Eddie Bauer Can't Step Down

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!

Bear's House of Cards

There’s a new book about the collapse of Bear Stearns. It’s House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, and it is getting good reviews. The New York Times calls it “...high drama that is gripping...”

The story may not seem so relevant or interesting today. After all, Bear’s demise was a year ago; Lehman’s was only last September. Bear’s vital organs were saved by transplant into the body of J.P. Morgan; Lehman was allowed to expire in the emergency room.

But we think the book will answer questions about Bear that are as urgent and compelling today as they were when the company failed. What brought the Bear down? Was it just arrogance, or did negligence, ignorance, or bad luck play a role? Was it ruthless attacks by short sellers or mainly extreme market conditions?

Mistakes in Liquidity Management

Whatever else contributed, mistakes in liquidity management were important in the company’s downfall. Thanks to the failure of two of its own hedge funds, Bear was painfully aware of problems in the financial markets. It took steps to improve liquidity, increasing cash and unpledged securities from $27.7 billion in November 2007 to $35.2 billion in February 2008.

It was too little, too late. By Bear’s own reckoning, those sources of liquidity in February had to cover at least $21.7 billion in potential uses, including maturing unsecured debt, funding commitments, and standby letters of credit. That left only $13.5 billion to cover client withdrawals and secured funding shortfalls.

At the time, Bear owed $91.6 billion to clients and had secured short-term debt of $98.3 billion. It would take only a small percentage decline in either of those amounts to exhaust the company’s liquidity reserves, and it did. In the three days starting March 10, Bear went through $12.1 billion in cash alone and was forced to turn to J.P. Morgan and the Federal Reserve for a rescue.

Bear failed to anticipate its liquidity needs. We’ll have to read Mr. Cohan's book to learn if it was through bad management, because of unprecedented illiquidity in the financial markets, or on account of those nasty short sellers. We can’t wait to find out.

I'm Thinking Structural Subordination

Wendy's/Arby's Group, Inc. (ticker WEN) was formed in September 2008 through the merger of the Wendy's and Arby's fast food chains. In March 2009, WEN announced it had redone its main loan agreement to reflect the merger. Nothing unusual there. The surprise is that Wendy's/Arby's Group, Inc. is not a party to the loan agreement. Here' why.

Holdco - Opco Structure

Wendy's/Arby's Group, Inc. is a holding company ("holdco") - it has over 60 direct and indirect subsidiaries that actually own, franchise, or operate the restaurants (the operating companies, or "opcos").

• The opcos have real assets (buildings, inventory, receivables, contracts, etc.) and hopefully generate cash flow from their operations.
• The holdco's assets are stock in the opcos, and the holdco's primary source of cash is dividends from the opcos.

A Quick Lesson on Bankruptcy

Under the absolute priority rule, a bankrupt company must repay its creditors (i.e. lenders, suppliers, employees, etc.) in full before it can distribute any cash to its owners. So, if WEN and its subsidiaries ever went bankrupt, who would be repaid first: lenders to the holdco (i.e. Wendy's/Arby's Group, Inc.) or lenders to the opcos (i.e. the 60 subsidiaries)? Answer: the opcos, since they have the assets and cash flow and must repay their creditors before paying dividends to the holdco.

Structural Subordination

The idea that opco creditors are paid before holdco creditors is referred to as structural subordination. Because of structural subordination:

• Lenders to high risk companies (such as WEN) often prefer to lend to operating subsidiaries rather than to a parent company.
• Loans to holdcos often include a subsidiary debt limitation and upstream guarantees in order to limit the impact of structural subordination.
• The rating agencies typically rate the debt of a holdco lower than the debt of its operating subsidiaries. For example, Standard and Poor's rates Wendy's/Arby's Group, Inc. "B-" but assigned the slightly higher "B" to the loans of its subsidiaries.

See also our entries on contractual subordination and effective subordination.

The Coming Wave of Restructuring Charges

What do Whirlpool, Fiat, Sony, and Heinekin have in common? All took major restructuring charges recently, driving down profits that already were under pressure from the global economic slowdown. As the recession lasts longer and spreads farther, we'll see many more companies taking big restructuring charges.

What are restructuring charges and how do they affect the company's operating results and financial condition? This video gives a quick answer.

How do restructuring charges affect credit risk analysis? At the technical level, they complicate things by prompting us to make adjustments to important profitability, coverage, and leverage measures. At the fundamental level, they signal problems with unsustainable operating costs or overstated asset values or both.

How to Package a Bankruptcy

Why does a company go bankrupt? We often point to factors such as the economy, high leverage, bad management, falling asset values, or strong competition. While all of these can be contributing factors, ultimately a company will file a bankruptcy petition when it can't generate enough cash to service its operating and financial obligations - when it runs out of cash.

Does this mean a bankrupt company has no value and should be liquidated? Not at all. The purpose of Chapter 11 (and similar provisions in other countries) is to allow companies to reorganize and continue to operate. A debtor can use the bankruptcy process to improve operating cash flow by canceling burdensome contracts and leases and closing or disposing of underutilized or unprofitable assets. Just as important, however, a company can use the bankruptcy process to reorganize the liabilities and equity side of its balance sheet to reflect the new reality of its asset values and cash flow.

The Journal Register Company Faces a New Reality

The Journal Register Company publishes 20 daily newspapers and over 150 (mostly weekly) other publications. It has been hurt by the general decline in the newspaper industry, which was greatly accelerated by the recession. The company responded by cutting costs, closing money-losing operations, and selling assets. Still, its margins and cash flow have been declining since 2005.

Source: The Journal Register Company

It became clear by late-2008 that the company was insolvent. Its stock was at $0.10 and it was in default on its debt. The company received a 3-month forbearance from its lenders and hired a Chief Restructuring Officer. On February 21, 2009, the company announced it reached agreement with investors holding 77% of its debt on a restructuring, and it filed a "prepackaged" Chapter 11 petition.

How Does a Prepackaged Bankruptcy Work?

In a prepackaged bankruptcy, the debtor negotiates the key elements of a plan of reorganization before filing for bankruptcy. If all goes as planned, the bankruptcy can be completed relatively quickly; perhaps in 6 months instead of the 18-24 months typical for a large-company Chapter 11. The Journal Register's plan provides for the company to continue to operate as usual and for existing shareholders to get wiped out. The company's existing $695 million of debt will be converted into:

• $175 million term loan A
• $100 million term loan B (with an option for pay-in-kind interest)
• The common stock of the reorganized company

Thus, the debt load of the company is reduced by $420 million to a level the reorganized company expects to be able to service, the company's creditors receive a combination of new debt and stock, and the old owners get nothing. While it doesn't ensure that the Journal Register can survive the secular downturn in the newspaper industry, this reorganization is how the bankruptcy process is supposed to work.

Bridge Loans Make Large Acquisitions Possible

For many companies, financing an acquisition is a two-step process.  The long-term strategy might call for raising cash using syndicated term loans and revolvers, bonds, equity, and asset sales. However, many companies use bridge loans to initially fund acquisitions, then repay those loans with other financings and/or assets sales.  In fact, according to Reuters, the largest syndicated loan in the U.S. in 2008 was the $14.5 billion one-year bridge loan backing Verizon Wireless' acquisition of Alltel Corp.

What is a Bridge Loan?

A bridge loan is a term loan where the expected source of repayment is a specific event, typically a debt or equity financing and/or asset sale.  These loans typically have a bullet maturity (i.e. no amortization) of 1 year or less.  As an incentive to borrowers to refinance bridge loans quickly, they typically include interest rate increases and "duration fees" tied to how long the loan is outstanding.  For example, the Altria bridge loan (described below) calls for the interest rate to increase by 0.25% and for an additional 0.75% fee if the loan is not repaid within 90 days (with additional step-ups and fees each 90 days thereafter).  Bridge loans are typically underwritten by a small group of banks rather than being widely distributed in the syndicated loan market.  These underwriting banks typically also manage the "takeout financing" (e.g. the bonds issued to repay the bridge loan).

Altria Uses a Bridge Loan

On September 8, 2008, Altria Group, Inc., the parent company for cigarette maker Philip Morris USA and other companies, announced an agreement to purchase UST Inc., a leading manufacturer of smokeless tobacco.  The transaction, scheduled to close within 4 months, called for Altria to pay UST shareholders $10.4 billion cash and to assume $1.3 billion of UST debt.  The company's plan was to finance the purchase with $11 billion of long-term, public bonds.  However, at the time they announced the acquisition, they also announced a $7 billion dollar commitment (split between J.P. Morgan and Goldman Sachs) for a 364 day bridge loan which, when added to the company's existing unused credit facilities, could fund the entire purchase.

Here's the timeline:

• September 8 - Altria announces agreement to buy UST and $7 billion loan commitment.
• November 4 - Altria issues $6 billion in 5, 10 and 30 year bonds.
• December 18 - Altria issues $775 million in 18 month bonds.
• December 19 - Altria closes (but does not draw down) on $5 billion 364 day bridge loan (reduced from the original $7 billion commitment).  The bank group expands from JPM and Goldman to include 6 other banks.
• January 6 - Altria closes on the purchase of UST and draws down $4.3 billion from the bridge loan.
• February 3 - Altria issues $4.225 billion in 5, 10 and 30 year bonds (bringing the total bond issuance to the planned $11 billion) and repays the bridge loan.  The 8 banks that underwrote the bridge loan are all joint book-running managers on these bonds.

Early Warning Signs at Satyam

We mentioned the absence of early warning signs in our earlier post on Satyam – especially the lack of a gap between earnings and cash flow. It turns out there were a few. We can classify them either as behavioral or financial.

Behavioral Warning Signs
Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire - without proper shareholder approval and at an inflated price - two struggling companies controlled by Chairman Ramalinga Raju’s family.

Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.

On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”

This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.

Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.

In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.

If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.

The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.

But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.

Satyam Surpasses Enron

It’s the biggest corporate fraud in Indian history, and the press labeled it “India’s Enron” as soon as the news broke. But Satyam looks to be worse than Enron in scope, if not in scale. How can we say that before the authorities have completed their investigation? We can tell by the absence of early warning signs.

Satyam Computer Services is one of India’s leading information technology companies and ranks 185 of the Fortune 500 companies among its clients. Early last December, the company’s Chairman, Ramalinga Raju, confessed to using fake revenues to inflate profits over a number of years. That led to a build up of what Raju called “artificial cash” of over $1.0 billion (Rs 50 billion) by the end of September 2008.

Through long, bitter experience, investors have developed a set of early warning signs of financial reporting fraud. One of the strongest is the difference between income and cash flow. Because overstated revenues cannot be collected and understated expenses still must be paid, companies that misreport income often show a much stronger trend in earnings than they do in cash flow from operations.

But you can see there is no real difference in the trends in Satyam’s net income and its cash flow from operations over the last five years. That’s not because the earnings were genuine; it’s because the cash flows were manipulated too. To do that, Raju had to forge accounts receivable and falsify collections.

The fake cash flows led to the bogus bank balances. To keep from tripping the income-cash flow alarms, Raju had to manipulate nearly every account related to operations. It was a stunningly comprehensive fraud, likely to be far more extensive than what Skilling, Lay, and Fastow did at Enron.

Inventories Explode

Over the past 15 year, many businesses have adopted sophisticated inventory tracking systems and just-in-time inventory policies.  As a result, they have gotten much more efficient in their use of inventory, as shown in this chart:

Source: Wachovia Economics

This long downward trend in the inventory-to-sales ratio has recently and dramatically reversed.  What happened?

As we noted in an earlier post, companies are often slow to respond to lower sales, waiting to cut production and/or reduce purchases.  As managements "catch up" to the current sales reality (or as sales improve), we would expect the inventory-to-sales ratio to return to normal, lower, levels (with the associated benefits for corporate cash flow).

Confidence Sensitive Cash Flows: Watch the Trade

The 2007 year-end selling season was not good for the home furnishings retailer "Linens 'n Things." Quarterly sales were up 0.6%, but only because the company opened four new stores. Ignoring the new stores, same store sales were down 1.0% for the quarter and 3.4% for the full year 2007. Even worse, margins were hurt by the "highly promotional environment" and increased marketing spending: quarterly gross margin declined from 36.7% to 33.8% and operating margin (adjusted for non-recurring items) turned negative.

Cash is King: What About Liquidity?

The news was not all bad. For the quarter, adjusted EBITDA was $15.3 million and cash from operating activities was $137.9 million (the large difference between EBITDA and cash flow was the result of the normal year-end sell-through of inventory). Standard liquidity measures looked good at year-end: the current ratio was 1.9x (about the same as the prior year-end) and it had excess availability under its asset-based revolving credit facility of over $300 million.

So what went wrong?

The sales decline accelerated in the first quarter of 2008 and the company responded with an aggressive cost cutting plan. In an effort to conserve cash, the company also began to aggressively manage working capital: it slowed purchases to reduce inventory levels and it began to slow pay some of its vendors. This strategy backfired. By late March, many vendors stopped shipping to Linens 'n Things, citing slow pay and even no pay on outstanding invoices. By mid-April, the company had begun paying cash before delivery to certain key vendors in order to obtain goods.

This cash drain was unsustainable. In the four months from year-end 2007 until its bankruptcy filing on May 2, 2008, the company's use of credit (i.e. revolver borrowings and letters of credit) increased by over $170 million, a burn rate of over $42 million per month.

Lessons Learned

This situation highlights the importance in credit analysis of of looking at a company's confidence sensitive cash flows. This refers to funding (or other cash flow) which depends on a third party's willingness to accept the company's (typically unsecured) credit risk. Examples of confidence sensitive cash flows include short-term borrowings (such as commercial paper), counterparty risk, and (as in the case of Linens 'n Things) trade credit.