How Many Companies Will Amazon Bankrupt?

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Grocery (Short EVERYTHING). So much to unpack in grocery world this past week so here is a brief summary for you: WholeFoods ($WFN) CEO John Mackey called Jana Partners greedy bastards; food deflation trends continued albeit at a markedly slower rate which means that someone wickedly smart may just be timing grocery at a time when it starts benefiting from inflation (imagine that); a Nomura Instinet analyst said - on Thursday - that Amazon ($AMZN) will next disrupt the grocery space (weeks after Scott Galloway predicted something big in grocery); Wegman's announced same day delivery via partnership with Instacart; Kroger ($KR) announced its numbers won't meet guidance and the stock, already down 14% on the year, dipped another 20% (only to fall more a day later on this...); Amazon dropped an atomic bomb on everyone and initiated a $13.7b play for Wholefoods making those greedy bastards pretty damn happy bastards (and sending stocks of everyone else - including Kroger - into even more of a tailspin); people then got busy questioning the viability of Instacart (the goodwill from the Wegman's news instantly evaporated) and BlueApron and Hello Fresh and Costco ($COST) and, well, we could go on and on but suffice it to say that if the food-oriented company was private it will likely stay private longer and if its public then its stock got decimated (including big boxes like Target ($TGT) and Walmart ($WMT)). And we were really beginning to warm to the "How to Beat Amazon" think pieces that have been making the rounds. The real question is: how many bankruptcies in 2018 will mention Amazon as one of the reasons why...?

Divided Recaps Under Attack in Payless Holdings Case

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Niiiiiiiiiice. We're impressed that Reuters and Bloomberg both picked up on something that happens - or at least appears to happen - often in bankruptcy cases: a conflict. 

Here's the drill: the official committee of unsecured creditors (UCC) in the Payless Holdings LLC case filed an application seeking to employ The Michel-Shaked Group as expert consultants. The mandate included providing "expert consulting services and expert testimony regarding the Debtors' estates' claims relating to the pre-petition dividend recapitalizations and leveraged buyout, including solvency and capital surplus analysis." As a quick refresher, Payless' private equity overlords Golden Gate Capital and Blum Capital dividended themselves hundreds of millions of dollars of value via debt incurred - albeit under relatively low interest rates - on the company's balance sheet. The company's debt load - in addition to various other factors characteristic of retail players today - was a major factor in the company's eventual bankruptcy filing.

Payless Holdings LLC - through Munger Tolles & Olson LLP ("MTO") as counsel to "the independent director of the Debtors" - subsequently objected to the UCC's application. The independent director (the "ID") claimed that the application is, at a maximum, duplicative of the services to be rendered by another UCC professional and at a minimum, premature. Why premature? Well, because the ID is conducting, through MTO, his own investigation into the dividend recapitalization claims the company might have against the private equity firms. That investigation is ongoing. Having a simultaneous analysis runs the danger of not only being duplicative and premature but also hindering the Debtors' aggressive proposed timeline for emergence from bankruptcy. 

As loyal readers of PETITION know, we're big fans of the (shadiness of the) dividend recap and, as such, we really enjoyed Bloomberg's snark: "That's right, someone close to private equity is investigating private equity firms for doing a very private equity thing." To be clear, separate counsel at the direction of an independent director is investigating the private equity firms. But, close enough. 

Let's pull the thread. Payless' main counsel, Kirkland & Ellis LLP, does a ton of private equity work - including, upon information and belief, work for the private equity sponsors implicated here. According to its own retention application, K&E has been representing Payless since 2012 as general corporate counsel. The private equity transaction dates back to 2012. Curious. K&E began representing the Debtors in connection with restructuring matters in November 2016; its engagement letter is dated January 4, 2017. 

The ID presumably got his mandate because he has "served as an independent or disinterested director for various companies in financial distress and restructurings." Among his qualifications are four other current director engagements including iHeartMedia Inc. and Energy Future Intermediate Holding Company LLC. Recognizing that the recap might be at issue, the ID hired separate counsel shortly after joining the board in January 2017 - right around the same time that K&E got hot-and-heavy on the restructuring side (if the engagement letter date is any indication). 

So, to summarize, K&E and management have been working with the private equity owners for five years. During that time, the dividend recaps occurred. The ID came on board right around the same time that K&E's restructuring team got enmeshed with the company. The same ID has a board portfolio of 5 directorships, 60% of which are for companies that are using K&E as restructuring counsel as we speak. Meanwhile, we have to assume that the ID gets paid tens of thousand of dollars for each board mandate with, perhaps, some equity consideration thrown in for good measure. Defensively, the objection drops a nice little footnote to assure us all that the ID is truly independent:

From the Debtors' Objection to the Shaked Application.

From the Debtors' Objection to the Shaked Application.

Perhaps the benefit of the doubt ought to be given to the ID and approval of the Shaked application delayed until after the ID completes his investigation. After all, if he comes down against the private equity shops, the application is moot. On the flip side, well, he won't. Notably, the objection already lays the case that the company relied in its business judgment on the opinions of Duff & Phelps, which issued a solvency opinion and presentation at the time of the transaction(s). Naturally, the UCC won't believe it and will push, again, for this engagement. Presumably, the company will jam them with the "train has left the station" defense. The upshot: if we were litigating this on behalf of the UCC we would certainly call into question the actual "independence" of the investigation sooner rather than later and see if the Judge bites. If done tastefully and in a way that doesn't impugn the character of the ID (which we are in no way advocating), it will at least somewhat offset the impression the Debtors are leaving with the Duff & Phelps bit and plant the seed in the Judge's mind for consideration upon the results of the investigation.

The hearing on the matter was scheduled for May 31 but was subsequently pushed indefinitely. 

Private Equity Track Record

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Back in October, Garden Fresh Restaurants* filed for bankruptcy. In January, The Limited Stores* filed and ultimately sold for a pittance to Sycamore Partners. Soon, if the rumors are true, Gordman's will file. What do all of these companies have in common? Sun Capital Partners. Gordman's would be the third Sun Capital portfolio company bankruptcy in five months - which doesn't really enhance the image of private equity firms now, does it? Thousands of jobs are now gone (a typical and increasingly earned PE trope), but Sun Capital has gotten its dividends and fed its LPs. Did Sun generate returns for its LPs? Looks that way. But we're not sure a track record of multiple liquidations is what Sun was hoping for. 

UPDATE: Shortly after publishing this, Gordmans Stores Inc. did, in fact, file for bankruptcy. You can find the case summary for it here. 

* click on company names for case rosters

The Great Escape

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"The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds." - John Maynard Keynes, The General Theory of Employment, Interest and Money (13 December 1935).

This past week, Michael Batnick, from Ritholtz Asset Management deployed a version of this quote to make a point about investing; he provided a nice callback to Blockbuster and an equity analyst's repeated bad calls vis-a-vis Netflix (which popped this week after impressive subscription growth - despite negative free cash flow (-$600mm+) and an increasingly levered balance sheet). TL;DR: don't be too wed to your ideas. 

This applies to the actual businesses that investors pour money into too. In today's rapidly transforming environment, businesses must now, more than ever, pivot, and innovate. They can't be too wed to legacy ideas. Recognizing that is the first step. It then becomes a question of execution in the face of constraints.  

Enter Avaya Inc., a privately-held provider of contact center, "legacy" unified communications and networking products and services with 176 global entities, $940mm of adjusted EBITDA, 200,000 customers and 9700 employees. To Avaya's credit, the company pivoted in 2009 away from its historical hardware-based operating model - recognizing the shift towards software-based and cloud-oriented services solutions. It undertook a massive reinvention, adapting its revenue model and streamlining operating performance in a manner that cut $700mm in costs since 2014. To some degree, the company's private equity overlords - TPG Capital and Silver Lake Partners - deserve some credit, too, for working with management and reconciling the need to pivot. After all, they had a $8.2 billion LBO to rationalize. 

But sometimes the constraints are insurmountable. Avaya has $6 billion of debt on its balance sheet; it has $440mm of annual interest expense along with an additional $180mm nut for annual pension and OPEB obligations. And it faces stiff competition from the likes of Microsoft, Cisco, and others, necessitating another ~$400mm in expenditures to fund R&D and other investments. It's been bleeding cash, losing over $505mm in the fourth quarter and over $750mm in fiscal '16.

And so the company is now a bankruptcy filer. Notably, the papers accompanying the filing have zero specificity about the company's go-forward business plan. Its one small victory is a robust DIP financing commitment and milestones intended to achieve a rapid turn in bankruptcy court. But then what? 

We rarely see big freefall bankruptcy cases anymore. Clearly there seems to be disagreement among the various constituencies about how best to proceed with this business in the face of competition and technological headwinds. That said, the company was able to secure $425mm of its proposed DIP facility at the "First Day" hearing on Friday. So there's that. 

"Software is eating the world," we noted last week (per Marc Andreesen). We'll see very soon whether Avaya gets swallowed along with TPG and Silver Lake's investment. Yes, they pivoted. But was it too little too late?

Thoughts? Opinions? Let us know at petition@petition11.com. 

Odd ad to place in the WSJ on the day after bankruptcy.

Odd ad to place in the WSJ on the day after bankruptcy.

Are Progressives Bankrupting Restaurants?

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According to the CEO of Garden Fresh Restaurant Intermediate Holdings (GFRIH), they are.  

This past week, John Morberg filed an affidavit in support of the chapter 11 bankruptcy filing of GFRIH, the holding company to restaurant brands Souplantation and Fresh Tomatoes. This family of restaurants includes 123 locations, 17 central kitchens and 2 distribution centers. All in, the company has 5500 employees, the majority of which work in the restaurants located in California, Texas and Florida.  

In addition to having approximately $135mm of funded debt, the company experienced increasing cash flow pressure which, according to Morberg, triggered the bankruptcy. Chief among the causes for this pressure was "declining sales consistent with the declines experienced in the entire restaurant industry." Morberg, here, is clearly referencing a string of recent restaurant bankruptcies including Cosi, Fox & Hound, Logan's Roadhouse, Don Pablo's, Zio Restaurants, Buffetts, and Champps. Cheap gasoline was supposed to translate into bigger consumer spending. Not so for these restaurants, apparently. 

Still, Morberg's explanation for the bankruptcy went a step farther. He noted that cash flow pressures also came from increased workers' compensation costs, annual rent increases, minimum wage increases in the markets they serve, and higher health benefit costs -- a damning assessment of popular progressive initiatives making the rounds this campaign season. And certainly not a minor statement to make in a sworn declaration.  

It's unlikely that this is the last restaurant bankruptcy in the near term. Will the next one also delineate progressive policies as a root cause? It seems likely.

Discounted Crackly-Crust Flatbread...

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"All Sorrows Are Less With Bread" - Miguel de Cervantes Saavedra

If crackly-crust flatbread and Squagels (yes, this exists...and it is what it sounds like) are on your Christmas wish-list this year, you may be in luck: the once high-flying Cosi Inc. could be yours via bankruptcy sale.

For those familiar with Cosi In NYC, the downfall of the fast casual chain is particularly surprising. Once upon a time, blockbusting lunch lines for Cosi were a regular occurrence. As they waited, people jostled for access to the excess baked crackly-crust bread the bakers regularly dispensed. In certain locations, the competition for the excess was so fierce that the bakers resorted to placing the pieces in a small metal bowl on the counter - the fast casual equivalent of a home owner lazily putting a basket of Halloween candy on the doorstep for trick-or-treaters. Never mind hygiene: 126,292 other people put their hands into that bowl between the hours of 12 and 2. Yech.  

Here are the stats:

  • 107 stores in 3 countries (but most in the US).
  • 1555 employees (many of whom will now be losing their jobs)
  • $7.5mm of (gulp, maybe) secured debt (which will position the lenders to own the business)
  • $3mm in net losses in Q2 '16 (hence why we're talking about bankruptcy in the first place).

The court filings contain a choice quote: "The deteriorating sales are at least partially due to macro-economic issues as the restaurant industry as a whole and the fast casual sector in particular are experiencing decreasing sales trends." So much to unpack here. First, what happened to the notion that the "gasoline windfall" would lead to greater consumer spending? Second, aren't millennials spending more on food and experiences than on physical goods? Third, how does this purported trend affect the likes of Panera Bread, Chipotle, and a whole host of other fast casual upstarts? Sadly, the filings don't substantiate this statement. Curious.  

Winners:

  • the original founders who blew out after the I.P.O. (yes, this thing is publicly-traded).

Losers:

  • the senior secured lenders - they'll either get pennies on the dollar or 78 rubber-chicken-serving fast casual locations facing (unsubstantiated) headwinds; and
  • the former CEO - the (public) filings go out of their way to note that he failed miserably to acknowledge the decline in the business and effectively turn it around (ouch). 
  • employees - many are losing there jobs with little to no advanced notice.  
  • shareholders - unlikely to see any recovery for their position.  

Thoughts, comments or questions? Note the comment section below.