caution against payning too much attention to a balance sheet showing only marginal equity value is that any Goodwill will likely be written down to zero. Also, one has to pay attention to other assets that may be written down. In MESAQ's case, it is highly unlikely that the planes are worth their book value so there is probably some impairment to be taken at some point. The 20 planes that were rejected and returned to the secured lenders were worth about $18 million less than what Mesa owed on them. The book value of the rejected planes was $14 million and the liabilities associated were $32 million. You can project that across the remaining fleet.

Also, as I mentioned before, don't ignore the effects of the plane lease rejections. Those are not currently in the liabilities section of the balance sheet. They are currently "off blance sheet". As each plane is rejected, there will be an associated liability injected on the balance sheet for which there will be no corresponding increase in an asset. This event will erode the equity by the amount of the allowed rejected claim.