Central European Distribution Company (CEDC) Equity Analysis

Christian Sgrignoli & Zach Friesner

February 13 2013

I. Summary

On July 31st 2012, the Blue & White Investment Group released an analysis on Central European Distribution Company (CEDC) equity. We suggest reading it, as it will provide a better context to this analysis. The thesis of the past analysis was that CEDC was a profitable long opportunity. The facts have changed in the past six months.

A primary reason for having a long stance on the company's equity was due to a strategic alliance that was in place with Russian Standard and affiliate Rouste Trading Ltd. (RTL). The upside to this strategic alliance would come from potential synergies in operations, Roustam Tariko's (Owner of Russian Standard) knowledge and connections with the Russian alcohol market, and assistance with CEDC's March 15th, 2013 convertible notes. This alliance has not played out as expected, and looks to backfire on CEDC stakeholders.

The alliance began adding uncertainty on November 13th, 2012, when Tariko "expressed his deep concerns" regarding operating, financial, and managerial issues within CEDC. He effectively sympathized with shareholders, and expressed that he had the solutions for a stock that had gone from $75 to $2 in the past few years. This letter, along with others to come, would assist in providing Tariko overwhelming leverage, and ultimately control of the company.

At first glance, it appeared desirable for Tariko to have a significant position in the company's turnaround. He is a Russian billionaire entrepreneur who owns a holding company comprised of alcohol production, banking, insurance, etc. William Carey, the CEO, had resigned in July. The management and board members that remained barely seemed competent while taking write-downs of approximately $1 billion in 2011.

With that said, Mr. Tariko has massive conflicts of interest. His vodka business, Russian Standard Vodka, is a competitor of CEDC. His equity ownership in CEDC is 19.5%, and he has never expressed intent to tender. Given these facts, the board should have stayed on high alert. It has failed in protecting shareholder interest, in our opinion breaching its duty of care.

Mark Kaufman, CEDC's second-largest shareholder, expressed his discontent for the recent events that have transpired. In his January 16th, 2013 open letter, he describes the dilemma of shareholders: 1. Surrender the company to RTL or 2. Move towards bankruptcy. Mr. Kaufman gives his take on the "Term Sheet", explaining it as a shell game. He calls for change in the board. We agree vehemently with Mr. Kaufman.

CEDC issued $310 million worth of convertible notes in March 2008 that are maturing on March 15th, 2013. There are a few different covenants on these debentures, which will be discussed in more detail in the appropriate section. These notes are a real issue given CEDC's lack of cash and

liquid assets. As stated in the company's restated 10K/A, its hope was to raise the cash by the "strategic alliance", sale of certain assets, an exchange of the convertibles, and issuing new equity.

In event of default, the cross default covenant makes the 2016 notes default as well. The acceleration event covenant makes all notes immediately due and payable. This would force CEDC into Chapter 11. With a tangible book value of approximately negative $1 billion, a fire sale is likely. Tariko will most likely be a buyer for Russian assets. He may even write an open letter to previous holders of senior secured notes stating contemptuously how he is spending a large percentage of his business time in Russian courts.

As if CEDC did not have enough problems, they have not met listing standards to be on the Nasdaq exchange for a multitude of reasons and face the possibility of being delisted. CEDC has scheduled its Nasdaq delisting hearing and its shareholder meeting after the March convertibles come due. The timing of the entire debacle is an enigma.

There are currently four legal proceedings regarding CEDC. Two are class action suits due to misleading statements in 2010. Recently, two more have been filed. Russell Partch v. William Carey, accuses the directors of breaching their fiduciary duty of care, good faith, and loyalty to the company by failing to establish and maintain adequate internal controls and by failing to exercise proper oversight over management. We expect more suits to be filed in the coming months. In our opinion, the best case has involved breach of duty, with the worst case involving collusion.

II. Investment conclusion

In our original valuation of the stock during July 2012, we applied a 20% probability to a liquidation/restructuring scenario. Liquidation and restructuring, formally chapter 7 and chapter 11 bankruptcies, would have the same de facto result for common shareholders. We now believe this event has a much higher probability.

Our previous long thesis advocates that we do not have an inherent bias in our current short thesis. The short thesis is a function of our past analysis and CEDC SEC filings within the time frame of July 2012 and February 2013. For full disclosure, readers may look towards the bottom of the Seeking Alpha page.

A statement from the 10K/A provides information to CEDC's strategy for mitigating chapter 11. CEDC has not indicated a strategic alliance with other investors in a public filing. The alliance with Russian Standard, as well discussed, has not provided the support needed. The company has not yet discussed a plan to sell assets. If this would occur, it seems unlikely they could perform this before the March 15th notes are due. Even if they were able to sell off assets, this would have an adverse effect on them being able to pay off the 2016 notes. We are uncertain to what capacity they may exchange the convertibles and issue new equity. There is no force convert provision on the convertibles, and the demand for any kind of equity seems unlikely.

Taking a look at CEDC's balance sheet, they are in a precarious situation. According to its 3rd quarter 10Q, its cash balance was approximately $100mm. The company has been utilizing its factoring abilities. In the 3rd quarter it sold approximately $40mm of its receivables. We expect CEDC did the same in the 4th quarter. If CEDC does enter chapter 11, we expect a fire sale due to a tangible book value of approximately negative $1 billion.

On 2/4/13 board member Robert Koch resigned abruptly. Mr. Koch was a member of the compensation, nomination, and corporate governance committee. The person that filled his roll was Joseph Farnan. Ironically, the new board member has no experience in vodka or European trade. He was a chief judge on cases involving complex commercial disputes and chapter 11 cases. His current law practice is focused on complex commercial matters and chapter 11 proceedings. Although a member of the board abruptly leaving and being replaced by a chapter 11 attorney is speculative, we believe there is value from the information.

Perhaps the greatest catalyst to our analysis is RTL's 13D on 2/7/13 exercising their put option on $30mm shares. CEDC is fighting RTL, stating they do not have the right to exercise. Logic proposes that Tariko and RTL are no longer interested in assisting CEDC in restructuring. It is our speculation that RTL never had the intention of a strategic alliance, but became a stakeholder to take advantage of a distressed company with incompetent executives.

We believe the company is headed for chapter 11, and due to the firm's capital structure, common shareholders will be wiped out. Given this, we advise shorting the shares or leveraging using puts. If puts are used, we would suggest utilizing an exercise date after mid-March, in which the convertible note debacle and Nasdaq delisting appeal hearing will have occurred. The need for time value embedded in the September puts appears de minimis, making June puts optimal.

III. Our July 31 analysis

Our past expected value lattice looked like:

(click to enlarge)

The facts at the time warranted such probabilities in our opinion. We previously assumed, albeit naively, that the Russian Standard alliance would solve liquidity problems caused by the convertible notes shortly approaching. With the 2013 convertible notes paid, CEDC would be able to focus on its operations, and continue as a going concern. This would provide the company time to pay off its much larger 2016 senior secured notes.

The facts within the past six months have changed considerably. In this analysis, we will not perform a probability based lattice. Any probability assumptions would be overwhelmingly subjective. We advise all readers to consider the facts presented, not necessarily by us, but through the public filings, and create their own opinions.

IV. Strategic alliance with Russian Standard

Initially, the Russian Standard alliance looked very beneficial. On 6/11/2012 a 13D was filed by RTL, positioning Tariko with 16.4% ownership. On 7/11/2012, the Amended & Restated Securities Purchase agreement was filed. Apart from this, a few transactions occurred. CEDC issued RTL $30mm common shares with a put option. There was also a "New Debt" deal which consisted of the issue of approximately $102mm of rollover notes. CEDC was also given a put option on backstop notes to RTL. This was to aid CEDC with its liquidity issues.

Beyond the financial assistance, it was perceived that Russian Standard would provide operational benefits. In our previous analysis, we stated "The synergies created in the alliance between CEDC and RS should be significant. Roust is the largest distributor of premium products in Russia." In an 8K filed 9/18/12, a corporate governance framework was approved by the board of directors. In the filing, a strategic development and synergy plan was said to be formed 45 and 30 days after RTL was appointed interim president. Four months have gone by and there has not been any information regarding a synergy or strategic plan.

V. TARIKO's Letters to Board & Stakeholders

The RTL alliance became uncertain on 11/13/12, when Tariko sent a letter to CEDC investors "expressing his deep concerns". What was material about the letter was that CEDC's 10K/A Restatement of EBITDA voided the amended purchase agreement in July. Tariko went on to talk about how poor management was performing, and how he could save the company if he had more control. Many of his points struck to emotions, such as "Together, we can work to save CEDC". This letter was a tool to assert pressure on management and the board to cede control to RTL.

Three days later (11/16/12) the "special committee" wrote a letter to shareholders denouncing Tariko. They claimed his letter was a ploy for more control. The committee stated that Tariko released the letter after he lost a vote 5 to 3 not providing him more control. We agree with the response by the board in this letter.

On 12/11/12, RTL released a 13D stating that CEDC rejected a proposal. Tariko pompously stated he was trying to "provide the issuer with access to interim and permanent capital, to

bolster the Issuers leadership, and to support its operational needs". Two of the seven elements of the proposal were:

1. Delegation of business, operational and financial oversight to directors designated by RTL

2. All related party transactions between the Issuer and RTL to be approved by non-RTL directors

Both of these ambiguous points potentially give RTL massive control of CEDC.

The next day (12/12/12), CEDC's special committee responded to RTL in an open letter filed in an 8K. The committee asked Tariko to tender if he wants control of the company. They also defined many of the terms illusory. These terms included a $50mm note and $107mm note, and the lack of support for the once favored backstop notes. This put stakeholders in a precarious position. The company would be back to step one without help towards the 2013 convertibles.

Essentially, Tariko leveraged the position he occupied further with the letters. He knew that, since CEDC had been spending a large amount of time and energy on the RTL deal, they would not have the time to shop another deal even if they happened to find an interested party. This was Icahn-level mastery of the investment meta-game, with the letters alluding to CEDC executives being incompetent criminals.

VI. Irresponsible Corporate Governance

On 12/28/12, the "Term Sheet" was released. We are unaware what occurred between the 12/12/12 special committee response and the Term Sheet release. Everything the committee stood for essentially was lost, at the expense of other stakeholders.

1. The $50mm term loan went through. This is on a senior status with liens, with no room for impairment, backed by assets such as business accounts, equipment, inventory, and even intellectual property. This must be paid off before CEDC may restructure.

2. RTL will not be backstopping the March 2013 convertibles.3. The management, including CEO and CFO, will report to the operational committee.4. The operational committee is Tariko, one RTL person, and one non-RTL person.5. For the annual meeting, the proxy will include: three RTL board members, three non-

RTL board members, and a RTL and non-RTL nominee.

There is no logical reason why the Term Sheet would be agreed to. It provides someone with 19.5% ownership de facto and de jure control. Let me provide an example:

We live in never-never land. Company A and Company B make magical juice. Company A falls on hard times due to excess debt. The owner of company B says he is going to help his competitor and they will be friends. He takes a 1/5 stake of his new "friend" and also says he's going to help out with the debt problems. Now, around this time, Company B makes special requirements to the deal. He says, "I want the right to give you back some of this stake- a put

option. He also knows company A will have to submit restatements called a 10K/A and 10Q/A. If the restatements are not what he wants, then the friendship is voided. This ends up happening.

Meanwhile, the due date on company A's debt is coming closer to maturity. Company A says "What are we going to do? We're about to go bankrupt!" Then company B says, "no my friend, I'll save you, just sign here". Company A signs and you know what happens? Company B says "I want those shares back"- remember the put option? The owner of company B now has complete control over company A. Sure, company A has some of company B's never land dollars, but they are fully backed by the magic juice makers, the buildings, etc.

Company A becomes closer to bankruptcy, and if it occurs, their juice makers get sold at really cheap prices. Guess who is first in line to buy them? Company B! So essentially, it's in company B's best interest to have company A file for chapter 11; and they have the control to make it happen. Where was company A management and board? They were apparently drinking too much magical juice.

Never-never land has come to planet earth in 2013. We believe Tariko's intention was to make an agreement which he knew CEDC would breach. This would occur while the clock ticked closer to debt maturity date. At the last second, he said take or leave my deal; the Term Sheet. This term sheet gives Tariko power over CEDC, at the same time benefiting from CEDC filing for chapter 11.

VII. KAUFMAN'S LETTER

On 1/16/13, Mark Kaufman, the company's second-largest shareholder, wrote a letter to CEDC stakeholders. In this letter, he explains how the Term Sheet is devastating for CEDC shareholders, and what events will most likely occur in the coming months. Here is a brief summary of Kaufman's letter:

"So what? Well, RTL's new capital commitment under the Term Sheet is conditioned on a restructuring of CEDC's capital that is acceptable and agreed by RTL, in its sole discretion. That is, it is no commitment at all. Absent new capital, CEDC will likely default on the 2013 Convertible Notes due March 15, 2013. That will trigger a cross-default under CEDC's 9.125% Senior Secured Notes due 2016 and 8.875% Senior Secured Notes due 2016 (collectively, the "2016 Notes"). To put it mildly, this gives Roustam Tariko significant negotiating leverage.

But on March 15, 2013, absent an acceptable restructuring of the capital (and the conversion of the New Credit Facility Debt (but not the entire New Debt) to capital that is junior to the 2016 Notes (but not necessarily common stock), and on automatic termination of the forbearance agreement, an Event of Default will immediately exist under the New Debt, allowing RTL to accelerate it, call the subsidiary guarantees and proceed to enforce the security interests over the subsidiaries' property and assets.

Further, since much of this enforcement would be through the Russian courts against assets located in Russia (where Roustam Tariko is a well-established figure and where the legal process

may still give rise to unpredictable results), RTL would have a good chance of taking over some or all of the Russian assets on a distressed basis. "

Management responded to Mr. Kaufman's letter on 1/30/13. Its response was laughable. It did not respond to any of Mr. Kaufman's points, but rather criticized him as being "misguided". CEDC states, "The December Deal is aimed at ensuring that shareholder democracy prevails." Given that the CEO and CFO report to the operational committee, which is majority run by RTL; what definition of democracy are they using?

We agree with Mr. Kaufman, and offer him luck in his activist roll. Mr. Kaufman insists on board changes. It's unfortunate the shareholder meeting was postponed until after the Term Sheet and March 15th convertible maturity date.

VIII. Chapter 11 Bankruptcy

We believe the company is headed for chapter 11. Its balance sheet cannot handle the March 15th convertibles. At this time, it does not look as if a third party is willing to stick its neck out to finance a failing company with terrible corporate governance.

The March convertible notes were issued in March 2008 for a principle amount of $310mm. In the prospectus, we could not find a force convert clause. The convert option is only given to the bondholders. "On or after December 15, 2012, holders may convert each of their notes, based on the applicable conversion rate, at any time prior to the close of business on the third scheduled trading day immediately preceding the maturity date. Notwithstanding anything herein to the contrary, notes may be converted only during business hours on a day that is a business day. The conversion rate will initially be 14.7113 shares of common stock per $1,000 principal amount of notes (equivalent to a conversion price of approximately $67.97 per share of common stock)." The prospectus did give CEDC a call option for full or partial cash payment. Unfortunately, that option has no value for the company.

The placement of Mr. Farnan on the board adds probability of chapter 11. We ponder the question, what other reason would CEDC nominate a Delaware chapter 11 specialist to join the board? We are unaware why they did not just hire him as fiduciary council.

If CEDC does file for chapter 11, it will be an interesting court procedure. We are unaware what will be filed in US, Russia, and Poland courts. It appears CEDC management does not know either. This statement was in the 10K/A:

"In the event that we are unable to successfully implement our business strategy and, as a result, are unable to continue as a going concern, local insolvency and other laws may be unpredictable in their application to a global company such as ours and the security interests and guarantees granted by us and our subsidiaries, and may restrict our ability to restructure our indebtedness in an orderly fashion or at all. This could materially negatively impact any potential recovery of our creditors and/or shareholders. We can give no assurance that the results of an insolvency, restructuring or liquidation proceeding in any relevant jurisdiction would be similar to the expected results in a proceeding conducted in a U.S. federal bankruptcy court. In addition, there

is uncertainty regarding the extent to which a court in one relevant jurisdiction will respect or enforce the insolvency or security-related judgments of a court in another relevant jurisdiction. "

A large portion of its assets are in Russia, which Mr. Tariko has shown a desire for through securing his notes. The list contains production facilities such as Topaz, Siberia, Parliament, and Bravo Premium. In fact, the Topaz plant is the main vodka plant in Russia, capable of producing 2.2 million liters annually.

We expect Tariko to have an edge in the Russian court system. In the 10K/A, CEDC states the developing legal system in Russia could adversely affect them. Here are a few points

The lack of judicial and administrative guidance on interpreting legislation The lack of an independent judiciary Poorly developed bankruptcy procedures that are subject to abuse

IX. Delisting from Nasdaq

The delisting notice of CEDC stock from the Nasdaq exchange only further adds to the current situation at hand. Nasdaq notified CEDC on 8/10/12 that it did not file its 10Q on time to meet listing requirements. It received another delisting notice for not holding a shareholder meeting, and Nasdaq said they would start the delisting process unless notified of an appeal. CEDC did appeal and scheduled the appeals hearing on 3/21/13, just after the March convertibles come due. The shareholder meeting was also subsequently scheduled for 3/26/13. It does not make much sense to hold these key events after the convertibles maturity date. If all this were to play out, the delisting and shareholder meeting would likely be useless.

X. Conclusion

Given the facts, we believe CEDC is a good short candidate. The liquidity pressure from the convertibles, Mr. Tariko's equivocal leverage in the outcome, mismanagement from the CEDC board, the new chapter 11 specialist board member, and the Nasdaq delisting provide significant probability of a chapter 11 filing. If this occurs, common shares will be wiped out. It should be noted that a takeover candidate is illogical before CEDC goes through the restructuring process, since they could wait until the debtor's take a haircut.

Additional disclosure: Both of the analyst were long the company from July 2012 until February 2013. In February, one of the analyst has bought put options.

http://seekingalpha.com/article/1177811-the-equivocal-hostile-takeover-of-central-european-distribution-company