Footwear Brands Reap Heaps of VC Investment (Short B&M Footwear Retailers)

Back in March, in “Nine West & the Brand-Based DTC Megatrend,” we noted the following:

The Walking CompanyPayless ShoesourceAerosoles. The bankruptcy court dockets have been replete with third-party sellers of footwear with bursting brick-and-mortar footprints, high leverage, scant consumer data, old stodgy reputations and, realistically speaking, limited brand value. Mere days away from a Nine West bankruptcy filing, we can’t help but to think about how quickly the retail landscape is changing and the impact of brands. Why? Presumably, Nine West will file, close the majority of - if not all of - its brick-and-mortar stores and transfer its brand IP to its creditors (or a new buyer). For whatever its brand is worth. We suppose the company’s lenders - likely to receive the company’s IP in a debt-for-equity swap, will soon find out. We suspect “not a hell of a whole lot”.

Shortly thereafter, Nine West did file for bankruptcy but we were a little off on the rest. That is, unless $340mm constitutes “not a hell of a whole lot.” That amount, landed on after a competitive bidding process, resulted in a greater-than-expected value to Nine West’s estate. Remember: the company filed for bankruptcy with a stalking horse bidder offering “approximately $200 million (inclusive of the above-stated $123 million allocation to IP, subject to adjustment).” This is where bankruptcy functions as a bit of alternative reality: $340 million is a good result for a company with $1.6 billion of debt, exclusive of any and all trade debt — particularly when the opening bid is meaningfully lower. For a more fulsome refresher on Nine West’s bankruptcy filing, go here.

Subsequent to Nine West’s filing, the tombstones for footwear retailers continued to pile up. For instance, in mid-May, The Rockport Company LLC filed for bankruptcy with a telling narrative. We highlighted:

The company notes, "[o]ver the last several years the Debtors have faced a highly promotional and competitive retail environment, underscored by a shift in customer preference for online shopping." And it notes further, "[t]he unfavorable performance of the Acquired Stores in the current retail environment has made it difficult for the Debtors to maintain sufficient liquidity and to operate their business outside of Chapter 11." PETITION NOTE: This is like a broken record, already.

We continued:

In light of this, armed with a $20 million new-money DIP credit facility (exclusive of rollup amounts) extended by its prepetition ABL lenders, the company has filed for bankruptcy to consummate a stalking horse-backed asset purchase agreement with CB Marathon Opco, LLC an affiliate of Charlesbank Equity Fund IX, Limited Partnership for the sale of the company's assets - OTHER THAN its North American assets — for, among other things, $150 million in cash. The buyer has a 25-day option to continue considering whether to purchase the North American assets but the company does "not expect there to be any significant interest in the North American Retail Assets." Read: the stores. The company, therefore, also filed a "store closing motion" so that it can expeditiously move to shutter its brick-and-mortar footprint at the expiration of the option. Ah, retail. 

And, ah, footwear. Check out this lineup:

And so we asked:

Given all of that, would you want Rockport’s brick-and-mortar business?

Answer: no. Apparently nobody did. And, in fact, nobody — other than the stalking horse, CB Marathon Opco, LLC — wanted any part of Rockport’s business.

On July 6, the company filed a notice that it cancelled its proposed auction. There were no qualified bidders, it noted, thereby making CB Marathon Opco, LLC the winning bidder by default. And given that the stalking horse agreement excluded the U.S. brick-and-mortar assets, those assets are now officially kaput. A hearing at which the bankruptcy court will bless the sale is scheduled for July 16. Aside from some additional administrative matters in the case, that hearing will mark a wretched ending for a company founded in the early 1970s.

*****

Juxtapose that doom and gloom with this Techcrunch piece about the rise of venture capital in footwear:

Over the past year-and-a-half, investors have tied up roughly $170 million in an assortment of shoe-related startups, according to an analysis of Crunchbase data. The vast majority is going to sellers and designers of footwear that people might actually want to walk in.

Top funding recipients are a varied bunch, including everything from used sneaker marketplaces to high-end designers to toddler play shoes. Startups are also experimenting with little-used materials, turning used plastic bottles, merino wool and other substances into chic wearables.

The piece continues:

It should be noted that recent footwear funding activity comes on the heels of some positive developments for the shoe industry.

Positive developments huh? “Some” must be the operative word given the preface above. There’s more:

First, this is a huge and growing industry. One recent report pegged the global footwear market at $246 billion in 2017, with annual growth rates of around 4.5 percent.

Second, public markets are strong. Shares of the world’s most valuable footwear company — Nike — have climbed more than 50 percent over the past nine months to reach a market cap of nearly $130 billion. Stocks of several smaller rivals, including Adidas, have also performed well.

Third, men are spending more on footwear. Though they’ve long been stereotyped as the gender with more restrained shoe-buying habits, men are putting more money into footwear and could be on track to close the spending gap.

And:

…one other bullish sneaker trend footwear analysts point to is the changing buying habits of women. Driven perhaps by a desire to walk more than a few blocks without being in pain, we’re buying fewer high heels and more sneakers.

The piece goes on to list a lineup of well-funded footwear companies. In marketplaces, GOAT and StockX. In streetwear, Stadium Goods. For children, Super Heroic. For comfort, AllbirdsRothy’s, and Birdies. And the article neglected to mention KoioGreats, and M. Gemi, to name a few. If you feel as if these names are unfamiliar because you didn’t see them at a brick-and-mortar footwear retailer in your last trip to the mall, well…yeahThat ought to explain a lot.

Interestingly, before unironically asking (and not entirely answering) whether any of these companies actually make money, the article also highlights Tamara Mellon,“a two-year-old brand that has raised more than $40 million to scale up a shoe design portfolio that runs the gamut from flats to spike heels.” Indeed, the company recently raised a $24mm Series B round* to grow its Italian-made pureplay e-commerce direct-to-consumer brand. In reality, though, Tamara Mellon is only technically two years old. It was around before 2016. In a different iteration. That iteration filed for bankruptcy.

In early 2016, Tamara Mellon Brand LLC filed for bankruptcy because of a liquidity crisis. And it couldn’t sufficiently raise capital outside of a chapter 11 filing to ensure its survival. After filing for bankruptcy, the company took on a $2mm debtor-in-possession credit facility from Ms. Mellon and, after combatting an equityholder-led “recharacterization”** challenge (paywall), swapped its term loan debt into equity. Winning prepetition equityholders like Ms. Mellon and venture capital firm New Enterprise Associates (NEA) came out with 16 and 31.1 percent of the equity, respectively. In turn, NEA capitalized the company to the tune of approximately $12mm.

Which highlights the obvious: not all of these companies will ultimately have renowned founders who merit second chances. A number of these high-flying e-commerce upstarts will fail; some of them will file for bankruptcy. The question is: as the funding rounds pour in from venture capitalists looking for the next big exit, how many other brands and shoe retailers will they push into bankruptcy first?

*****

*In October 2017, we wrote the following in “Sophia Amoruso's Nasty Gal Failure = Trite Lessons (Short Puffery)”:

We love how entrepreneurs are all about "move fast and break things" and "don't be afraid to fail" but then when they do, and do so badly, there is barely anything that really provides an in-depth post-mortem…Take, for instance, this piece of puffy garbage about Sophia Amoruso, which purports to inform readers about what Ms. Amoruso learned from Nasty Gal's rapid decline into bankruptcy. Instead it provides some evergreen inspirational advice that applies to virtually...well...everything and anything. TOTALLY USELESS.  

Apropos, the above-cited Fast Company piece is lip service Exhibit B. The piece notes:

Tamara Mellon cofounded Jimmy Choo with, well, Jimmy himself back in 1996. But in 2016, she decided to launch her own eponymous luxury shoe brand. It wasn’t easy, though: When she tried to go to high-end factories in Italy, she discovered that many refused to work with her, citing non-compete clauses with the Jimmy Choo brand.

But through persistence, she prevailed, and found factories that made shoes for other luxury brands.

We gather that what happened earlier in 2016 wasn’t relevant to the PR piece. Curious: is “persistence” a new euphemism for “bankruptcy”?

**If we understand what happened here correctly, other existing equityholders tried to recharacterize Ms. Mellon’s term loan holding as equity, effectively squashing her priority secured claim and demoting that claim to equal to or less than the equityholders’ claims. If successful, Ms. Mellon would not have been able to swap her debt for equity. Moreover, the other equityholders would have had a greater chance of a recovery on their claims. They failed, presumably recovering bupkis.

Direct-to-Consumer Retail Gets Big Funding

Away, Hims & Parachute All Get Growth Capital

This week was a big financing week for startups. In addition to the Pillpack purchase noted above, there was a ton of action in the direct-to-consumer consumer products space that should definitely have incumbents concerned.

Away, the NY-based “thoughtful” startup that makes travel products that “solve real travel problems” raised $50mm in fresh Series C funding from prior investors Forerunner Ventures, Global Founders Capital and Comcast Ventures. The company intends to use the funds to tap into global markets, expand its product line and continue its clicks-to-bricks initiative with six new retail stores in the second half of 2018. The company recently moved its headquarters within New York City in part thanks to a $4mm Empire State Development performance-based tax credit through the Excelsior Jobs Program.

Hims, the one-year old SF-based company that sells men’s prescription hair and sex products, raised $50mm in Series B-2 funding at a $400mm post-money valuation. Investors include IVP, Founders Fund, Cavu Venture Partners, Thrive Capital, Redpoint Ventures, Forerunner Ventures (notice a pattern here?), and SV Angel.

Earlier this year, beauty products maker Glossier raised $52mm in Series C funding (and subsequently added Katrina Lake from Stitch Fix to its board of directors), shaving company Harry’s raised $112mm in Series D funding, and athleisure brand Outdoor Voices raised $32mm.

But, wait. There’s more: here, there are a variety of startups going after your kitchenware and your bed. Parachute announced this week that it raised $30 million in Series C funding led by H.I.G. Growth Partners. Other investors include Upfront Ventures, Susa Ventures, Suffolk Equity, JAWS Ventures, Grace Beauty Capital and Daher Capital. With three stores currently, the company intends to take the funding to, like Away, expand its clicks-to-bricks plan with 20 more locations in the next 2 years.

Meanwhile, mattress e-tailer Purple is (strangely) doubling-down on its relationship with Steinhoff-owned Mattress Firm, the struggling bed B&M retailer. The tie-up now includes Mattress Firm locations in Sacramento, Austin, DC, Chicago and SF. We hope Purple has baked in bankruptcy protections into its deal agreements so that there’s not question as to ownership.

If you don’t think all of this has incumbent CPG executives worried, you’re not paying close enough attention.

Not to mention the private equity bros:

More from Ryan Caldbeck’s interesting thread here.

Slight tangent: note that nowhere is there any mention of disruption from consumer product subscription boxes.

💩Will KKR Pay Toys' Severance? Part II. 💩

On Wednesday we bashed Dan Primack’s notion that KKR would fund Toys R Us’ severance payments. Apparently we weren’t the only ones. Primack subsequently wrote:

 Equity share: In writing about Toys "R" Us on Tuesday, I mentioned that private equity firms have an obligation to portfolio company employees. Some readers pushed back via email, but it's worth noting that Toys backer KKR has been providing equity to some of its portfolio companies (including Gardner Denver, CHI Overhead Doors and Capsugel).

  • Obviously it's not apples-to-apples with Toys, but such equity-share does reflect a more modern private equity mentality toward portfolio company employees. Bloomberg wrote about the Gardner Denver example last year.

There’s ZERO CHANCE IN HELL KKR funds severance payments. Just stop Dan. If we’re wrong, we’ll gladly eat this.

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

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

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

And in the former we noted,

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

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

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

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

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

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AND this:

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More from the Economist:

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

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

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

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

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

Zerohedge noted:

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

Moody’s weighed in as well:

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

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

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

On the supply side, Moody’s continued:

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

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

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

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

🔥Amazon is a Beast🔥

The "Amazon Effect" Takes More Victims

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

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

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

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

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

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

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

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

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

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

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

Thompson notes further:

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

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

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

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

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

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

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

Expect some real healthcare reform ahead.

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

*****

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

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

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

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

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

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

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

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

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

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

#BustedTech (Short Busted IPOs…cough…DOMO)

Tintri Inc., a publicly-traded ($TNTR) Delaware-incorporated and Mountain View California based provider of enterprise cloud and all-flash and hybrid storage systems appears to be on the brink of bankruptcy. There's no way any strategic buyer agrees to buy this thing without a 363 comfort order. 

In an SEC filing filed on Friday, the company noted:

"The company is currently in breach of certain covenants under its credit facilities and likely does not have sufficient liquidity to continue its operations beyond June 30, 2018."

Furthermore, 

"Based on the company’s current cash projections, and regardless of whether its lenders were to choose to accelerate the repayment of the company’s indebtedness under its credit facilities, the company likely does not have sufficient liquidity to continue its operations beyond June 30, 2018. The company continues to evaluate its strategic options, including a sale of the company. Even if the company is able to secure a strategic transaction, there is a significant possibility that the company may file for bankruptcy protection, which could result in a complete loss of shareholders’ investment."

And yesterday the company's CEO resigned from the company. All of this an ignominious end for a company that IPO'd almost exactly a year ago. Check out this chart:

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

The company's capital structure consists of a $15.4mm '19 revolving credit facility with Silicon Valley Bank, a $50mm '19 facility with TriplePoint Capital LLC, and $25mm of 8% convertible notes. Revenues increased YOY from $86mm in fiscal 2016 to $125.1mm in fiscal 2017 to $125.9mm in fiscal 2018. The net loss, however, also moved up and right: from $101mm to $105.8mm to $157.7mm. The company clearly has a liquidity ("net cash") covenant issue (remember those?). Accordingly, the company fired 20% of its global workforce (~90 people) in March (a follow-on to a 10% reduction in Q3 '17). The venture capital firms that funded the company — Lightspeed Venture Partners among them — appear to be long gone. Silver Lake Group LLC and NEA Management Company LLC, unfortunately, are not; they still own a good amount of the company.

"Isn't cloud storage supposed to be all the rage," you ask? Yeah, sure, but these guys seem to generate product revenue largely from sales of all-flash and hybrid storage systems (and stand-alone software licenses). They're mainly in the "intensely competitive IT infrastructure market," sparring with the likes of Dell EMCIBM and VMware. So, yeah, good luck with that.

Don’t. Mess. With. Daisy. Chapter 4. (Petsmart: Long Asset-Stripping Shenanigans)

Man this dog series (and John Wick referencing) is fun. With regard to Petsmart Inc., we previously we wrote:

The company financed the purchase with a two-part debt offering of (a) $1.35 billion of ‘25 8.875% senior secured notes and (b) $650 million of ‘25 5.875% unsecured notes. Rounding out the capital structure is a $750 million ABL, a $4.3 billion cov-lite first-lien term loan and $1.9 billion cov-lite ‘23 senior unsecured notes. Let us help you out here: 1+2+3+4 = $8.2 billion in debt. The equity sponsors, BC PartnersGICLongview Asset ManagementCaisse de dépôt et placement du Québec and StepStone Group, helped by writing a $1.35 billion new equity check.

That capital structure refresher is important…

Taking a page out of J.Crew’s asset-stripping, litigation-inducing, bird-flip-to-senior-lenders-activating playbook, Petsmart this week announced that it moved a 16.5% stake in Chewy.com (a/k/a the savior) to an unrestricted subsidiary — unironically using a sponsor dividend mechanic for the transaction; it also dividended 20% of the equity in Chewy.com to its parent company, Argos Holdings, an entity controlled by private equity firm BC Partners. Consequently, Chewy.com is no longer a wholly-owned subsidiary of Petsmart. Moreover, per The Financial Times,

“Chewy will no longer guarantee PetSmart's debt, according to Xtract Research, though the remaining 63.5 per cent of the shares will still be pledged to secure term loans and senior bonds.”

We love financial shenanigans that weaken lender collateral packages to the apparent benefit of junior creditors and private equity sponsors. Particularly when they’re done so quickly after the original transaction!

How did the market react? Well, per Bloomberg, initially:

PetSmart’s bonds rallied as the move of the online vendor’s assets was seen as less aggressive than what bondholders had originally priced in, according to the people, who said the initial buyers of the notes have unloaded the positions. Investors sold PetSmart’s debt last year on fears it would sell or spin off as much as 100 percent of the Chewy equity to the private equity owner, removing it from the pool of assets they have recourse to as bondholders.

Haha, right. So instead of getting potentially 100% effed, bondholders only got 33% effed. Can you say: Credit positive!? This is what makes the distressed world just so unmistakably poetic and nasty at the same time: everything is largely a function of…well…you guessed it: asset price and asset value. With the par guys out and buyers at distressed levels in, “credit positive” is entirely relative.

Anyway, more from Bloomberg,

The company’s management said that said they will continue to actively monitor the capital structure and potentially pursue additional strategic opportunities to extend debt maturities, reduce overall leverage and invest in the business, according to the people. Management didn’t have a question and answer portion at the end of the call.

Of course not. Why would they? The first question would be “By ‘reduce overall leverage’ does that mean issuing new bonds secured by the newly siphoned off equity of (valuable?) IP in exchange for the cov-lite unsecured notes?” Even Eli Manning couldn’t so obviously telegraph his next move (The Financial Times, citing Covenant Review, cites some other options here).

This bit is great:

Petsmart’s transfer of assets to an unrestricted subsidiary was not surprising given what J. Crew was able to do with its transfer of intellectual property under its loan documents, James Wallick of Xtract Research said in an interview. The move is “symptomatic” of the current market for loans and bonds, where agreements “are so flexible that you can do a transaction such as this.”

Hahaha. Man people love to gripe about the capital markets these days. Said another way,

Mmmm hmmm. Yield, baby, yield.

L Brands (Long "Misplaced Optimism in Retail")

On Valentine’s Day, in “Misplaced Optimism in Retail: L Brands - What the Holy F*#*?,” we clowned on Leslie Wexner’s aggressive approach to retail and said “tell us that you don’t want to short the sh*t out of the stock.” It was trading at $49.87/share. Now...

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Direct-to-Consumer Food (Short the Butcher Section)

We have spoken a lot about direct-to-consumer digitally native brands having a tremendous — and understated (in restructuring circles) — affect on brick-and-mortar retail. Apparel in particular. PETITION readers are already familiar with Wish, a unicorn shopping platform with a valuation north of $8 billion. It’s secret sauce is allowing consumers to purchase clothes directly from Chinese factories. Imagine all of the middlemen cut out of that equation. No “brand tax” either.

Earlier this week Sequoia Capital China led an investment in Jollychic, a China-based e-commerce startup that lets Middle Eastern shoppers order unbranded products from Chinese factories.

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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 MotorsFord 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:

Screen Shot 2018-05-31 at 10.54.05 AM.png

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.

Screen Shot 2018-05-31 at 10.48.30 AM.png

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

Screen Shot 2018-05-19 at 8.42.01 AM.png

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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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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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:

Screen Shot 2018-05-09 at 11.14.00 AM.png

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:

Screen Shot 2018-05-09 at 11.15.55 AM.png

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 AxiosDan 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.

Screen Shot 2018-05-06 at 11.14.51 AM.png

And then they kept falling.

Source: Bloomberg

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!!!”

-----

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:

Screen Shot 2018-05-01 at 4.58.26 PM.png

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:

Screen Shot 2018-04-28 at 8.11.16 PM.png

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.

The Latest and Greatest on Guitar Center (Part 2)

Long Electronic Dance Music's Musical Awakening?

In “The Latest and Greatest on Guitar Center,” we cast some shade on the guitar retailer’s amend-and-extend transaction. We wrote,

On Monday, Guitar Center — with the help of bankers UBS and Houlihan Lokey and the consent of Ares — launched an exchange offer and consent solicitation related to its unsecured notes. The offer is to swap the existing $325 million 9.625% notes for $325 million of 5% cash/8% PIK notes due 2022 (along with with some warrants). Per the company’s press release, $299 million worth of holders have already agreed (92% of the issuance). This swap would save the company $13,812,500 a year in interest expense AND have the effect of pushing out the maturity for three years. Gotta love the capital markets these days.

In tandem, the company is proposing to offer $635 million of new 9.5% senior secured notes due 2021. The use of proceeds of these new notes would be to redeem the $615 million 6.5% senior secured notes due 2019. With this piece of the transaction, the company will be taking on an additional $20.35 million of annual interest expense.

Finally, the company will also refinance the $375 million ABL, extending the maturity out by 5 years.

So, if you made it this far, here’s the upshot: if these transactions are successful, the company will have availed itself of a few years to turn itself around by pushing out its debt maturities. But, it will have eliminated ZERO INTEREST EXPENSE in the aggregate. Said another way: this is a band-aid, not a solution.

All of which means that the company needs to hope and pray some rock God hits the scene and reinvigorates the market for guitars in the next two years. We’ll take the under.

As it turns out, the company ultimately downsized the amount of 5% cash/8% PIK notes due 2022 from $325 million to $318 million which will, naturally, have the affect of...to read this rest of this a$$-kicking commentary, you must be a Member...