Disruption Dominos 2.0: The McClatchy Company (Long CDS Shenanigans)

In “Credit Default Swaps (Long Yield, Baby, Yield),” we discussed credit default swaps and the ongoing battle between hedge funds in the Hovnanian matter.* The Commodity Futures Trading Commission has finally weighed in. There were no minced words:

"The CDS market functions based on the premise that firms referenced in CDS contracts seek to avoid defaults, and as a result, the instruments are priced based on the financial health of the reference entity.  However, recent arrangements appear to involve intentional, or ‘manufactured,’ credit events that could call that premise into question. In a public statement dated April 11, 2018, the International Swaps and Derivatives Association’s (ISDA) board of directors criticized manufactured credit events, writing that they ‘could negatively impact the efficiency, reliability, and fairness of the overall CDS market,’ and ISDA’s board indicated that it advised its staff ‘to consult with market participants and advise the Board on whether...amendments to the ISDA Credit Derivatives Definitions should be considered’ to address manufactured credit events.     
 
"Manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities.  This would affect entities that the  CFTC is responsible for overseeing, including dealers, traders, trading platforms, clearing houses, and market participants who rely on CDS to hedge risk. Market participants and their advisors are advised that in instances of manufactured credit events, the Divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate.”

Better late than never we guess. You’d think they would have awakened to these issues after Codere, Radio Shack, and others. But, hey. Regulators. Enough said.

*****

Enough said, indeed. Query whether the The Commodity Futures Trading Commission will have more to say given the aforementioned “cherry on top” in the McClatchy transaction.

What is the cherry? Well this — per Bloomberg:

It seemed like a sure-fire bet: short the debt of a highly leveraged newspaper company that’s losing money. And for a while, it worked as investors piled up almost $500 million of wagers by buying credit-default swaps on the publisher, McClatchy Co.

That is until hedge fund Chatham Asset Management stacked the deck with a deal that’s threatening to make those swaps all but worthless.

The McClatchy situation is the latest trade that’s drawing jeers from critics who say the $11 trillion CDS market has devolved into a haven for manipulation.

Whoops.

At issue is the “newly established LLC” bit we noted above. As Bloomberg further explains,

Because the new debt would be shifted away from the parent and into the new unit, it’s fueling speculation that the Chatham deal will create what’s commonly known in the CDS world as an orphaned contract. In other words, anyone who bought insurance on a McClatchy default would effectively be paying insurance on an entity with no significant debt.

Which, naturally, begs the question: who is on the other side of the contract? Well, Chatham, of course. Because CDS! There’s no measure of how America has become great again like one fund ripping off other funds. Take a look at this chart:

More from Bloomberg,

Leading up to the deal, Chatham had been selling swaps insuring against a default by McClatchy. So if the transaction were to be completed, it would be getting paid CDS premiums to guarantee against a default that could never technically happen.

“The whole market is losing credibility when you have events like this where you try to trigger the CDS or create orphaning situations,” XAIA’s Felsenheimer said.

Joshua Friedman from Canyon Partners appears to agree that these trades “go beyond the bounds” (video). And, so, people are losing their minds (query whether these same people led to the upsized WeWork debt financing). As always, Matt Levine puts this whole event in perspective,

The thing is, if you bet against McClatchy’s credit by buying CDS on it, you were betting not only that it would have problems with cash flow or whatever, but also that no white knight would come along to keep it afloat until after your CDS expired. A realistic credit analysis asks not only about the company’s own paying capacity but also about its external sources of financing. If you buy five-year CDS on a company, you are betting that it will default on its debt within five years. If the next day a deep-pocketed shareholder (Chatham owns 19.8 percent of McClatchy) refinances all of the company’s debt into a seven-year zero-coupon bond—or a seven-year PIK-toggle bond, or whatever, some form of debt that it cannot default on during the life of the CDS—then you have lost your bet. But you weren’t cheated out of your bet or anything. You just bet that the credit would implode, and then it didn’t. 

He’s right. And in the absence of regulators paying more attention to CDS work-arounds, this will be just one more needle in a stack of perceived-manipulated-needles.

*Yesterday, Hovnanian upheld its end of the bargain with GSO by skipping its interest payment.

Disruption Dominos: The McClatchy Company (Long Local, Short #MAGA)

The McClatchy Company ($MNI) may not be well known to you on its face but if you’ve ever read the Miami Herald, The Kansas City Star, The Sacramento Bee, The Charlotte Observer, The (Raleigh) News and Observer, The (Fort-Worth) Star-Telegram, The (Durham NC) Herald-Sun or one of 24 other media companies, you’ve read one of its properties. It is a provider of digital and print news and advertising services. And it reported Q1 earnings last week.

The earnings — as you might imagine for a company with a large print-media division — were far from gangbusters and are highly cyclical in nature. Take a look at this chart:

The company missed estimates on both EPS and revenue. Total revenues were down 10.1% YOY. Total advertising revenues were down 16.7% YOY. Direct marketing advertising revenues declined 21.9% YOY. On the flip side, the company experienced growth in its digital initiatives, including increases in digital-only subscribers and average total unique visitors to online properties. The company also partnered with Subscribe with Google to push further improvements in the digital business. But, all in, this is a company that it is facing a massive wave of disruption coming at it from all angles.

First, its capital structure. The company’s leverage ratio stands at 4.42x as of the end of Q1 on the basis of its existing cap stack. Currently, it has about $30 million of outstanding letters of credit issued against its $65 million revolving credit facility (Bank of America). As of 12/31/17, the company had $344.6 million of 9% ‘22 senior secured first lien notes outstanding on top of (a) as of 4/27/18, $82.1 million of 7.15% ‘27 debentures and (b) $274 million of 6.875% ‘29 indentures.

But, not for long. Enter Chatham Asset Management. The fund — which may or may not be fresh off of a shiny new $1b private equity vehicle for debt-related investments — is taking out a large chunk of the capital structure. The company filed an 8k on April 26th, indicating that there is a term sheet pursuant to which a newly established LLC will issue $250 million of 7.372 % ‘30 Tranche A Term Loan paper and $168.5 million 6.875% ‘31 of Tranche B Term Loan paper, the proceeds of which will be used to take out the long-dated debentures (except $8.3 million) and a portion of the senior secured notes. The structure isn’t yet determined but the interest expense is expected to increase incrementally. There is a makewhole as well, as you might expect, and we’re guessing it will have some fairly iron clad verbiage. In other words, this reeks of loan-to-own — with a cherry on top (see #2 below). Perhaps Chatham will eventually roll up the properties with American Media Inc., parent to The National Enquirer, which Chatham owns 80% of and, per The Wall Street Journal, appears to be having issues of its own.

Some notable bits in the company’s earnings call:

A. Tariffs. Tariffs on newsprint may have an effect on traditional print media companies. Note the following comments:

One more word on the print newspaper world. We are often asked on these calls about the impact of newsprint prices on our operating model. As the print side of our business has declined so has our operating sensitivity to fluctuations in newsprint supply and pricing, now less than 4% of our operating expense, down from 20% at the peak of print newspaper revenues more than a decade ago.

Nonetheless, policies such as the newsprint tariffs announced by the administration earlier this year are unhelpful we believe, both to free market and to public policy. We oppose them and we have made our position clear to the administration. We say this as an equity owner of one of the few remaining U.S. domestic newsprint producers. So one might assume we would be on the other side of this issue, but we are not. Public policy that makes these input prices more costly at a time of great stress in this industry harms our local communities and is against the public interest.

Interesting. The company is guiding towards higher print costs, including increases in pricing coming from Canadian mills. #MAGA!!

B. Cost Controls. This company has all of the makings of a company in triage. Operating expenses were down 8.4%. The company outsourced printing operations. It entered into a sale leaseback transaction, pursuant to which $13 million of proceeds is being offered to the company’s senior secured noteholders in a tender offer at par. It sold off some intellectual property (CareerBuilder LLC). All of this is meant to buy the company time to effectuate its digital transformation.

C. Ad Spend. This should come as a surprise to nobody that follows the world of restructuring but the trickle-down effect of battered grocery and retail is notable here. This is the company’s statement about the higher-than-expected ad spend decline:

I mean retail results were disappointing. Obviously, that’s something that we’ve been seeing for some time now. Total retail revenues finished a bit better actually in Q1 and Q4, but that was driven entirely by digital growth. Revenue from preprints delivered with the newspaper actually got worse. And as Elaine said, our direct marketing circulars delivered to non-subscribers also softened. So our retail customers are facing some tough citing and it continues to have an impact on our print products. And some of those advertisers obviously in direct marketing are the same as the ones that are in the print newspaper, and their troubles affect both.

In retail print revenue, our largest declines were coming from the food and drug department store category, and we’ve seen that strand for a while. Preprints took a steeper decline in Q1. And then we’ve seen in previous quarters down about 38% over last year. Again though due to continued losses from the major department stores like Macy's, Sears, Stein Mart, Penne and stores no longer in business that were rolling over from last year like hhgregg and Toys "R" Us, or at least going in bankruptcy, Toys "R" Us is still struggling.

And so in preprints or about 12% of total advertising revenues, so when that gets hit that’s of percentage, it takes the whole category down. So mostly I think a story on the retail side, Avi, and continuing pressure on the print part of that business.

The company continued,

We sometimes talk about the importance of our role in local communities and with our neighbors, and these are the places we live where our employees are residents all across the country. The impact on local retail across the country has been, as you know, very widespread. This is an earnings call about a news and information company. So it’s the wrong place to talk about those underlying trends. But I would say we’re super aware of them. We obviously bare the impact from an advertising perspective, which also having a big impact on our communities. And that’s something that we’re extremely aware of as in many cases the leading local news and information company in those communities.

We appreciated the reminder. Jokes abound about the #retailapocalypse. For many local communities, the far-reaching effects of such are no laughing matter.

⛽️Oil & Gas is...Back? Baby.⛽️(Long Comebacks)

As concerns grow about Iranian and Venezuelan production levels, oil and gas is now hovering around $67-68, and there are headlines like this: “Is Big Oil Back?” You’d think, therefore, there’d be a bit less talk about distressed oil and gas companies. After all, distressed oil and gas is so 2015.

Think again. This past week Houston-based Erin Energy Corporation ($ERN) filed for bankruptcy; it is a Sub-Saharan Africa-focused exploration and production company. Meanwhile, we’ve all heard about Rex Energy’s imminent restructuring, but now there are fissures appearing at Austin-based Jones Energy ($JONE) as well.

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What to Make of the Credit Cycle (Part 5)

Moelis & Company Pounds Chest

In "What to Make of the Credit Cycle (Part 4)," we wrote:

The point is: some opportunistic folk sure seem to think that there’s another cycle coming. And they’re putting their money where their mouth is, thinking that there will be money to be made in the (seemingly saturated) case administration business. Time will tell.

In the meantime, those who can leverage robust M&A activity will. But let’s take a step back…

Do you remember THAT scene in the “Wolf of Wall Street?” The one where Leo and Matty-C pound their chests in the most bro-ey of bro-ey banker moments…? We’re pretty sure this is what the bankers over at Moelis & Company ($MO) were doing before, after and as they were announcing earnings on Monday.

Take this quote for instance:

Analyst: “Ken, I still get plenty of investors that mispronounce the name of your firm, so I guess we’re still working on it.”

Ken Moelis: “There is no mispronunciation, there’s only a wrong phone number. If they get the phone number right….”

Kind of hard to argue with that. Who gives a crap how your name is pronounced if the phone is ringing, the rates are increasing and the dollars are coming in? Marlo Stanfield’s “My name is my name” proclamation in the final season of The Wire clearly doesn’t apply to Ken Moelis. Have to admire that.

So, right after we gave Evercore ($EVR)(which reports earnings today) and PJT Partners($PJT) props in our Q1 review of bankers (to be fair: covering company-side only), Moelisdropped these numbers:

We achieved $219 million of revenues in the first quarter, up 27% over the prior year. This represented our highest quarter of revenues on record. Our performance compares favorably to the overall M&A market in which the number of global M&A completions greater than $100 million declined 14% during the same period. Our growth was primarily attributable to very strong M&A activity in the quarter. We're participating across industries and deal sizes, and we are also earning higher average fees per transaction. In addition, restructuring activity continue to be a solid contributor.

The fee part of this is interesting. Achieving pricing power in this environment is a big accomplishment. Query whether that relates more to M&A and less so to restructuring given the relative dearth of bankruptcy deal flow. Regardless, here’s what the stock did on Tuesday, a day the S&P 500 otherwise declined 1.34% and the Dow was down 424 points:

Source: Yahoo! Finance

When asked about restructuring, specifically, this is what Mr. Moelis had to say:

Well, never expect things to only get better, but it's been - look, it's been a low default environment for a long time. And I think some of the peers and competitors have kind of - who were edging into restructuring might have edged out a bit; we're not. We think we have the leading restructuring group on the Street. They've been together for years and years and years, and now the way we integrate them, the amount of spread we can get using the 120 on these to really make sure that they are talking to companies that are having issues. And those issues could be opportunities, too. It's almost - it crosses over with liability management. It might stay to be a 1% or 2% default rate for a while []. You can never tell. But there's a large amount of paper out there. So even at 1% or 2%, you can stay busy if you have a market-leading restructuring group which we do. Look, it could get worse. I guess nobody could default, but I think between 1% and 0% defaults and 1% and 5% defaults, I would doubt we hit 5% before we hit 0%. So, I'm happy we held the team together, we've added to it, we've integrated it, it continues to be a solid part of our business, and I think it has a lot more upside than downside.

Ok, so this must be a misstatement. He must have meant that he doubts that we reach 0% rather than 5%. And so: A. Lot. More. Upside. In late 2019? Early 2020? Who has edged out? Will others between now and then? The analysts didn’t ask those questions.

What to Make of the Credit Cycle (Part 1)

Moody's, Fitch & Guggenheim Partners Chime In

Earlier this week, Moody’s Default and Ratings Analytics team forecasted that the US’ trailing 12-month high-yield default rate will sink to 2% — from its February 2018 3.6% level — by February 2019. That is not a good sign for restructuring professionals itching for an uptick in activity.

FitchRatings chimed in as well, noting that underwriting standards underscore that the leveraged debt market is in the later stages of the credit cycle. But, it added,

“Aggressive documentation terms now prevalent could challenge recoveries in the next downturn. However, a surge in refinancing activity since 2016 should increase time between the credit cycle's bottom and peak in default rates. Looser documentation, such as the prevalence of covenant-lite (cov-lite) loans, should also lower the risk of technical default while enabling issuers to access additional funding via secured debt and unrestricted subsidiary provisions.” (emphasis ours)

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Eddie Lampert Speaks (Short Sears, Long Principled Kidnappers)

This week William Cohan and Vanity Fair released a once-in-fifteen-years piece with the infamous Sears Holding ($SHLD) investor, Eddie Lampert. It’s a whopper and worth a read.

The mess that is Sears is quantified here:

“But today those triumphs are largely obscured by his worst mistake: the 2005 merging of Sears, the iconic retailer whose doorstop mail-order catalogue was once a fixture in nearly every American home, with the downmarket Kmart chain, which he had brought out of bankruptcy in 2003. Twelve years on, this blundering into retail has made him a poster boy for what some people think is wrong with Wall Street and, in particular, hedge funds. Under his management the number of Sears and Kmart stores nationwide has shrunk to 1,207 from 5,670 at its peak, in the 2000s, and at least 200,000 Sears and Kmart employees have been thrown out of work. The pension fund, for retired Sears employees, is underfunded by around $1.6 billion, and both Lampert and Sears are being sued for investing employees’ retirement money in Sears stock, when the top brass allegedly knew it was a terrible investment.”

To put this in perspective, people are in an uproar about the liquidation of Toys R Us which has 33,000 employees. Sears, while still in business, has had attrition of 6x that. But wait. That’s just on the human capital side. What about the actual capital side:

“In 2013, Lampert, who was chairman of the board, had himself named C.E.O. of Sears Holdings, as the combined company is known. He’s had a rough four years since then. The company has suffered some $10.4 billion in losses and a revenue decline of 47 percent, to $22 billion.”

And on the financial side:

“…Sears Holdings stock price has slumped to $2 a share, down considerably from the high of $134 per share some 11 years ago. Sears Holdings now has a market value of around $250 million, making Lampert’s nearly 60 percent stake worth $150 million.”

How. The. Eff. Is. This. Business. Still. Alive. Well, this:

“The vultures are circling, waiting for Lampert to throw in the towel so they can try to make money by buying Sears’s discounted debt. But Lampert continues to claim that’s not going to happen if he can help it.”

Gotta give the guy credit for perseverance.

For those who may be too young or too weathered to remember, KMart was actually a successful turnaround for the first few years after Lampert converted his (acquired) debt position into equity. Operating profit was $1.3 billion in 2004 and 2005. But then he decided to combine KMart and Sears. Thereafter, the big issues began.

Interestingly, the piece suggests that Lampert was “ahead of his time” by de-emphasizing investment in the in-store experience and focusing on e-commerce. But shoppers didn’t buy online. Cohan writes,

“At the time they were just not comfortable enough with the technology to do so. Whatever the reason, Sears’s Web site never remotely rivaled the sales in the stores. Or on Amazon.”

Maybe because, even today, the website is a cluttered mess that will give even those with the most robust heart arrhythmia. In that respect, the online experience mirrors the offline experience. And this runs afoul of current theories of retail. Jeremy Liew of Litespeed Venture Partners writes about new “omnichannel” retailers like Bonobos, Allbirds, Away, Modcloth and Glossier and the new “customer acquisition channel”:

“All retailers need to be wherever their customers are. And for all retailers, their best customers are in every channel. This is just as true for DNVBs. For Bonobos for example, customers who buy first in store spend 2x more and have half the return rate. But more importantly, they spend 30% more online over the next 12 months.

But these DNVBs think about physical retail in a very different way than incumbent retailers. They are not measured purely on “four wall profitability” or $/sq foot, some of the traditional metrics in retail. Many of the stores are showrooms, they don’t carry full inventory. Most support iPads or other ways to browse the online catalogue.

These brands understand the importance of experiential marketing, and they see their physical spaces as a platform to engage deeply with their customers. In short, they see physical retail as customer acquisition channels for their online business. In some cases, a contribution positive customer acquisition channel. In others, a customer acquisition channel whose costs you can compare to Facebook, Instagram, Google or other customer acquisition channels. But always the online business grows.”

For this to work, Everlane’s Michael Preysman says you “must make it look good.” If only Lampert bought in to this premise. Instead, Sears’ online experience mirrors the offline experience: horrible user experience + dilapidated stores = a wholesale contravention of, as Liew points out, everything that successful retailers are doing today. It’s the customer rejection channel. Hence the suspicions from outsiders — which Lampert vehemently denies — that he’s treating Sears like a private company, milking the company for his own benefit, and slowly liquidating it to the point of bankruptcy. Once in bankruptcy, Lampert will allegedly be able to leverage his place in the capital structure to own the company on the backend. It would be a leaner version of Sears — free of debt, onerous leases and pension obligations. Why invest in customer or employee experience now if this is a possibility later? Good question.

Busted Narratives: Fast Fashion Falters (Short H&M)

We’re old enough to remember when fast fashion was allegedly decimating retail and every apparel retailer under the sun was rejiggering its supply chain to fight fire with fire. Well, yesterday, fast fashion retailer Hennes & Mauritz HB — better known in the U.S. as H&M —reported earnings and to say that they were dogsh*t would be an understatement. Here is the stock as of yesterday:

Man that chart is ugly: that’s a 50% drop in the last year. This takes the company all the way down to 2005 levels. What is going on?

For starters, operating profit fell 62% in the three months through February from 3.2 billion SEK to 1.3 billion SEK. And more problematic: the company has $4.3 billion of unsold inventory. This is the stock-in-trade picture as of yesterday:

Y’zikes. Analysts are freaking out.

In the words of Karl-John Persson, the company’s CEO:

“While the assortment is appreciated by our customers, we have not improved fast enough. In addition to this, we made some mistakes in the assortment mix in the second half of 2017 that affected the top line. And now, we're working hard to ensure improvements, including fashion improvements and to improve value for money further as well as, of course, and also to have the right balance and assortment mix with the right products in the right -- at the right time, in the right amount to the right channels.”

Clearly. So, after dropping this steaming pile of bad news, Persson does what all good retail CEOs do these days: drop buzzwords and hot catch phrases like they’re hot. In trying to assuage analyst concerns after this buzzsaw of an earnings report, Persson goes all in with '“new store concepts", “optimize the store portfolio,” “image recognition,” “personalized product feeds,” “automated warehouses,” “advanced analytics and artificial intelligence,” “cloud, APIs and microservices,” and “RFID and 3D.” Did you catch all of that? Don’t know about you, but we’re impressed. These guys really threw the whole kitchen sink at us with this pixie cloud of meaninglessness. Take note: if you’re a restructuring advisor or performance improvement specialist seeking a company-side retail mandate, you have our permission to cut and paste this paragraph into your deck. Perhaps you can win over an executive team too-embarrassed to ask you what the hell any of it actually means as a practical matter.

GNC Holdings Inc. Kicks the Can

The Rise of DTC Supplements Constitutes a Threat to GNC

via GIPHY

Speaking of a concessions business, GNC Holdings Inc. ($GNC) is a big proponent (have you been to Rite-Aid lately?) and look how well…oh, wait…nevermind.

When we last wrote about GNC back in February, the company had reported surprising earnings, margins and free cash flow; it also paid down its revolving credit facility and seemed on the verge of amending and extending its term loan. It had also just received a cash infusion commitment from a Chinese investment fund in exchange for 40% of the company. Subsequently, the company was able to amend and extend the term loan to 2021. Concurrently, the company entered into a new $100 million asset-backed loan due August 2022 and engaged in certain other capital structure machinations to obtain $275 million of asset-backed “first in, last out” term loans due December 2022. Textbook. Kicking. The. Can. Which, of course, helped the company avoid Vitamin World’s bankrupt fate. 👊 Goldman Sachs!

Meanwhile, this is what the stock looks like:

Pretty ugly. And it may get worse when you factor in what’s going on in the world of supplements, generally. What’s going on, you ask? A sh*t ton of venture capital investment, corporate cash infusion and growth.

Earlier in March, a company called Ancient Nutrition, producer of bone broth protein and collagen supplement, raised $103 million of funding from VMG Partners, Hillhouse Capital and ICONIQ Capital. Notably, the product is available throughout Chicago — just not at GNC. Rather, it is available at Whole Foods, Fresh Thyme Farmers Market and Heinan’s. Similarly, in New York City, it is predominantly found at Whole Foods, Fairway and Natural Green Market, among other places.

Supplements are going gangbusters elsewhere too. Earlier this month, Hims, an erectile dysfunction and hair loss company aimed at millennials and dubbed “Viagra, but for hipsters” (yup, you read that right), raised $40 million of funding at a $200 million valuation (kudos to GQ for creative photography). It’s distribution channel? Direct-to-consumer. Sorry GNC. Same goes for Roman and Keeps, two Hims-like competitors.

Meanwhile, The Clorox Company got into the game last week with an $700 million acquisition (3.5x sales) of Nutranext, a Florida-based wellness company that makes supplements and has a strong direct-to-consumer business. You know where you can’t get Nutranext…?

That’s right: GNC.

Perhaps those restructuring professionals disappointed by Goldman Sachs’ success in securing the refinancing should just put that GNC file in a box labeled “2021.”

The Fallacy of "There Must be One" Theory

Dick's Sporting Goods, Toys R Us, iHeartMedia, & Amazon

Ah, R.I.P. Toys R Us.

This week has undoubtedly been painful for employees, vendors, suppliers and fans of Toys R Us. The liquidation of the big box toy retailer is a failure of epic proportions; many creditors will be fighting over the carcass for months to come — both inside and outside of the United States; many employees now have two months to find a new gig; many suppliers need to figure out if and how they’ll be able to manage now that they’re exposure to unpaid receivables has increased. Good thing the company’s CEO is a man-of-the-people who can help cushion the blow.

Hardly. Enter CEO David Brandon and his shameless, out-of-touch attempts to cast blame onto outside parties: “The constituencies who have been beating us up for months will all live to regret what’s happening here.” Wait. Huh?!

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Orexigen Therapeutics - Long Obesity & Patents, Short Massive Cash Burn

Only Oprah Winfrey Can Sell Weight Loss

Orexigen Therapeutics Inc. is a publicly-traded ($OREX) biopharmaceutical company with one FDA-approved product named "Contrave.” Contrave is an “adjunct” to a reduced-calorie diet and exercise for chronic weight management in certain eligible adults. In English, it’s a drug to help adults (allegedly) lose weight. And before we continue, please take a minute to appreciate the exquisite creativity these folks deployed with the name, "Contrave." We can only imagine the whiteboarding sessions that went down before someone said in MacGuyver-esque fashion, “Wait! Control + cravings = Contrave!” We hope the company didn't shell out too much cash money to the brand consultants for that one. But we digress.

Anyway, the drug could theoretically service the 36.5% of adults the Center for Disease Control & Prevention has identified as obese — a potential market of 91-93 million people in the United States alone. And that’s just today: that number is predicted to rise to 120 million people in the next several years. Yikes: that's 33% of the U.S. population. Apropos, the company claims that the drug is the number one prescribed weight-loss brand in the US with over 1.8 million prescriptions written to date, subsuming 700,000 patients. The drug is also approved in Europe, South Korea, Canada, Lebanon, and the UAE. 

All of that surface-level success notwithstanding, the company has lost approximately $730 million since its inception. This is primarily because it has been spending the last 16 years burning cash on R&D, clinical studies for FDA approval, recruitment, manufacturing, marketing, etc., both in and outside the U.S. PETITION Note: And people wonder why drugs are so expensive. The company believes it could be profitable by 2019 under its existing operating model and revenue forecasts; it enjoys a patent until 2030. Clearly, the patent is the critical piece to this company’s future.

Prior to filing for bankruptcy, the company’s bankers attempted to effectuate a sale of the company to no avail. The goal of the bankruptcy filing, therefore, is to pursue a sale with the benefit of "free and clear" status (⚡️Nerd alert ⚡️: this means the buyer doesn’t need to take on the substantial litigation risk to clear title in the asset). While no stalking horse bidder is lined up, The Baupost Group LLC, is leading a group of secured noteholders (including Ecori Capital, Highbridge Capital and UBS O'Connor) to provide a $35 million DIP credit facility and buy the company some time. Will they end up owning it? 

Two other things of note here:

1. The Baupost Group LLC is really toning its bankruptcy musculature lately. Between this deal and Westinghouse, the firm has been active.

2. Note to company management: Oprah Winfrey may have some more room in her weight loss asset portfolio now that she’s dumped a meaningful amount of her Weight Watchers International Inc. ($WW) stock holdings at a considerable gain.

America's Second-Largest Retailer is Closing Stores

Guest Post By Mitch Nolen (@mitchnolen)

Source: Kroger & Co. 

America’s largest supermarket operator is shrinking.

Kroger Co., the owner of over 20 grocery chains and other retailers, is closing supermarkets and jewelry stores, as well as selling hundreds of convenience stores, while simultaneously hitting the brakes on new openings that the company had already publicly announced.

It's a major U-turn for a serially acquisitive company that has become the nation's second-largest retailer, behind only Walmart in total U.S. sales. While cutting its store count, Kroger is prioritizing $9 billion in spending over three years on initiatives like splashy technology upgrades at its remaining stores.

The upheaval is just the latest in a grocery industry grappling with Amazon’s aggressive advances into its territory.

The Cincinnati-based retailer sold 762 convenience stores to British firm EG Group last month, is shutting an undisclosed number of jewelry stores and has shed net total of 13 jewelers in the first three quarters of 2017, and has closed or is closing at least 18 of its grocery stores since the start of the company's fourth quarter, a development one community leader describes as a “crisis.”

The supermarket closures are a departure for Kroger from recent years. Their store count grew in 2015 and 2016, and there was no store reduction in the final quarters of those years. Combined with the suspension of planned openings, and the company’s explanations, it becomes clearer that this isn't normal annual pruning.

Already in the first three quarters of Kroger's fiscal year that ended February 3, there's been a net closure of six grocery stores.

Kroger is suspending multiple — but not all — store openings and other major projects, such as store remodels, replacements and expansions.

A Kroger spokesperson declined to comment for this story, citing a quiet period before the company’s annual earnings report due out Thursday morning. However, in earlier statements made to local media, one representative said, “Company wide, the pace of construction has slowed down.”

Another official described a “shifting of capital expenditures in the short term from brick and mortar to focus on the customer experience in our existing stores, e-commerce and digital technology.”

The supermarkets that are shutting down are just a fraction of the more than 2,700 that Kroger operates, but any grocery store that closes has an impact on the neighborhood it served. Some closures are devastating.

Two supermarkets have closed in Peoria, Ill., a city once considered synonymous with Middle America. Kroger says neither store had been profitable in over 15 years. Two food deserts have been left in their stead.

“I am not exaggerating when I say we are now in a food crisis in this zip code, 61605,” says Peoria City Councilwoman Denise Moore. “That is one of the most hard-pressed zip codes in the country, let alone the state.”

“There is no supermarket in the entire district,” she adds, referring to her constituency that stretches along the Illinois River and cuts through Downtown Peoria. The district was home to Caterpillar Inc.’s corporate headquarters until earlier this year.

Moore worries about residents not only losing access to healthy food, but also to the store’s pharmacy and Western Union facility, where people without bank accounts can pay their bills.

The company is also shelving store expansions at two of Peoria’s other Krogers.

Another city, Memphis, was also hit by two Krogers closing. The city's mayor, Jim Strickland, took to Facebook to say he was “disappointed by Kroger's decision.”

In a potential reference to the predominantly African-American communities the stores served, he added that “these neighborhoods are no less important than any other neighborhoods in our city, and citizens who live there absolutely deserve access to a quality grocery store.”

The impetus for the closures may be financial, but residents have noticed the affected neighborhoods’ demographics.

In Peoria, one of the closed stores, on Wisconsin Ave., served a majority-minority neighborhood. The closest supermarket now is a Save-A-Lot discount grocer in a majority-white neighborhood two miles away. Walking there from the closed store would take 44 minutes, according to Google Maps.

The other Peoria Kroger sat just outside the edge of city limits, on a highway across from a predominantly black neighborhood where 36 percent of households and 83 percent of families with children under five live below the poverty line. The store is a mile and a half from the next-closest supermarket in a predominantly white neighborhood.

Kroger didn't respond to a Memphis news station that asked last month about an effort to boycott the company, but Kroger had previously stated that each closing store in the city had lost more than $2 million since 2014. The company similarly declined to respond for this story, citing the quiet period.

In other cities, Kroger is closing in different types of neighborhoods. One location, a concept store called Main & Vine, closed in a predominantly white neighborhood in suburban Seattle where the median household income is $82,000. The store went dark less than two years after it opened.

Kroger is said to be eyeing potential e-commerce acquisitions. Online bulk seller Boxed reportedly rejected a bid from Kroger, and the company was said in January to be considering an offer for Overstock.com. Kroger was also reported to be weighing a partnership with Alibaba, China's largest e-commerce site.

At its supermarkets, Kroger is rolling out a scan-as-you-shop system to 400 stores called “Scan, Bag, Go.” Available as a phone app or a dedicated handheld device, it will eventually let customers transact their own payments, too, so shoppers can just walk out with their items.

The sudden ramp-up of “Scan, Bag, Go” came after Amazon teased Amazon Go, Amazon’s newly opened convenience store with “just walk out” technology, which uses cameras and sensors to eliminate checkout lanes.

But just because retailers offer new technology doesn't mean shoppers will use it. Earlier pilots of grocery scanning apps failed to gain traction. And mobile payment systems like Apple Pay and the newly rebranded Google Pay aspire to be the future of commerce, but three years after they first launched, everyday usage remains stubbornly low, according to data from PYMNTS.com, an industry journal.

Kroger is also expanding its online grocery service, called ClickList, which is now available at over 1,000 of the company’s approximately 2,800 grocery stores. Amazon is rolling out free two-hour shipping for Prime members at Whole Foods.

Kroger-owned stores known to have closed or be closing since the start of the company's fourth quarter include:

Tucson, AZ: Fry’s at 3920 E Grant Rd.

Savannah, GA: Kroger at 14010 Abercorn St.

Peoria, IL: Kroger at 2321 N Wisconsin Ave.

Peoria, IL: Kroger at 3103 W Harmon Hwy.

Mitchell, IN: JayC at 1240 W Main St.

Jackson, MI: Kroger at 3021 E Michigan Ave.

Clarksdale, MS: Kroger at 870 S State St.

Charlotte, NC: Harris Teeter at 16405 Johnston Rd.

Columbus, OH: Kroger at 3353 Cleveland Ave.

Portland, OR: Fred Meyer at 5253 SE 82nd Ave.

Memphis, TN: Kroger at 1977 S 3rd St.

Memphis, TN: Kroger at 2269 Lamar Ave.

Brownwood, TX: Kroger at 302 N Main St.

Plano, TX: Kroger at 4836 W Park Blvd.

Gig Harbor, WA: Main & Vine at 5010 Point Fosdick Dr. NW

Cudahy, WI: Pick ’n Save at 5851 S Packard Ave.

1000 store closures have been announced in the past two weeks. Follow @mitchnolen to get updates and @Petition for news about disruption, generally.

Retail Roundup (Some Surprising Results; More Closures)

Retail Remains in a State of Transition

• Macy’s ($M) reported earnings earlier this week and surprised to the upside - particularly with the news that its sales grew in the latest quarter (after 2.75 years of consistent decline). Most of the upside came from cost control measures (and the expansion of its off-price offering, Backstage). Likewise, Dillard’s.

• Toys R Us entered administration in the UK.

• Charlotte Russe earned itself what we would deem a “tentative” upgrade after consummating an out-of-court exchange transaction that delevered its balance sheet. S&P Global cautioned that it expects “liquidity to be tight” over the next 12 months.

• Chico’s FAS Inc. ($CHS) reported same store comp sales down 5.2% and indicated that it closed 41 net stores in 2017, including 14 net stores in Q4. Net income and EPS was higher.

• Foot Locker ($FL) intends to close net 70 stores in 2018 after closing net 53 stores in 2017.

• Kohl’s Corp. ($KSS) is becoming a de facto co-retailing location after first partnering with Amazon ($AMZN) and now Aldi.

• JCPenney ($JCP) announced that it is cutting full-time employees and increasing use of part-time employees instead. Total sales rose 1.8% but missed estimates. Comparable sales rose 2.6% and net income, ex-tax reform benefits, was down 6.6%.

• Office Depot ($ODP) reported comp store sales declines of 4% and total sales down 7%. It closed 63 stores, including 26 in Q4. Note that we’re not reporting net closures: the company didn’t open any stores.

• Supervalu may be shutting down 50 Farm Fresh Supermarkets in North Carolina and Virginia.

iHeartMedia 👎, Spotify 👍?

Channeling Alanis Morissette: In the Same Week that Spotify Marches Towards Public Listing, iHeartMedia Marches Towards Bankruptcy

In anticipation of its inevitable direct listing, we’d previously written about Spotify’s effect on the music industry. We now have more information about Spotify itself as the company finally filed papers to go public - an event that could happen within the month. Interestingly, the offering won’t provide fresh capital to the company; it will merely allow existing shareholders to liquidate holdings (Tencent, exempted, as it remains subject to a lockup). Here’s a TL;DR summary:

And here’s a more robust summary with some significant numbers:

• Revenue: Up 39% to €4.1 billion ($4.9 billion) in ‘17, ~€3 billion in ‘16 and €1.9 billion in ‘15. Gross margins are up to 21% from 16% in 2014 - and this is, in large part, thanks to renegotiated contracts with the three biggest music labels. Instead of paying 88 cents on every dollar of revenue, the company now only pays 79 cents. Only.

• Free Cash Flow: €109 million ($133 million) in ‘17 compared to €73 million in ‘16.

• Profit: 0. Net loss of €1.2 billion in ‘17, €539 million in ‘16, and €230 in ‘15.

• Funding: $1b in equity funding from Sony Music (5.7% stake), TCV (5.4%), Tiger Global (6.9%) and Tencent (7.5%). Notably, Tencent’s holdings emanate out of a transaction that converted venture debt held by TPG and Dragoneer into equity - debt which was a ticking time bomb. Presumably, those two shops still hold some equity as Spotify reports that it has no debt outstanding.

• Subscribership. 159 million MAUs and 71 million premium (read: paid) subscribers as of year end - purportedly double that of Apple Music. Services 61 countries.

• Available Cash. €1.5 billion

• Valuation. Maybe $6 billion? Maybe $23.4 billion? Who the eff knows.

For the chart junkies among you, ReCode aggregates some Spotify-provided data. And this Pitchfork piece sums up the ramifications for music fans and speculates on various additional revenue streams for the company, including hardware (to level the playing field with Apple ($AAPL) and Amazon ($AMZN)…right, good luck with that), data sales, and an independent Netflix-inspired record label. After all, original content eliminates those 79 cent royalties.

Still, per Bloomberg,

Spotify for a long time was a great product and a terrible business. Now thanks to its friends and antagonists in the music industry, Spotify's business looks not-terrible enough to be a viable public company. 

Zing! While this assessment may be true on the financials, the aggregation of 71 million premium members and 159 million MAUs is impressive on its face - as is the subscription and ad-based revenue stemming therefrom. Imagine the disruptive potential! Those users had to come from somewhere. Those ad-dollars too.

*****

Enter iHeartMedia Inc. ($IHRT), owner of 850 radio stations and the legacy billboard business of Clear Channel Communications. In 2008, two private equity firms, Bain Capital and Thomas H. Lee Partners, closed a $24 billion leveraged buyout of iHeartMedia, saddling the company with $20 billion of debt. Now its capital structure is a morass of different holders with allocations of term loans, asset-backed loans, and notes. The company skipped interest payments on three of those tranches recently. While investors aren’t getting paid, management is: the CEO, COO and GC just secured key employee incentive bonuses. Ah, distress, we love you. All of which will assuredly amount to prolonged drama in bankruptcy court. Wait? bankruptcy court? You betcha. This week, The Wall Street Journal and every other media outlet on the planet reported that the company is (FINALLY) preparing for bankruptcy. And maybe just in time to lend some solid publicity to the DJ Khaled-hosted 2018 iHeartRadio Music Awards on March 11.

For those outside of the restructuring space, we’ll spare you the details of a situation that has been marinating for longer than we can remember and boil this situation down to its simplest form: there’s a f*ck ton of debt. There are term lenders who will end up owning the majority of the company; there are unsecured lenders alleging that they should be on equal footing with said term lenders who, if unsuccessful in that argument, will own a small sliver of equity in the reorganized post-bankruptcy company; and then there is Bain Capital and Thomas H. Lee Partners who are holding out to preserve some of their original equity. Toss in a strategic partner like billionaire John Malone’s Liberty Media ($BATRA) - owner of SiriusXM Holdings ($SIRI), the largest satellite radio provider - and things can get even more interesting. Lots of big institutions fighting over percentage points that equate to millions upon millions of dollars. Not trivial. Would classifying this tale as anything other than a private equity + debt story be disingenuous? Not entirely.

*****

"It is telling when companies like Spotify hit the markets while more traditional players retrench. Like we've seen in retail, disruption is real and if you stand still and don't adapt, you'll be in trouble. It gets harder to compete when new entrants are delivering a great product at low cost." - Perry Mandarino, Head of Restructuring, B. Riley FBR.

Indeed, there is a disruption angle here too, of course. Private equity shops - though it may seem like it of late - don’t intentionally run companies into the ground. They hope that synergies and growth will allow a company to sustain its capital structure and position a company for a refinancing when debt matures. That all assumes, however, revenue to service the interest on the debt. On that point, back to Spotify’s F-1 filing:

When we launched our Service in 2008, music industry revenues had been in decline, with total global recorded music industry revenues falling from $23.8 billion in 1999 to $16.9 billion in 2008. Growth in piracy and digital distribution were disrupting the industry. People were listening to plenty of music, but the market needed a better way for artists to monetize their music and consumers needed a legal and simpler way to listen. We set out to reimagine the music industry and to provide a better way for both artists and consumers to benefit from the digital transformation of the music industry. Spotify was founded on the belief that music is universal and that streaming is a more robust and seamless access model that benefits both artists and music fans.

2008. The same year as the LBO. Guessing the private equity shops didn’t assume the rise of Spotify - and the $517 million of ad revenue it took in last year alone, up 40% from 2016 - into their models. Indeed, the millennial cohort - early adopters of streaming music - seem to be abandoning radio. From Nielsen:

Finally, Pop CHR is one of America’s largest formats. It ranks No. 1 nationwide in terms of total weekly listeners (69.8 million listeners aged 12+) and third in total audience share (7.6% for listeners 12+), behind only Country and News/Talk. In the PPM markets it leads all other formats in audience share among both Millennial listeners (18-to-34) and 25-54 year-olds. However, tune-in during the opening month of 2018 was the lowest on record for Pop CHR in PPM measurement, following the trends set in 2017, the lowest overall year for Pop CHR, particularly among Millennials. While CHR still has a substantial lead with Millennials (Country ranked second in January with 8.4%), it will be interesting to track the fortunes of Pop CHR as the year goes on, and music cycles and audience tastes continue to shift.

This is the hit radio audience share trend in pop contemporary:

And, consequently, radio ad revenues have essentially flattened. And if Spotify has its way, the “flattening” will veer downward:

With our Ad-Supported Service, we believe there is a large opportunity to grow Users and gain market share from traditional terrestrial radio. In the United States alone, traditional terrestrial radio is a $14 billion market, according to BIA/Kelsey. The total global radio advertising market is approximately $28 billion in revenue, according to Magna Global. With a more robust offering, more on-demand capabilities, and access to personalized playlists, we believe Spotify offers Users a significantly better alternative to linear broadcasting.

One company’s disruptive revenue-siphoning is another company’s bankruptcy. Now THAT’s “savage.”

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PETITION LLC is a digital media company focused on disruption from the vantage point of the disrupted. We publish an a$$-kicking weekly Member briefing on Sunday mornings and a non-Member "Freemium" briefing on Wednesday. You can subscribe HERE and follow us on Twitter HERE.

Ad Agencies Get Hammered (Short Don Draper)

Changes Afoot as Large Corporates Like P&G Shift Spend

Draper never would’ve made it in the age of #MeToo anyway.

This week, Proctor & Gamble ($PG) announced that it cut its digital ad spending by approximately $200mm, a shot across the bow of certain undisclosed big ad players (cough, Google) and a major blow to the middlemen ad agencies that seem to be caught in a maelstrom of disruption. Back to that in a sec. More on P&G,

P&G, however, has not cut overall media spending. Funds have been reinvested to increase media reach, including in areas such as TV, audio and ecommerce media, a company spokeswoman told Reuters.

Not yet, anyway. P&G intends to cut an additional $400mm in agency and production costs over the next 3 years. In so doing, they’re also going back to the old school after realizing that the 1.7 seconds of eyeball view time doesn’t necessarily translate into sales. Podcast producers take note.

So what about those middlemen? Judging by WPP’s 10% stock price plummet this week ($WPP), investors are bearish. WPP is a British multinational advertising and public relations company besieged by the ease with which advertisers can publish directly on Facebook ($FB) and Google ($GOOGL) and, in an instant, receive performance metrics. Ad agencies, therefore, are no longer needed as much to connect brands with end users. Per the Wall Street Journal:

For their part, big ad agency companies that have traditionally bought advertising space on behalf of marketing clients are under pressure to reinvent themselves to remain relevant as the industry changes. Advertisers are demanding that their agency partners be more transparent about media-buying, so it is clear that agencies are getting the best possible deal for the clients and aren’t receiving rebates from sellers.

Disrupting kickbacks too? Rough.

GNC Makes Moves (Long Brand Equity, Meatheads & Chinese Cash)

GNC Buys Itself Some Time

GNC Holdings Inc. ($GNC) reported earnings recently and, to the chagrin of distressed folks who probably hoped it would be a bigger, messier bankruptcy filing than Vitamin World, the company doesn't look slated for bankruptcy court after all. At least not in the short term. The company reported EPS up $0.18 YOY on a $12.2mm drop in consolidated revenue (weighed down primarily by wholesale). Margins increased by nearly 2% - mostly on account of cost cutting initiatives (which include the closure of 90 locations in 2017). The company reported $196.7mm of free cash flow. That's more than Netflix!

The company is using its cash to pay down its revolver and, as of 12/31/17, had no borrowings outstanding. The company also looks close to an amend and extend of its term loan for two years to 2021 - as of Valentine's Day, the company had garnered the support of nearly 50% of its term lenders. Net debt to EBITDA is 4.6x. The company expects to see a short-term hit on account of the tax reform (limitations on net interest and expensing of capital investments) but a long term benefit.

Interestingly, GNC's brand demonstrated that it still retains some value - even if that value isn't what it once was. CITIC Capital, a Chinese investment fund and controlling shareholder of Harbin Pharmaceutical Group, will inject a $300mm cash infusion in the form of a convertible perpetual preferred security with a 6.5% coupon (cash or PIK) at a $5.35 conversion price. As-converted, this represents roughly 40% of GNC’s outstanding equity. It will also take 5 board seats. The deal is contingent upon the amend-and-extend and a refi of the current revolver. 

But wait. There's more. GNC will also form a JV in China whereby it will drop its current China business into the JV for a 35% interest and $22mm cash payment; it will recognize wholesale sales and receive annual royalty fees, including a $10mm advance on annual royalties. Clearly GNC needed some liquidity now. And clearly this is a branding deal: GNC's brand will be slapped onto Harbin Pharmaceutical Group's product.

We suppose its a good idea to generate value out of your IP BEFORE filing for bankruptcy rather than after. S&P Credit Ratings seemed to think so: it issued an upgrade. While this likely means GNC will stay out of bankruptcy (for now), these transactions, in total, do reflect stress in the franchise. We'll have to keep a close eye on it to see where it goes from here. 

More Retail Dominos Fall

Tax Credits Can't Save Failing Bon-Ton Stores

We're going to stay thematically on-point. If you missed us last week, we recommend that you go back and read our take on the Cenveo bankruptcy. In fact, we owe an apology to some of you: there were about 400 of you who did not get our a$$-kickingness at all due to an inexplicable Mailchimp screw-up. Mailchimp ≠ a$$-kicking (more on this soon). Anyway, here is a link to the entire newsletter.

A quick preface:

Protection of dying industry extends beyond federally-imposed #MAGA (see, e.g., coal, solar tariffs), and trickles down to local communities. Indeed, local-level legislators are looking at tax credits to prop up industry in the wake of, among other things, Appvion’s chapter 11 bankruptcy (and job cuts) and Kimberly-Clark’s reorganization (and mass job cuts). This is familiar: tax incentives to prop up industry aren’t extraordinary. Sheesh, just look at all the governors getting bent in the hope of drawing Jeff Bezos’ attention. The question is, though, how sound is the social contract? How many dying industries can we as taxpayers prop up all at once? We don’t have an answer. But keep reading.

******

Inside and outside of the startup context, people often ask stupid questions about companies. "How many employees does it have?” That’s a regular one. Or “How many locations?” Also common. “What’s revenue?” Irrelevant on its own. Uber makes a ton of revenue but is still bleeding cash. Netflix has gobs of revenue but is free cash flow negative. Cenveo, as we noted last week, had $1.59 billion of gross revenue in ’17. Now it’s in bankruptcy court. 

What if we told you about a particular business that had 23,000 employees and that those employees had an average tenure of 12 years? That had 256 locations. That owned 22 properties. That made $2.55 billion - yes, BILLION - in revenue in 2017. That would sound like a pretty damn successful company wouldn’t it? 

It’s not. 

We omitted some key data points: like the company’s capital structure and business vertical. 

Here’s the capital structure:

• a Tranche A revolving credit facility of up to $730mm
• a Tranche A-1 term facility of up to $150mm

The interest rate on the debt is a formula but, if we understand it correctly, it was no less than 9.5%. Funded debt as of Monday was $339mm under Tranche A (ex-interest), $150mm under Tranche A-1 (ex-interest of $3.9mm), and millions more in letters of credit.  

The company also has $350mm of 8% senior secured notes outstanding (Wells Fargo Bank NA) and due in 2021. Combined with the above debt, that’s a hefty interest expense. Oh, and the company is publicly-traded. Because this particular company is NOT successful - and with equity ranking in “absolutely priority” below debt - we reckon that there are a lot of Moms and Pops eating sh*t right now in their personal accounts. They won’t be the only ones.

The problem is that this company operates in an “increasingly challenging retail environment.” And, therefore, its story  - The Bon-Ton Stores story - is wildly unoriginal. In the company’s words, "Like many other department store and retail companies, the Debtors have been subjected to adverse trends in the retail industry, including consumers’ shift from shopping in brick-and-mortar stores to online retail channels. Bon-Ton, with a significant geographic operating footprint and operating presence, is dependent on store traffic, which has decreased as customers shift increasingly toward online retailers. In addition to competing against online retailers, Bon-Ton faces competition from other established department stores, such as J.C. Penney, Kohl’s and Macy’s.” It's like a zombie cage fight.

More specifically, it continues, "The department store segment of the U.S. retail industry is a highly competitive environment that has evolved significantly in response to new and evolving competitive retail formats, such as the increased prominence of mass merchandisers and increased competition among national chain retailers, specialty retailers and online retailers, as well as the expansion of the internet and, most significantly, the ubiquitous role that mobile technology and social media now play in the retail consumer shopping experience. The Debtors’ results and performance (and that of their competitors) has been significantly impacted by the aforementioned factors in the U.S. retail industry. Presently, numerous business and economic factors affect the retail industry, including the department store sector. These include underemployment and the low labor participation rate, fluctuating consumer confidence, consumer buying habits and slow growth in the U.S. economy and around the globe.” But, but…#MAGA?!?

Given these factors, the company has been engaged in a tug-of-war with its senior creditors for the better part of months. We’ll spare you the back-and-forth but suffice it to say, no concrete long-term plan that would’ve avoided bankruptcy came to pass. Only the retention of a liquidation agent to close 42 stores. And acquisition of a new $725mm credit facility to fund the cases while the company scrambles to find a buyer. Or liquidate.

Remember all of those shiny, positive numbers up above? Um, yeah. 

It gets worse. Though they were ultimately shot down - at least for now - in court yesterday (Feb 6), the bondholders argued “that the best and only available path for the Debtors to maximize value for their creditors in these freewill bankruptcy cases is to conduct an immediate orderly liquidation of the Debtors’ inventory and other assets. The Second Lien Noteholders made this determination after conducting their own due diligence, and following repeated missteps by the Debtors and their various boards and management teams, who proved themselves unwilling and/or unable to adapt to the fierce headwinds facing brick and mortar retailers and in particular, department stores”(emphasis in original). Savage.

Unwilling. Or unable. To adapt. Sadly, this seems to sum up a lot of distressed retailers these days. 

Even sadder, remember those long-tenured 23k employees we mentioned above? Per the company, “[Bon-Ton] has been part of its employees’ and customers’ lives in their communities for years.”

Probably not for much longer. At this point, no tax credits can change that. 

Cenveo Inc. = Poster Child for Disruption

Envelope Manufacturer Succumbs to Technology. And Debt.

As loyal PETITION readers know, our tagline is “Disruption, from the vantage point of the disrupted.” After its Chapter 11 bankruptcy last week, Cenveo Inc. may very well be the poster child for disruption.

Founded in 1919, Cenveo is a 100 year-old, publicly-traded ($CVO), Connecticut-based large envelope and label manufacturer. You may not realize it, but you probably regularly interact with Cenveo’s products in your day-to-day life. How? Well, among other things, Cenveo (i) prints comic books you can buy at the bookstore, (ii) produces specialized envelopes used by the likes of JPMorgan Chase Bank ($JPM) and American Express($AMEX) to deliver credit card statements, (iii) manufactures point of sale roll receipts used in cash registers, (iv) makes prescription labels found on medication at national pharmacies, (v) produces retail and grocery store shelf labels, and (vi) prints (direct) mailers that companies use to market to potential customers. Apropos to its vintage, this is an old school business selling old school products in the new digital age.

And, yet, it sells a lot of product. In fiscal year ended December 31 2017, Cenveo generated gross revenue of $1.59 billion with EBITDA of $102.8mm. Those are real numbers. But so are those on the other half of the company’s balance sheet.

After years of acquisitions (16 between 2006 and 2013, representing a strategic shift from print-focus to envelope manufacturing), Cenveo has more than $1 billion of funded debt on its balance sheet and a corresponding $99.4mm in annual debt payment obligations (inclusive of cash and “principle” payments). That’s the problem with a lot of debt: eventually you’re going to have to pay it back. And the only way to do that is to have sustained and meaningful cashflows that are, hopefully, trending upwards rather than down. Therein lies the problem with Cenveo. As liquidity gets tight, a business may start getting a bit looser with payments, a bit less reliable. Savvy trade creditors sniff this from a mile away. With the company (very) publicly struggling under the weight of its balance sheet, vendors started hedging by contracting trade terms and de-risking; they start throwing off business to Cenveo’s competitors, further challenging Cenveo’s liquidity — to the tune of a net liquidity reduction of approximately $20mm. Initiate death spiral.

But, wait! There’s more. And it’s textbook disruption. Per the company,

“In addition to Cenveo’s leverage issues, macroeconomic factors, including the introduction of new e-commerce, digital substitution for products, and other technologies, are transforming the industry. Consumers increasingly use the internet and other electronic media to purchase goods and services, pay bills, and obtain electronic versions of printed materials. Moreover, advertisers increasingly use the internet and other electronic media for targeted campaigns directed at specific consumer segments rather than mail campaigns.”

Ouch. To put it simply, every single time you opt-in for an electronic bank statement or purchase a comic book on your Kindle rather than from the local bookstore (if you even have a local bookstore), you’re effing Cenveo. More from the company,

“As society has become increasingly dependent on digital technology products such as laptops, smartphones, and tablet computers, spending on advertising and magazine circulation has eroded, resulting in an overall decline in the demand for paper products, and in-turn lowering reliance on certain of Cenveo’s print marketing business. In addition, there is generally a decline in supply of paper products in the industry, such that only a handful of paper mills control the majority of the paper supply. As a result, paper mills and other vendors that sell paper products have a large amount of leverage over their customers, including Cenveo. The overall decline in the paper industry combined with the diminished supply in paper products has led to overall decline in the industry, dramatically impacting Cenveo’s revenues.”

Consequently, the company has spent years trying to implement an operational restructuring (read: streamline operations and cut costs). The company adds,

“Faced with an industry in transformation, Cenveo, beginning in 2014, commenced a strategic review of a significant portion of its businesses and concluded that it needed to focus its portfolio on profitable segments that would be better-positioned to grow in the future and to divest non-core, unprofitable segments. To implement this strategy, between 2014 and 2017, Cenveo applied a number of broad-based cost savings and profitability initiatives, which included downsizing its workforce, reducing its geographic footprint, and divesting certain non-core business segments, which was designed to reduce costs, minimize the possible effect of decreased sales volume for underperforming product lines, and remain competitive.”

While the company notes that it currently employs nearly 5200 people in the US, it is clear that many people have lost their jobs. 100 people in Orchard Park, New York. 108 people in Exton, Pennsylvania. 112 people in the Twin Cities. 91 people in Portland, Oregon. You get the point. You should read theGlassdoor reviews for this company. The employees sound miserable. The comment board is riddled with critiques of management, allegations of squandering, tales of job cuts and no raises. Even sexual harassment. We can’t wait for the uproar over the inevitable Key Employee Incentive Plan.

So what now? The company claims it’s ready for the e-commerce age and that it can make a ton of money on package labels. Provided that it can shed its debt. Accordingly, the company engaged the holders of its first and second lien debt and was able to secure a (shaky?) restructuring support agreement (RSA) and a commitment of $290mm in financing. The RSA exhibits the company’s intent to equitize the first lien holders’ debt. Notably, Brigade Capital Management — representing over 60% of the second lien debt and a meaningful percentage of first lien debt — isn’t on board with the RSA and noted in a filing that the bankruptcy may be “more contentious and protracted than indicated” by the company. Indeed, they are already agitating against the company and certain insiders alleging, among other things, that the Burton family has received approximately $80mm of disclosed compensation between 2005 and 2016 that ought to be investigated. And that the RSA seeks to enrich the insiders with a generous post-reorg equity grant of 12%. In other words, this could get ugly. Fast.

We should also note that the company will also need to address its underfunded pensions (approximately $97.3mm) and 18 active collective bargaining agreements. Funding contributions for 2018 are over $10mm. The pension plan(s) cover 5700 retirees and 734 active employees. And so while sophisticated funds duke it out over valuation and the corresponding value of their claims/recoveries, thousands of employees and retirees will be left in the lurch. Yikes.

As you can see, disruption is hard. Silicon Valley types love to talk about their big revolutionary products and how they’re going to change the world. That sexy stuff gets CEOs on magazine covers. Cameos in Iron Man movies. And more. The attorney from Kirkland & Ellis LLP representing Cenveo used an IPad in court. Symbolic.

But there is a dark underbelly to disruption too. As new technologies come online and habits change, long-standing businesses like Cenveo falter. People lose jobs — or struggle one day at a time to keep them. People lose pensions they’d planned to live on. Hopefully the professionals who make money managing these elements in-court don’t lose sight of these factors and work hard to optimize efficiency in the process. And hopefully the engineers and disrupters take note of what their “big revolution” may mean for others. Cenveo is a great reminder.

Recent Feedback - The (Hard) Business of Eating

"Excellent narrative on the restaurant industry in Sunday’s Petition. Btw, I really love the snarky tone of the writing – it’s awesome!" - Managing Director, Financial Advisor. 

PETITION Response: Thank you! We love receiving feedback like this; we noted that QSRs were generally doing fine while fast casual was looking a bit shaky and casual dining was looking like total dogsh*t. Insert Restaurant Brands International Inc. ($QSR), owner of Burger King (comps up 3.6%), Tim Hortons (up 0.3%), and Popeyes (down 1.8%). It reported an earnings beat on higher revenues (and then stock traded down). Meanwhile, Chipotle Inc.($CMG) - bloodbath. No queso for you. Meanwhile, if you feel like trusting Uber with even MORE of your data, maybe THIS new credit card (which promotes 4% off UberEATS) is for you. With news that Aldi's move into the US is compressing grocery prices even further, the casual dining space looks primed for a lot more hurt. 

10/31/17 Updated: Not to belabor the point, but this story by The New York Times helps drive home the issue currently in the restaurant space. There are currently 620,000 eating establishments in the United States. 620,000. That is bananas. 

Too many restaurants? Too many brands? You think? It's a shame that so many folks are sinking their livelihoods into these businesses. We expect the chart to the right to show continued downward trends given recent reports of the likes of McDonalds ($MCD) and Shake Shack ($SHAK) automating.