Guitar Center, Weight Loss Drugs & TV Advertising
Curated Disruption News
Midweek Freemium Briefing - 3/14/18
Read Time = 4.3 a$$-kicking minutes
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In “Private Equity Faces Increasing Headwinds,” we discussed various pressures currently confronting private equity firms. We also covered Claire’s Stores, Toys R Us, Warby Parker, LEGO, Remington Outdoor, Cenveo Inc, widespread transportation issues, inflation….ah you get the point. You missed out.
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News of the Week (3 Reads)
1. Advertising - Short(ened) Ad Time and Short(ed) Ad Companies
Earlier this week Fox Networks Group’s ad sales chief floated the idea of cutting commercial ad time down from 13 minutes to 2 minutes an hour in a speech he gave in Los Angeles. This is interesting on a number of levels.
First, this would pose a real challenge to advertisers who, undoubtedly, would have to fight for limited but costly supply. Yes, television advertising has flat-lined, but it is still one of the most effective means to get brand messaging out.
Second, such a maneuver could have the effect of squeezing Netflix ($NFLX). Numerous underwriters highlight that Netflix can always open the ad spigot to help it grow into its ever-growing capital structure. And they’re not talking about product placement. If ads are eliminated elsewhere, will consumers focused on the ultimate user experience tolerate ads before watching treasured content like Ozark or 13 Reasons Why? Or will that result in friction and, in turn, leakage? If this decision gains traction, this as-of-yet-untapped revenue stream for Netflix could be collateral damage.
Ultimately, minimal advertising may help draw users back to non-Netflix content. But it will create all sorts of issues for brands trying to sell product AND, by extension, the advertising companies trying to place those brands.
To point, earlier this week the Financial Times reported that “[h]edge funds have amassed bearish bets of more than $3bn against the world’s largest advertising companies in an attempt to profit as the industry undergoes wrenching disruption and slowing growth.” Publicis, WPP, Omnicom Group ($OMC), and Interpublic Group of Companies ($IPG) are all short targets of funds like Lone Pine and Maverick Capital. With corporates like Proctor & Gamble ($PG) cutting ad spend and Facebook ($FB) and Google ($GOOGL) monopolizing same and building custom tools that cut out the middlemen, this is an area worth continued watching.
2. Guitar Center - Long Capital Structure Rehabilitation 2.0
Before we dive into the current status of Guitar Center Inc., let’s first establish that there is almost zero chance ⬆️ this kid ⬆️ ends up playing guitar when he’s older given today’s music trends. Just saying.
As everyone knows, the instrument retailer recently popped up on a variety of retail doom and gloom lists due to its over-levered capital structure and (relatively) near-term maturities. A quick flashback: the company was the target of a $2.1 billion 2007 leveraged buyout by Bain Capital. In a 2014 out-of-court restructuring, Ares Capital Management swapped its debt for equity in the company, effectively eliminating Bain from the equation and removing $500 million of debt and nearly $70 million in annual interest expense. The transaction was accompanied by a refinancing and maturity extension of other parts of the capital structure.
As a consequence of that transaction, the current capital structure stands as follows:
$375 million asset-backed revolving credit facility due April 2019 (“ABL”);
$615 million senior secured notes at 6.5% and due April 2019; and
$325 million senior unsecured notes at 9.625% due April 2020.
Yes, that’s a total of $1.2 billion of debt. Despite an uptick in pre-holiday sales, the dominant narrative remains that nobody plays guitar anymore. Consequently, there hasn’t been enough revenue coming into the coffers to service this debt. You can blame Yeezy and The Chainsmokers for that. We’ve harped on about the state of music here and, in a separate guest post about Gibson Brands’ struggles, Ted Gavin of Gavin/Solmonese added some additional perspective. Longer-term trends notwithstanding, Guitar Center seeks to live another day on the back of the short-term uptick. To do so, however, it must address that debt.
On Monday, Guitar Center — with the help of bankers UBS and Houlihan Lokey and the consent of Ares — launched an exchange offer and consent solicitation related to its unsecured notes. The offer is to swap the existing $325 million 9.625% notes for $325 million of 5% cash/8% PIK notes due 2022 (along with with some warrants). Per the company’s press release, $299 million worth of holders have already agreed (92% of the issuance). This swap would save the company $13,812,500 a year in interest expense AND have the effect of pushing out the maturity for three years. Gotta love the capital markets these days.
In tandem, the company is proposing to offer $635 million of new 9.5% senior secured notes due 2021. The use of proceeds of these new notes would be to redeem the $615 million 6.5% senior secured notes due 2019. With this piece of the transaction, the company will be taking on an additional $20.35 million of annual interest expense.
Finally, the company will also refinance the $375 million ABL, extending the maturity out by 5 years.
So, if you made it this far, here’s the upshot: if these transactions are successful, the company will have availed itself of a few years to turn itself around by pushing out its debt maturities. But, it will have eliminated ZERO INTEREST EXPENSE in the aggregate. Said another way: this is a band-aid, not a solution.
All of which means that the company needs to hope and pray some rock God hits the scene and reinvigorates the market for guitars in the next two years. We’ll take the under.
3. Orexigen Therapeutics - Long Obesity & Patents, Short Massive Cash Burn
Orexigen Therapeutics Inc. is a publicly-traded ($OREX) biopharmaceutical company with one FDA-approved product named "Contrave.” Contrave is an “adjunct” to a reduced-calorie diet and exercise for chronic weight management in certain eligible adults. In English, it’s a drug to help adults (allegedly) lose weight. And before we continue, please take a minute to appreciate the exquisite creativity these folks deployed with the name, "Contrave." We can only imagine the whiteboarding sessions that went down before someone said in MacGuyver-esque fashion, “Wait! Control + cravings = Contrave!” We hope the company didn't shell out too much cash money to the brand consultants for that one. But we digress.
Anyway, the drug could theoretically service the 36.5% of adults the Center for Disease Control & Prevention has identified as obese — a potential market of 91-93 million people in the United States alone. And that’s just today: that number is predicted to rise to 120 million people in the next several years. Yikes: that's 33% of the U.S. population. Apropos, the company claims that the drug is the number one prescribed weight-loss brand in the US with over 1.8 million prescriptions written to date, subsuming 700,000 patients. The drug is also approved in Europe, South Korea, Canada, Lebanon, and the UAE.
All of that surface-level potential notwithstanding, the company has lost approximately $730 million since its inception. This is primarily because it has been spending the last 16 years burning cash (like a boss) on R&D, clinical studies for FDA approval, recruitment, manufacturing, marketing, etc., both in and outside the U.S. PETITION Note: And people wonder why drugs are so expensive. The company believes it could be profitable by 2019 under its existing operating model and revenue forecasts; it enjoys a patent until 2030. Clearly, the patent is the critical piece to this company’s future.
Prior to filing for bankruptcy, the company’s bankers attempted to effectuate a sale of the company to no avail. The goal of the bankruptcy filing, therefore, is to pursue a sale with the benefit of "free and clear" status (⚡️Nerd alert ⚡️: this means the buyer doesn’t need to take on the substantial litigation risk to clear title in the asset). While no stalking horse bidder is lined up, The Baupost Group LLC, is leading a group of secured noteholders (including Ecori Capital, Highbridge Capital and UBS O'Connor) to provide a $35 million DIP credit facility and buy the company some time. Will they end up owning it?
Two other things of note here:
The Baupost Group LLC is really toning its bankruptcy musculature lately. Between this deal and Westinghouse, the firm has been active.
Note to company management: Oprah Winfrey may have some more room in her weight loss asset portfolio now that she’s dumped a meaningful amount of her holdings in Weight Watchers International Inc. ($WW). At a considerable gain. Remember: Weight Watchers was once high on distressed watch lists. But then Oprah made her investment and - boom! - the company has been flying ever since. Hint hint Orexigen: influencer marketing does has its merits. Even more so when the influencer puts her money where her mouth is.
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Feedback - Healthcare Issues
“There has been a lot of pressure on health care providers in general as insurance companies, and government, are increasingly reducing reimbursement fees for procedures and care year over year. It's absurd, 'well last year we know we paid you x for this procedure, but this year, completely arbitrarily, we will pay you x-25/30%'“
When rents go up, salaries go up, supply costs go up, seeing reimbursement fall that drastically and being told take it or leave it is putting a lot of pressure on the health care industry.
Insurance companies seeing windfall profits year over yr, but patients are getting less and sh*ttier while doctors are going out of business or selling to hospital groups who then make them shift workers. Soon the whole country will be the VA.” - Medical Professional
Literally every sizable healthcare chapter 11 filing has listed “reimbursements” as a root cause of decreasing revenues and, in turn, debt service problems. Hence, bankruptcy. You’re right on.
Notably, Moody’s agrees with you too. They reported recent higher health system downgrade levels than during the Great Recession. In 2016, there were 32 downgrades and 41 in 2017. What is this attributable to? Apparently,
“Hospitals and health systems today are dealing with rising pharmaceutical, supply and labor expenses and difficult payer environments in which commercial payers in some cases steer members toward free-standing imaging and urgent-care centers, contributing to the ongoing issue of flat volumes at some hospitals. That leaves many systems with expense growth that outpaces revenue growth.
Importantly, more than 60% of last year's downgrades were among small to medium-sized hospitals and health systems with less than $1 billion in operating revenue, demonstrating that larger systems are better positioned to weather industry challenges.”
The pain is hitting hospitals in Pennsylvania and Ohio particularly hard. In Pennsylvania, “half of the state’s rural hospitals operated at a net loss in 2016….” And in Ohio, 61 hospitals have low or negative operating margins. Eeesh. Choice quote,
"‘The challenges facing … all Ohio hospitals, are clearly driven by reimbursement pressure from Medicare and Medicaid, renewed efforts by commercial payers to exclude more services from payment, growing pharmaceutical and supply chain costs, physician and nursing shortages, and the costs of keeping up with new health care technology.’"
Wondering: what, if anything, is Washington doing about the reimbursement piece of this? 🤔
Meanwhile, this perfect storm has some wondering whether hospitals will become obsolete. Notably,
“What year saw the maximum number of hospitalizations in the United States? The answer is 1981. That might surprise you. That year, there were over 39 million hospitalizations — 171 admissions per 1,000 Americans. Thirty-five years later, the population has increased by 40 percent, but hospitalizations have decreased by more than 10 percent. There is now a lower rate of hospitalizations than in 1946. As a result, the number of hospitals has declined to 5,534 this year from 6,933 in 1981.”
And the author emphasizes that these trends are on the basis of poor care! We wonder if significant debt loads have any part in that? 🤔🤔
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