Marchionne Madness? Can Fiat Really Help Chrysler?

When someone asked Sergio Marchionne what he would do if someone asked him to start a car company from scratch, he replied, "Lie down until the feeling passes." Anyone counting on him to do for Chrysler what he did at Fiat has to be hoping he won't be tempted to lie down soon.

Marchionne is the man behind the nearly miraculous turnaround at Fiat. Before he took over in 2004, Fiat's car company had been losing money at a bankruptcy-inducing rate. In less than two years it was profitable and growing.


The Turnaround at Fiat
How did he do it? He overhauled management, replacing twenty senior managers with energetic talent from the company's middle ranks. He tackled the sales problems at Fiat by revamping one faltering product line, the Fiat Bravo, and introducing a new one, the Fiat 500.

He cut costs, not by closing plants or laying off workers, but by making key processes more efficient. For example, he cut the time to market on the Fiat Bravo from 36 months to 18 months.

He raised €1.5 billion by getting General Motors buy itself out of a joint venture with Fiat. He reduced capital spending needs through joint ventures, like sharing an assembly plant in Poland with Ford. He also worked tirelessly to convince Fiat's managers, workers, and lenders to back his plan.

Successful Turnarounds
Anxious lenders and bondholders are wondering if he can do the same at Chrysler. But with problem credits on the rise and more companies facing turnarounds, the broader question is, what can we learn from all this? What are the hallmarks of a successful turnaround plan?

A good turnaround works in three dimensions: operations, finance, and management.

• Operations
  The focus in operations is on sales, operating costs, and working capital. The goal is to improve cash flow not just in the short-term but for the long-run as well. New products and better processes were key to Fiat's success.

• Finance
  Here the focus is on liquidity and financial flexibility. The goal is to increase readily available reserves and extend debt maturities -- boost sources of liquidity now and reduce uses in the future. The GM buyback and the Ford joint venture were ways for Fiat to raise capital and enhance liquidity at the same time.

• Management
  Management's strategy, ability, and credibility are crucial. Top leaders have to come up with a strategy that addresses the problem(s) and balances operating and financial needs as well as short-term and long-term needs. They have to be able to execute, to make the strategy happen. And they have to convince junior managers, workers, suppliers, lenders, and customers that the plan will work. Marchionne's new management team saw Fiat's problems clearly and worked hard to achieve their new goals. Marchionne constantly promoted his plans to workers, creditors, and shareholders, earning vital support during the crucial transition period in 2004 and 2005.

Michael Foods Term Loans Avoid Effective Subordination

When Thomas H. Lee Partners purchased Michael Foods in 2003, it financed the deal with a combination of term loans and bonds.  All parties agreed that if there was ever a problem, the term loans would be repaid before the bonds.  In exchange for agreeing to take this higher risk, the bondholders receive a higher return than the term loans.

Contractual Subordination

To ensure the term loans are repaid first, the bond documents include a subordination agreement.  This contract between the bondholders and the borrower says that if the company ever defaults on its debt, it must repay the loans in full before it pays anything to the bondholders.  This arrangement is referred to as contractual subordination: the bonds are called subordinated and the loans are called senior (see also our discussion of structural subordination).  Contractual subordination can also be accomplished via a contract between lenders called an intercreditor agreement.

What's the Problem?

The loans had an original maturity of 6 and 7 years, so they are due in 2009 and 2010.  The company is now looking to refinance these loans with new loans with maturities in 2014 and beyond.  These new loans will still be contractually senior to the original bonds, which don't mature until 2013.  The problem is that the new (senior) loans mature after the (subordinated) bonds.  If all goes as planned, the bonds will now be paid before the loans, defeating the purpose of the subordination agreement.  This situation, where subordinated debt is repaid before senior debt because it matures first,  is referred to as effective subordination (a banker friend of ours calls this "first in time is first in line").

What's the Solution?

Michael Foods will need to refinance the original bonds before they mature in 2013.  The new term loans include an "acceleration feature" that will bring the maturity date of the loans forward if the company can't refinance the bonds.  Thus, the loans will always come due before the bonds, avoiding effective subordination.

Competitive Strength Under Stress

Competition affects credit strength, and never more than in tough times. Favorable conditions can mask competitive weaknesses. Consider General Motors at the peak of the SUV craze. Unfavorable conditions can amplify weaknesses. Consider General Motors today.

This video is about Southwest Airlines and American Airlines and the recent problems in the airline industry. It explores the subject of sustainable competitive advantage. How does a company get it? How likely is it to last? The video is about four minutes long.

Bank Accounting - Rules or Reality?

The U.S. accounting authorities are finishing a round of changes to the way banks account for the value of their impaired assets. A number of rules are involved: FAS 114, FAS 115, FAS 124, FAS 157. The combined effect will make it easier for banks to avoid reporting losses on their loan portfolios.

There's been a lot of discontent among analysts and in the press about the changes. Critics complain that the new rules make it easier for banks to overstate their capital. The Wall Street Journal warned about "a loophole big enough to fit a bloated bank balance sheet through ("Accounting Rules Should Avoid Impairment," April 1, 2009)."

The article accuses the rule makers of allowing a kind of capital arbitrage, where banks keep losses out of regulatory capital but include them in regular shareholders' equity. That's not the case. The new rules will let the banks keep some losses on the fair value of assets out of earnings, but not out of capital or shareholders' equity.

Whatever the accounting technicalities, the economic reality of bank capital is difficult to analyze. The regulatory concept of Tier 1 and Tier 2 capital is complex and impossible to verify directly from a bank's balance sheet. Analysts have to rely on the bank's calculations for those measures.

That's why analysts are beginning to favor a simpler measure: tangible equity capital, often abbreviated as TEC. TEC is shareholders equity less intangible assets, both as reported on the balance sheet. Divide that into total assets to get the TEC ratio, a direct, efficient measure of a bank's capital position.

Let's see how it works on a real bank, PNC Financial Services Group.

The emerging standard for an adequately capitalized bank is a TEC ratio of at least 4%. PNC's Tier 1 ratios are much higher than its TEC ratios, but the bank still meets the TEC capital standard -- as long as you ignore the fair value of its loan portfolio.

In 2008, PNC had $2.95 billion in unrealized losses on its loans. Under the fair value rules, those losses would still be unrealized as long as the bank treats them as assets held to maturity. But PNC is required to disclose those losses in the notes to its financial statements. If we take them into account and use adjusted ratios, both PNC's ratios fall, and its capital doesn't look so healthy.

Financial reporting is loaded with confusion and uncertainty, and never more than when the rules are changing. Financial analysis is a struggle against the darkness with a set of imperfect tools. When the rules are changing and key measures aren't working anymore, it's still possible to get at the economic reality by trying new measures and making thoughtful adjustments.

We're All Cash Flow Lenders Now

Loans to non-investment grade and middle-market companies are typically secured by the borrower’s receivables, inventory, and fixed assets. Pledging this collateral, however, does not reduce the borrower’s likelihood of default. Security should reduce the loan’s loss given default, but not necessarily in the way you expect. Here’s how.

How Are Loans Repaid?

Banks that make secured loans do not expect to foreclose on the collateral to repay the loans. Loans are typically repaid from cash flow from operations or by refinancing with new debt. Foreclosing on collateral is a last resort. Some lenders, such as those that provide asset based loans, equipment finance, or mortgages, are expert in disposing of foreclosed assets, but most banks are ill-prepared to seize assets and sell them.

So Why Take Collateral?

Most secured lenders to bankrupt large corporate and middle-market companies never take possession of their collateral. Instead, the companies are reorganized or sold using the bankruptcy system (e.g. Chapter 11 or Chapter 7 in the U.S.). Proceeds from the bankruptcy, either cash or new securities, are then distributed to creditors. Secured creditors have a higher priority when these proceeds are distributed, giving them lower losses than unsecured creditors.

Does Collateral Mean the Loan Will Be Repaid?

Unfortunately not. Even if the value of the collateral exceeds the amount of the loan when it is made, it is likely that the value of the pledged assets will be substantially lower when the borrower is in financial distress. After all, an asset is only worth what someone will pay for it, and, as we’ve seen, many assets decline in value in a recession.

What’s the Lesson?

As a lender, by all means take collateral when you can get it - just don’t rely on the collateral as your primary (or even secondary) source of repayment. Instead, analyze the company’s ability to generate cash flow to repay its debt. Remember, taking collateral doesn’t mean the company or its assets will retain their values. Unless you are an asset based lender, the biggest benefit you get from collateral is that it moves you to the front of the line in a bankruptcy.

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.