Eddie Bauer did not have a good fourth quarter of 2008. Reflecting the worsening economy, sales were down 5.7% compared to the forth quarter of 2007. Still, adjusted EBITDA for the full year 2008 was almost $53 million, up over 25% from 2007. As for liquidity, the company ended the year with over $60 million in the bank, zero drawn on its $150 million revolver, and with no principal payments due on its other debt (a $193 million term loan and $75 million in convertible notes) until 2014. What could go wrong?Covenant Compliance
The company’s debt agreements contain covenants limiting certain activities and requiring the company to maintain certain ratios. The most restrictive covenants are in the term loan, which required (as of year-end 2008) senior leverage to be no greater than 5x EBITDA and fixed charge coverage to be at least 0.9x (as well as limiting capital expenditures, dividends, new debt, and new liens). As of December 31, 2008, the company was in compliance with its debt covenants.
Now For the Step-Down
On March 18, 2009, Eddie Bauer announced it is "seeking an amendment to the term loan agreement to provide covenant relief and flexibility to manage through a recessionary economy." The problem is not that the company expects leverage to go above 5x or coverage to go below 0.9x; the problem is that the financial covenants in the term loan agreement step down. As of March 31, 2009, leverage must be at or below 4x, compared to the 5x requirement just 3 months earlier. The coverage requirement also increases, eventually hitting 1.1x in 2012. Why did the company and its banks, led by Goldman Sachs and JP Morgan, include these changing covenant levels in the loan agreement?
Covenants Should Reflect the Business Deal
Setting loan covenant levels is an art not a science. Ideally, covenants should reflect the shared expectations of the borrower and lenders. In the case of Eddie Bauer, the company and its banks clearly expected the retailer to improve cash flow and bring down leverage, and set the leverage and coverage covenants at levels that both sides thought were achievable. When a company's performance is materially worse than both sides expected when they did the deal, there should be a covenant default.
What Happens After a Default?
Rarely does a covenant breach in a corporate loan agreement result in foreclosure or bankruptcy; usually the borrower and lenders agree on an amendment. The borrower gets looser covenants, but what do the lenders get? It varies, but the amendment can include more collateral for the lenders, higher interest rates, an amendment fee, and additional restrictions on the borrower, all intended to reduce the lenders' risk and increase the return on the loan.
So far, Eddie Bauer has not reached agreement with its lenders, but the amendment under discussion includes an 8% amendment fee (with 5% of that deferred until 2014), warrants for almost 20% of the company's stock, and a significantly higher interest rate. Quite a cost for failing to step up!
4 comments:
Simply put EBHI currently doesn't have sufficient cash flow to meet its obligations, this will trigger the defaults and in turn the question will be waiver for what duration and what cost. The market already recognizes the reality and is trading this as potential liquidation.
EBHI needs to show sufficient voluntary restructuring and plan to induce the waiver.
If the economy doesn't improve or if Eddie Bauer doesn't improve its market position, it may eventually not have sufficient cash flow to meet its obligations. The point is that the covenant default is happening before they run out of cash - the covenants (including the step down) get the company and bankers to the negotiating table earlier than if they had to wait until a payment default.
I think 5x leverage for a retailer seems pretty steep. On retail deals, we also typically look at rent adjusted leverage which consists of net debt plus capitalised rent (rule of thumb 6-8 times annual rent) divided by the sum of EBITDA and rent. This shouldnt be higher than 5 or 6 times. Anybody else have useful rules of thumb.
As Arthur says, when doing ratio analysis for retailers (or any company or industry with high rent expense), you should use EBITDAR (i.e. EBITDA plus rent) instead of EBITDA. The idea is that operating leases are really a type of financing (despite what the accountants say), so we should treat rent the same way we treat interest expense, and thus add it back to calculate EBITDA.
That is also the reason we capitalize rent expense and treat it like debt in our leverage ratio. The correct way to capitalize rent payments is to discount all future payments to present value using the company's average cost of debt, but this is cumbersome and almost no one does this. Instead, most debt analysts take the most recent historical year's rent expense and multiply it by some factor - 6 and 8 are the ones we see used most often. This shortcut method gives you a rough approximation of what you would get if you did it the long way.
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