Where’s the Auto Distress? (Short PETITION’s Prognistications)

Back in October, we asked “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” The (free) piece is worth revisiting — particularly in light of Tesla’s recent travails. Among many other things, we wrote:

Supply Chain Distress. Last year we saw DACCO Transmission Parts Inc. file for bankruptcy. During the Summer, Takata Inc. filed for bankruptcy (on account of a massive liability, but still) and Jack Cooper Enterprises Inc., a finished-vehicle logistics/transportation provider, reached a consensual agreement with its noteholders that kept the company out of bankruptcy court. For now. Then, a little over a week ago, GST Autoleather Inc. filed for bankruptcy, citing declining auto output. Is this the canary in the coal mine? Hard to say. Literally on the same day that GST filed for bankruptcy - again, citing declining auto output - General Motors, Ford and other OEMs reported the first YOY sales increase (10%), surprising to the upside. It seems, however, that the (sales) uptick may be artificial: in part, it's attributable to (a) Hurricane Harvey damage and mass vehicle replacement; and (b) heavy vehicle discounting. On a less positive note, Ford announced that it will be slashing billions in costs to shore up its financial condition; it also announced back in September that it would slash production at five of its plants. And General Motors Co. announced earlier this week that it would be idling a Detroit factory and cutting production. 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. 

But, with limited exception (like Nissan’s announcement this week that it would cut U.S. production by 20%), the auto world has been largely quiet since then. Another exception: International Automotive Components Group S.A., a Detroit-based interior parts manufacturer with 77 manufacturing plants worldwide, announced, in April, a new financing transaction through the issuance of $215 million of ‘23 second lien notes funded by Gamut Capital Management LP. Perhaps we just need to be more patient?

Rumblings abound around two more names that may be in more near-term trouble. First, American Tire Distributors’ suffered downgrades on the heels of the announcement that Goodyear Tire & Rubber Co. ($GT) opted to discontinue use of ATD as a distributor. Notably, GT’s stock, itself, is down 20% in the last year:

Anyway, back to ATD. Per Crain’s Cleveland Business,

The news cratered the market value of ATD's $975 million of bonds and its $700 million term loan. S&P Global Ratings quickly cut the company's credit grade deeper into junk and Moody's followed suit, saying its capital structure was no longer sustainable.

Then, on May 9, the 800-pound gorilla entered the industry, as Amazon.com Inc. teamed up with Sears Holdings Corp. to allow customers to buy replacement tires online and have them installed at the troubled department store.

The moves signal radical changes in the replacement-tire market. Manufacturers are taking control of their own distribution, cutting out wholesalers like ATD, and along with retailers are developing their own internet capabilities to reach consumers directly, according to New York-based research firm CreditSights.

Ah, there it is: Amazon ($AMZN). Is a PETITION entry complete without the mandatory Amazon reference? Indeed, Moody’s noted,

“All else being equal, the magnitude of the associated earnings and cash flow decline will compound an already levered financial risk profile, rendering a pre-emptive debt restructuring increasingly likely, in our estimation.”

The Huntersville North Carolina company is a wholesale distributor of tires, custom wheels and other related auto equipment; it is a behemoth with $5.3 billion in revenues in 2017 and 140 distribution centers located across the U.S. and Canada. It also happens to have $1.8 billion of debt. The company is equally owned by private equity firms Ares Management LP and TPG Capital.

The debt — coupled with the loss of a major customer — is a big concern. More from Crain’s,

But ATD's capital structure is stretched tight, said Lawrence Orlowski, a director in corporate ratings at S&P. While the company has access to $465.4 million in asset-based lending facilities and $22.7 million in cash as of the end of 2017, even that liquidity may not be enough to stay solvent if ATD permanently loses Goodyear's business or if any other major tire makers pressure the company for concessions, according to Orlowski.

Something tells us (restructuring) advisors may be circling around trying to determine whether it can get together a group of the company’s term lenders.

*****

Second, Tweddle Group Inc., a The Gores Group-owned manufacturer of automotive owners’ manuals (that nobody ever reads) likewise suffered a disastrous blow when Fiat Chrysler Automobiles N.V. announced back in April that it was no longer using Tweddle’s services. Fiat reportedly accounted for 40% of Tweddle’s 2017 revenue and will be hard to replace. Consequently, Moody’s issued downgrades noting,

“The downgrades reflect a credit profile that is expected to be significantly weakened following Tweddle's loss of certain work from a key customer, and the resultant mismatch between the company's earnings and cash flow prospects and its now much more levered balance sheet.”

This reportedly put pressure on the company’s $225mm ‘22 first lien term loan and now the company reportedly has hired Weil Gotshal & Manges LLP for assistance. While it will likely take some time for the loss or revenue to trip any leverage ratios in the company’s credit agreement, this is a name to watch.

*****

Finally, Bloomberg New Energy Finance recently released its “Electric Vehicle Outlook 2018” report. Therein in noted that there are a variety of factors driving EV sales forward:

• Lithium-ion battery prices have tumbled, dropping 79% in seven years. Meanwhile, the batteries’ energy density has improved roughly 5-7% per year.

• Chinese and European policies are pushing fleet electrification.

• Automakers are aggressively pushing the electrification of their fleets. Choice bit: “The number of EV models available is set to jump from 155 at the end of 2017 to 289 by 2022.”

Bloomberg notes:

Our latest forecast shows sales of electric vehicles (EVs) increasing from a record 1.1 million worldwide in 2017, to 11 million in 2025 and then surging to 30 million in 2030 as they become cheaper to make than internal combustion engine (ICE) cars.

Marinate on that for a second. That is a massive 10x increase in the next 7 years followed by an additional 3x increase in the following 5 years.

Bloomberg continues,

By 2040, 55% of all new car sales and 33% of the global fleet will be electric.

But what about President Trump (#MAGA!) and efforts to limit future alternatives subsidies?

The upfront cost of EVs will become competitive on an unsubsidized basis starting in 2024. By 2029, most segments reach parity as battery prices continue to fall.

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

Is Delivery Killing Fast Casual Too? (Long Busted Narratives)

Zoe's Kitchen is Latest Restaurant Showing Signs of Trouble

Fast casual is supposed to be a bright spot for restaurants. But as the segment has grown in recent years, there are bound to be winners and losers. Zoe’s Kitchen Inc., a fast casual Mediterranean food chain with 250 locations in 20 states ($ZOES), is increasingly looking like the latter.

Last week the company reported sh*tty earnings. Comp restaurant sales declined by 2.3% despite rising prices pushed on to the consumer. The decline is attributable to the usual array of externalities (e.g., weather) but also location cannibalization. Apparently, the company’s growth strategy is pulling consumers from previously established locations. Moreover, the company noted “inflationary pressures in produce and freight costs, that are expected to impact cost of goods sold for the balance of the year.” Wages also increased 3.3%, an acceleration from the 2.9% realized in Q4 ‘17. Accordingly, adjusted EBITDA decreased 30.9%. The net loss for the quarter was $3.6mm or -$0.19/share. The company lowered guidance. The stock tumbled.

Before you get too excited, note that this is a debt-light company: it currently has a ‘22 $50mm revolving credit facility with JPMorganChase Bank NA, of which $16.5mm is outstanding (with $3.7mm of cash on hand, net debt is only $12.8mm). It also, believe it or not, has covenants — leverage and interest coverage, among others — and the company is in compliance as of April 16, 2018. It also plans to continue its expansion: in the sixteen weeks ended 4/16/18, the company opened 11 company-owned restaurants with a plan to open approximately 25 (inclusive) over the course of fiscal year ‘18. That said, it does intend to rationalize existing locations (and expects some impairment charges as a result), cut G&A and take other operational performance improvement measures to combat its negative trends. There’s a potential opportunity here for low-to-middle-market FAs and real estate advisors.

For our part, we found this bit intriguing (unedited):

We are definitely seen more competitive intrusion, more square footage growth in some of those smaller kind of mid to kind of large markets where we've been there for some time now that's a little bit of what we're seeing in those markets.

We've also seen more competitive catering competition as every ones ramped up catering. And also the value and discounting as we spoke to in the call, in the prepared remarks we've seen that $10 check with that single user kind of moving around and we think that's so from the new competition square footage growth, the value and discounting and then the delivery interruption, we've seen or felt that in many of our markets.

There’s a lot to unpack there. Clearly competition, as we noted upfront, is increasing in the $10-check size cohort of fast casual. Catering is always a competitive business for restaurants like this too. But, the point that really got out attention was that about delivery. The company says pointedly, “We also believe that disruption from delivery and discounting has created headwinds.” The company further states,

Digital comps were 26% positive in Q1 as we leverage improvements from last year's investments in web and mobile platforms to build greater convenience for our guests. Early in Q2, we relaunched and upgraded our loyalty program, which is expected to help drive traffic by making it easier and clearer for our guest to earn and redeem rewards. Delivery sales grew in both our non-catering and catering businesses by 155%. And we have a clear plan to build out the channel for more profitable growth in 2018.

The impact of mobile food ordering and the need for delivery cannot be overstated. Companies need to act fast to activate delivery capabilities that makes sense to a mobile consumer who, more and more, goes to Postmates, Caviar, UberEats and other food delivery services for discovery. This is precisely why Shake Shack ($SHAK) is now on Postmates and Chipotle Mexican Grill Inc. ($CMG) is now available on Doordash. Others, like privately-owned Panera Bread are taking a step farther by building out its own delivery infrastructure in an attempt to own all its data and deliver without owing a cut to a middleman. Query whether this is far too much dependence on the likelihood of people to go directly to Panera’s app when they’re hungry…?

It sounds like the Zoe folks are increasing their focus on delivery. The question is whether they can execute fast enough to offset in-store dining declines. And whether they can do it on their own.

Dentistry (Long Unnecessarily Techie Toothbrushes)

Subscription-based razors? Check. Subscription-based contact lenses? Check. Now the direct-to-consumer digitally-native-vertical-brand world is coming for your teeth. Direct to consumer teeth alignment? Check. Subscription-based dental floss? Check. Subscription-based bluetooth compatible toothbrushes. Check. No. This is not a joke.

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🚲Well-Funded Machines Terrorize Sidewalks 🚲

The Rise of the Electric Scooter

Do y’all remember the segway? It was supposed to revolutionize transportation but it never took off as anything more than the butt of a joke. Why? Look at the above photo. Homeboy can pump as many curls as he needs to but all the bulging biceps in the world won’t make him look bada$$ riding one of those things. Plus, watch the eye level broheim.

Anyway, there is a new mode of transportation that is all the rage. Introducing the dockless electric scooter…

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BJ's Wholesale Files for IPO

Use of Proceeds? Pay Back Dividend Recap Incurred Debt

CVC and Leonard Green & Partners have filed for a $100 million IPO of portfolio company, BJ’s Wholesale Club Holdings Inc. With Costco ($COST) killing it of late and the IPO marking champing at the bit for more new issues, this reeks of (sound capitalistic) opportunism. BJ’s has 215 locations nation-wide; it generated net income of $50 million on total sales of $12.8 billion for fiscal 2017. The company highlights that new implementations "delivered results rapidly, evidenced by positive and accelerating comparable club sales over the last two quarters and net income growth of over 109% and Adjusted EBITDA growth of 31% in aggregate over the last two fiscal years."

The BJ’s story is an interesting one for private equity. Take a look at these numbers from the company’s S-1 filing:

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“Independent” Directors Are Under Attack (Long Quid Pro Quo)

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What to Make of the Credit Cycle (Part 5)(Yield Baby Yield)

This series just keeps getting better and better. You can go back and read parts 1-4 here.

This week the Wall Street Journal reported that “junk bonds are getting junkier.” Oh boy. You have to hand it to to the private equity bros: they have a real sense of the markets these days...

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More Pain in Casual Dining (Short Soggy Mozzarella Sticks)

RMH Franchise Holdings Inc. Files for Bankruptcy

In 🍟Casual Dining is a Hot Mess🍟, we wrote:

…don’t let the lull in restaurant activity fool you. As we’ve stated before, this is a space worth watching given intense competition and the rise of food delivery and meal kit services - both direct-to-consumer and in-grocery.

Looks like we spoke to soon about a lull. Earlier this week RMH Franchise Holdings Inc.filed for bankruptcy in the District of Delaware. If you’ve never heard of RMH Franchise Holdings Inc., have no fear. You haven’t. Nor had we. But it is...

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Pharma (Short Generics): Aceto Corporation

Aceto Corporation ($ACET) reported earnings last week and followed them up with a 10Qthis week. The company, in coordination with a new interim CFO from AlixPartners and advisors from PJT Partners and Lowenstein Sandler LLP, is seeking strategic alternatives. Meanwhile, the company was recently non-compliant with its maximum net leverage and minimum debt service coverage ratios under its credit facility and obtained a waiver for the quarter. There is no waiver for the next quarter and so June will be interesting — particularly given downward trends across the board in consolidated net sales, gross profit, gross margins, etc. Not to mention a rise in SG&A...

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Busted Tech (Long Venture Debt, Short Venture Capital): Videology Inc.

In what could amount to a solid case study in #BustedTech and the up/down nature of entrepreneurship, Videology Inc., a Baltimore based software ad-tech company that generated $143.2 million in revenue in fiscal 2017 has filed for bankruptcy.

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Disruption Disrupted (Short Money Burning Data Plays): Moviepass

Ok. Soooooo…this won’t shock anyone who has been paying attention. Apparently Moviepass — the company that lets subscribers see one movie a day for only $9.99 a month — is burning cash like nobody’s business. S.H.O.C.K.E.R. A first grade student can do THAT math.

Moviepass’ parent company Helios and Matheson Analytics Inc. ($HMNY) reported in an 8K filed this week that it burned $21.7 million per month from September 2017 through April 2018. The company now has $15.5 million in available cash with another $27.9 million in accounts receivable. Hang on: 15.5 + 27.9 (carry the four) = 43.4. Minus 21.7 and another 21.7 and….💥🔥💥🔥. Which prompted CNN to ask, “is the end near?” Here’s a choice quote...

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GNC Holdings Inc. Isn’t Out of the Woods Yet

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Professional Shots Fired: Jay Alix Sues McKinsey

In “McKinsey Gets Thrown Under the Bus (Long Relationships with the WSJ),” we began,

Okay, this WSJ article is bananas. What are the chances that Jay Alix has a direct line in to Gerard Baker?

Given that the WSJ piece is now front in center in the “Complaint and Jury Demand” filed by Jay Alix in Alix v. McKinsey & Co. Inc., et al (page 4, paragraph 11), wethinks the chances are pretttttttty prettttttty high (we’re 100% speculating here so take this with the usual PETITION grain of salt). Crack open a beer, break out the popcorn, and kick back: there’s a lot to unpack here…

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Ponder This: The Bankruptcy Code's Treatment of Veterans

By: Ted Gavin, Managing Director & Founding Partner of Gavin/Solmonese

In recent years, ABI Presidents have pursued lengthy agendas, including the ABI Chapter 11 Commission, launching an ethics task force, and creating the Consumer Bankruptcy Commission – all worthy projects deserving our respect. I have a tough act to follow as the incoming president.

Last month, I was pleased to announce the formation of the ABI Task Force on Veterans Affairs. Led by members and U.S. veterans John Ames, John Penn and Jack Williams, the group is comprised of individuals who are committed to changing veterans’ lives in a meaningful way. The Task Force will examine how the bankruptcy system treats veterans differently, and unfortunately— less favorably. Recommendations and corrective steps will be proposed to Congress or the Rules Committee in the coming year to improve bankruptcy outcomes for all veterans.

Consider what it’s like for vets to return home with any one of the many issues our brave warriors experience after serving their country. And then add to that the financial burden imposed by their service— a burden exacerbated by the cost of transitioning to civilian life; the medical fees associated with caring for injuries; transportation expense to healthcare professionals located at inconveniently-located VA hospitals; and lost income each time they have to see a VA doctor.

Then imagine as the crushing burden of medical or consumer debt mounts, you may be treated in an unfavorable way under the current Bankruptcy Code— especially if you’re a disabled vet.

When a civilian qualifies for and receives social security disability payments, those payments are based on their past income, and in the event of a bankruptcy filing, are not counted as income under the means test. When a disabled veteran files a bankruptcy petition, their disability payments are counted as income under the means test. The effect of this disparity is that someone on veteran disability has a lower likelihood of being able to avail themselves of the complete discharge offered by chapter 7 than a debtor who receives social security disability payments. This is but one of the ways in which the Code fails to work for veterans and service members.

I look at this problem, and I am reminded that ABI’s membership has shown, time and time again, that when its talents are utilized and focused, we can literally redefine our field. And I ask, what solutions to this problem might be unlocked by the brainpower of our members? I know that we haven’t done enough to change the things we can for veterans.

For an organization that many associate with corporate mega-bankruptcies, we’ve achieved quite a lot to improve outcomes for individuals whose lives are impacted by bankruptcies – either their own, their employer’s, or the companies they have built that have fallen on hard times. And now, we’re going to make bankruptcy function better for those who have served our country.

---

Ted Gavin is a Certified Turnaround Professional and the managing partner of Gavin/Solmonese. In 2016, The Deal Pipeline ranked Ted the #1 Crisis Manager in the U.S. based upon the number of active engagements. He has over 20 years of experience working with distressed companies and their stakeholders in diverse industries, including retail, transportation, regulated and non-regulated manufacturing, pharmaceutical and healthcare, professional services, construction, and metal-forming. He has served in leadership roles in engineering, manufacturing, information technology, and regulatory affairs functions. Ted has extensive experience in strategic planning and process re-engineering, with hands-on management experience in nonprofit, for-profit, and public sector operations. Ted testifies frequently as an expert witness on matters such as ordinary course of business issues in preference litigation, as well as on fiduciary duties of management in distressed companies.

Is rue21 Becoming rue22? (Short Liberal Return Policies)

On Mary 15, 2017 - nearly exactly a year ago — rue21 Inc. became the latest in what was a string of specialty fashion retailers to file for bankruptcy; it sought to pursue both an operational and a financial restructuring. The company had 1179 brick-and-mortar locations in various strip centers, regional malls and outlet centers. It also had a capital structure that looked like this:

Much of the leverage emanated out of an Apax Partners LLP-sponsored take-private transaction in 2013. We recently discussed Apax Partners in the context of FullBeauty here, in our recent Members’-only briefing.

Without any real contest, it was clear that the term loan holders constituted the “fulcrum” security and would end up swapping said loans for equity in the reorganized company. And that is precisely what happened. The ABL was covered, the term lenders funded a roll-up DIP credit facility along with new money to finance the pendency of the cases and then converted that DIP into an exit facility. The post-emergence capital structure consists of:

• $125 million ABL; and

• $50 million term loan (plus accrued interest on the DIP term loan as of the effective date).

General unsecured claimants were provided an equity “kiss” on the petition date and then, after the Official Committee of Unsecured Creditors’ (“UCC”) formed, it extricated additional value in the form of, among other things, (i) a put option to sell its post-reorg equity to one of the reorganized debtors, and (ii) a waiver by the prepetition term lenders of their $200 million deficiency claim. While the UCC did try and go after third-party releases for Apax, Apax ultimately succeeded in obtaining the release pursuant to the bankruptcy court’s September 9 confirmation order on the basis that it…

“…agreed to (i) support the Plan, including by promptly facilitating and participating in prepetition Plan discussions that culminated in the Restructuring Support Agreement and the Plan, notwithstanding that their equity position would likely be eliminated thereunder; and (ii) participate in the financing of the DIP Term Loan Credit Facility.”

In other words, Apax bought its release for $2 million in DIP allocation.

All told, this was a solid deleveraging of roughly $700 million. Moreover, the company closed roughly 400 stores. The company was seemingly well-positioned to effectuate the rest of its proposed restructuring, including (i) revamping its e-commerce strategy, (ii) improving the in-store experience, and (iii) pursuing a long-term business plan under relatively new management in a highly competitive retail atmosphere.

“Seemingly” being the operative word. In January, The Wall Street Journal reported (paywall) that the retailer experienced lackluster sales and tightening trade terms. Then, in February, Reuters reported that the company “is seeking financing after lackluster holiday sales failed to generate the cash it had hoped for….” It noted, further, that the company had engaged Piper Jaffray Companies ($PJC) to raise the funds. Notably, there has been nothing new on this front since. No news is probably not good news when it comes to this situation. Start the sewing machines: a Scarlet 22 tag may be in order and a liquidation on the horizon.

In the meantime, if the company is looking for ways to preserve liquidity, it might want to consider a far less generous return policy:

With clothes like this and a customer like that, what could go wrong?

WeWork’s Unintentional Comedy

Short “State of Consciousness” Companies

Back in “WeWork Invents a New Valuation Methodology,” we snarked about how WeWork pioneered an entirely new valuation technique. We noted,

"Indeed, to assess WeWork by conventional metrics is to miss the point, according to Mr. Neumann. WeWork isn’t really a real estate company. It’s a state of consciousness, he argues, a generation of interconnected emotionally intelligent entrepreneurs. And Mr. Neumann, with his combination of inspiration of chutzpah, wants to transform not just the way we work and live, but the very world we live in.”

A state of consciousness. A state of effing consciousness. Being a biglaw associate is also a state of consciousness but that doesn’t necessarily mind-port you to partner after 8 years, let alone 12.

We continued,

"Even Adam Neumann, a co-founder of WeWork and its CEO, admits that his company is overvalued, if you’re looking merely at desks leased or rents collected. ‘No one is investing in a co-working company worth $20 billion. That doesn’t exist.’ he told Forbes in 2017. ‘Our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue.'“

We’re sure bankers all across the world will be happy to add “energy and spirituality analysis” to the lineup of valuation methodologies like precedent transaction, comparable company and discounted cash flow analyses. What the bloody hell.

Then last Wednesday, in 💵WeWork Taps Cap Markets; People Lose Minds 💵, we briefly covered the proposed WeWork’s proposed $500 million high yield bond issuance. People went nuts because the offering memorandum finally shed some more light on the business. And it was a feeding frenzy. Little did we know, that was only Part II of this (unintentional) comedy.

Introducing “Community-adjusted EBITDA.” Per Barron’s:

As The Wall Street Journal reported, while revenue doubled last year, to $866 million, WeWork’s losses also doubled, to $933 million. But WeWork “earned $233 million, based on a metric the company dubbed “community adjusted Ebitda.” That consists of earnings before interest, taxes, depreciation, and amortization — a widely used measure of operating cash flow — but also excludes basic operating expenses, such as marketing, general and administrative, development, and design costs. That’s not in any accounting textbooks I’m aware of.

Per The Wall Street Journal,

“I’ve never seen the phrase ‘community adjusted Ebitda’ in my life,” said Adam Cohen, founder of Covenant Review, a bond research company.

There’s a first time for everything, homie. Or as Bloomberg’s Matt Levine put it,

Well, sure, Mr. Covenant Review, but I bet you’ve never reviewed the covenants of a state of consciousness either. 

Some more choice commentary:

Indeed, Moody’s was mildly schizophrenic (registration required) in its evaluation of the company’s new notes; it didn’t deign to even discuss WeWork’s accounting gymnastics as it assigned a B3 Corporate Family rating and a Caa1 rating to the notes.

Dealbreaker’s Thornton McEnery was far less measured. In lofty prose worthy of a Pulitzer, he led his piece entitled “WeWork’s First-Ever Bond Offering Is A Master Class in Financial Masturbation” with “[n]o company has its head farther up its own ass than WeWork.” We literally laughed out loud at that. But wait. There’s more,

That said, making up your own holistic, artisan, New Age Brooklyn accounting principle just to pretend that you’re hemorrhaging less money than you really are? Well, that’s actually super-ballsy and we’d almost respect it if WeWork wasn’t trying to write down Kombucha on tap and losses associated with ping pong ball replacements. It’s the height of Millennial hipster exceptionalism and it would truly make our skin crawl if, again, we didn’t respect the balls-out ego involved here.

Can you even say “balls-out” anymore? We thought #MeToo killed that. And ping pong? C’mon. That’s so 2014. It’s esporting Fortnite matches that are all the rage now, broheim. Anyways…

Then Bloomberg’s Matt Levine and Axios’ Dan Primack crashed the party by issuing a bit of defense. Levine’s is here — noting that the calculus is a bit different for bond investors. Primack spoiled some of the fun by clarifying what the new-fangled metric represents:

The metric includes all tenant fees, rent expense, staffing expense, facilities management expense, etc. for active WeWork buildings.

The exclusions are company-wide expenditures, which do not get pro rated. Much of that relates to growth efforts, although not all of it (executive salaries, for example).

One comp, and its not perfect, could be how Shake Shack reports "shack-level operating profit margins."

Bottom line: It's still kind of silly, but less silly than it at first appears. And obviously the ratings agencies and bond markets didn't seem put off.

Silly? Less silly? Whatevs.

Either way, the Twitterati largely neglected to take into account today’s dominant theme-among-themes: yield, baby, yield. Or said another way — per The Financial Times,

WeWork does have substantial backing, blue-chip customers and a good plan to increase profit-sharing leases. A high yield in its first bond, adding 150 basis points or so to the index average yield, would help, too. That could swell the offer above $500m. Even sober bond investors may not prove immune to the appeal of succulents and exposed brick.

Prescient. And bond investors did not prove immune. Nor sober.

Welcome to Part III. This is the part in the story where the record scratches, the jukebox stops, and everyone has an utterly perplexed look on their faces. Like, wait. WHAT? That’s right. Demand for this paper was so high, that it upsized from $500 million to $702 million. And just like that, poof! Adam Neumann looks into the camera, smirks, and then walks down the street like Kaiser-m*therf*ckin-Soze. He can tap the venture capital markets — stateside and abroad (in the case of Softbank) — and the debt market.

The Real Deal somewhat inexplicably stated,

WeWork sold $700 million in bonds Wednesday to investors wary of another startup with unstable cash flow entering the debt market.

Wary? How do you explain the upsized offering then? The only thing people should be wary of are other people who are shocked to see this happening. Again: YIELD. BABY. YIELD. And, to be clear, it was actually $702 million (at 7.785%). The notes are guaranteed by US subsidiaries that hold approximately 60% of the company’s assets at year end; “adjusted ebitda” was also used as the base for leverage requirements under the notes’ covenants. There’s hair all over this thing. The Financial Times took a deeper dive into lender protections as it…

wanted to get a general idea of the rights its bondholders might have if the bonds were sold under the terms laid out in the preliminary prospectus and then Millennials everywhere suddenly decided they would prefer to work from home.

Right, exactly. Or in a cafe where you can sit for hours for $3/day. Anyway, you can read that FT analysis here. Moreover, BloombergGadfly cautions about the rent duration mismatch here — a subject of particular note for restructuring professionals well-versed in section 365 of the bankruptcy code. Bloomberg notes,

WeWork acknowledges that its expenditures "will make it difficult for us to achieve profitability, and we cannot predict whether we will achieve profitability in the near term or at all." Risk is all part of the game for junk investors, and this one looks like it will be priced to go with a fat yield. But the more prudent will take that caveat seriously. 

Investors must’ve REALLY wanted in on the action. Many didn’t take that caveat seriously. Something tells us Burton Malkiel will be adding an addendum to his “Greater Fool Theory” coverage in “A Random Walk Down Wall Street” and this will be the case study.

What explains the enthusiasm? As The Wall Street Journal notes, this isn’t a $20 billion decacorn-x2 for nothing:

The numbers offer some positive signs for WeWork. Its net construction costs per desk fell 22% in 2017 to $5,631. And its corporate business—as opposed to revenue from freelance and small companies—appears to be growing well, as rating agency Standard & Poor’s said in its analysis. The agency said it expects large corporations will occupy 50% of WeWork’s desks within two years, up from 25% today.

But then they flip right around and note,

There also are concerns for investors in WeWork’s growth trajectory. Its revenue per user fell 6.2% to $6,928 in 2017, while sales-and-marketing costs more than tripled to $139 million, representing 16% of revenue, up from 9.9% in 2016.

Taking on debt adds risk to a company whose business model hasn’t been tested in a downturn. Given that its members typically sign monthly or annual leases, a drop in demand during a recession would mean the rents it charges tenants would fall, while the payments it owes to landlords would stay constant.

Nevertheless, the market spoke. It gobbled up those bonds.

But then, in Part IV, the market spoke again, mere days later. As Bloomberg noted,

WeWork Cos.’s bonds extended their losses on Tuesday, as investors who were at first enthused to get a piece of the action have since been cashing in their chips.

The $702 million of speculative-grade bonds, which sold last week at par, fell for the fourth straight day on Tuesday to 95.75 cents on the dollar, according to Trace bond-price data. That’s a sharp contrast to the outsized orders the company saw when it marketed its debt in primary markets last week.

And then they kept falling.

Source: Bloomberg

Per Trace, the bonds last printed on Friday, May 4 at 94.9 — a pretty impressive decline on the week (h/t @donutshorts).

This sequence of events likely has bondholders screaming, “Yield, baby. YIELD!!!”

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PETITION is twice-weekly newsletter covering disruption from the vantage point of the disrupted. We meander sometimes to other areas. This piece was in today's Members'-only newsletter. You can check us out here and follow us on Twitter here.

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.

McKinsey Gets Thrown Under the Bus (Long Relationships with the WSJ)

Okay, this WSJ article is bananas. What are the chances that Jay Alix has a direct line in to Gerard Baker? Choice passage,

A Wall Street Journal analysis of disclosure filings in all 13 chapter 11 cases in which McKinsey’s restructuring unit, called McKinsey RTS, has participated shows the company routinely discloses far fewer names and descriptions of connections than other advisers.

 It continues,

McKinsey initially identified by name a total of 59 connections to participating debtors, creditors, lawyers and accountants in those cases. The roughly 45 other bankruptcy professionals involved in those cases, including law firms, accounting firms and restructuring advisers, reported more than 15,000 named connections in total. On average, McKinsey reported five such relationships per case compared with the other firms’ disclosures of 171 connections each.

Typically conflicts disclosures don’t figure as high drama warranting a major newspaper’s #longform front-page coverage.

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⛽️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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