💰All Hail Private Equity💰

Private Equity Rules the Roost (Long Following the Money)

So, like, private equity is apparently a big deal. Who knew?

Readers of PETITION are very familiar with the growing influence, and impact of, private equity. We wouldn’t have juicy dramatic bankruptcies like Toys R UsNine West and others to write about without leveraged buyouts, excessive leverage, management fees, and dividend recapitalizations. Private equity is big M&A business. Private equity is also big bankruptcy business. And it just gets bigger and bigger. On both fronts.

The American Lawyer recently wrote:

Private equity is pushing past its pre-recession heights and it is not expected to slow down. Mergermarket states that the value of private equity deals struck in the first half of 2018 set a record. PricewaterhouseCoopers expects that the assets under management in the private equity industry will more than double from $4.7 trillion in 2016 to $10.2 trillion in 2025.

With twice as much dry powder to spend on deals, private equity firms will play a large role in determining the financial winners and losers of the Am Law 100 over the next five-plus years. It amounts to a power shift from traditional Wall Street banking clients and their preferred, so-called white-shoe firms to those other outfits that advise hard-charging private equity leaders.

Indeed, PE deal flow through the first half of the year was up 2% compared to 1H 2017:

In August, the American Investment Council noted that there was $353 billion of dry powder leading into 2018. No wonder mega-deals like Refinitiv and Envision Healthcare are getting done. But, more to the point, big private equity is leading to big biglaw business, big league. Say that five times fast.

The American Lawyer continues:

It is hard to find law firm managing partners who don’t acknowledge the attraction of private equity clients. Their deals act as a lure, catching work for a variety of practice groups: tax, M&A, finance and employee benefits. And lawyers often end up handling legal work for the very companies they help private equity holders buy. Then, of course, there is always the sale of that business. A single private equity deal for one of the big buyout firms can generate fees ranging from $1 million to $10 million, sources say.

“It’s kind of like there’s a perfect storm taking all those things into consideration that makes private equity a big driver in the success of many firms, and an aspirational growth priority in many more firms,” says Kent Zimmermann, who does law firm strategy consulting at The Zeughauser Group.

Judging by league tables that track deals (somewhat imperfectly, as they are self-reported by firms), Kirkland has a leading position in the practice. According to Mergermarket, the firm handled 1,184 private equity deals from 2013 through this June. Latham is closest with 609. Ropes & Gray handled 323, while Simpson Thacher signed up 319.

Hey! What about “catching work” for the restructuring practice groups? Why is restructuring always the red-headed step child? Plenty of restructuring work has been thrown off by large private equity clients. And Kirkland has dominated there, too.

Which would also help explain Kirkland’s tremendous growth in New York. Per Crain’s New York Business:

In just three years, Kirkland & Ellis has grown massively. The company, ranked 12th on the 2015 Crain's list of New York's largest law firms, has increased its local lawyer count by 61% to climb into the No. 4 spot.

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Much of that growth has come in its corporate and securities practice, where Kirkland's attorney count has nearly doubled in three years. The 110-year-old firm's expansion in this area is by design, said Peter Zeughauser, who chairs the Zeughauser Group legal consultancy.

"There aren't many firms like Kirkland that are so focused on strategy," Zeughauser said. "Their strategy is three-pronged: private equity, complex litigation and restructuring. New York is the heart of these industries, and Kirkland has built a lot of momentum by having everyone row in the same direction. They've been able to substantially outperform the market in terms of revenue and profit."

Kirkland's revenue grew by 19.4% last year, according to The American Lawyer, a particularly remarkable increase, given that it was previously $2.7 billion. Zeughauser has heard that a growth rate exceeding 25% is in the cards for this year. The firm declined to comment on whether that prediction will hold, but any further expansion beyond the $3 billion threshold will put Kirkland's performance beyond the reach of most competitors.

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Zeughauser, the consultant featured in both articles, thinks all of this Kirkland success is going to lead to law firm consolidation. Kirkland has been pulling top PE lawyers away from other firms. To keep up, he says, other firms will need to join forces — especially if they want to retain and/or draw top PE talent at salaries comparable to Kirkland. We’re getting PTSD flashbacks to the Dewey Leboeuf collapse.

As for restructuring? This growth applies there too — regardless of whether these outlets want to acknowledge it. Word is that 40+ first year associates started in Kirkland’s bankruptcy group recently. That’s a lot of mouths to feed. Fortunately, PE portfolio companies don’t appear to stop going bankrupt anytime soon. Kirkland’s bankruptcy market share, therefore, isn’t going anywhere. Except, maybe,…up.

That is a scary proposition for the competition. And those who don’t feast at Kirkland’s table — whether that means financial advisors or…gulp…judges.

*****

Apropos, on Monday, Massachusetts-based Rocket Software, “a global technology provider and leader in developing and delivering enterprise modernization and optimization solutions,” announced a transaction pursuant to which Bain Capital Private Equity is acquiring a majority stake in the company at a valuation of $2b.

Dechert LLP represented Rocket Software in the deal. Who had the private equity buyer? Well, Kirkland & Ellis, of course.

We can’t wait to see what the terms of the debt on the transaction look like.

*****

Speaking of Nine West, Kirkland & Ellis and power dynamics, we’d be remiss if we didn’t point out that a potential fight in the Nine West case has legs. Back in May, in “⚡️’Independent’ Directors Under Attack⚡️,” we noted that the Nine West official committee of unsecured creditors’ was pursuing efforts to potentially pierce the independent director narrative (a la Payless Shoesource) and go after the debtor’s private equity sponsor. We wrote:

In other words, Akin Gump is pushing back against the company’s and the directors’ proposed subjugation of its committee responsibility. They are pushing back on directors’ poor and drawn-out management of the process; they are underscoring an inherent conflict; they are highlighting how directors know how their bread is buttered. Put simply: it is awfully hard for a director to call out a private equity shop or a law firm when he/she is dependent on both for the next board seat. For the next paycheck.

Query whether Akin continues to push hard on this. (The hearing on the DIP was adjourned.)

The industry would stand to benefit if they did.

Well, on Monday, counsel to the Nine West committee, Akin Gump Strauss Hauer & Feld LLP, filed a motion under seal (Docket 717) seeking standing to prosecute certain claims on behalf of the Nine West estate arising out of the leveraged buyout of Jones Inc. and related transactions by Sycamore Partners Management L.P. This motion is the culmination of a multi-month process of discovery, including a review of 108,000 documents. Accompanying the motion was a 42-page declaration (Docket 719) from an Akin partner which was redacted and therefore shows f*ck-all and really irritates the hell out of us. As we always say, bankruptcy is an inherently transparent process…except when it isn’t. Which is often. Creditors of the estate, therefore, are victims of an information dislocation here as they cannot weigh the strength of the committee’s arguments in real time. Lovely.

What do we know? We know that — if Akin’s $1.72mm(!!) fee application for the month of August (Docket 705) is any indication — the committee’s opposition will cost the estate. Clearly, it will be getting paid for its efforts here. Indeed, THREE restructuring partners…yes, THREE, billed a considerable amount of time to the case in August (good summer guys?), each at a rate of over $1k/hour (nevermind litigation partners, etc.). Who knew that a task like “Review and revise chart re: debt holdings” could take so much time?🤔

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That’s a $10k chart. That chart better be AI-powered and hurl stats and figures at the Judge in augmented reality to justify the fees it took to put together (it’s a good thing it’s redacted, we suppose).

Speaking of fees it takes to put something together, this is ludicrous:

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The debtor has to pay committee counsel $100k for it to put together an application to get paid? For heaven’s sake. Even committee members should be up in arms about that.

And people wonder why clients are reluctant to file for bankruptcy.

*****

Speaking of independent directors, one other note…on the fallacy of the “independent” director in bankruptcy. Yesterday, October 9, Sears Holdings Corporation ($SHLD)announced that it had appointed a new independent director to its board. To us, this raised two obvious questions: how many boards can one human being reasonably sit on and add real value? At what point does a director run into the law of diminishing returns? Last we checked, it’s impossible to scale a single person.

But we may have been off the mark. One PETITION reader emailed us and asked:

The question you want to be asking is "what sham transaction that probably benefits insiders is the independent director being appointed to bless" or "what sham transaction that benefitted insiders is the independent director being appointed to "investigate" and find nothing untoward with?"

Those are good questions. Something tells us we’re about to find out. And soon.

Something also tells us that its no coincidence that the rise of the “independent fiduciary” directly correlates to the rise of fees in bankruptcy.

Tell us we’re wrong: petition@petition11.com.

☠️R.I.P. Sears (Finally)?☠️

Sears, Malls & Shorting the "End of the #Retailapocalypse" Narrative (Short Karl).

It’s official: the media apparently cares more about Sears Holding Corp. ($SHLD) than consumers do. Sure, it’s a public company and so “investors” may also care but, no offense, if you’re still holding SHLD stock than you probably shouldn’t be investing in anything other than passive index funds. If anything at all (not investment advice).

Anyway, the internet is replete with commentary about what went wrong, what the bigbox retailer did and didn’t do right, what plans may not have ever existed, what could have happened and what’s going to happen (video). It didn’t build an online brand OR invest in stores! It was mismanaged! Choice bit:

Ted Nelson, CEO and strategy director at Mechanica, agreed that financial management played a big role. He believes the story of Sears and its downfall isn’t a brand story at all. “[It’s one of] financial engineering and hedge-fund manager hubris gone awry,” he said. “There are a lot of places that brand [and collection of owned brands] could have evolved to. But that would have required a savvy, cross-functional and empowered leadership team, which isn’t what Sears got.”

Oh my! It’s such a shame that Sears may liquidate!

Meetings with lenders only lasted one hour!

Maybe it will get itself a DIP credit facility and last through Christmas! Either way, it is likely to immediately shutter up to 150 locations! This is all such a shame! Look at what it used to be!

From Bloomberg:

“The handwriting has been on the wall for years,” said Allen Adamson, co-founder of Metaforce, a marketing consultancy. “It’s been like watching an accident. You can’t look away, but you know it’s coming.”

Right. We’re over it. We honestly could not care less about Sears at this point. Bankruptcy professionals will make money and this thing finally…FINALLY…may get the burial it deserves. Like we previously said, “This thing is like ‘Karl’ in Die Hard.” Even Karl did, eventually, die.

That all said, we do care about how Sears’ demise affects malls.

First, a bit about malls generally…

On October 7, AxiosFelix Salmon wrote “Retailpocalypse Not,” and highlighted a Q2 2018 retail report from CBRE, concluding “The death of shopping malls is exaggerated: They are currently 94% occupied, according to CBRE.” Yet, he missed key parts of CBRE’s report:

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And mall rents are on the decline:

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Other reports substantiate these trends. Per RetailDive:

It's still not a pretty picture on the ground, however. Second quarter mall rents fell 4.6% from the first quarter and 7.1% year over year, hit by major store closures from Toys R Us, Sears and J.C. Penney, according to a trend report from commercial real estate firm JLL. Mall vacancy rates hit 4% during the period, JLL said. The retail sector suffered its worst quarter in nine years with net absorption of negative 3.8 million square feet, which pushed the regional mall vacancy rate up by 0.2% to 8.6% as the average mall rent increased 0.3%, according to another report from commercial real estate firm Reis emailed to Retail Dive.

And things have gotten worse since then. On October 3, four days before the Axios piece, The Wall Street Journal reported on Q3 numbers:

Mall vacancy rates rose to 9.1% in the third quarter, their highest level in seven years. Many of the older shopping centers that lack trendy retailers, lively restaurants, or other forms of popular entertainment continue to lose tenants, or even close down.

But many lower-end malls are still struggling to benefit from the economic revival, especially in some of the more economically depressed areas in Pennsylvania, Ohio and Michigan. They suffer from a glut of shopping centers but not enough consumers.

The average rent for malls fell 0.3% to $43.25 a square foot in the third quarter, down from $43.36 in the second quarter, according to data from real-estate research firm Reis Inc. The last time rents slid on a quarter-over-quarter basis was in 2011.

What sparked the vacancy jump? Bankrupted Bon-Ton Stores closing and, gulp, Sears closures too. Which, obviously, could get a hell of a lot worse. Indeed, Cowen and Company recently concluded that “we are only in the ‘early innings’ of mass store closures.” As noted in Business Insider:

"Retail square footage per capita in the United States has been widely sourced and cited as being far above most developed countries — more than double Australia and over four times that of the United Kingdom," Cowen analysts wrote in a 50-page report on the state of the retail industry. The data "suggests that the sector remains in the early innings of reduction in unproductive physical retail."

On point, one category that had largely remained (relatively) unscathed in the last 2 years of retail carnage is the home goods space. But, now, companies like Pier 1 Imports Inc. ($PIR) and Bed Bath & Beyond Inc. ($BBBY) appear to be in horrific shape. Bloomberg’s Sarah Halzack writes:

Two major companies in this category, Bed Bath & Beyond Inc. and Pier 1 Imports Inc., are mired in problems that look increasingly unsolvable. Bed Bath & Beyond saw its shares tumble 21 percent on Thursday after it reported declining comparable sales for the ninth time in 10 quarters. And Pier 1’s stock fell nearly 20 percent in a single day last week after it saw an even ghastlier plunge in same-store sales and discontinued its full-year guidance.

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The struggles of those two retailers ought to compound problems in the overall retail environment. Pier 1 has 1000 stores. Bed Bath & Beyond has 1024 stores.

Still, not all malls are created equal.

Barron’s writes:

Sears’ poor performance has long been an issue for owners, but landlords are split between those that are probably cheering the possibility of reclaiming its locations for more profitable tenants and those that see its potential bankruptcy as a negative tipping point.

Wells Fargo’s Jeffrey Donnelly compiled a list of REIT exposure to Sears, ranking various REITs by how much revenue exposure there is to Sears.

Seritage Growth Properties (SRG) is at the top of the list, with 167 properties, or 72% of its space and 43% percent of its revenue. Urban Edge (UE) has four properties for 3.5% of space and 4.2% of revenue. Next comes Washington Prime Group (WPG) with 42 locations, or 9.8% of space and 0.9% of revenue, followed by CBL & Associates(CBL) with 40 properties, a negligible amount of its space and 0.8% of revenue. Brixmor (BRX) has 11 locations for 1.4% of its space and 0.6% of revenue, Kimco (KIM) has 14 locations, 1.9% of its space and 0.6% of revenue. Simon Property Group (SPG) is at the bottom of the list with 59 locations, 5.3% of its space, and 0.3% of revenue.

Among the companies he covers, he says, CBL & Associates is the most at risk because the “low productivity and demographics of its mall portfolio could make re-leasing challenging and extended vacancies could trigger co-tenancy.” By contrast, Macerich (MAC) is the best positioned, Donnelly argues, due to its “negligible exposure and industry-leading productivity of [its] portfolio.”

Here (video) is Starwood Capital Group ($STWD) CEO Barry Sternlicht opining on the demise of Sears. He says about Sears filing:

“Probably a net positive. So, in our malls that we own…the income that comes near the Sears store is 3% of the mall’s income. Nobody wants to be in front of the Sears because there’s nobody in the Sears. So, we take it back and make it an apartment building or a Dave & Busters or a Kidzania or…a theater…so honestly its good for the owners to get on with this…and we’ll see what happens with Penney’s too….”

In “Sears Exit Would Leave Big Holes in Malls. Some Landlords Welcome That,” The Wall Street Journal noted:

Mall owners with trendy retailers, lively restaurants and other forms of popular entertainment have continued to prosper. Many of these landlords would welcome Sears’ departure, mall owners and analysts said. The department store’s exit would allow them to take over a big-box space and lease it to a more profitable tenant.

In malls where leases were signed decades ago, Sears rents could be as low as $4 a square foot. New tenants in the same space could bring as much as six times that amount.

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J.C. Penney ($JCP) and Best Buy ($BBBY) are other theoretical beneficiaries (though that would STILL require people to go to malls).

Who is not benefiting? Apparently those hedge funds that famously shorted malls.

Looks like Sears won’t be the last loser playing in the mall space.

💤Sears 💤

Eddie Lampert, ESL & Shenanigans

BREAKING NEWS: SHORT SEARS HOLDING CORP.

We’re old enough to remember when Sears Holding Corp. ($SHLD) was last rumored to file for bankruptcy. In 2017. 2016. 2015. 2014. 2013. 2012. 2011. And 2010 (the last year it turned a profit). This thing is like “Karl” in Die Hard.

Or this lady:

It just won’t die.

So this week’s reports that Sears’ CEO Eddie Lampert “Urges Immediate Action to Stave Off Bankruptcy” were met with, shall we say, a collective yawn. Lampert has been performing financial sleight-of-hand for years, all the while the five-year SHLD stock chart looks like this:

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This is what the Twitterati had to say about this: [ ].

Yes, that blank space is intentional. We’ve never seen Twitter so quiet. Grandma was like, “Sears? Sears? I last shopped in Sears when I was prom shopping…in 1956.” Mom was like, “I once bought you a Barbie at Sears…in 1989.” Some millennial somewhere was probably like, “Sears? What’s a Sears, brah?”

Just kidding: nobody is talking about Sears. That would imply mindshare. 🔥

Lack of mindshare notwithstanding, the company, despite a wave of closures over the years (including 46 unprofitable stores slated for closure in November ‘18), consists of 820 stores (including KMart). As of 2017, the company had 140,000 employees. Thats Toys R Usx 4.5. The company also has approximately $5.5 billion of debt, $1.1 billion of pension and post-retirement benefits, declining revenues, negative (yet improving) same store sales percentages, negative gross margin, and increasing net losses.

  Source: SHLD Q2 Earnings Release Presentation, September 13, 2018

Source: SHLD Q2 Earnings Release Presentation, September 13, 2018

It also had $941mm of cash available as of the end of Q2 2018.

On Sunday, Lampert filed a Schedule 13D with the SEC outlining his proposal to save Sears in advance of a $134 debt payment due on October 15. High level, the proposal was…

“…to the Board requesting Holdings to consider liability management transactions, real estate transactions and asset sales intended to extend near-term debt maturities, reduce long-term debt, eliminate associated cash interest obligations and obtain additional liquidity.”

The proposed liability management transactions…provide for exchange offers to eligible holders of second lien debt…and eligible holders of unsecured debt…. These potential exchange offers together could save Holdings approximately $33 million per year in cash interest and eliminate approximately $1.1 billion in debt.

More specifically, the proposal calls for, among other options, ‘19 and ‘20 second lien debtholders and ‘19 unsecured noteholders to swap into zero-coupon mandatorily convertible secured debt (no yield, baby?)(read the 13D link above for more detail). It also calls for the sale of $3.25 billion worth of real estate and assets, including Sears Home Services and Kenmore.

After all of this time, why now? Per Bloomberg:

Lampert and ESL acted after watching other retailers including Toys “R” Us Inc. and Bon-Ton Stores Inc. wind up in liquidation, according to people with knowledge of the plan. The aim is to get something done out of court to preserve value for shareholders, since they don’t usually fare well in bankruptcy proceedings, said the people, who weren’t authorized to comment publicly and asked not to be identified.

There’s something strangely poetic about Lampert and ESL using the ghosts of Toys R Us and BonTon past to coerce creditors into an exchange transaction now.

Anyway, Twitter may have been quiet, but naysayers abound.

From Bloomberg:

“It seems the next natural iteration of all the financial engineering the company has been engaging in over the last few years,” Bloomberg Intelligence analyst Noel Hebert said. “For non-bank creditors not named Eddie Lampert, there is a bit of prisoner’s dilemma -- maybe something more tomorrow, or the near certainty of very little today.”

“This is simply storing up trouble for the future,” according to a note from Neil Saunders, managing director of research firm GlobalData Retail. “Sears is focusing on financial maneuvers and missing the wider point that sales remain on a downward trajectory,” he wrote. “Even in a strong consumer economy, customers are still drifting away to other brands and retailers.”

From the Washington Post:

“Eddie Lampert is seeking permission from himself to keep Sears on life-support while he continues to drain every last remaining drop of blood from its corpse,” said Mark Cohen, director of retail studies at Columbia Business School and the former chief executive of Sears Canada. “The operation is a failure, and there is no plan to turn that around."

From the Wall Street Journal:

“Given Lampert’s shuffling of Sears assets in ways some creditors suspect was more to his benefit than theirs, there is a chance they will hesitate to let him reorganize unless it is under the watchful eye of a bankruptcy judge,” said Erik Gordon, a University of Michigan business school professor.

Ugh. Wake us up when its finally over. Even Karl eventually died.


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Oil & Gas is Back Baby

Long the West Texas’ Permian Basin; Short Anadarko

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If you’re Steve RogersEncino Man, or were otherwise frozen somehow from 2014 through 2017 and missed the oil and gas downturn, Bethany McLean’s “Saudi America” will give you a nice high-level overview of American oil policy and fracking. It discusses Aubrey McClendon, the Obama-era change oil export policy, President Trump’s notion of energy independence, the rise of the West Texas’ Permian basin and more. She writes:

“What people still fail to understand is that the most cyclical number we have is the theoretical break-even,” one oil man says. “There will be stories about how the $40 break-even became the $70 break-even, and people will say ‘Who lied to me?’”

And so it is that the most important factor in the comeback of shale is the same thing that started the boom in the first place: The availability of capital. “It came back because Wall Street was there,” says longtime short-seller Jim Chanos. In 2017, U.S. frackers raised $60 billion in debt, up almost 30 percent since 2016, according to Dealogic.

Wall Street’s willingness to fund money-losing shale operators is, in turn, a reflection of ultra-low interest rates. That poses a twofold risk to shale companies. In his paper for Columbia’s Center of Global Energy Policy, Amir Azar noted that if interest rates rose, it would wipe out a significant portion of the improvement in break-even costs.

But low interest rates haven’t just meant lower borrowing costs for debt-laden companies. The lack of return elsewhere also let pension funds, which need to be able to pay retirees, to invest massive amounts of money with hedge funds that invest in high yield debt, like that of energy firms, and with private equity firms — which, in turn, shoveled money into shale companies, because in a world devoid of growth, shale at least was growing. Which explains why Lambert, portfolio manager of Nassau Re, says “Pension funds were enablers of the U.S. energy revolution.”

Ah, yield baby yield.

A lot of the U.S. energy revolution and recovery from ‘14-’17 is coming from the West Texas’ Permian basin. McLean writes:

In 2010, the Permian Basin was producing just shy of 1 million barrels a day. In 2017, that had more than doubled to over 2.5 million barrels a day. By August, output from the Permian alone exceeded that of 8 of the 13 members of OPEC, according to Bloomberg. The International Energy Agency predicts that output will hit more than 4 million barrels a day within a few years. Production from the Permian is the primary driver behind skyrocketing estimates of how much oil the U.S. will produce.

Apropos, Bloomberg noted this week:

To get a toehold in the prolific Permian Basin, private equity is increasingly betting on a relatively obscure, and potentially risky, part of the pipeline industry.

Operations in the Permian that gather oil and gas, and process fuel into propane and other liquids, have drawn almost $14 billion in investment since the start of 2017, with $9.2 billion of that coming from private companies, according to Matthew Phillips, an analyst at Guggenheim Securities LLC.

Specifically, Bloomberg is referring to midstream companies manufacturing gathering and processing pipeline assets that transport oil and gas across states. Producers commit to pay for space in the pipes over a period of years. Restructuring professionals are very familiar with these gathering contracts: they were the subject of many a dispute during the recent downturn.

…investors in gathering pipes and processing plants are forced to lean on long-term projections, since their projects depend on continuous output over time from the same area.

“Any time there’s massive supply growth, there is some risk-seeking behavior,” said Jeff Jorgensen, portfolio manager and director of research at Brookfield Asset Management Inc.’s Public Securities Group. There’s a tendency by some to “invest in production profiles that are, let’s just say, hilariously aggressive in their assumptions” for the future, he said.

It’s easy to see where that aggressiveness is coming from. Researcher IHS Markit predicts output in the Permian Basin will double by 2023 to reach 5.4 million barrels a day. That’s more than every OPEC country except Saudi Arabia. By 2035, it could hit 6.3 million barrels, according to Wood Mackenzie.

Bloomberg continues:

…with the surge of private equity money giving way to smaller players that may be taking on added debt to pay for pricey projects, the risk increases dramatically.

“There’s definitely some sloppiness in the gathering and processing space,” she said. “The cash flow isn’t going to be what they expected, so we could see some of the smaller players financially weaken, and that may lead to consolidation.”

With oil prices on the rise, however, the risk may seem worth taking. Memories are short. And confidence in break-even costs must be through the roof. Regardless of whether President Trump is happy with oil prices where they are.

The bottom line is that in this oil and gas recovery, there are clear winners and losers. The Permian is a big winner. This explains the recent S-1 filing of Riley Exploration — Permian LLC ($REPX)(owned by Yorktown Partners LLCBluescape Energy Partners LLC and Boomer Petroleum LLC), which has 65k+ net acres in the Permian as of June 30, 2018. Look at that name: they’re clearly sending a message that screams “pureplay Permian exploration and development company.” It’s like companies putting “.com” in their name during the dot.com bubble and “blockchain” in their name in the more recent crypto bubble. Smart move.

The Bakken in North Dakota appears to be back too. Per Bloomberg:

North Dakota’s oil production surged to a new record in July, putting the mid-western state on par with OPEC member Venezuela.

Home to the Bakken shale play, North Dakota pumped 1.27 million barrels a day in July, according to state figures released Friday. That’s roughly the same output as Venezuela during the month. The South American nation, whose oil industry has collapsed amid a prolonged financial crisis, saw production fall further in August to 1.24 million barrels a day -- about half the level seen in early 2016, according to data from OPEC secondary sources.

Where are the losers? Look at the Anadarko/Woodford area (read: West Oklahoma). In quite the juxtaposition to Riley Exploration, this week Tapstone Energy, a Blackstone-backed oil and gas exploration and production company withdrew its proposed $400mm IPO. Those closely watching Gastar Exploration Inc. ($GSTC) will find it located there too. The stock was delisted, trades over-the-counter at $0.06/share. The bankruptcy clock is ticking.

Like we said. Winners and losers.

What to Make of the Credit Cycle Part 12 (Long Yield, Baby, Yield).

The Rise of Litigation Finance

Investors have to generate yield somewhere. Hence, as we’ve discussed ad nauseum, the rise of alternative investment avenues such as venture capital and litigation finance. Wait. Litigation finance? Yes. Think Peter Thiel, Hulk Hogan and Gawker. This is a booming space.

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🎆Lehman = Anniversary Fever🎆

Initiate the Deluge of Lehman Retrospectives (Short History)

The onslaught of “10 years ago” retrospectives about the collapse of Lehman Brothers, the “Great Recession,” and lessons learned (and not learned, as the case may be), has officially begun. Brace yourselves.

Bloomberg’s Matt Levine writes:

Next weekend marks 10 years since the day that Lehman Brothers Inc. filed for bankruptcy. I suppose you could argue for other dates being the pivotal moment of the global financial crisis, but I think most people sensibly take Lehman Day as the anniversary of the crisis. Certainly I have a vivid memory of where I was on Sept. 15, 2008 (on vacation, in Napa, very confused about why no one around me was freaking out), which is not true of, say, Bear Stearns Hedge Funds Day. So expect a lot of crisis commemoration in the next week or two.

Fair point about Bear Stearns. As we’ll note in a moment, that isn’t the only pivotal moment that is getting lost in the Lehman Brothers focus.

Anyway, Levine pokes fun at a Wall Street Journal piece entitled, “Lehman’s Last Hires Look Back.” It is worth a read if you haven’t already. The upshot: all four of the folks who started at Lehman on or around the day it went bankrupt ended up landing on their feet. In fact, it doesn’t sound like any of them really suffered much of a gap of employment, if any at all.

Levine continues:

I mean he stayed there for two and a half years and left, not because he was working for a bank that had imploded and couldn’t pay him anymore, but because he got “super jaded.” Another one “was fortunate that my position was maintained at Neuberger Berman [an investment-management firm then owned by Lehman], and I spent eight years there” — and now works for Dick Fuld at his new firm. It is all a bit eerie to read. Of course Lehman’s bankruptcy led, fairly rapidly, to many job losses in the financial industry, and particularly — of course — at Lehman.  But there is a lot of populist anger to the effect that investment bankers brought down the global economy and escaped relatively unscathed, and that anger will not be much assuaged by learning that these young bankers — who, to be fair, had nothing to do with bringing down the economy! — kept their jobs for years after Lehman’s bankruptcy and left only when they felt super jaded.

He’s got a point.

It’s not as if this is a happy anniversary and so there are a number of folks who are doubling-down on the doom and gloom. McKinsey, for instance, notes that global debt continues to grow and households have reduced debt but are still over-levered. They also note, as we’ve written previously, that (i) corporate debt serves as a large overhang (e.g., developing country debt denominated in foreign currencies, growth in junk bonds, the rise in “investment grade” BBB bonds, the resurgence of CLOs), (ii) real-estate prices are out of control and creating housing shortages, (iii) China’s growth trajectory is becoming murkier in the face of significant debt, and (iv) nobody fully knows the extent to which high-frequency trading can affect markets in a panic. They don’t even mention the possible effects of Central Banks’ tightening and unwinding QE (Jamie Dimon must be shaking his head somewhere). Nevertheless, they conclude:

The good news is that most of the world’s pockets of debt are unlikely to pose systemic risk. If any one of these potential bubbles burst, it would cause pain for a set of investors and lenders, but none seems poised to produce a 2008-style meltdown. The likelihood of contagion has been greatly reduced by the fact that the market for complex securitizations, credit-default swaps, and the like has largely evaporated (although the growth of the collateralized-loan-obligation market is an exception to this trend).

But one thing we know from history is that the next crisis will not look like the last one. If 2008 taught us anything, it’s the importance of being vigilant when times are still good.

Arturo Cifuentes writes in The Financial Times that, unfortunately, ratings agencies, insurance companies and investment executives got off relatively unscathed (in the case of the former, some fines notwithstanding). The Economist notes that housing issues, offshore dollar finance, and the post-Great Recession rise in populism (which prevents a solution to the euro’s structural problems) continue to linger. Ben BernankeTimothy Geithner and Henry Paulson Jr. worry that Congress has de-regulated too much too soon.

Others argue that the crisis made us too afraid of risk, at least initially — particularly at the individual level. And that this is why the recovery has been so slow and, in turn, populism has been on the rise. Indeed, some note that the response to the crisis is why “the system is breaking now.” And still others highlight how the return of covenant-lite is Exhibit A to the argument that memories are short and any lessons went flying right out the window. Castles in the air theory reigns supreme.

Anyway, The Wall Street Journal has a full section devoted to “The Financial Crisis: 10 Years Later” so you can drown yourself in history all you want. This Financial Times pieceresonated with us: we remember embarking on the same prophylactic personal financial protections at the time. And how eerie it was.

But what haven’t we seen much of? We would love to see “A Man in the High Castle”-like coverage of what would have happened had AIG not been bailed out and been allowed to fail. The bailout of AIG has largely been relegated to a footnote in the history of the financial crisis — much like, as Levine implied, the failure of Bear Stearns. Make no mistake, it’s undoubtedly better off that way. But remember: the AIG bailout occurred one day afterLehman Brothers bankruptcy filing. It, therefore, didn’t take long for the FED to conclude amidst the carnage of Lehman’s failure that an AIG failure would do ever-more unthinkable Purge-like damage to the international financial system. In fact, many believed at the time that, through its relationships with all of the big banks and the extensive exposure it had to credit default swaps, that AIG was more strongly correlated to the international system (and hence more dangerous) than even Lehman.

After seeing what was happening once Lehman went bankrupt, this was simply a risk that the FED wasn’t willing to take. What if they were willing? Where would the world economy look like now? It’s interesting to think about.

One last note on AIG: Lehman had 25,000 employees. AIG is currently twice that. Even from the perspective of headcount, it was literally too big to fail.

Initiate the Deluge of Lehman Retrospectives (Short History)

10 Years Have Passed Since the Great Recession. What has Changed?

The onslaught of “10 years ago” retrospectives about the collapse of Lehman Brothers, the “Great Recession,” and lessons learned (and not learned, as the case may be), has officially begun. Brace yourselves.

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💣Diebold. Disrupted.💣

Are Point-of-Sale & Self-Checkout Systems Effed (Short Diebold Nixdorf)?

Forgive us for returning to recently trodden ground. Since we wrote about Diebold Nixdorf Inc. ($DBD) in “💥Millennials & Post-Millennials are Killing ATMs💥,” there has been a flurry of activity around the name. The company…

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🍟Casual Dining is a Hot Mess. Part IV 🍟

Short Kona Grill ($KONA)

We’ve been all over the casual dining space so much that it’s time to just make this a recurring series. We’ve previously discussed casual dining here (Macro trends, Kona GrillP.F. Ghang China Bistro Inc.Ruby Tuesday and Bertucci’s), here (Applebee’s Neighborhood Grill & Bar) and here (Luby’s Inc. and Steak ‘n Shake).

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The Rise of Net-Debt Short Activism (Short Low Default Rates)

Aurelius Goes After Windstream Holdings Inc. 

🤓Another nerd alert: this is about to get technical.🤓

With default rates low, asset prices high, and a system awash with heaps of green, investors are under pressure by LPs and looking for ways to generate returns. They’ll manufacture them if needs be. These forces help explain the recent Hovnanian drama, the recent McClatchey drama and, well, basically anything involving credit default swaps (“CDS”) nowadays. To point, the fine lawyers at Wachtell Lipton Rosen & Katz (“WLRZ”) write:

The market for corporate debt does not immediately lend itself to the same kind of “activism” found in equity markets.  Bondholders, unlike shareholders, do not elect a company’s board or vote on major transactions.  Rather, their relationship with their borrower is governed primarily by contract.  Investors typically buy corporate debt in the hope that, without any action on their part, the company will meet its obligations, including payment in full at maturity.

In recent years, however, we have seen the rise of a new type of debt investor that defies this traditional model.

Right. We sure have. Boredom sure is powerful inspiration. Anyway, WLRZ dubs these investors the “net-short debt activist” investor.

The net-short debt activist investor has a particular modus operandi. First, the investor sniffs around the credit markets trolling for transactions that arguably run afoul of debt document covenants (we pity whomever has this job). Once the investor identifies a potential covenant violation, it scoops up the debt (the “long” position”) while contemporaneously putting on a short position by way of CDS (which collects upon a default). The key, however, is that the latter is a larger position than the former, making the investor “net short.” Relying on its earlier diligence, the investor then publicly declares a covenant default and, if it holds a large enough position (25%+ of the issuance), can serve a formal default notice to boot. The public nature of all of this is critical: the investor knows that the default and/or notice will move markets. And that’s the point: after all, the investor is net short.

In the case of a formal notice, all of this also puts the target in an unenviable position. It now needs to go to court to obtain a ruling that no default has occurred. Absent that, the company is in a world of hurt. WLRK writes:

Unless and until that ruling is obtained, the company faces the risk not only that the activist will be able to accelerate the debt it holds, but also that other financial debt will be subject to cross defaults and that other counterparties of the company — such as other lenders, trade creditors, or potential strategic partners — may hesitate to conduct business with the company until the cloud is lifted.  

Savage. Coercive. Vicious. Long low default rate environments!

In the case of Little Rock Arkansas-based Windstream Holdings Inc. ($WIN), a provider of voice and data network communications services, all of this is especially relevant.

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💰Goldman Sachs Has its Cake and Eats it Too💰

Short GNC Holdings Inc. Long Care/of. 

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We’ve written extensively hereherehere and here about GNC Holdings Inc. ($GNC) and the challenges that the company faces. We won’t revisit all of that here other than to note that GNC was, upon information and belief, preparing for a bankruptcy filing prior to it amending and extending its term loan, entering into a new ABL, and obtaining $275mm of asset-backed FILO term loans. We quipped that this was the quintessential “kick-the-can-down-the-road” transaction. Goldman Sachs ($GS) advised the company on the entire capital structure fix. Suffice it to say, then, that Goldman Sachs is intimately familiar with the GNC business.

Which, naturally, makes the fact that Goldman Sachs Investment Partners (a division of Goldman Sachs Asset Management) served as the lead investor in vitamin startup Care/of’s Series B financing all the more interesting.

Now, of course, we know Goldman is a big shop. They’re probably talking to WeWorkabout how to design their spaces to balance the sheer volume of “Chinese walls” with the need for an aesthetic that appeals to the millennial mindset. And, surely, Goldman Sachs’ capital advisory arm is entirely different and separate from Goldman’s asset management and venture arm.

But still.

Earlier this week Care/of, a direct-to-consumer wellness brand that specializes in monthly subscriptions of personalized vitamins and supplements, announced the new round of $29mm. In addition to Goldman, investors included Goodwater Capital, Juxtapose, RRE Ventures and Tusk Ventures. Former President of GNC, Beth Kaplan, also invested and will be joining the Board. 🤔

Bloomberg notes:

Care/of, a startup selling vitamins and herbal supplements online, raised funds from investors including Goldman Sachs Group Inc.’s venture arm that value the company at $156 million, within striking distance of publicly traded retail chains that are among the industry’s leaders.

The startup’s $156 million valuation isn’t far from Vitamin Shoppe Inc., with 3,860 employees and a market capitalization of about $203.5 million, or GNC Holdings Inc., which has a market value of $254.2 million with 6,400 employees. Care/of has about 100 workers, Chief Executive Officer Craig Elbert said.

“Consumers are increasingly shifting spend online and so I think large retail footprints have the potential to be a liability,” Elbert said in an interview. “There’s a lot of growth ahead of us and lot of reasons why this should be an e-commerce business.”

This is so Goldman-y. Collect an advisory fee to extend the life of the dominant brick-and-mortar retailer with one hand while investing in a nimble direct-to-consumer upstart that will chip away on that very same retailer on the other hand. Even before the former requires capital markets advice from a Goldman-type in a few years — which, it undoubtedly will — it may be on the lookout for an M&A banker. Perhaps to sell itself. Perhaps to buy a start-up and build a moat against Amazon. How convenient that Goldman will have familiarity with both businesses. We’d say that maybe there’d be a conflict somewhere in there but, well…do those really even exist anymore??

⚡️Is PG&E in Trouble?⚡️

PG&E Reported Earnings (Long Climate Change)

Long time PETITION readers know that our general theme is “disruption, from the vantage point of the disrupted.” Disruption can come in various forms. In many cases it comes from technological innovation. The dreaded “Amazon Effect” that everyone is so tired of hearing about falls into this category. But as we’ve said time and time again, mobile e-commerce is a big part of that story and that would never have been made possible — and perhaps brick-and-mortar would still be intact — if it weren’t for the Apple Iphone ($AAPL), for Shopify ($SHOP), and for Instagram ($FB), among many other disrupters. Today’s innovations are leading indicators for tomorrow’s bankruptcies.

Disruption — and, no, we don’t always use this term in the Clayton Christensen sense — can come in other forms. There can be regulatory and/or legislative disruption, political disruption, environmental disruption, etc. In the case of PG&E — short for Pacific Gas and Electric Company — it may be all of the above.

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Home Security is a Tough Business

Short Ascent Capital Group

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Tough is one word for it.

Saturated is another.

There are countless players in the home security and monitoring space including (i) recently-IPO’d ADT Inc. (owned by Apollo Asset Management),* (ii) Vivint Inc., (iii) Guardian Protection Services, (iv) Vector Security Inc., (v) Comcast Corporation, and (vi) SimpliSafe Inc. And there is also the identity-confused schizophrenic Monitronics International Inc., formerly known as MONI Smart Security and now known as Brinks Home Security, which is a wholly-owned subsidiary of publicly-traded holding company Ascent Capital Group ($ASCMA)(did you get all of that?). Nearly all of these companies compete in the market for “alarm monitoring agreements” (AMAs) — contracts pursuant to which these companies provide home monitoring services in exchange for predictable recurring revenue. Predictable in a manner of speaking: with this much competition, the industry is getting a wee bit…less…predictable…?

Ascent Capital Group noted in its most recent 10-K:

Competition in the security alarm industry is based primarily on reputation for quality of service, market visibility, services offered, price and the ability to identify and obtain customer accounts. Competition for customers has also increased in recent years with the emergence of DIY home security providers and other technology companies expanding into the security alarm industry. We believe we compete effectively with other national, regional and local alarm monitoring companies, including cable and telecommunications companies, due to our reputation for reliable monitoring, customer and technical services, the quality of our services, and our relatively lower cost structure. We believe the dynamics of the security alarm industry favor larger alarm monitoring companies, such as MONI, with a nationwide focus that have greater resources and benefit from economies of scale in technology, advertising and other expenditures. (emphasis added).

Make no mistake: ASCMA is purposefully highlighting its monitoring expertise, size and scale. And that is because the market for AMAs is getting increasingly challenged by a number of home security providers. And many of them are of the do-it-yourself (“DIY”) variety. For instance, home owners can get home security devices from Arlo by Netgear.** Or Canary. Or Honeywell ($HON). Or Google (Nest)($GOOG). Amazon Inc. ($AMZN) recently bought Ring Doorbell for $1 billion and that, too, has a home security system. Gadget stores are replete with options for DIY home security systems. Do people even need professional installation and/or monitoring anymore? With property crimes on a nationwide decline, is a self-monitoring system viable enough? Why bother when you can just get alerts to the phone in your pocket or the watch on your wrist? These are the big questions.

Especially for Monitronics.

Monitronics primarily sells its home security and monitoring services through a network of authorized dealers. While it also deploys certain direct-to-consumer initiatives under its DIY-focused subsidiary, LiveWatch Security LLC, the company’s real action is from the recurring fees baked into AMAs. Unfortunately:

In recent years, MONI's acquisition of new customer accounts through its dealer sales channel has declined due to the attrition of large dealers, efforts to acquire new accounts from dealers at lower purchase prices, consumer buying behaviors, including trends of buying security products through online sources and increased competition from telecommunications and cable companies in the market. MONI is increasingly reliant on its internal sales channel and strategic relationships with third parties, such as Nest, to counter-balance this declining account generation through its dealer sales channel. If MONI is unable to generate sufficient accounts through its internal sales channel and strategic relationships to replace declining new accounts through dealers, MONI's business, financial condition and results of operations could be materially and adversely affected. (emphasis added)

Was that a borderline “Amazon Effect” reference mixed in there? 🤔 Wait. There’s more:

As of December 31, 2017, MONI was one of the largest alarm monitoring companies in the U.S. when measured by the total number of subscribers under contract. MONI faces competition from other alarm monitoring companies, including companies that have more capital and that may offer higher prices and more favorable terms to dealers for alarm monitoring contracts or charge lower prices to customers for monitoring services. MONI also faces competition from a significant number of small regional competitors that concentrate their capital and other resources in targeting local markets and forming new marketing channels that may displace the existing alarm system dealer channels for acquiring alarm monitoring contracts. Further, MONI is facing increasing competition from telecommunications, cable and technology companies who are expanding into alarm monitoring services and bundling their existing offerings with monitored security services. The existing access to and relationship with subscribers that these companies have could give them a substantial advantage over MONI, especially if they are able to offer subscribers a lower price by bundling these services. Any of these forms of competition could reduce the acquisition opportunities available to MONI, thus slowing its rate of growth, or requiring it to increase the price paid for subscriber accounts, thus reducing its return on investment and negatively impacting its revenues and results of operations.

And here we thought people were shunning the cable companies?

Anyway, can Monitronics circumvent these issues with a superior product? By investing in new technology to ward off the onslaught of newcomers? More from the 10-K:

…the availability of any new features developed for use in MONI's industry (whether developed by MONI or otherwise) can have a significant impact on a subscriber’s initial decision to choose MONI's or its competitor’s products and a subscriber's decision to renew with MONI or switch to one of its competitors. To the extent its competitors have greater capital and other resources to dedicate to responding to technological innovation over time, the products and services offered by MONI may become less attractive to current or future subscribers thereby reducing demand for such products and services and increasing attrition over time. Those competitors that benefit from more capital being available to them may be at a particular advantage to MONI in this respect. If MONI is unable to adapt in response to changing technologies, market conditions or customer requirements in a timely manner, such inability could adversely affect its business by increasing its rate of subscriber attrition. MONI also faces potential competition from improvements in self-monitoring systems, which enable current or future subscribers to monitor their home environments without third-party involvement, which could further increase attrition rates over time and hinder the acquisition of new alarm monitoring contracts. (emphasis added)

Luckily this isn’t an issue because Monitronics currently has the best most technologically-advanced home security offering on the market. Oh. Hmmm. Wait. We spoke to soon…

Here is Wirecutter reviewing “The Best Home Security System.” And suffice it to say, the Monitronics’ product is not the winner. In fact, Wirecutter knocks the “Brinks Home Complete with Video” system on cost.

Here is PCmag reviewing “The Best Smart Home Security Systems of 2018” and the LiveWatch Plug & Protect IQ 2.0 is buried down the list with a 3.5 star rating (out of 5).

And here is Reviews.com’s list of “The Best DIY Home Security” and neither LiveWatch nor Brinks are listed. 😜

To offset all of these current challenges, the company luckily has unconstrained liquidity and a clean balance sheet to invest in marketing to dealers and upgrading its technology for the future. Oh. Hmmm. Wait. We spoke to soon. Again. 😜

Late last week, Moody’s Investors Service Inc. downgraded Monitronics International Inc.to Caa2 from B3; it also downgraded (i) the company’s $1.1 billion senior secured first-lien L+5.50% term loan due 2020 to Caa1 from B2 and (ii) its 9.125% $585 million senior unsecured notes to Caa3 from Caa2. To complete the capital structure picture, the company also has approximately $68.5 million outstanding on a $295 million L+4% credit facility “super priority” revolver due 2021. So, to make sure you grasp the magnitude here: 1 + 2 + 3 = $1.8 billion of debt. Yup, you read that right. There’s a lot of interest expense attached to that. Oh, and per ASCMA’s last 10-K:

The maturity date for both the term loan and the revolving credit facility under the Credit Facility are subject to a springing maturity 181 days prior to the scheduled maturity date of the Senior Notes. Accordingly, if MONI is unable to refinance the Senior Notes by October 3, 2019, both the term loan and the revolving credit facility would become due and payable.

Hmmm. 🤔 Siri, set an alarm for April 2019‼️💥

Moody’s noted:

The downgrade of Monitronics' CFR and facility ratings reflects strains on the company's liquidity and capital structure caused by impending maturities, as well as its continued lackluster operating performance.

The liquidity rating downgrade to SGL-4 reflects the approaching debt maturities. Moody's views Monitronics' liquidity as operationally adequate, but weak in terms of imminent, likely accelerating debt maturities. As a result of the company's continued lackluster performance, Moody's expects Monitronics to generate barely breakeven free cash flow this year. The (unrated) $295 million, super-priority revolving credit facility is large and has, as of early July 2018, a time of seasonally heavy revolver borrowing, roughly $80 million drawn. Reliance on the revolver also creates liquidity risk because the revolver expiration will spring to October 2019 if the notes are not refinanced. While cash on hand continues to be modest ($30 million at March 31st), Monitronics' parent company, Ascent Capital Group, Inc.("Ascent"), has nearly $110 million of cash, which may be viewed as providing additional implied support. Still, Monitronics' combined sources of liquidity are weak relative to the quantum of debt coming due in the next few years. Reliance on the revolver for operational initiatives and to fund purchases of new subscriber contracts from dealers will also prevent meaningful deleveraging over the next year. Weak operational metrics also continue to shrink the cushion it has relative to covenant limits, and the risk of a covenant violation over the next 12-15 months is elevated.

Ergo, the capital structure is rumored to be advisored up with (a) Houlihan Lokey and Stroock & Stroock & Lavan working with an ad hoc group of unsecured holders and (b) Jones Day and Evercore working with the term lenders. Latham & Watkins LLP reportedly represents the company. Anchorage Capital may be a bit of a wild card here as they allegedly hold a meaningful position in the term loan and the unsecured bonds.

All of this drama has taken its toll on ASCMA’s stock:

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This company is looking a bit insecure.

* ADT IPO’d earlier this year championing its revenue-generation. In its S-1 filing it noted, “In the nine months ended September 30, 2017 and the year ended December 31, 2016, we had total revenues of $3,210 million and $2,950 million, respectively, and net losses of $296 million and $537 million, respectively.” Um, okay. This looks like a textbook Apollo dump. And the market seems to be responding. Here is the range-bound stock performance post-IPO:

Hard to blame Apollo for getting out while the gettin’ is good.

** As we were researching and writing this piece, Arlo Technologies filed its S-1 for a planned $194mm IPO. The firm posted $6.6 million in income on $370.7 million in revenue for 2017.

As we said, “saturated.”

🍟Casual Dining Continues to = a Hot Mess🍟

Luby's & Steak N Shake Look Stressed (Short Soggy Mac N’ Cheese)

We’ve previously covered this topic in “🍟Casual Dining is a Hot Mess🍟” and “More Pain in Casual Dining (Short Soggy Mozzarella Sticks).” Recall that, back in April, Bertucci’s Holdings Inc. filed for bankruptcy and said the following in its First Day Declaration:

"With the rise in popularity of quick-casual restaurants and oversaturation of the restaurant industry as a whole, Bertucci’s – and the casual family dining sector in general – has been affected by a prolonged negative operating trend in an ever increasing competitive price environment. Consumers have more options than ever for spending discretionary income, and their preferences continue to shift towards cheaper, faster alternatives. Since 2011, Bertucci’s has experienced a year-over-year decline in sales and revenue."

Unfortunately for those in the space, those themes persist.

On Monday, Luby’s Inc. ($LUB) — the owner and operator of 160 restaurants (86 Luby’s Cafeteria, 67 Fuddruckers and 7 Cheeseburger in Paradise) reported Q3 earnings and they were totally on trend. While the company reported positive same-store sales at Luby’s Cafeteria — its largest brand — the company’s financial results nevertheless cratered on account of increased costs (in food, labor and operating expense) without a corresponding acceleration in sales (via either increased prices or guest traffic). The company’s overall same store sales decreased 0.9%, its total sales decreased 3.1%.

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The company noted:

“…the current competitive restaurant environment is making it difficult for our brand and the mature brands of many others to gain significant traction. We've been faced with the environment for quite some time, which has been a large drag on our financial results and our company valuation.

The challenge of rising costs, flattish-to-down sales, and a sustained debt balance are restricting the company's overall financial performance.”

Like many other chains, therefore, Luby’s is rationalizing its store count. The company previously committed to shedding at least 14 of its owned locations to the tune of an estimated $25mm in proceeds; it is accelerating its efforts in an attempt to generate an additional $20mm in proceeds. The use of proceeds is to pay down the company’s $44.2mm of debt. The company also announced that it hired Cowen ($COWN) to assist it with a potential restructuring of its Wells Fargo-agented ($WFC) credit facility. That hire was a requirement to a July 12-dated financial covenant default waiver (expiration August 10) provided by the company’s lenders.

This company does have one advantage over several distressed competitors: it owns a lot of its locations (in addition to its franchise business; a separate licensee operates an additional 36 Fuddruckers locations). The question therefore becomes whether the company’s lenders will provide the company with enough latitude (via continued waivers or otherwise) to sell enough locations to generate proceeds to pay down or “reduce [its] outstanding debt to near zero.” If patience wears thin or buyers balk at purchasing locations that later may become subject to a fraudulent conveyance attack, this may be yet another casual dining chain to find itself in bankruptcy. The stock, which has been range-bound for about a year, trades as follows:

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*****

Likewise, Steak ‘n Shake is also beginning to look stressed — at least as far as its senior secured term loan goes. The casual dining restaurant company has somewhere between 580 and 616 locations, approximately 2/3 of which are company-owned. According to Reorg Researchit also has a group of lenders who are agitating given (i) under-budget revenues, (ii) liquidity concerns, and (iii) lower loan trading levels. Per Reorg:

The lenders’ move to organize comes as Steak ‘n Shake has shifted its focus from company-owned locations to franchise opportunities in the face of declining revenue, same-store sales and customer traffic as well as increased costs. A wholly owned subsidiary of Biglari Holdings, Steak ‘n Shake is a casual restaurant chain primarily located primarily in the Midwest and South United States; the chain is known for its steak burgers and milkshakes. Biglari says that unlike company-operated locations, franchises have “continued to progress profitably.” “Franchising is a business that not only produces cash instead of consuming it, but concomitantly reduces operating risk,” the 2017 chairman’s letter says.

Even so, 415 of the total 616 Steak ‘n Shake locations are company-operated and creditors are pushing the company to bring in operational advisors, sources say. The company’s $220 million term loan due in 2019, which according to the Biglari 10-Q had $185.3 million outstanding as of March 31, has dipped to the 86/88 context, according to a trading desk. The term loan, which matures March 19, 2021, is secured by first-priority security interests in substantially all the assets of Steak ‘n Shake, although is not guaranteed by Biglari Holdings.

The company has been struggling for years. Per Restaurant Business:

Same-store sales fell 0.4% in 2016 and another 1.8% in 2017. Traffic last year fell 4.4%.

The decline in traffic wiped out the chain’s profits. Operating earnings per location declined from $83,300 in 2016 to just $1,000 in 2017.

Part of the issue may be the company’s geography-agnostic “consistent pricing strategy” which keeps prices static across the board — regardless of whether a location is in a higher cost region. This strategy has franchisees in an uproar which, obviously, could curtail efforts to switch from an owner-owned model to a franchisee model. Indeed, a franchisee is suing. Per Restaurant Business:

For franchisees that operate 173 of the 585 U.S. locations and have to pay for royalties on top of other costs, the traffic declines risk sending many locations into financial losses. In addition, rising minimum wages in many markets, along with competition for labor, could put further pressure on that profitability.

Steaks of Virginia, the franchisee that filed the lawsuit last week, claimed it was losing money at all nine of its locations.

Curious. Apparently the company’s reliance on higher traffic to generate profits didn’t come to fruition. Insert lawsuit here. Insert lender agitation here. Insert questionable business model shift here.

In a February shareholder letterBiglari Holdings Chairman Sardar Biglari channeled his inner-Adam Neumann (of WeWork), stating:

We do not just sell burgers and shakes; we also sell an experience.

And if by “experience” he means getting shotbeing on the receiving end of an armed robbery or getting beat up by an employee…well, sure, points for originality? 👍😬

Given all of the above and the perfect storm that has clouded the casual dining space (i.e., too many restaurants, the rise of food delivery and meal kit services, the popularity of prepared foods at grocers), lender activity at this early stage seems prudent.

#BustedIPO: Tintri Inc. Files for Bankruptcy

What is the statute of limitations for declaring an IPO busted?

We previously wrote about Tintri Inc. ($TNTR) here and, frankly, there isn’t much to add other than the fact that company has, indeed, filed for bankruptcy. The filing is predicated upon a proposed 363 sale of the company’s assets as a “going concern” or a liquidation of the company’s intellectual property in what should be a fairly short stint in bankruptcy court. Shareholders likely to be wiped out include New Enterprise Associates (yes, the same firm mentioned above in the Tamara Mellon bit), Insight Venture PartnersLightspeed Venture Partners and Silver Lake Kraftwerk.

Meanwhile, in the above-cited piece we also wrote:

Nothing like a $7 launch, a slight post-IPO uptick, and then a crash and burn. This should be a warning sign for anyone taking a look at Domo — another company that looks like it is exploring an IPO for liquidity to stay afloat.

This bit about Tintri''s financial position offers up an explanation for the bankruptcy filing -- in turn serving as a cautionary tale for investors in IPOs of companies that have massive burn rates:

"The company's revenue increased from $86 million in fiscal 2016 to $125.1 million in fiscal 2017, and to $125.9 million in fiscal 2018, representing year-over-year growth of 45% and 1 %, respectively. The company's net loss was $101.0 million, $105.8 million, and $157.7 million in fiscal 2016, 2017, and 2018, respectively. Total assets decreased from $158.1 million as of the end of fiscal 2016 to $104.9 million as of the end of fiscal 2017, and to $76.2 million as of the end of fiscal 2018, representing year-over-year change of 34% and 27%, respectively. The company attributed flat revenue growth in fiscal 2018 in part due to delayed and reduced purchases of products as a result of customer concerns about Tintri's financial condition, as well as a shift in its product mix toward lower-priced products, offset somewhat by increased support and maintenance revenue from its growing installed customer base. Ultimately, the company's sales levels have not experienced a level of growth sufficient to address its cash burn rate and sustain its business."

With trends like those, it's no surprise that the IPO generated less capital than the company expected. More from the company:

"Tintri's orders for new products declined, it lost a few key customers and, consequently, its declining revenues led to the company's difficulties in meeting day-to-day expenses, as well as long-term debt obligations. A few months after its IPO, in December 2017, Tintri announced that it was in the process of considering strategic options and had retained investment bank advisors to assist it in this process."

As we previously noted a few weeks ago, "[t]here's no way any strategic buyer agrees to buy this thing without a 363 comfort order."  With Triplepoint Capital LLC agreeing to provide a $5.4mm DIP credit facility, this is precisely the path the company seeks to take.

*****

Meanwhile, Domo Inc. ($DOMO) is a Utah-based computer software company that recently IPO’d. Per Spark Capital’s Alex Clayton:

Domo recently drew down $100M from their credit facility and currently only has ~6 months of cash left with their current burn rate. Given they raised $730M in equity capital from investors and another $100M through their credit facility, it implies they have spent roughly $750M over the past 8 years to reach a little over $100M in ARR, an extraordinary and unprecedented amount of cash burn for a SaaS company. They have $72M in cash.

That was before the IPO. This is after the IPO:

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Draw your own conclusions.

Bubbles (Short Prognisticators…Nobody Effing Knows)

This Morgan Housel piece talks about the psychology of bubbles. Good investors understand fundamentals but also have a sense for which direction the wind is blowing. This bit resonated:

Lehman Brothers was in great shape on September 10th, 2008. That’s what the statistics said, anyway.

Its Tier 1 capital ratio – a measure a bank’s ability to endure loss – was 11.7%. That was higher than the previous quarter. Higher than Goldman Sachs. Higher than Bank of America. Higher than Wells Fargo. It was more capital than Lehman had in 2007, when the banking industry and economy were about the strongest they had ever been.

Four days later, Lehman was bankrupt.

The most important metric to Lehman during this time was confidence and trust among short-term bond lenders who fed its balance sheet with capital. That was also one of the hardest things to quantify.

🚗Where’s the Auto Distress? Part II (#MAGA!!)🚗

In “🚗Where's the Auto Distress?🚗,” we poked fun at ourselves and our earlier piece entitled “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” because the answer to the latter has, for the most part, been “no.” But both pieces are worth revisiting. In the latter we wrote,

Production levels, generally, are projected to decline through 2021. Obviously, reduced production levels and idled plants portend poorly for a lot of players in the auto supply chain. 

And in the former we noted,

So, sure. Distressed activity thus far in 2018 has been light in the automotive space. But dark clouds are forming. Act accordingly.

And by dark clouds, we didn’t exactly mean this but:

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With a seeming snap-of-the-finger, Harley Davidson ($HOG) announced that it would move some production out of the US to Europe, where HOG generates 16% of its sales, to avoid EU tariffs on imported product. Per the Economist:

It puts the cost of absorbing the EU’s tariffs up to the end of this year at $30m-45m. It has facilities in countries unaffected by European tariffs that can ramp up relatively quickly.

Trump was predictably nonplussed, saying “don’t get cute with us” and this:

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AND this:

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More from the Economist:

AMERICAN companies “will react and they will put pressure on the American administration to say, ‘Hey, hold on a minute. This is not good for the American economy.’” So said Cecilia Malmström, the European Union’s trade commissioner, on news that Harley-Davidson plans to move some production out of America to avoid tariffs imposed by the EU on motorcycles imported from America.

Will react? Harley Davidson has reacted. Likewise, motorcycle-maker Polaris Industries Inc. ($PII) indicated Friday that it, too, is considering moving production of some motorcycles to Poland from Iowa on account of the tariffs. Per the USAToday:

In its first quarter earnings released in April, Polaris projected around $15 million in additional costs in 2018. Rogers said the latest tariffs would raise costs further, declining to estimate by how much. "But we're definitely seeing an increase in costs," she said.

General Motors Co. ($GM) also weighed in. Per Reuters:

The largest U.S. automaker said in comments filed on Friday with the U.S. Commerce Department that overly broad tariffs could "lead to a smaller GM, a reduced presence at home and abroad for this iconic American company, and risk less — not more — U.S. jobs."

Zerohedge noted:

The Auto Alliance industry group seized on the figure, arguing that auto tariffs could increase the average car price by nearly $6,000, costing the American people an additional $45 billion in aggregate.

Moody’s weighed in as well:

US auto tariff would be broadly credit negative for global auto industry. Potential US tariffs on imported cars, parts are broadly credit negative for the auto industry. The Commerce Department is conducting a review of whether auto imports harm national security. A similar probe resulted in 25% tariffs on imported steel and 10% on aluminum being implemented 1 June. A 25% tariff on imported vehicles and parts would be negative for most every auto sector group – carmakers, parts suppliers, dealers, retailers and transportation companies.

Relating specifically to Ford Motor Company ($F) and GM, it continued further:

US automakers would be negatively affected. Tariffs would be a negative for both Ford and GM. The burden would be greater for GM because it depends more on imports from Mexico and Canada to support US operations – 30% of its US unit sales versus 20% of US sales for Ford. In addition, a significant portion of GM's high-margin trucks and SUVs are sourced from Mexico and Canada. In contrast, Ford's imports to the US are almost exclusively cars — a franchise it is winding down. Both manufacturers would need to absorb the cost of scaling back Mexican and Canadian production and moving some back to the US. They would also probably need to subsidize sales to offset the tariffs for a time, with higher costs eventually passed on to consumers.

On the supply side, Moody’s continued:

Tariffs would also hurt major auto-parts manufacturers. The largest parts suppliers match automakers' production and vehicles and may struggle to adapt following any tariffs. Suppliers' efforts to keep cost down often result in multiple cross-border trips for goods and could incur multiple tariff charges. Avoiding those costs may disrupt the supply chain. Some parts makers have US capacity they could restart at a price. Companies with broad product portfolios, large market share, or that are sole suppliers of key parts will fare better.

And what about dealers and parts retailers? More from Moody’s:

Significant negative for US auto dealers, little change for parts retailers. Dealers heavily weighted toward imports (most of those we rate) will suffer. Penske Auto and Lithia would fare best. Many brands viewed as imports, such as BMW and Toyota, are assembled in the US, so there could be model shifting. Tariffs would be fairly benign for part retailers insulated by demand from the 260 million vehicles now on the road.

Upshot: perhaps its too early to give up on our predictions. Thanks to President Trump’s trade policy, there may, indeed, be auto distress right around the corner as big players adjust their supply chain and manufacturing models. Revenue streams are about to be disrupted.

🔥Amazon is a Beast🔥

The "Amazon Effect" Takes More Victims

Scott Galloway likes to say that mere announcements from Amazon Inc. ($AMZN) can result in billions of dollars of wiped-out market capitalization. Upon this week’s announcement that Amazon has purchased Boston-based online pharmacy startup Pillpack for $1 billion — beating out Walmart ($WMT) in the process — his statement proved correct. Check this out:

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We like to make fun of the Amazon narrative because we’re of the view that it’s overplayed — particularly in restructuring circles — and reflects a failure to understand broader macro trends (like the direct-to-consumer invasion noted below). Still, the market reaction to this purchase reflects the undeniable power of the “Amazon Effect” and we’d be remiss not to acknowledge as much. This purchase will likely be a turning point for pharmacies for sure; perhaps also, farther down the line, for benefits managers and pharmaceutical manufacturers. It also may provide Amazon with meaningful cross-pollination opportunities with its payments business — a subject that nobody seems to be talking about (more on this below).

Putting aside the losers for now, there are a variety of winners. First, obviously, are Pillpack’s founders, TJ Parker and Elliot Cohen. They stand to make a ton of money. Also its investors — Accel Partners, Atlas Venture, CRV, Founder Collective, Menlo Ventures, Sherpa Ventures and Techstars — at an 8x return, at least. Oh, and Nas apparently. And then there is Amazon itself. Pillpack isn’t a massive revenue generator ($100mm in ‘17) and it isn’t a big company (1k employees) but it packs a big punch: licenses to ship drugs in 50 sates. With this purchase, Amazon just hurdled over a significant regulatory quagmire.

So what is Pillpack? Per Wired (by way of Ben Thompson):

PillPack is trying to solve the problem of drug adherence by simplifying your medicine cabinet. Medication arrives in the mail presorted into clear plastic packets, each marked in a large font with vital information: day, time, pills inside, dosages. These are ordered chronologically in a roll that slots into the dispenser. Let’s say you need to take four different pills in the morning and two others in the afternoon every day: Those pills would be sorted into two tear-off packets: one marked 8am, followed immediately by the 2pm packet.

Put another way, Pillpack specializes in the convenience of getting you your medications directly with a design and user-experience focus to boot. The latter helps ensure that you’re taking the proper levels of medication at the right time.

Still, there are some limitations. Per The Wall Street Journal:

Amazon will be limited in what it can do, especially to start. PillPack’s specialty—packaging a month’s supply of pills for chronic-disease patients—is a small part of the overall market. It has said it has tens of thousands of customers versus Amazon’s hundreds of millions.

Current limitations notwithstanding, Thompson notes how much Pillpack’s service aligns with Amazon:

Amazon, particularly for Prime customers, is seeking to be the retailer of habit. That is, just as a chronic condition patient may need to order drugs every month, Amazon wants to be the source of monthly purchases of household supplies, and anything else one might want to buy along the way.

Like all aggregators, Amazon wins by providing a superior user experience, particularly when it comes to delivering the efficient frontier of price and selection. To that end, moving into pharmaceuticals via a company predicated on delivering a superior user experience makes total sense.

Thompson notes further:

The benefit Amazon will provide to PillPack, on the other hand, is primarily about dramatically decreasing the customer acquisition costs for a solution that is far better for consumers; to put it another way, Amazon will make a whole lot more people aware of a much more customer-friendly solution. Frankly, I have a hard time seeing why that is problematic.

To be sure, Amazon will benefit beyond its unique ability to supercharge PillPack’s customer acquisition numbers: just as Walgreen and CVS’s pharmacies draw customers to their traditional retail stores, PillPack’s focus on regular ordering fits in well with Amazon’s desire to be at the center of its customers day-to-day lives. This works in two directions: first, that Amazon now has a direct connection to a an ongoing transaction, and second, that would-be Amazon customers are dissuaded from visiting a retail pharmacy and, inevitably, buying something else along the way. This was a point I made in Amazon’s New Customer:

This, though, is why groceries is a strategic hole: not only is it the largest retail category, it is the most persistent opportunity for other retailers to gain access to Prime members and remind them there are alternatives.

A similar argument could be made for prescription drugs: their acquisition is one of the most consistent and predictable ways by which potential customers exist outside of the Amazon ecosystem. It makes a lot of sense for Amazon to reduce the inclination to ever go elsewhere.

It seems that Amazon is doing that lately for virtually everything. Consistently, further expansion beyond just chronic-disease patients seems inevitable. Margin exists elsewhere in the medical chain too and, well, Jeff Bezos once famously said “Your margin is my opportunity.” David Frankel of Founder Collective writes:

The story of the last five years has been that of bricks and mortar retailers frantically trying to play catch-up with Amazon. By acquiring PillPack, Amazon is now firmly attacking another quarter trillion dollars of TAM. Bezos is a tenacious competitor and has just added the most compelling consumer pharmacy to enter the game since CVS was founded in 1963.

TJ Parker understands the pharma business in his bones, has impeccable product sensibilities, and now has the backing of the most successful retail entrepreneur in history.

Expect some real healthcare reform ahead.

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No wonder those stocks all sh*t the bed. That all sounds downright horrifying for those on the receiving end.

*****

Recall weeks back when we noted this slide in Mary Meeker’s “Internet Trends” presentation:

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Healthcare spending continues to rise which, no doubt, includes the cost of medication — a hot button issue of price that even Donald Trump and Hillary Clinton have agreed on. This purchase dovetails nicely with Amazon’s overall health ambitions. Per the New York Times:

But Mr. Buck and others said Amazon might have a new opportunity. A growing number of Americans are without health insurance or have such high deductibles that they may be better off bargain shopping on their own. He estimated that 25 million Americans fell into that category.

Until now, he said, PillPack has not aggressively competed on price. With Amazon in charge, “how about they start posting prices that are really, really aggressive?” Mr. Buck said.

As Pillpack increases its scale, Amazon will be able to exert more leverage in the space. This could have the affect of compressing (certain) pharmaceutical prices. To get there, Amazon will undoubtedly seize the opportunity to subsume Pillpack/pharma into Amazon Prime, providing Members discounts on medicine much like it provides Whole Foods shoppers discounts on bananas.

There is other opportunity to expand the user base as well. People are looking to save money on healthcare as much as possible. With cash back rewards, Amazon can offer additional discounts if consumers were to carry and use the Amazon Prime Rewards Visa Signature Card — which already offers 5% back on Amazon.com and WholeFoods purchases (plus money back elsewhere too). Pillpack too? We could envision a scenario where people scrap their current plastic to ensure that they’re getting discounts off of one of the most rapidly rising expenditures out there. Said another way, as more and more consumer staples like food and medicine are offered by Amazon, Amazon will be able to entice Pillpack customers with further card-related discounts. And grow a significant amount of revenue by way of its card offering. No doubt this is part of the plan. And don’t forget the data that they would compile to boot.

Per Forbes shortly after Amazon launched its Amazon Prime Rewards Visa Signature Card,

Given that Amazon credit card holders spend the highest on its platform, the company is looking at ways to expand its credit card consumer base. CIRP estimates that approximately 15% of Amazon’s U.S. customers have any one of Amazon’s credit cards, representing approximately 21 million customers. However, growth of its card base has not kept pace with its growing Prime membership. In June 2016, it was estimated that Amazon has around 63 million Prime members. Assuming that only Prime members have an Amazon credit card, it would mean that only a third of its Prime customers have one of its credit cards. According to a survey by Morgan Stanley, Amazon Prime members spend about 4.6 times more money on its platform than non-prime members. Its credit card holders spend even greater amounts than what Prime members spend. By enticing its prime customers to own its credit cards, Amazon will be encouraging them to spend more on its platform. Its latest card is aimed at attracting Prime customers by offering deals not only on Amazon.com but on other shopping destinations as well. This can lead to higher spending by existing Prime customers and help convert the fence sitters into Prime memberships.

And those numbers are dated. Amazon Prime now has 100mm members. Imagine if they could all get discounts on their meds. 💰💥💰💥

All of which begs the question: who gets hurt and who benefits (other than Visa ($V)) from this potential secondary effect? 🤔