🛋There's Disruption Afoot in the Furniture Space🛋

Add Furniture to the List of Disrupted Categories (Home Heritage Group Inc. Filed for Bankruptcy)

“New Chapter 11 Filing!” Or is it technically a Chapter 22? 🤔

We know what you’re thinking. You’re thinking “this filed a few days ago and I’ve already read all about it.” You may have read something about it, but not like this. Bear with us…

Home Heritage Group Inc. (“HHG”) is a North Carolina-based designer and manufacturer of home furnishings; it sells product via (i) retail stores, (ii) interior design partners, (iii) multi-line/independent retailers, and (iv) mass merchant stores.” In addition, the company has an international wholesale business.

Why do we mention Chapter 22? For the uninitiated, Chapter 22 in bankruptcy doesn’t actually exist. It is a somewhat snarky term to describe companies that have round-tripped back into chapter 11 after a previous stint in bankruptcy court. That, to some degree, is the case here.

WAAAAAAAY back in November 2013, KPS Capital Partners LP formed the newly bankrupt HHG entity to acquire a brand portfolio and related assets out of the bankruptcy estate of Furniture Brands International Inc. (“FBI”). FBI had been, in the early 2000s, a very successful purveyor of various furniture brands — to the tune of $2b in annual sales. But in the 12 months prior to the acquisition, the company’s sales were down to $940mm and, more importantly, its EBITDA was negative $58mm. At the time of filing, it had $142mm in total funded debt outstanding, $200mm in unfunded pension obligations and another $100mm in general trade obligations.

Given this debt, a decline in sales at the time was devastating. The company noted in its court filings on September 9, 2013 (Docket #16):

As a manufacturer and retail of home furnishings, Furniture Brands’ operations and performance depend significantly on economic conditions, particularly in the United States, and their impact on levels of existing home sales, new home construction, and consumer discretionary spending. Economic conditions deteriorated significantly in the United States and worldwide in recent years as part of a global financial crisis. Although the general economy has begun to recover, sales of residential furniture remain depressed due to wavering consumer confidence and several, ongoing global economic factors that have negatively impacted consumers’ discretionary spending. These ongoing factors include lower home values, prolonged foreclosure activity throughout the country, a weak market for home sales, continued high levels of unemployment, and reduced access to consumer credit. These conditions have resulted in a decline in Furniture Brands’ sales, earnings and liquidity.

Sales have continued to be depressed as a result of a sluggish recovery in the U.S. economy, continuing high unemployment, depressed housing prices, tight consumer lending practices, the reluctance of some households to use available credit for big ticket purchases including furniture, and continuing volatility in the retail market.

PETITION Note: My, how things have changed. Just reflect on that synopsis of the economy a mere five years ago. The company also noted that:

…some of the Company’s larger brands have lost some of their market share primarily due to competition from suppliers who are able to produce similar products at lower costs. The residential furniture industry is highly competitive and fragmented. Furniture Brands competes with many other manufacturers and retailers, some of which offer widely advertised, well-known, branded products, and other competitors are large retail furniture dealers who offer their own store-branded products.

All of these factors stormed together to constrain the company’s liquidity and force a chapter 11 filing and eventual sale. KPS purchased several of the FBI brands for $280mm (subject to working capital adjustments), including Thomasville, Broyhill, Lane, Drexel Heritage, Henredon, Pearson, Hickory Chair, Lane Venture, and Maitland-Smith. In other words: brands that your grandfather would know and you would shrug at the mere mention of. Well, some of you anyway.

Fast forward five years and the successor entity HHG has $280mm of debt and…you guessed it…severe liquidity constraints. In its first day filing papers, HHG notes that the previous bankruptcy continues to have lasting effects on its business; it highlights:

Following years of sales declines, many furniture retailers had lost faith in the ability of the Company to produce, deliver, and service its products, and the bankruptcy led many of them to shift their purchases to a variety of competitors or even further utilize their own private label offerings.

This is what people still nostalgically refer to as “bankruptcy stigma.” Indeed, it still exists. The company continued:

In addition, the Company’s operations and performance depend significantly on economic conditions, particularly in the United States, and their impact on levels of existing home sales, new home construction, and consumer discretionary spending. Although economic conditions have been steadily improving in recent years, the Debtors have struggled to adjust to certain shifts in consumer lifestyles, which include: (i) lower home-ownership levels and more people renting; (ii) more apartment living and single-person households; (iii) older consumers that want to age in place; and (iv) cash-strapped millennials that are slow in forming households relative to prior generations.

Haha! The poor millennials. Apparently an entire generation is “cash-strapped” and prefers to sleep in a tent under their WeWork desks. Blame the avocado toast and turmeric lattes. But, wait, there’s more:

Consumer browsing and buying practices are rapidly shifting as well toward greater use of social media, internet- and app-based catalogs and e-commerce platforms, and the Company has been unable to develop a substantial sales base for its brands through this key growth channel.

Furthermore, the residential furniture industry is highly competitive and fragmented. The Company competes with many other manufacturers and retailers, some of which offer widely advertised, well-known, branded products, and other competitors are large retail furniture dealers who offer their own private label products. This competitive landscape has proved challenging for some of the Company’s larger brands as well-capitalized competitors continue to gain market share at the expense of the Debtors. (emphasis added)

PETITION Note: My, how things have remained the same. Sound familiar? Have to hand it to the professionals here: why reinvent the wheel when you can just crib from the prior filing? We guess being a repeat customer in bankruptcy has its benefits!! Chapter 22!!!

<p>Meanwhile a short digression relevant to those last two quoted paragraphs. According to Statista, worldwide online furniture and homewares sales are expected to be close to $190 billion. Take a look at this chart:

RetailDive notes:

E-commerce furniture sales have emerged as a major growth area, rising 18% in 2015, second only to grocery, according to research from Barclays.

Accordingly, GartnerL2 cautions that:

…home brands now have an outsized onus to produce best-in-class product pages for the influx of online shoppers. However, many brands have failed to deliver and aren’t keeping pace with industry disruptors.

Sounds like HHG has, admittedly, fallen into this category.

GartnerL2 highlights the disparate user experiences offered by Williams-Sonoma-owned West Elm and Chicago-based DTC disruptor Interior Define, which was founded in 2013 and has raised $27mm in funding (most recently a Series B in March). The latter offers extensive imagery, a visual guide and an augmented reality mobile app. All of these things appeal to the more-tech-savvy (non-cash-strapped??) millennial buyer.

And that is precisely the demographic that La-Z-Boy Incorporated ($LZB) is going after with its purchase of Joybird, a California-based direct-to-consumer e-commerce retailer and manufacturer of upholstered furniture. Founded in 2014, its $55mm in reported revenue last year took a chunk out of, well, someone. Other players in that space include Burrow ($19.2mm in total funding; most recent Series A in March from New Enterprise Associates) and, of course, Amazon’s in-house furniture brands, Rivet and Stone & Beam. <p><end>

All of these factors resulted in continual YOY declines in sales and a liquidity squeeze. Now, therefore, the company is in bankruptcy to effectuate a sale — or sales — of its brands to prospective bidders. It has one purchaser in line for the “Luxury Group” and, according to the court filing, appears close to an agreement with a stalking horse buyer of the Broyhill and Thomasville & Co. properties. In the meantime, the company has a commitment from prepetition lender PNC Bank NA for a $98mm DIP, of which $25mm Judge Gross granted on an interim basis.

⚡️Is PG&E in Trouble?⚡️

PG&E Reported Earnings (Long Climate Change)

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

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

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Home Security is a Tough Business

Short Ascent Capital Group

Tough is one word for it.

Saturated is another.

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

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

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

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

Especially for Monitronics.

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

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

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

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

And here we thought people were shunning the cable companies?

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

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

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

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

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

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

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

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

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

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

Moody’s noted:

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

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

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

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

This company is looking a bit insecure.

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

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

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

As we said, “saturated.”

Restaurants, Co-Cooking & Delivery. The Future is Now.

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Major League Baseball Continues to Sh*t the Bed (Long Ninja, Short Manny Machado)

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New York City CRE (Long the Changing Retail Landscape)

Is anything available in New York City for less than $5? Some of you are about to find out.

Yesterday, Bloomberg noted the following:

Retail rents are tumbling in Manhattan, especially in the toniest neighborhoods.

In the area around the Plaza Hotel on Fifth Avenue, home to the borough’s priciest retail real estate, rents fell 13.5 percent in the second quarter from the previous three months, the largest decline among the 16 neighborhoods tracked by brokerage CBRE Group Inc. The drop was due in part to a single space that had its price cut from $3,500 a square foot to $2,500, CBRE said in a report Tuesday.

Tenants have the upper hand in New York as landlords contend with a record number of empty storefronts. Across Manhattan, 143 retail slots have sat vacant for the past year, and rents have been reduced on more than half of those spaces, CBRE said. Property owners are increasingly willing to negotiate flexible terms in an effort to get tenants to commit to leases, according to the report.

Apparently a number of commercial real estate brokers didn’t get the memo. Brokers reportedly lashed out last week upon news that General Growth Properties ($GGP) leased out a large space to Five Below, a discount consumer products chain, at 530 Fifth Avenue. Per Commercial Observer:

Some brokers expressed disappointment with the tenant selection.

“It’s not a Fifth Avenue-type tenant. Everyone is pissed,” one broker said of the deal because of the nature of the tenant on a prized part of Fifth Avenue. He added: “There goes the neighborhood.” A more suitable location, the broker said, would have been south of 42nd Street.

“Not sure this was the tenant surrounding landlords with available space were hoping for,” said Jeffrey Roseman, a vice chairman at Newmark Knight Frank Retail, who was not involved in the deal.

Wait. What? Currently, there’s literally a JPMorgan Chase Bank, a Walgreens and a Kaffe 1668 right there there. Who among that lot can rightfully object?

What these brokers don’t appear to grasp is that the brick-and-mortar landscape has dramatically changed. There aren’t very many tenant options for landlords — at least not for 10,800 square foot spaces (which is what this is). And there’s no benefit to any of the other retailers in the vicinity of the space for it to remain vacant. Apropos, as noted in Commercial Observer, one broker appears to get it:

“Five Below is the updated variety store or five-and-dime store of our day—something for everyone,” said Faith Hope Consolo, the chairman of the retail leasing and sales division at Douglas Elliman. “As for the character or image of the street, that is not really affected or important. The key is that a big space was absorbed and this type of tenant will generate traffic.”

Our thoughts exactly. Those adhering to a New York City of yesteryear clearly haven’t noticed the influx of coffee shops, pharmacies and banks on every corner. Who else would take such a large space? Toys R Us?

What? Too soon?

🍟Casual Dining Continues to = a Hot Mess🍟

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

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

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

Unfortunately for those in the space, those themes persist.

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

The company noted:

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

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

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

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

*****

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Auto Distress (Short Short Memories)

With interest rates rising and fears of an imminent recession gaining increasing traction (see below), many remain concerned about the subprime auto lending market. The professionals at Davis & Gilbert LLP note:

Total auto loan debt increased to $1.23 trillion in Q1 2018, up from $1.17 trillion versus a year ago, and accounted for 9.3% of the $13.21 trillion in national household debt – remaining greater than credit card debt, but less than student loan and mortgage debt, according to Federal Reserve Bank of New York data.

While subprime originations have...

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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 Company. Payless Shoesource. Aerosoles. 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, Allbirds, Rothy’s, and Birdies. And the article neglected to mention Koio, Greats, 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…yeah. That 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:

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:

AND this:

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:

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.

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:

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:

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 EMC, IBM 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 Partners, GIC, Longview Asset Management, Caisse 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.

When Will ICOs Become a Thing in Distress? (Short SEC Regulations)

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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 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.

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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.

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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.