⛅The Rise of the Cloud. (Long Cloud Usage. Short Debt-Laden Intermediaries).⛅

 

The “cloud” is such a fundamental business component today that cloud considerations inform various aspects of business planning. Look no farther than Amazon Inc. ($AMZN)Microsoft Inc. ($MSFT)Cisco Inc. ($CSCO), and Google Inc. ($GOOGL), and you’ll see cloud computing providers who are minting money on a quarterly basis for providing services that alleviate the server and storage burden of businesses across all kinds of industry verticals. Underscoring the importance of the cloud, IBM Inc. ($IBM) spent a fortune — $34 billion! — acquiring Red Hat Inc. to boost its cloud-for-business offering. Furthermore, recent IPOs have illustrated just how important cloud services are: Pinterest Inc.Snap Inc. ($SNAP)Lyft Inc. ($LYFT), and many other high-flying companies pay hundreds of millions in fixed contracts for cloud computing services that power their applications in ways that everyday end users almost certainly don’t recognize and/or appreciate.

The “cloud,” however, subsumes various other services in addition to computing/storage. There are connectivity-focused applications (provided by the likes of AT&T Inc. ($T)Comcast Corporation ($CMCSA), and others) unified cloud communications applications (i.e., Vonage Holdings Corp. ($VG)), and point solutions (e.g., Citrix Systems Inc. ($CTXS)). One could be forgiven for thinking that everything and anything touching cloud would be gold in this environment. Imagine, for instance, if one firm could serve as an intermediary linking together various cloud-based solutions for other small, medium and large businesses!! Cha Ching!! 

Apparently that’s not the case.

New York-based Fusion Connect Inc., “a provider of integrated cloud solutions, including cloud communications, cloud connectivity and business services to small, medium and large businesses” is bucking the hot cloud trend and barreling quickly towards a bankruptcy court. This begs the question: what the holy f*ck? How is that even possible?

Per a January investor presentation, this is Fusion’s cloud services revenue:

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The 2018 revenue is annualized: revenue in Q3 ‘18 was actually $143.4mm with gross margins of 49.1%. Net operating income was $4mm. Yet the company lost $0.23/share. How does that work? Well, the company had $21.6mm in interest expense.

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The weighted-average rate of interest across the company’s credit facilities is approximately LIBOR + 7.7%. 😬 Not exactly cheap. Compounding matters is that the debt isn’t exactly cov-lite (shocking, we know): rather, the company is subject to all kinds of affirmative and negative covenants. Yes, once upon a time, those did exist.

The company’s recent SEC reports constitute a perfect storm of bad news. On April 2, the company filed a Form 8-K indicating that (i) a recently-acquired company had material accounting deficiencies that will affect its financials and, therefore, certain of the company’s prior filings “can no longer be relied upon,” (ii) it won’t be able to file its 10-K, (iii) it failed to make a $7mm interest payment on its Tranche A and Tranche B term loan borrowings due on April 1, 2019, and (iv) due to the accounting errors, the company has tripped various covenants under the first lien credit agreement — including its fixed charge coverage ratio and its total net leverage ratio. Rounding out this horror show of news, the company disclosed that it may need to seek a chapter 11 filing (combined with a CCAA in Canada) and has hired Weil Gotshal & Manges LLPFTI Consulting Inc. ($FTI) and Macquarie Capital USA Inc. to advise it vis-a-vis strategic options. B.Riley/FBR ($RILY) analyst Josh Nicholsimmediately downgraded the company from “buy” to “neutral” (huh?!?) with a price target of $0.75 from $9.75. Uh, okay:

This is why you should never listen to equity analysts. This is the stock chart from the past year:

Like, the stock has been nowhere near $9.75, but whatevs.

On Monday, the company filed another Form 8-K. The company and 18 of its affiliated bankrupt US debtors…uh, we mean, guarantors…entered into a forbearance agreement with lenders under the Wilmington Trust NA-agented first lien credit agreement. The lenders will forbear from exercising rights and remedies stemming from the company’s defaults until April 29. The company had to pay 200 bps for the time to try and work this all out and agree to pay a slew of lender professionals, including Greenhill & Co. Inc. ($GHL) and Davis Polk & Wardwell LLP for an ad hoc group of Tranche B term lenders, Simpson Thacher & Bartlett LLP for the lenders of Tranche A term loans and the revolving lenders, and Arnold & Porter Kaye Scholer for Wilmington Trust.

The company’s Tranche B term lenders include East West BankGoldman SachsMorgan StanleyOnex Credit PartnersOppenheimer Funds and a whole bunch of CLOs. The latter fact may make a debt-for-equity swap interesting (PETITION Note: most CLOs are unable to hold equity securities).

The clock is ticking on this one.

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Ferrellgas Partners LP Lights Money on Fire

 
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Kansas-based Ferrellgas Partners LP ($FGP) is an old school business. For nearly 80 years, it has been a nationwide home and business propane provider with propane demand driven primarily by users of space and water heaters, and large engine operators (i.e., forklifts, mowers, and generators). According to the EIA, “[a]bout 5% of all U.S. households heat primarily with propane, and many of those households are in the Northeast and Midwest.” The market for the product, however, is fairly static, thereby limiting the company’s go-forward growth prospects. Accordingly, a few years back, it sought to supplement its core business and diversify its revenue streams via acquisition.

In 2015, therefore, the company acquired Bridger Logistics, a midstream services business involving the shipping and storage of oil, for approximately $837.5mm. The company paid nearly $563mm in cash (read: issued debt to pay cash) and the rest in stock: this elevated purchase price represented a 8.4x multiple on estimated next twelve months EBITDA of $100mm. The company noted the following at the time of the acquisition:

"The move positions Ferrellgas to significantly expand its midstream platform and is expected to be immediately accretive to Ferrellgas and supportive of future distribution growth.”

Only it wasn’t. Rather than being accretive, the transaction became the epitome of (i) haphazardly reaching beyond a core competency, (ii) stretched economics during a frothy seller’s market, and (iii) bad timing. Shortly after the transaction, the midstream services sectors got napalmed. And never recovered. In 2018, the Company reported that Bridger and other accumulated midstream asset gross margin decreased an astounding 75% to $12.6mm. Burdened by an over-levered capital structure, the company reversed course and rather than attempt to fit a square peg into a round hole, decided to start shedding assets to paydown debt. Indeed, the company sold the same acquired assets for a total of $92mm — which amounts to an absolutely BRUTAL level of value destruction.

Clearly that acquisition didn’t go as planned. After a brutal 18-month failure, the transaction left the most lasting impression on the company’s balance sheet:

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Bankruptcy, Transparency and the White Knight: McKinsey (Short Logic)

Another week, another chapter in the Jay Alix and McKinsey drama. And, seriously, folks, this sh*t is fiercer than a White Walker facing off against some dragons so hold on to your seats.

On Tuesday, Law360 reported:

Restructuring consultant Jay Alix again urged a New York bankruptcy court on Tuesday to let him investigate McKinsey & Co. over alleged conflicts of interest in the SunEdison Inc. Chapter 11 case, just days after McKinsey revealed that it paid $17.5 million to SunEdison’s estate to resolve nearly identical claims.

Tuesday’s motion comes as U.S. Bankruptcy Judge Stuart M. Bernstein is considering whether to take additional action in the SunEdison case, or let the $17.5 million settlement end matters as far as McKinsey is concerned.

And on Wednesday:

Alix’s filing in the SunEdison case comes as a Texas bankruptcy court rejected his pleas to dig further into McKinsey in the case of the Westmoreland Coal Company, which emerged from bankruptcy last month and is another McKinsey client.

The conflict of interest claims Alix raised in that case forced McKinsey to disgorge $5 million in fees in a settlement with Westmoreland’s estate, but on Wednesday U.S. Bankruptcy Judge David R. Jones shot down Alix’s request for an “emergency order” that would allow him to conduct further discovery.

Indeed, Mr. Alix sought an “emergency motion” for entry of an order compelling McKinsey to disclose all of the investments of its affiliate MIO Partners Inc. Mr. Alix wrote:

The time to move forward on Mar-Bow’s objection and determine whether McKinsey is qualified to serve as a professional in this matter is long overdue. It is notable that McKinsey has never denied the MIO’s holdings in the Debtors’ estates or in interested parties. Accordingly, this emergency motion seeks prompt and highly discrete relief: an order compelling McKinsey to (a) identify all equity or debt investments held or managed by it or any of its affiliates (including MIO) in any Debtor, or in any party in interest, competitor, customer, or supplier; and (b) disclose information sufficient to allow the Court to evaluate the amount and nature of those investments.

The judge — perhaps a bit miffed that his docket had been completely overrun by motion practice relating to the Alix/McKinsey dispute…you know, rather than issues specific to the actual Westmoreland Coal Company matter — summarily dismissed the motion. In an order issued on Wednesday April 10, 2019, he wrote:

At best, the motion represents a self-created emergency with no underlying substance. At worst, the motion constitutes an improper collateral attack on the Court’s prior order at Docket No. 1427 for an illegitimate purpose. Counsel are advised that they are responsible for the words and allegations contained in pleadings on which their names appear. Candor and professionalism must never be sacrificed in the name of overzealous advocacy.

ZING!

Of course, we find this language to be a wee bit hypocritical coming from a Judge who has skewered professionals of all types — lawyers, service providers, whomever — from his perch on the Bench. As just one example, recall this classy bit from an August 4, 2016 hearing in the matter of Sherwin Alumina Company LLC (that related to the Noranda Aluminum matter too):

You are on my radar screen. The financial transaction that ought to be being discussed a first-year business student can see. I’m not the smartest guy in the world, and I see it. I have been reading pleadings. And I cannot express the degree of disappointment that I have in the professionals that have been running these cases. If this case is going to fail, if the Noranda cases are going to fail, then so be it. But that’s going to create a block of time, and I’m going to use all of my education, all of my training, all of my experience in deciding where to lay the blame for this failure. That’s not a threat; it’s a promise. And if anyone wants to test my resolve, I encourage them to do it. Anyone doubts my commitment? Noranda’s local counsel spent a lot of years with me. They know exactly how I can be. You all are a talented group of people. I find it offensive that egos have gotten in the way. If we really want to try and have a contest as to who’s got the biggest set, I promise you I will win that battle.

“That’s not a threat; it’s a promise.” Really?

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🐶Petsmart Gets its Deal🐶

DON’T. MESS. WITH. DAISY. CHAPTER 5. (LONG ASSET STRIPPING AND COERCIVE CONSENT SOLICITATIONS).

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It's a beautiful day. You're walking down the street with your cute little puppy, Bacca, enjoying some much-needed serenity. The wind is blowing your hair back and the smell of flowers permeates the air. Life is good. You’re happy. Maybe you'll treat sweet lil' Bacca to some of that sweet organic sh*t today; after all, you're only a short walk to the local pet store. But then your phone rings.

"Bro. We need to make a decision."

"About what?" you ask, your chill vibes violently crushed by the voice of your excited junior analyst.

"PetSmart. They're doing an exchange. And it's coercive AF!"

Frikken Petsmart. You look down at Bacca and you swear you see a grimace on his cute little face as he stares back at you. You refocus your attention on your analyst, "Alright dude. Relax. What's the story?"

"Arnold & Porter Kaye Scholer is hosting an all hands term lender call soon. At issue is whether the group of term lenders will, in exchange for some enhanced economics, amend the credit docs governing the loan to post facto bless the company's absurd Chewy.com dividend." 

You reflect a bit on Petsmart as you continue your walk. Nearly exactly two years ago the company announced its whopper of a $3.35b Chewy.com transaction; it took on massive amounts of debt to fund the deal. It was the largest e-commerce acquisition ever — topping Walmart Inc’s acquisition of Jet.com. Venture capitalists instantaneously made a boatload of money (the pre-acquisition funding topped out at $451mm) but immediately the Petsmart capital structure looked wobbly after 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 was a $750 million ABL, a $4.3 billion cov-lite first-lien term loan and $1.9 billion of cov-lite ‘23 senior unsecured notes. The company’s leverage ratio was approximately 8.5x.

You then reflect on June 2018. You recall reading this in PETITION:

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💥Sycamore Partners is a B.E.A.S.T. Part I(b).💥

 
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Speaking of feedback, one investor wrote us that the Twitterati — and PETITION to a lesser extent — had the Sycamore/Staples story all wrong. The dividend recapitalization doesn’t affect the retail story one way or another. That is because Sycamore did, in fact, separate the Staples business into multiple businesses, with the debt remaining at the Staples North American Delivery (“NAD”) entity. Staples U.S. Retail and Staples Canada Retail, as the other two units are now called, aren’t on the hook for the billions of dollars of debt. And, so, other than a bitchin’ new logo, Staples Retail isn’t really the story.* Once again, Sycamore is.

The Staples NAD lender presentation is an enlightening (and somewhat propagandist) look at the fast, furious and savage nature of the private equity model. In less than two years, Sycamore has (i) completed its intended business separation, (ii) improved EBITDA by $160mm “through stable top-line performance, expanded merchandise margins, and SG&A reductions, (iii) identified an additional $185mm of additional cost opportunities beyond 2019, (iv) bolted on some acquisitions, and (v) recruited 8 new members of the senior leadership team. Adjusted EBITDA is $1.2b (providing for certain acquisition-related addbacks). How the hell did Sycamore achieve all of this?

In part, by squeezing. The company has increased merchandise margins through “vendor negotiations.” Eat it vendors! Private equity is in the HOUSE!! The company reduced fiscal year ‘18 SG&A by over $100mm “through restructuring initiatives.” Eat it employees!! Private equity is in the HOUSE!! 900 of you can pack yo’ bags!! And hey you. Yeah you. Sales force employee #901 who thinks she’s safe. Well, newsflash: you’re not. Sycamore predicts another $19mm in sales force savings in 2019.

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What about you, Mr. IT guy? That’s right:

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Sycamore has another 70 full-time employees in the IT department slated for termination to the tune of $6mm in headcount savings. How? “Order management system consolidation.” Read: tech is replacing humans. Another $20mm of savings will come from robotics within Staples’ facilities. And yet another $10mm will come from outsourcing support from internal to low cost contractors (PETITION Note: short the US; long India). When talking heads say that PE strips out costs like a bawse, they’re not kidding. Is this dude on payroll?

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NAD has fiercely competed to retain revenue and promote existing customer growth. Staples NAD now purportedly has ~2x as much revenue as Office Depot and ~3-4x more than Amazon Inc. ($AMZN). These guys sell a f*ck ton of office supplies, ink/toner and paper — about $5b worth. That’s insane. And they’re getting after the private label space, where the company has margins over 50%.

To put a finer point on this, look at this slide:

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These guys aren’t messing around. These guys did their thing and now they’ve got an eye towards an IPO or a sponsor-to-sponsor transaction. And then it — and its 4.5x net debt ratio — will be someone else’s problem potentially heading into a downturn. There is no coincidence here from a timing perspective. Vicious.

*****

You’ll recall that Staples NAD went out to market shopping Sycamore’s scraps….uh…we mean a new $3.2b first lien term loan and a package of secured and unsecured notes to refinance its capital structure and give Sycamore one hell of a check to cash out its equity:

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Well, the market reaction was…uh…interesting. Rather than issue $3.25b of senior secured term loans, the company will complete a $2.3b term loan, splitting the rest of the capital structure between secured ($2b) and unsecured notes ($1b). And the company did have to upsize the secured note piece relative to the unsecured piece. While the yield on the secured bit was mildly tighter than anticipated, the yield on the unsecured piece priced slightly wider than initially expected, indicating that the appetite for the unsecured notes was cautious — even at nearly 11% yield. Looks like certain investors didn’t buy in to the propaganda. Or Sycamore’s reputation precedes it. Either way, Sycamore reportedly took down 18% of the unsecured allotment and apparently agreed not to trade the notes for several months to help push the deal through. 

That said, will Sycamore’s dividend get paid? Well, duh, of course. The market’s reaction to the issuance has no bearing on that whatsoever. Which is not to say the reaction isn’t telling — especially when the paper immediately trades lower as it did here. Short Sycamore’s scraps.

*This thread about Staples’ new logo, however, is pure comedy:

Just imagine how amped Sycamore must be to pull out all of its equity and just ride an option for the next few years.

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⚡️Feedback re: Sycamore Partners & More⚡️

Another quarter is in the books and we here at PETITION continue to be flattered by the reception that you’ve given us. Thank you for your continued readership and support. If you’re not yet a Member, please consider joining our ever-growing community today. If you’re a student, email us for special student rates.

One thing we particularly enjoy is feedback from our readers. We endeavor to do our very best to be accurate with our coverage but sometimes we make mistakes. When we do, please don’t hesitate to call us the morons that we can sometimes be. Just email us at petition@petition11.com.

For instance:

  • One Managing Partner at a law firm wrote us that we made a mistake in “Disruption May Be About to Affect Your Wallet (Long Infrastructure Needs)️” (paywall). We incorrectly stated that Governor Mike DeWine of Ohio is a Democrat. He is actually a Republican. We have corrected the mistake on the website.

  • Another Partner at a law firm pointed out that we misstated the amount of the committed DIP credit facility in the Hexion Holdings LLC matter. We have corrected the mistake here.

Of course, not all feedback was of the “you guys are morons” ilk. Thankfully. We get some general feedback too:

When’s the podcast launching? Your following of lazy rascals will be ecstatic with a lazier way to get all the info.” — Restructuring Advisor

PETITION Response: It’s in development but there are some obvious complications. 

You should know it takes me much longer to read your weekly email newsletter than your estimated published times.” — Liquidator

PETITION Response: Maybe if we use bright yellow, red and black fonts it will speed things up for you.

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And then there is more specific feedback. In response to “Sycamore Partners is a B.E.A.S.T. Part I.,” a number of you wrote in. Some feedback included:

You are the voice of a generation. This was pure gold!” — Restructuring Advisor

This article is next level hilarious.” — Student

As someone who used to summarize lots of cases and hearings when I was more junior, I can say that your Aero summary is the single greatest thing I’ve ever read.

I think you’ve got the difficulties with equitable remedies flipped.  It’s not the prongs on prongs on prongs that are difficult, it’s the evidentiary burden.  You hit it right on the head with 14(!) witnesses (and probably hundreds of trial exhibits). Funds that are experts in these types of transactions won’t get caught dead with the smoking gun needed to prove this stuff at trial - either through careful record building early on and/or discovery practice.

But like a judge once told me, sometimes you need to shoot one of the sheep in front of the flock.  If this were to happen in a big case with lots of publicity, then behaviors might change. Too many road blocks to that like lowball UCC settlements (a la Payless) and judicial temperaments.” — Biglaw Attorney

But this one took the cake (edited to conceal the writer):

Petition, can't tell you how much I loved the Sycamore Partners article! Can't wait for Pt. 2 to drop.

Your mention of Aeropostale triggered some old thoughts... at the time Aero filed its petition, [I dug] around to see what could be learned about Aero's post-petition real estate tactics... since 2016, I can't stop surmising…

I marveled at this deal then and now. Once the $SPG/$GGP(nka $BRP)/ABG deal was approved, Buyer got to pick lease rejections and assumptions. Simon/GGP's initial proposal (Sept 12) rejected every store lease that wasn't in a GGP/Simon mall. Savage. In the weeks following, I can only imagine the back alley beatings put on $TCO $MAC Westfield $CBL and others as they begged their collective arch-rivals to keep the stores open--oh the blood(rent)letting! The assumption notices started flowing in… no way to know what concessions were in those lease amendments! Just to think of $TCO surrendering rental revenue to Aero to keep Aero in place knowing it [sic] inflicting harm to $TCO's metrics (and possibly its valuation) and was flowing back to $SPG and $BRP. Double bitter. Initially, the deal structure was hush-hush, but in the subsequent earnings transcripts over the last 2 years both $SPG and $GGP have stated plainly that they bought Aero for 1xEBITDA, so have made a killing on the investment alone, not to mention the far more juicy bits.

More importantly, $SPG and $BRP control some of their own tenancy now--all the Aero spaces are available to rent to the right new tenants without sacrificing current occupancy rates. Aero stores are inventory on-demand. Is there a dreadful zombie space of 8,000sf at the wrong end of the mall? Just slot in Areo: goose occupancy rates and ease worries of co-tenancy claims! Bring home all that international licensing revenue, and "distribute" it to the owners in the form of rents, as they may be adjusted. Probably as tax-slick as it gets. $SPG and $BRP scratch each other's backs--I can't image what the Aero Real Estate committee looks like in action! [Authentic Brands Group] presenting leases and amendments in $SPG and $BRP malls to representatives of $SPG and $BRP! Oy! The rents in those new stores could really goose their owner REITs’ reported leasing spreads, occupancy rates and NOI metrics. If the stores’ profitability is not the real objective, then the lines get even blurrier.

Since exiting, I wonder what has changed in footprint within the $BRP and $SPG portfolios, since it is a "captive" tenant? The operator is ABG, of course, but I’ll bet lunch that 100% of the growth stores are in either $SPGor $BRP centers. Or, if Aero has opened in a competitor's mall, I would have to believe it would be at nearly breakeven for the outsider-landlord. So, Aero's store would be oh-so-cash-flow-positive to continue to fund the very competitors of that hapless landlord.

That’s quite a “store growth” story. A decidedly different “where are they now” post Ch 11 success story, indeed.

Is the next chapter ABG's acquisition of Nautica, et al. vis a vis $SPG's Premium Outlets division? I don't know what the right metaphor is… from the perspective of other retailers… but maybe something like the fox setting up an omelet stand in the hen house! — Real Estate Investor

 Maybe some bank analysts should start asking some detailed questions about Aero on future earnings calls: as far as conspiracy theories go, that one is pretty damn meaty.

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💥Sycamore Partners is a B.E.A.S.T. Part I.💥

🔥Rinse Wash & Repeat (Long Sycamore Partners)🔥

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Sycamore Partners is a private equity firm that specializes in retail and consumer investments; it “partner[s] with management teams to improve the operating profitability and strategic value of their businesses.” Back in the summer of 2017, Sycamore Partners acquired Massachusetts-based office retailer Staples Inc. for $6.9b — a premium to the company’s then-trading price but a significant discount from its 2014 high. Your office supplies, powered by private equity! The acquisition occurred shortly after Staples ran afoul of federal regulators who prevented Staples from acquiring Florida-based Office Depot Inc. ($ODP)(which, itself, appears to just trudge along).

Sycamore’s reported thesis revolved around Staples’ delivery unit, a B2B supplier of businesses. Accordingly, per Reuters:

Sycamore will be organizing Staples along three lines: its stronger delivery business, its weaker retail business and its business in Canada, two sources familiar with the deal said. This structure will give Sycamore the option to shed Staples’ retail business in the future, one of the sources said.

The retailer had 1255 US and 304 Canadian stores at the time of the deal. The business reportedly had 48% of the office supply market, generating $889mm of adjusted free cash flow in 2016.

*****

Fast forward 18 months and, Sycamore is already looking to take equity out of the company. According to Bloomberg, the plan is for Staples to issue $5.2b of new debt ($3.2b in term loans and $2b of other secured and unsecured debt), which will be used to take out an existing $3.25b ‘24 term loan and $1b of 8.5% ‘25 unsecured notes (which Sycamore reportedly owns roughly $71mm or 7% of).* This is textbook Sycamore, so much so that it’s actually cliche AF — or as Dan Primack said, “…this sort of myopic greed gives ammunition to private equity’s critics.” Like this guy:

And this gal:

Talk about reputations preceding…

Anyway, here’s what the deal would look like once consummated:

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That $1b difference is the equity that Sycamore is taking out of the company. What does the company get in return? F*ck all, that’s what. Zip. Zero. Dan Primack also wrote:

Dividend recaps are a mechanism whereby private equity-owned companies issue new debt, and then hand proceeds over to the private equity firm (as opposed to using it to grow the business). Sometimes they don't matter too much. Sometimes they form leveraged anchors around a company's neck. (emphasis added)

Yup. That about sums it up. Here is Sycamore placing a leveraged anchor on…uh…improving “the strategic value” of Staples:

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This is the market reacting to Sycamore’s strategy for Staples:

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If the above GIF looks familiar, that’s because this is like the Taken series: Sycamore has a very particular set of skills. Skills it has acquired over a very long run. Skills that make them a nightmare for retailers like Staples. They look poised to deploy those particular skills over the course of a repetitive trilogy: the first chapter centered around Aeropostale. And here’s how that ended:

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The sequel was Nine West and this is how that ended:

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And, well, you get the point. Staples looks like it may be next to experience those very particular skills.

———

Okay, so the above was a bit unfair. In Aeropostale, the company went after Sycamore Partners hard, seeking to ding Sycamore, among others, for equitable subordination and recharacterization of their (secured) claims. Why? Well, Sycamore was not only the company’s term lender (to the tune of $150mm), but it was also a major equity holder with 2 board seats and the majority-owner of Aeropostale’s largest (if not, second largest) merchandise sourcer and supplier, MGF Sourcing Holdings Ltd.

NERD ALERT: for the uninitiated, equitable subordination is an equitable remedy that a bankruptcy court may apply to render justice or right some unfairness alleged by a debtor (or some other party in the shoes of the debtor, if applicable). It is generally VERY DIFFICULT TO WIN on this argument because the burden of proof is on the movant and there are multiple factors and subfactors that the accuser needs to satisfy — because, like, this is the law and so everything has a test, a sub-test, and a sub-sub-test and maybe even a sub-sub-sub-test. Judges love tests, sub-tests, and multi-pronged sub-tests. Three-prongs. Four-prongs. Everywhere a prong prong. Just take our word for it. It’s true.

Recharacterization is another equitable remedy that, if satisfied and granted by the court, would have resulted in Sycamore’s $150mm secured term loan position being reclassified as equity. This is a big deal. This would be like Mike Trout being on the verge of winning the MVP and the World Series AND securing a $350mm 10-year contract only to, on the eve of all of that, get (a) caught partying with R. Kelly til six in the morning with enough PED needles lodged in his butt to kill a team of horses, (b) suspended from baseball, (c) exiled into an early retirement a la Alex Rodriguez or Barry Bonds, and (d) forced into personal bankruptcy like Latrell Sprewell or Antoine Walker. Or, more technically stated, since secured debt is way higher in “absolute priority” than equity, this would instantaneously render Sycamore’s position worthless and juice the potential recovery of unsecured creditors. Then there is the practical side: for this remedy to apply, the bankruptcy court would have to make a “finding” that prong after prong has been satisfied and issue an order saying you’re the shadiest m*therf*cker on the planet because you’re actually dumb and careless enough to have met all of the prongs. So, as you might imagine, this is pretty much the worst case scenario for any secured party in bankruptcy and a career ender for the poor schmo who orchestrated the whole thing.

In Aeropostale, the Debtors argued that Sycamore and its proxy MGF engaged in inequitable conduct prior to Aeropostale’s filing, including (a) breach of contract, (b) “a secret and improper plan to buy Aeropostale at a discount” and (c) improper stock trading while in possession of material non-public information. This one had the added drama of arch enemies Kirkland & Ellis LLP (Sycamore) and Weil Gotshal & Manges LLP (Aeropostale) duking it out to the ego-extreme. Just kidding: this was all about justice! 😜

Anyway, there was a trial with fourteen testifying witnesses over eight presumably PAINFUL days that, in a nutshell, went like this:

WEIL GOTSHAL: “Sycamore are a bunch of conspiratorial PE scumbags who ran this company into the ground, your Honor!

JUDGE LANE: “Not credible. Good day, sir. I said GOOD DAY!

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KIRKLAND & ELLIS/SYCAMORE:

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In the end, Sycamore fared pretty well. They got nearly a full recovery** and releases under the plan of reorganization. Relatively speaking, the company also fared well. It didn’t liquidate.*** Instead, two members of the official committee of unsecured creditors — GGP and Simon Property Group ($SPG)— formed a joint venture with Authentic Brands Group and some liquidators and roughly 5/8 of the stores survived — albeit as a shell of its former self and with heaps of job loss (improved strategic value!!). Sure, millions of dollars were spent pursuing losing claims but that’s exactly the point: when Sycamore is involved, they win**** and others lose.***** The extent of the loss is just a matter of degree.

———

Speaking of degrees, all the while Nine West was lurking in the shadows all like:

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WHOA. BOY. THIS ONE WAS A COMPLETE. AND UTTER. NEXT LEVEL. SH*TSHOW.

We’ve discussed Nine West at length in the past. In fact, it won our 2018 Deal of the Year! We suggest you refresh your recollection why (including the links within): it’s worth it. But what was the end result? We’ll discuss that and the (impressively) savage tactics deployed by Sycamore Partners therein in Part II, coming soon to an email inbox near you.

*At the time of this writing, the unsecured bonds last traded at $108.01 according to TRACE. This potentially gives Sycamore the added benefit of booking significant gains on the $71mm of unsecured notes in its portfolio.

**It’s unclear whether Sycamore recovered 100% but given that they got $130mm under the cash collateral order out of an approximately $160mm claim, it’s likely to have been close. Now, they did lose $53mm on AERO stock.

***A f*cking low bar, sure, but still. Have you seen what’s happening in these other retail cases?

****Putting aside nation-wide destruction, hard to blame LPs for investing in the fund. They get returns. Plain and simple. This ain’t ESG investing, people.

*****Sure, Weil “lost” its attempt to nail Kirkland…uh Sycamore…here but they got paid $15.3mm post-petition and $4.4mm pre-petition so that’s probably the best damn consolation prize we’ve ever heard of in the history of mankind. Weil has, to date, also avoided having a chapter 22 and liquidation in its stable of quals so there’s that too. In retail, you have to take the victories where you can get them.

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🥑#BustedTech: Munchery Filed for Bankruptcy.🥑

Short VC-Backed Hyper-Growth

We've previously discussed the process of an assignment for the benefit of creditors and posited that, as the private markets increasingly become the public markets, (later stage) "startups" will be more likely to file for chapter 11 than go the ABC route. Our conclusion was based primarily on three factors: (a) a number of these startups would have highly-developed and potentially valuable intellectual property and data, (b) more venture-backed companies have "venture debt" than the market generally recognizes, and (iii) parties involved, whether that's the lenders or the VCs, would want releases with respect to any failure and subsequent chapter 11 bankruptcy filing. Given continuing low — and as of this week, lower — yields and a system awash in capital looking for alternative sources of yield (read: venture capital), there's been a dearth of high profile startup failures of late. And, so, technically, we've been wrong. 

Yet, on February 28th, Munchery Inc. filed for bankruptcy in the Northern District of California (we previously noted the failure here and again here in a broader discussion of what we dubbed, “The Toys R Us Effect”). Munchery was a once-high-flying "tech" company founded in 2011 with the intent of providing freshly prepared meals to consumers. It made and fulfilled orders placed on its own app and also had a meal kit subcription business where customers received weekly kits with recipes and ingredients. Its greatest creation, however, might be its shockingly self-aware first day declaration — a piece of work that functions as a crash course for entrepreneurs on the evolution and subsequent trials and tribulations of a failing startup. 

Interestingly, the meal kit business wasn't part of the original business model. This represented the quintessential startup pivot: originally, the company's model was predicated upon co-cooking (another trend we've previously discussed) where professional chefs would leverage Munchery's kitchens (and, presumably, larger scale) to sell their products directly through Munchery's website and mobile apps. Of late, the co-cooking concept — despite some recent notable failures — has continued to gain traction. Apparently, former Uber CEO, Travis Kalanick, is very active in this space (see CloudKitchens). 

At the time, "food delivery was in its early stages." But local restaurant delivery has exploded ever since: Grub HubSeamlessDoor DashPostmatesCaviar, and Uber Eats are all over this space now. Similarly, in the meal kit space, Blue Apron inc. ($APRN)PlatedHello Fresh and SunBasket are just four of seemingly gazillions of meal kit services that time-compressed workaholics or parents can order to save time. 

As you can probably imagine, any company worth anything — especially after nearly a decade of operation and tens of millions of venture funding — will have some interesting proprietary technology. Here's the company's description of its tech (apologies in advance for length but it marks the crux of the bankruptcy filing): 

"The team’s early focus was to develop a proprietary technology platform to operate and optimize the entire process of making and delivering fresh food to customers. The technology developed and deployed by the company included: a front-end ecommerce platform, which allowed the company to post items daily and consumers to select, purchase and pay for meals through the company’s website and native apps; the production enterprise resource management (“ERP”) system, which enabled the company to develop and launch new recipes, manage the supply chain for fresh ingredients and supplies, produce the meals through batch cooking, and plate individual meals; the logistics and last-mile platform, which enabled the company to accurately and quickly pack-and-pack individual items and assemble orders using modified hand scanners, distribute orders via a hub-and-spoke system where refrigerated trucks would transport orders to specific zones and hand-off the orders to the assigned drivers; and, a driver app that assisted in managing and routing orders to arrive in the windows specified by customers. All of this was managed through a set of proprietary tracking and administrative tools used by the teams to monitor and mitigate operational issues—and connected to a customer relationship management platform. The team later developed algorithms to optimize the various aspects of the service to scale operations, increase efficiency, and improve the quality of the service. In addition, the company developed over three thousand meal recipes, including descriptions, nutritional information, and photographs. Over the life of the business, the company invested significantly in its technology capabilities, believing that the company’s ability to efficiently scale its operations leveraging technology would be a competitive advantage in the food delivery market."

All of that tech obviously required capital to develop. The company raised $120.7mm in three preferred equity financing rounds between 2013 and 2015. Investors included Menlo VenturesSherpa Capital, and E-Ventures. The company also had $11.8mm in venture debt ($8.4mm Comerica Bank and $3.4mm from TriplePoint Venture Growth BDC Corp.). 

The bankruptcy filing illustrates what happens when investors (the board) lose faith in founders and insist upon rejiggering the business to be operationally focused. First, they bring in a new operator and relegate the founders to other positions. With new management as cover, they then cut costs. Here, the new CEO's "first action" was to RIF 30 people from company HQ. Founders generally don't like to lose control and then see friends blown out, and so here, both founders resigned shortly after the RIF. This, in turn, gives the investors more latitude to bring in skilled operators which is precisely what they did.

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👚Resale is Real Real. Eff “The Amazon Effect.”👚

The #RetailApocalypse is More Than Amazon Inc.

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In September 2017 in “Minimalistic Consumption by Inheritance,” we wrote:

Much has been made about the death of retail and the "Amazon Effect." We mention it quite a bit … but we are also on record as calling the Amazon narrative lazy. After all, there's a reason why resale apps are among the highest downloaded apps in the Itunes app store. We've noted this before: millennials have no problem buying, reselling, buying, and reselling. I mean, sh*t, we're now seeing commercials for OfferUp on television. We've noted the rise of Poshmark and other apps here and here. Perhaps there's more here than meets the eye.

We doubled down with “Enough Already With the ‘Amazon Effect’” in April 2018. Citing the ThredUp 2018 Resale Report, we noted:

…the resale market is on pace to reach $41 billion by 2022 and 49% of that is in apparel. Moreover, resale is growing 24x more than overall apparel retail. “[O]ne in three women shopped secondhand last year.” 40% of 18-24 year olds shopped resale in 2017. Those stats are bananas. This comment is illustrative of the transformation taking hold today,

“The modern consumer now has a choice between shopping traditional retail or trying new, innovative business models. New apparel experiences and brands are emerging at record rates to replace old ones. Rental, subscription, resale, direct-to-consumer, and more. The closet of the future is going to look very different from the closet of today. When you get that perfectly curated assortment from Stitch Fix, or subscribe to Rent the Runway’s everyday service, or find that killer handbag on thredUP you never could have afforded new, you start realizing how much your preferences and behavior is changing.”

Finally, we wrote in January — in “ Retail May Get Marie Kondo'd ,” — that the Force is now strong(er) with the resale trend.

We concluded:

The RealReal is signaling that resale is so big that it’s ready to IPO. Talk about opportunistic. No better time to do this than during Kondo-mania. The company has raised $115mm in venture capital … most recently at a $745mm valuation.

None of this is a positive for the likes of J.C. Penney. They need consumers to consume and clutter. Not declutter. Not go resale shopping. We can’t wait to see who is first to mention Marie Kondo as a headwind in a quarterly earnings report. Similarly, we wonder how long until we see a Marie Kondo mention in a chapter 11 “First Day Declaration.” 

So, where are we going with all of this?

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💥Projection Poppycock: Casper vs. Mattress Firm💥

🛏 Casper Joins Long List of Unicorns & Prospective IPOs 🛏

News emerged this week that Casper — the direct-to-consumer mattress company that is now becoming less-and-less direct-to-consumer and more-and-more brick-and-mortar (solo, and at Costco and Target) — intends to join the frenzied rush of money-losing companies headed towards a public offering in the midst of once-inverted yield curves and fears of recession. The appetite for IPOs is so frenetic that Lyft’s IPO was over-subscribed after a mere two days of roadshow — this, notwithstanding the fact that the company (a) has blown through crazy piles of money and (b) is unsure of its business model and whether it will ever even earn a profit. It then priced above the high end of its initial range and then popped like a champagne cork once shares opened for trading.

Source: Yahoo Finance

Source: Yahoo Finance

Because, you know, whatevs: details shmetails. IPO!!*

The Information got its hands on some leaked Casper financials (paywall) and…spoiler alert! It, too, “continued to lose money” ($18mm in Q3). That said, in Q3 of 2018, the mattress maker reportedly had net revenue of $105.3mm (a 60% YOY increase) on $34.9mm of marketing spend (“only” a 12.9% increase), projecting net revenue of $373mm for fiscal year 2018 and $8mm of EBITDA for 2019. Per The Information, here is a summary of Casper’s financials:

Source: The Information

Source: The Information

Also:

Casper’s presentation also contained bullish forecasts for the future, with net revenue jumping to $1.655 billion and $2.135 billion in 2022 and 2023 respectively, and EBITDA of $33 million and $450 million during those years. (emphasis added)

For North America, which accounts for the vast majority of the company’s business, ecommerce represented over 68% of its third quarter gross revenue, while retail was just over 11%. (emphasis added)

The Information piece includes no data points about the number of stores that Casper ultimately expects to deploy for its growth push but CNN reported last year that Casper hopes to have 200 stores by 2021 (a figure reiterated by Fortune in the tweet below). News surfaced recently that Casper also just closed on a $100mm Series D financing provided by, among others, Target Corp ($TGT), the CEO of Canada Goose Holdings ($GOOS) and the former co-founder and chairman of Crate & Barrel. Total funding is up to $340mm. Per Fortune, “[t]he startup will use the capital to expand internationally and grow its physical retail stores.

In total, those are some bullish projections considering the competitive landscape:

The online mattress market has seen increasing competition in recent years from retailers including Amazon and Walmart. There are also other startups, such as Purple and Tuft & Needle, which was acquired by the mattress manufacturer Serta Simmons Bedding last year. A large mattress store chain, the Mattress Firm, filed for bankruptcy protection last year, which Casper noted in its presentation as a favorable event for the competitive landscape. (emphasis added)

Oy, Mattress Firm. SAVAGE BURN, BRO!! 🔥

Speaking of Mattress Firm, we have projections there too: thank you bankruptcy!! And this allows for a fascinating juxtaposition.

Source: Mattress Firm Disclosure Statement

Source: Mattress Firm Disclosure Statement

With a fraction of the brick-and-mortar presence, Casper projects to have net revenue that is merely $300mm less than Mattress Firm by 2023! How’s that for a commentary about disruption, e-commerce and brick-and-mortar retail? Note that Mattress Firm expects to have $630mm in fixed store expenses (for approximately 2500 stores)** while Casper would have approximately $127mm. Per The Information:

Casper said each new store in the U.S. typically involves $635,000 in capital expenditures and $70,000 in inventory, with an average payback of less than 24 months.

If we’re doing our math right, that means Casper has a significantly larger per-store capex spend than Mattress Firm. On the plus side, unless they’re total frikken morons (or trolls), Casper likely won’t have competing stores sitting literally across the highway from one another.*** So, there’s that.

CEO Philip Krim once said, “We’ve never been anti-retail — just anti-mattress retail.

ANOTHER SAVAGE BURN, BRO!! 🔥🔥

He also said:

"Normally you open a store, have to build presence, then the store loses money and eventually pays back after many years," Krim said. "We have such a productive digital business that we’re profitable on day one of opening a store."

(PETITION Note: not sure how you’re “profitable on day one of opening a store” when the average payback is “less than 24 months” but who are we to call out competing narratives?)

Casper projects $450mm in EBITDA by 2023. In contrast, Mattress Firm projects merely $274mm. Casper has the benefit of landing brick-and-mortar space at a time when landlords are more forgiving with rents; it also has the hyped-up DTC narrative blowing at its back — a clear contrast to the old and stodgy market view of Mattress Firm (which, to be fair, also was able, over the course of its bankruptcy, to renegotiate a meaningful number of its leases with landlords). Said another way, Casper simply seems better positioned to omni-channel its way to success while incumbents like Mattress Firm continue to play catchup. 

Now, these are projections, right? So, query which kind of projection is more full of sh*t? Startup projections or bankrupted debtor projections? It’s a coin flip. In reality, the competitive posture of Casper vs. Mattress Firm four years from now is anyone’s guess. More likely than not, one or both of them are overly optimistic here. But if Casper is right about its projections, that could lead to a significant surprise for Mattress Firm. And given Mattress Firm’s previous strategies, would you want to put your money on Mattress Firm over Casper?

Continue to short strip mall landlords.

*****

Elsewhere in sleep disruption, S&P Global Ratings downgraded Serta Simmons Bedding LLC from B- to CCC+, stating:

…operating performance deteriorated in the fourth quarter of 2018 well below our expectations due to large volume declines with top customers and industry headwinds, leading to adjusted leverage increasing to near 11x as of Dec. 29, 2018.

😳


*Who stands to make money from such an IPO? Investors include Target Corp. ($TGT), Lerer Hippeau Ventures, IVP and New Enterprise Associates. Leonardo DiCaprio, Kyrie Irving and 50 Cent are also early backers.

**Mattress Firm had approximately 3250 stores on its chapter 11 bankruptcy petition date. According to certain bankruptcy materials, the company indicated that it would shed approximately 700 locations.

***Callback to “Mattress Firm Finally Rips the Band-Aid Off (Short Landlords),” wherein we wrote:

Thanks to an overly aggressive growth-by-acquisition strategy, you could essentially turn left and see a Mattress Firm, turn right, see a Mattress Firm, and turn around and see a Mattress Firm. 

And the company actually noted in its bankruptcy filing:

While these acquisitions have allowed Mattress Firm to enter major markets in which it previously did not have a significant presence, and to significantly expand its share of the retail market, they also left Mattress Firm with too many newly-rebranded stores in close proximity to existing Mattress Firm stores. The result has been a significant increase in Mattress Firm’s occupancy and related costs and a negative impact on the profitability of hundreds of its stores. There are many examples of a Mattress Firm store being located literally across the street from another Mattress Firm store.

⚡️Auto is the New Healthcare⚡️

Restructuring Professionals Salivate Over Supply Chain Disruption

In Sunday’s Members’-only briefing entitled “Auto Disruption ⬆️. Syncreon Group ⬇️,” we discussed, among many other topics (e.g., the macroeconomy, oil and gas distress, FTD Companies Inc., etc.), Syncreon Group BV as a proxy for upcoming auto distress. It seems that bankruptcy professionals have grown tired of saying that healthcare will be the hot area of distress and so focus is turning to auto. Here is Foley & Lardner LLP highlighting warning signs of supplier distress.

On Tuesday, auto industry consultants J.D. Power and LMC Automotive indicated that:

U.S. auto sales are expected to drop about 2.1 percent in March from a year earlier, partly due to bad weather, mixed economic data and lower tax refunds….

Mmmm hmmm.

Per Reuters:

Retail sales are expected to touch 1,195,000 units in March, a 3.4 percent decline from a year earlier, the consultancies said on Tuesday.

The first-quarter sales are off to its slowest start since 2013, according to the industry consultants, who estimate retail sales in the quarter to be about 2.94 million vehicles - a decline of 4.9 percent compared to the same period a year ago.

“This is the first time in six years that Q1 sales will fall short of 3 million units. While the volume story could be better, there is remarkable growth in transaction prices, with records being set monthly,” Thomas King, senior vice-president of the data and analytics division at J.D. Power, said.

Interestingly, the average transaction price increased over $1,000 YOY. It is unclear but that could be attributable to the move from lower cost sedans to higher-priced utility vehicles. If consumer confidence wanes — and there are some indications that it is increasingly shaky — this upward trend in pricing should be next to slow down.

💸Goldman Sachs Hops Aboard the Mall Short💸

Mall Shorts Gather Steam

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In last Wednesday’s “Thanos Snaps, Retail Disappears👿,” we included a LOOOOOONG list of retailers that are shutting down stores. Subsequently, J.Crew Group announced that it is closing a net 10 stores (20 J.Crew locations offset by 10 Madewell openings), Williams-Sonoma Inc. ($WSM) announced that it plans to close a net total of 30 stores, Hibbett Sports Inc. ($HIBB) announced approximately 95 stores will close this year, and Tommy Hilfiger closed its global flagship store on Fifth Avenue (Query: is New York City f*cked?) and its Collins Avenue store in Miami.

The point of the piece, however, wasn’t to wallow in retail carnage: rather, it was to make the point that there’s no way the malls — or at least certain malls — could continue business as usual.* With thousands of stores coming offline, we argued, there have to be malls that start feeling the pain and, eventually, run afoul of their lenders. We used $CBL as our poster child and closed by stating that Canyon Partners was shorting mall-focused CMBS via a CDS index, the Markit CMBX.BBB- (and lower indices).

Apparently Goldman Sachs Inc. ($GS) is in on the action. Late last week, Goldman urgedclients join the "big short" bandwagon by going short CMBX AAA bonds (while hedging in a pair trade by going long five-year investment-grade corporate CDX).” ZeroHedgesummarizes the Goldman report as follows:

Citing the bank's recent review of potential areas of financial imbalance across the US corporate and household sectors, [the Goldman analyst] notes that stretched CRE valuations ranked near the top in terms of risk level; and while a large and immediate commercial property price downturn is not the bank's baseline forecast, "a scenario with falling commercial property prices in the next 1-2 years is one to which we would attach non-negligible probability" the analysts caution.

And, then, in customary hyperbolic form, Zerohedge concludes:

Why is this notable? Because regular readers will recall that the 2007/2008 financial crisis really kicked in only after Goldman's prop desk started aggressively shorting various RMBS tranches, both cash and synthetic, in late 2006 and into 2007 and 2008, with the trade eventually becoming the "big short" that was popularized in the Michael Lewis book.

Will Goldman's reco to short CMBX-6 AAA be the trigger that collapses the house of cards for the second time in a row? While traditionally lightning never strikes twice the same place, the centrally-planned market is now so broken that even conventional idioms have to be redone when it comes to the world's (still) most important trading desk. In any case, keep an eye on commercial real estate prices: while residential markets have already peaked with most MSAs sliding fast, commercial may just be the first domino to drop that unleashes a tsunami of disastrous consequences across the rest of the market.

It is far from certain that all of this noise about shorting CMBS is anything more than isolated trades. One thing that is certain? Zerohedge is better at drumming up fear than Jordan Peele.

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*****

Speaking of J.Crew, S&P took a dump all over it yesterday as it downgraded the issuer credit rating to CCC and simultaneously downgraded its “intellectual property notes” — ouch, that must sting some (short asset stripping?) — and its secured term loan facility. The ratings agency maintains a “negative outlook” on the company, saying that “operating results deteriorated considerably in the most recent quarter,” and “approaching maturities of the company’s very high debt burden could lead J.Crew to restructure its debt in the next 12 months.” S&P provides a damning assessment:

We think the company continues to face significant headwinds to turn around operations which haven’t meaningfully improved since the J Crew brand relaunch in 2018. These threats include fast fashion and online retail, as well as continued declines in mall traffic and greater price transparency across the apparel industry. We believe these trends are especially heightened for U.S. mid-priced apparel retail players as consumers shift apparel spending toward brands with a consistent customer message or more appealing prices, given the continued preference for value, freshness, and convenience.

Tell us how you really feel, S&P.

*****

Speaking of damning assessments, there was this flamethrower of a press release issued by Legion Partners Holdings LLC, Macellum Advisors GP LLC, and Ancora Advisors LLC regarding Bed Bath & Beyond Inc. ($BBBY). Burn, baby, burn.

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PETITION readers will recall our previous discussion of BBBY. In January in “Is Pier 1 on the Ropes? (Short “Iconic” Brands),” we included discussion of BBBY and declared:

Bed Bath & Beyond swam against the retail tide last week as the company’s stock showed huge gains after it said that it is ahead of its long-term plan and that it is successfully slowing down declines in operating profit and net earnings per share. Which is interesting because, putting forward guidance aside, the ACTUAL numbers weren’t all that great. In fact, the company’s trend of disappointing same-store sales continues unabated (negative 1.8%, worse than forecast). EPS and revenue numbers were slightly better and slightly worse, respectively, than expected. Which means that to drive the higher EPS, the company must be taking costs out of the business. We have no crystal ball and this is in now way meant to be construed as investment advice, but we’re not seeing justification for a massive stock price increase (up 15% from when we wrote about it and 30% from its December 24 low).

Suffice it to say, the aforementioned investors were far from impressed. The press release kicks off with:

Magnitude of value destruction necessitates wholesale board and leadership changes. CEO Steven Temares has overseen the destruction of more than $8 billion in market value over his 15-year tenure, with total shareholder returns of negative 58%. Since early 2015, the stock has lost over 80% of its value.

Certainly not mincing words there, that’s for sure.

It then follows with:

Failed retail execution and strategy. Apparent inability to prioritize a long list of poorly implemented initiatives and management’s lack of success in adapting its business model to a changing retail landscape, has resulted in stagnant sales and adjusted EBITDA margins declining from 18% in fiscal 2012 to 7% in the last 12-month period ending November 2018.

Deeply entrenched board lacking retail experience is an impediment to serving shareholder interests. Average director tenure is approximately 19 years and the lack of retail expertise and stale perspectives on the board have hindered proper oversight of the management team.

We mean…those are just cold. Hard. Facts. And they’re not wrong about the board: it strains credulity to think that the Head of the TIAA Institute, a pensioned partner at Proskauer Rose LLP, and an EVP for Verizon Communications Inc. know f*ck all about the travails afflicting retail these days (to be fair: it seems the founder and CEO of Red Antler, a reputable branding agency that has helped build the likes of Casper, Keeps, Boxed, Google, allbirds and Birchbox makes sense…if anything has value here…and, yes, we’re REALLY stretching here…its the, gulp, brand…like, maybe??…or, like, maybe not???).

Seriously, it’s not really difficult to argue with this (even if the investors take some liberties in defining companies like Restoration Hardware ($RH) as “retail peers”):

Screen Shot 2019-03-26 at 6.00.31 PM.png

Problematically, however, the three firms own merely 5% of the outstanding common stock so there’s not a ton that they can do to agitate for change. The market, though, doesn’t seem to give a sh*t: it just wants something…anything…to happen with this business.

Screen Shot 2019-03-26 at 6.04.54 PM.png

More significantly, investors simply cannot sit on the sidelines anymore and watch retail management teams flail in the wind. We discussed certain management teams that really seem to be skating to where the puck is going, see, e.g., $PLCE. But many others aren’t and those that aren’t act at their own peril. Here, at least, investors are putting management and the board of directors on notice.

Expect to see other investors act similarly in other cases.

*There are a number of malls, however, that do seem to be continuing business as usual. This piece makes the point that apocalypse is not as bad as the media makes out.

Disruption is Afoot in the Auto Space (Short Syncreon)

Rod Lache, Managing Director of Wolfe Research and Institutional Investor’s #1 ranked auto analyst every year since 2012 puts it bluntly: “The automotive landscape will change dramatically over the next five or 10 years.” Recode’s Kara Swisher asks, will owning a car “[b]e as quaint as owning a horse” one day?

We’ve been talking about a coming wave of auto disruption and distress since our inception. Here we discussed the cascading effects of EVs (“Removing the engine and transmission destabilizes the car industry and its suppliers” h/t Benedict Evans); here, using the case of GST AutoLeather Inc., we declared, “Disruption, illustrated”; and here, in October 2017, we asked “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” Ok, fine, “around the corner” is open to interpretation. ……

One company that garnered our attention provides services on both sides of the border: Auburn Hills-based Syncreon Group BV is a specialized contract logistics company focused specifically on tech and auto supply chains with locations scattered throughout the US and Canada, including Detroit and just over the border in Windsor. Major clients include FCAU, Ford Motor Company ($F)General Motors Inc. ($GM)Volkswagen Group ($VWAGY), and many others (e.g., Harley Davidson Inc. ($HOG)Audi AG ($AUDVF)BMW ($BMWYY), etc.). The company is at risk.

Exemplifying this risk are some recent events:

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What to Make of the Credit Cycle. Part 26. (Long Anxiety)

The FED sent bearish signals on Wednesday when Chairman Jerome Powell (i) lowered its GDP and headline inflation projections, (ii) committed to holding interest rates steady for “some time” and (iii) pumped the breaks on its balance sheet unwind.

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Taken together, these actions reflect serious caution about the status of the economy — particularly in the face of headwinds emanating from trade issues, Brexit, and slowing growth in China/Europe.

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Oil and Gas Continues to Crack

Long Houston-Based Hotels

The bankruptcy waiting room is becoming standing room only for oil and gas companies despite oil resting near 2019 highs (even after a rough 2% decline on Friday). We’ve previously mentioned Jones Energy ($JONE)Sanchez Energy Corporation ($SN)Southcross Energy Partners LP ($SXEE)Vanguard Natural Resources, Alta Mesa Holdings LP ($AMR) and Chaparral Energy Inc. ($CHAP) in “⛽️Is Oil & Gas Distress Back?⛽️.” Based on earnings reports or other SEC filings this week, add Emerge Energy Services LP ($EMES), EP Energy Corporation ($EPE) and Approach Resources Inc. ($AREX) to the list.

Emerge Energy Services experienced some wild stock fluctuation this week after it filed a Form 12b-25 with the SEC indicating that was unable to timely file its FY 2018 Form 10K. Therein, the company stated that it has been distracted by negotiations with its revolving credit facility agent, PNC Bank NA, and second lien note purchase agreement agent, HPS Investment Partners LLC, on several forbearance agreements and amendments to the two agreements. Tee this baby up for a potential BK.

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Cracks in Malls Grow Deeper (Long Thanos, Short CMBS)

Retail Carnage Continues Unabated (R.I.P. Payless, Gymboree, Charlotte Russe & Shopko)

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Talk of retail’s demise is so pervasive that the casual consumer may be immune to it at this point. Yeah, yeah, stores are closing and e-commerce is taking a greater share of the retail pie but what of it?

Well, it just keeps getting worse.

Consider 2019 alone. The Payless ShoeSourceGymboreeCharlotte Russe, Shopko, and Samuels Jewelers* liquidations constitute thousands of stores evaporated from existence. It’s like Thanos came to Earth and snapped his fingers and — POOF! — a good portion of America’s sh*tty unnecessary retail dissipated into dust. Tack on bankruptcy-related closures for Things RememberedBeauty Brands and Diesel Brands USA Inc. and you’re up to over 4,300 stores that have peaced out.

That, suffice it to say, would be horrific enough on its own. But “healthy” (read: non-bankrupt) retailers have only added to the #retailapocalypse. Newell Brands Inc. ($NWL)is closing 100 of its Yankee Candle locations to focus on “more profitable” distribution channels. Gap Inc. ($GPS) announced it is closing 230 of its more unprofitable locations and spinning Old Navy out into its own separate company — the good ol’ “good retail, bad retail” spinoff. Chico’s FAS Inc. ($CHS) is closing 250 stores. Stage Stores Inc. ($SSI) — which purchased once-bankruptcy Gordmans — is closing between 40-60 department stores. Kitchen Collection ($HBB) is closing 25-30 stores. E.L.F. Beauty ($ELF) is closing all 22 of its locations. Abercrombie & Fitch Co. ($ANF)? Yup, closing stores. Up to 40 of them. GNC Inc. ($GNC) intends to close hundreds more stores over the next three years. Foot Locker Inc. ($FL)? Despite a strong earnings report, it is closing a net 85 stores. J.C. Penney Inc. ($JCP)…well…it didn’t report strong earnings and, not-so-shockingly, it, too, is closing approximately 27 stores this year. Victoria’s Secret ($LB)? 53 stores. Signet Jewelers Ltd. ($SIG)? Mmmm hmmm…it’s been closing its Zales and Kay Jewelers stores for years and will continue to do so. As we noted on SundayThe Children’s Place Inc. ($PLCE) also intends to close 40-45 stores this year. Build-A-Bear Workshop Inc. ($BBW) will close 30 stores over the next two years. Ascena Retail Group Inc. ($ASNA) recently reported and disclosed that it had closed 110 stores (2% of its MASSIVE footprint) in the last quarter. Even the creepy-a$$ dolls at American Girl aren’t moving off the shelves fast enough: Mattel Inc. ($MAT) indicated that it needs to rationalize its retail footprint. There’s nothing Wonder Woman — or even a nightmare-inducing American Girl version of Wonder Woman — can do to prevent all of this carnage.

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As a cherry on top, EVEN FRIKKEN AMAZON INC. ($AMZN) IS CLOSING ALL 87 OF ITS POP-UP SHOPS! Alas, The Financial Times pinned the total store closure number for 2019 alone at 4,800 stores (and just wait until Pier 1 hits). Attached to that, of course, is job loss at a pretty solid clip:

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All of this begs the question: if there are so many store closures, are the landlords feeling it?

In part, surprisingly, the number appears to be ‘no.’ Per the FT:

“Investors in mall debt have also shown little sign of worry. The so-called CMBX 6 index — which tracks the performance of securitised commercial property loans with a concentration in retail — is up 4.4 per cent for 2019.”

Yet, in pockets, the answer also appears to be increasingly ‘maybe?’

For example, take a look at CBL & Associates Properties Inc. ($CBL) — a REIT that has exposure to a number of the names delineated above.

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On its February 8th earnings call, the company stated:

“We are pleased to deliver results in line with expectations set forth at the beginning of the year notwithstanding the challenges that materialized.”

Translation: “we are pleased to merely fall in line with rock bottom expectations given all of the challenges that materialized and could have made sh*t FAR FAR WORSE.

The company reported a 4.4% net operating income decline for the quarter and a 6% same-center net operating income decline for the year. The company is performing triage and eliminating short-term pressure: it secured a new $1.185b ‘23 secured revolver and term loan with 16 banks as part of the syndicate (nothing like spreading the risk) to refinance out unsecured debt (encumbering the majority of its ‘A Mall’ properties and priming the rest of its capital structure in the process); it completed $100mm of gross dispositions plus another $160mm in “sales” of its Cary Towne Center and Acadiana Mall; it reduced its dividend (which, for investors in REITs, is a huge slap in the face); and it also engaged in “effective management of expenses” which means that they’re taking costs out of the business to make the bottom line look prettier.

Given the current state of affairs, triage should continue to remain a focus:

“Between the bankruptcy filings of Bon-Ton and Sears, we have more than 40 anchor closures.”

“…rent loss from anchor closures as well as rent reductions and store closures related to bankrupt or struggling shop tenants is having a significant near-term impact to our income stream.”

They went on further to say:

“Bankruptcy-related store closures impacted fourth quarter mall occupancy by approximately 70 basis points or 128,000 square feet. Occupancy for the first quarter will be impacted by a few recent bankruptcy filings. Gymboree announced liquidation of their namesake brand and Crazy 8 stores. We have approximately 45 locations with 106,000 square feet closing.”

Wait. It keeps going:

We also have 13 Charlotte Russe stores that will close as part of their filing earlier this month, representing 82,000 square feet.

Earlier this week, Things Remembered filed. We anticipate closing most of their 32 locations in our portfolio comprising approximately 39,000 square feet.”

And yet occupancy is rising. The quality of the occupancy, however — on an average rental basis — is on the decline. The company indicated that new and renewal leases averaged a rent decline of 9.1%. With respect to this, the company states:

As we've seen throughout the years, certain retailers with persistent sales declines have pressured renewal spreads. We had 17 Ascena deals and 2 deals with Express this quarter that contributed 550 basis points to the overall decline on renewal leases. We anticipate negative spreads in the near term but are optimistic that the positive sales trends in 2018 will lead to improved lease negotiations with this year.

Ahhhhh…more misplaced optimism in retail (callback to this bit about Leslie Wexner). As a counter-balance, however, there is some level of realism at play here: the company reserved $15mm for losses due to store closures and co-tenancy effects on company NOI. In the meantime, it is filling in empty space with amusement attractions (e.g., Dave & Buster’s Entertainment Inc. ($PLAY), movie theaters, Dick’s Sporting Goods Inc ($DKS) locations, restaurants, office space and hotels. Sh*t…given the amount of specialty movie theaters allegedly going into all of these emptying malls, America is going to need all of those additional gyms to work off that popcorn (and diabetes). Get ready for those future First Day Declarations that delineate that, per capita, America is over-gym’d and over-theatered. It’s coming: it stretches credulity that the solution to every emptying mall is Equinox and AMC Entertainment Holdings Inc. ($AMC). But we digress.

All of these factors — the average rent decline, the empty square footage, etc. — are especially relevant considering the company’s capital structure and could, ultimately, challenge compliance with debt covenants. Net debt-to-EBITDA was 7.3x compared with 6.7x at year-end 2017. Here is the capital structure and the respective market prices (as of March 19):

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The new Senior secured term loan due ‘23:

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The Senior unsecured notes due ‘23:

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The notes due ‘24:

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The notes due ‘26:

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Additionally, the company is trying to promote how flexible it is with its ability to pay down debt and invest in redevelopment properties. Here is a snippet of the company presentation that displays the debt covenants on its revolver, term loan and other unsecured recourse debt:

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What is the real value of the mall assets that are left unencumbered? Recently, the Company has been slowly impairing a number of its assets and many of the Company’s tier 2 and 3 malls have yet to be revalued. If appraisers lower the value of these assets that are really supposed to be supporting the debt, what then?

And that doesn’t even take into consideration the co-tenancy clauses. As anchor tenants fall like flies, you’ll potentially see a rush to the exits as retailers with four-wall sales that don’t justify rents (and rising wages) exercise their rights.

So, given all of above, does the market share management’s (misplaced) optimism?

J.P. Morgan’s Michael W. Mueller wrote in a February 7, 2019 equity research report:

"While commentary in the earnings release noted some sequential improvement in 4Q results, we still see it being a grind for the company over the near to intermediate term."

BTIG’s James Sullivan added on February 20, 2019:

"We see no near-term solution for the owners of more marginal “B” assets like CBL & Associates. Sales productivity for such portfolios has shown little growth over the last eight quarters in contrast to the better-positioned “A” portfolios."

"The recent re-financing provides CBL with some near-term liquidity but limits future access to the mortgage market as only a small number of readily “bankable” assets remain unencumbered."

“We expect the challenging conditions in the industry to continue to create pressure on the operating metrics of mall portfolios with average sales productivity of less than $400/foot. More anchor closures are likely and in-line tenants are also likely to manage their brick-and-mortar exposure aggressively and close marginal locations. We reiterate our Sell rating and $2 price target.”

“With overall flat sales productivity in the portfolio, there is limited evidence that a turnaround in performance is likely in the next 24 months. Instead, we expect continued declines in SSNOI with negative leasing spreads and lower operating cost recovery rates.”

“CBL’s new facility which totals $1.185B is secured and replaces a series of unsecured term loans and a line of credit. Collateral includes 20 assets, of which three are Tier 1 Malls, 14 are Tier 2 Malls, and three are Associated Centers. As a result, CBL now has a much smaller number of unencumbered malls.”

“There are no unencumbered Tier 1 Malls (Sales exceeding $375/foot). There are nine unencumbered Tier 2 Malls (sales $300 -$375/foot) and those malls averaged $337/foot in 2017. The 2018 data is not available yet, but sales/foot for Tier 2 assets in 2018 declined by an average $5/foot. So assuming the law of averages applies, the average productivity of the unencumbered Tier 2 assets is $332/foot. Malls with that level of productivity cannot be financed in the CMBS market per CBL management.”

“With limited access to financing using their unencumbered malls, CBL has to look to its available capacity on its new line of credit, $265m, and projected free cash flow after paying its dividends, we estimate, of $155m in 2019 and $135m in 2020. CBL is currently estimating an annual capital requirement of $75m - $125m to redevelop closed anchor boxes. The per box range is $7m - $10m which we believe is low compared to peers whose cost per unit is closer to $17m. So CBL faces dwindling capital sources at the same time that its portfolio is suffering significant quarterly drops in SSNOI.”

Apropos, the shorts are getting aggressive on the name:

The historical stock chart is ugly AF:

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Which brings us to commercial mortgage-backed securities (CMBS) — derivative instruments comprised of loans on commercial properties. Canyon Partners’ Co-Chairman and co-CEO Joshua Friedman is shorting the sh*t out of mall-focused CMBS (containing among many other things, CBL properties) via a well known CDS index: the Markit CMBX.BBB- (and lower Indices) — to the tune of approximately $1b (out of $25b AUM). This is the mall-equivalent of the big short, except for commercial real estate. 🤔🤔

Here is a CMBX primer for anyone who wants to nerd out to the extreme. Choice bit:

CMBX allows investors to short CMBS credit risk across a wide array of vintages and credit ratings. Shorting individual cash bonds is difficult and rarely done, with the exception of a few very liquid names. The market for cusip level CMBS CDS used to exist, but the liquidity proved very poor and it was quickly replaced by trading of the synthetic indices.

And here is some color on what Mr. Friedman said regarding his trade:

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Wowzers. Just imagine what happens to retail — including the malls — when the noise gets even louder.

*Samuels Jewelers filed chapter 11 last year but announced liquidation this year after failing to secure a buyer for its assets.

The Sporting Goods Space Takes it in the Groin ($DKS)

Short Bricks, D*cks and Mortar

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In “The Fallacy of "There Must be One" Theory,” we questioned whether Dick’s Sporting Goods Inc. ($DKS) has a reason to exist. The stock was trading at $34.92/share at that point and has largely been on the slow-roll rise ever since, reaching as high as $39.38/share in late February. It reported earnings on Tuesday and, suffice it to say, it ain’t pushing $40 anymore:

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🍿Sears = The Gift That Just Keeps Oooooon Giving🍿

The Sears estate and Eddie Lampert are at it again

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Oh, Sears. We just can’t quit you.

On Sunday in “Sears is Such a Drama Queen (Long Contract Interpretation Issues),” we discussed how — SHOCKER!! — there are already problems brewing between Transform Holdco (ESL’s buyer entity) and the debtors’ estate (the seller). Transform Holdco delineated a laundry list of beefs it had with the estate and filed a motion seeking mediation — a thoughtful strategy given that White Plains already foreshadowed how it might come out on any APA interpretation issues. Knowing full well that we were only getting one side of the story — and Eddie Lampert being Eddie Lampert — we hedged a bit:

Given all of the evidence pointing towards administrative insolvency to begin with, any obstreperousness on the part of the sellers (if true, as alleged) is wildly counter-productive: again, the estate is more likely than not administratively insolvent!! It would seem, then, that mediation would be a no brainer (though we reserve judgment for when the sellers respond — which we’re sure will be an entertaining dig at how much they think Lampert is retrading on certain parts of the deal…time to ramp up those PR machines again!!).

Now was that an easy call or was that an easy call?

On Monday night, the debtors responded with a motion to enforce the APA (and the automatic stay) and compel turnover of estate property — the main crux of which is the debtors allegation that Transform Holdco is in breach “by refusing to deliver $57.5 million that are the property of the Debtors….” They allege:

The Buyer’s request for mediation is nothing more than an attempt to delay turning Estate property over to the Debtors by conflating unrelated post-closing disputes (to which the Debtors have fully responded) with the Buyer’s refusal to deliver $57.5 million that plainly belongs to the Debtors per the APA, despite the Debtors’ repeated demands.

And jab:

…the Buyer is well aware of the extent to which the Debtors have limited resources to engage in protracted litigation. The $57.5 million in funds improperly retained by the Buyer are critical to maintaining administrative solvency and the Buyer is jeopardizing the Debtors’ ability to timely file a chapter 11 plan by withholding these funds. Rather than simply turn over the Estate assets, or seek guidance from this Court (which is intimately familiar with the APA and its terms), the Buyer instead conflates its obligation to turn over Estate property with a litany of unsubstantiated claims of misrepresentations and breaches by the Debtors, and requests a mediation that would, at best, delay resolution of any of these issues by more than a month.

And jab, cross:

…if there is a dispute, the Debtors would prefer to keep these issues front and center with this Court, which is most familiar with the APA and the issues facing the Debtors and their Estates, as well as the dynamics currently affecting the Estates. The Motion to Mediate should be seen for what it is: the Buyer’s transparent attempt to delay the transfer of Estate assets to gain leverage in its ongoing effort to sidestep the liabilities which Buyer assumed under the APA, including the $166 million in assumed accounts payable that this Court previously indicated the Buyer would be very unlikely to avoid.

There it is: the ever-controversial $166mm in assumed accounts payable. Can someone please pass the butter for our popcorn?

Is there any wonder that the estate would like to keep any and all disputes in White Plains? The judge’s fingerprints are all over this deal; he’s incentivized to make sure that it proceeds without dispute, that a plan of reorganization gets filed, and that creditors get some sort of shot at a recovery — a shot that diminishes each day given the magnitude of fees that are accumulating in this case. Case and point:

Still, we can’t help but to question certain of the Debtors’ decisions here. This bit was…imprudent…maybe?:

Prior to the time of Closing, the Buyer advised that it had not done the work necessary to implement its own cash management system or to set up its own bank accounts. Meghji Decl. at ¶ 6. As a concession to the Buyer—in order to alleviate the risk to Closing and in an effort to help facilitate a seamless transition of the going-concern business in the interests of, among others, the Debtors’ employees and key stakeholders—the Debtors agreed to give the Buyer possession and control of the Debtors’ cash management system, including its bank accounts as of the Closing Date. Id. ¶ 7.

What is that old cliche about possession and the law? And that one about the road to hell being paved with good intentions? How is it that ESL hadn’t done the work necessary to set up bank accounts? HE HAD TEN FRIKKEN YEARS.

Anyway, to be fair to the debtors, they thought they had contracted around the issue, putting into place a protocol for the repayment of pre-closing-accrued funds that landed in the cash management account post-closing. Nevertheless, apparently ESL and their financial advisors, E&Y, be like:

And so money is apparently due and owing on both sides and the debtors want their money and ESL wants clarification on certain liabilities and trust has apparently broken down in the process. ESL — knowing that Judge Drain will be none-too-pleased — wants a mediator and all the while cash registers are ringing and the estate becomes more and more administratively insolvent.

Like we said on Sunday, “Like…does ANYTHING ever go easy for Sears?

Disruption Milks Milk Producers (Long…Oats?)

Dean Foods Co. Dips into Distressed Territory

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Dean Foods Co. ($DF), the largest US supplier of milk and dairy to retailers with over 50 brands, announced this week that, in light of “a significant amount of change happening in the marketplace” and a “dynamic retail environment,” that it would pursue strategic alternatives (read: a sale, a take-private transaction, asset sales, a JV, or a merger). The company’s stock plunged nearly 12% on the announcement before rebounding slightly later in the week.* It is down 90% since its peak in 2007.

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