Credit Default Swaps, Gibson Brands & Jobs
|May 2||Public post|
Curated Disruption News
Midweek Freemium Briefing - 05/02/18
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News of the Week (3 Reads)
1. Disruption Dominos: The McClatchy Company (Long Local, Short #MAGA)
The McClatchy Company ($MNI) may not be well known to you on its face but if you’ve ever read the Miami Herald, The Kansas City Star, The Sacramento Bee, The Charlotte Observer, The (Raleigh) News and Observer, The (Fort-Worth) Star-Telegram, The (Durham NC) Herald-Sun or one of 24 other media companies, you’ve read one of its properties. It is a provider of digital and print news and advertising services. And it reported Q1 earnings last week.
The earnings — as you might imagine for a company with a large print-media division — were far from gangbusters and are highly cyclical in nature. Take a look at this chart:
The company missed estimates on both EPS and revenue. Total revenues were down 10.1% YOY. Total advertising revenues were down 16.7% YOY. Direct marketing advertising revenues declined 21.9% YOY. On the flip side, the company experienced growth in its digital initiatives, including increases in digital-only subscribers and average total unique visitors to online properties. The company also partnered with Subscribe with Google to push further improvements in the digital business. But, all in, this is a company that it is facing a massive wave of disruption coming at it from all angles.
First, its capital structure. The company’s leverage ratio stands at 4.42x as of the end of Q1 on the basis of its existing cap stack. Currently, it has about $30 million of outstanding letters of credit issued against its $65 million revolving credit facility (Bank of America). As of 12/31/17, the company had $344.6 million of 9% ‘22 senior secured first lien notes outstanding on top of (a) as of 4/27/18, $82.1 million of 7.15% ‘27 debentures and (b) $274 million of 6.875% ‘29 indentures.
But, not for long. Enter Chatham Asset Management. The fund — which may or may not be fresh off of a shiny new $1b private equity vehicle for debt-related investments — is taking out a large chunk of the capital structure. The company filed an 8k on April 26th, indicating that there is a term sheet pursuant to which a newly established LLC will issue $250 million of 7.372 % ‘30 Tranche A Term Loan paper and $168.5 million 6.875% ‘31 of Tranche B Term Loan paper, the proceeds of which will be used to take out the long-dated debentures (except $8.3 million) and a portion of the senior secured notes. The structure isn’t yet determined but the interest expense is expected to increase incrementally. There is a makewhole as well, as you might expect, and we’re guessing it will have some fairly iron clad verbiage. In other words, this reeks of loan-to-own — with a cherry on top (see #2 below). Perhaps Chatham will eventually roll up the properties with American Media Inc., parent to The National Enquirer, which Chatham owns 80% of and, per The Wall Street Journal, appears to be having issues of its own.
A. Tariffs. Tariffs on newsprint may have an effect on traditional print media companies. Note the following comments:
One more word on the print newspaper world. We are often asked on these calls about the impact of newsprint prices on our operating model. As the print side of our business has declined so has our operating sensitivity to fluctuations in newsprint supply and pricing, now less than 4% of our operating expense, down from 20% at the peak of print newspaper revenues more than a decade ago.
Nonetheless, policies such as the newsprint tariffs announced by the administration earlier this year are unhelpful we believe, both to free market and to public policy. We oppose them and we have made our position clear to the administration. We say this as an equity owner of one of the few remaining U.S. domestic newsprint producers. So one might assume we would be on the other side of this issue, but we are not. Public policy that makes these input prices more costly at a time of great stress in this industry harms our local communities and is against the public interest.
Interesting. The company is guiding towards higher print costs, including increases in pricing coming from Canadian mills. #MAGA!!
B. Cost Controls. This company has all of the makings of a company in triage. Operating expenses were down 8.4%. The company outsourced printing operations. It entered into a sale leaseback transaction, pursuant to which $13 million of proceeds is being offered to the company’s senior secured noteholders in a tender offer at par. It sold off some intellectual property (CareerBuilder LLC). All of this is meant to buy the company time to effectuate its digital transformation.
C. Ad Spend. This should come as a surprise to nobody that follows the world of restructuring but the trickle-down effect of battered grocery and retail is notable here. This is the company’s statement about the higher-than-expected ad spend decline:
I mean retail results were disappointing. Obviously, that’s something that we’ve been seeing for some time now. Total retail revenues finished a bit better actually in Q1 and Q4, but that was driven entirely by digital growth. Revenue from preprints delivered with the newspaper actually got worse. And as Elaine said, our direct marketing circulars delivered to non-subscribers also softened. So our retail customers are facing some tough citing and it continues to have an impact on our print products. And some of those advertisers obviously in direct marketing are the same as the ones that are in the print newspaper, and their troubles affect both.
In retail print revenue, our largest declines were coming from the food and drug department store category, and we’ve seen that strand for a while. Preprints took a steeper decline in Q1. And then we’ve seen in previous quarters down about 38% over last year. Again though due to continued losses from the major department stores like Macy's, Sears, Stein Mart, Penne and stores no longer in business that were rolling over from last year like hhgregg and Toys "R" Us, or at least going in bankruptcy, Toys "R" Us is still struggling.
And so in preprints or about 12% of total advertising revenues, so when that gets hit that’s of percentage, it takes the whole category down. So mostly I think a story on the retail side, Avi, and continuing pressure on the print part of that business.
The company continued,
We sometimes talk about the importance of our role in local communities and with our neighbors, and these are the places we live where our employees are residents all across the country. The impact on local retail across the country has been, as you know, very widespread. This is an earnings call about a news and information company. So it’s the wrong place to talk about those underlying trends. But I would say we’re super aware of them. We obviously bare the impact from an advertising perspective, which also having a big impact on our communities. And that’s something that we’re extremely aware of as in many cases the leading local news and information company in those communities.
We appreciated the reminder. Jokes abound about the #retailapocalypse. For many local communities, the far-reaching effects of such are no laughing matter.
2. Disruption Dominos 2.0: The McClatchy Company (Long CDS Shenanigans)
In “Credit Default Swaps (Long Yield, Baby, Yield),” we discussed credit default swaps and the ongoing battle between hedge funds in the Hovnanian matter.* The Commodity Futures Trading Commission has finally weighed in. There were no minced words:
"The CDS market functions based on the premise that firms referenced in CDS contracts seek to avoid defaults, and as a result, the instruments are priced based on the financial health of the reference entity. However, recent arrangements appear to involve intentional, or ‘manufactured,’ credit events that could call that premise into question. In a public statement dated April 11, 2018, the International Swaps and Derivatives Association’s (ISDA) board of directors criticized manufactured credit events, writing that they ‘could negatively impact the efficiency, reliability, and fairness of the overall CDS market,’ and ISDA’s board indicated that it advised its staff ‘to consult with market participants and advise the Board on whether...amendments to the ISDA Credit Derivatives Definitions should be considered’ to address manufactured credit events.
"Manufactured credit events may constitute market manipulation and may severely damage the integrity of the CDS markets, including markets for CDS index products, and the financial industry’s use of CDS valuations to assess the health of CDS reference entities. This would affect entities that the CFTC is responsible for overseeing, including dealers, traders, trading platforms, clearing houses, and market participants who rely on CDS to hedge risk. Market participants and their advisors are advised that in instances of manufactured credit events, the Divisions will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate.”
Better late than never we guess. You’d think they would have awakened to these issues after Codere, Radio Shack, and others. But, hey. Regulators. Enough said.
Enough said, indeed. Query whether the The Commodity Futures Trading Commission will have more to say given the aforementioned “cherry on top” in the McClatchy transaction.
What is the cherry? Well this — per Bloomberg:
It seemed like a sure-fire bet: short the debt of a highly leveraged newspaper company that’s losing money. And for a while, it worked as investors piled up almost $500 million of wagers by buying credit-default swaps on the publisher, McClatchy Co.
That is until hedge fund Chatham Asset Management stacked the deck with a deal that’s threatening to make those swaps all but worthless.
The McClatchy situation is the latest trade that’s drawing jeers from critics who say the $11 trillion CDS market has devolved into a haven for manipulation.
At issue is the “newly established LLC” bit we noted above. As Bloomberg further explains,
Because the new debt would be shifted away from the parent and into the new unit, it’s fueling speculation that the Chatham deal will create what’s commonly known in the CDS world as an orphaned contract. In other words, anyone who bought insurance on a McClatchy default would effectively be paying insurance on an entity with no significant debt.
Which, naturally, begs the question: who is on the other side of the contract? Well, Chatham, of course. Because CDS! There’s no measure of how America has become great again like one fund ripping off other funds. Take a look at this chart:
More from Bloomberg,
Leading up to the deal, Chatham had been selling swaps insuring against a default by McClatchy. So if the transaction were to be completed, it would be getting paid CDS premiums to guarantee against a default that could never technically happen.
“The whole market is losing credibility when you have events like this where you try to trigger the CDS or create orphaning situations,” XAIA’s Felsenheimer said.
Joshua Friedman from Canyon Partners appears to agree that these trades “go beyond the bounds” (video). And, so, people are losing their minds (query whether these same people led to the upsized WeWork debt financing). As always, Matt Levine puts this whole event in perspective,
The thing is, if you bet against McClatchy’s credit by buying CDS on it, you were betting not only that it would have problems with cash flow or whatever, but also that no white knight would come along to keep it afloat until after your CDS expired. A realistic credit analysis asks not only about the company’s own paying capacity but also about its external sources of financing. If you buy five-year CDS on a company, you are betting that it will default on its debt within five years. If the next day a deep-pocketed shareholder (Chatham owns 19.8 percent of McClatchy) refinances all of the company’s debt into a seven-year zero-coupon bond—or a seven-year PIK-toggle bond, or whatever, some form of debt that it cannot default on during the life of the CDS—then you have lost your bet. But you weren’t cheated out of your bet or anything. You just bet that the credit would implode, and then it didn’t.
He’s right. And in the absence of regulators paying more attention to CDS work-arounds, this will be just one more needle in a stack of perceived-manipulated-needles.
*Yesterday, Hovnanian upheld its end of the bargain with GSO by skipping its interest payment.
3. Gibson Brands (Finally) Files for Bankruptcy
What Mr. Juszkiewicz didn't say was that "a plan" actually meant a "plan of reorganization." Which is okay: nobody believed him anyway.
And here's why: in the company's First Day Declaration, the company proudly boasts,
The Debtors' strength, rooted in their iconic Gibson, Epiphone, KRK, and other brands that have shaped the music industry for over 100 years, have been the brands of choice for countless musicians and recording artists, including some of the most legendary guitarists in history such as Muddy Waters, BB King, Elvis Presley, Pete Townsend, Keith Richards, Duane Allman, Elvis Costello, Lenny Kravitz, Slash, Dave Grohl, Joe Bonamassa, and Brad Paisley, among others.
Anyone else see an issue with this lineup? Legends, sure, but not exactly a group of artists you see listed on Coachella posters. Even in a publicly-available document, this company doesn't know how to market itself to the masses. Case and point, after Guitar Center got its out-of-court deal done last week, we wrote the following in “Long EDM’s Musical Awakening?”:
Of course, none of this stopped this reporter from writing — literally on Tuesday, the day before UBS released this marketing — that “Guitar Center Faces Imminent Bankruptcy After 59 Years in Business.” Gulp…#fakenews!
Perhaps the reporter actually meant Gibson Brands, which still looks like its closer to the bankruptcy court steps than Guitar Center. But…but…is there hope? The new rage in electronic dance music (“EDM”) may just be…wait for it…live instruments?! As The Wall Street Journal reported,
Coachella kicked off last Friday and continues this weekend. On Sunday at the Sahara tent, where the music festival typically schedules its EDM performances, the 18-year-old French producer Mehdi Benjelloun, aka Petit Biscuit, played a live set surrounded by electronic gear, his guitar and drums.
Wait, what? His guitar? Say it isn’t so. Check out the photo: even more notable is the fact that Mr. Biscuit is rockin’ a Gibson axe. Forget about a “rock God”…maybe an 18 year-old EDM producer will do.
Gibson may want to embrace the present. But we digress.
Unbeknownst to many, however, Gibson is more than just its legendary guitars. That said, guitars are a big part of its business. The company notes, (in its First Day Declaration, which, for the record, is one of the more jumbled incoherent narratives we've seen in a First Day Declaration in some time),
Gibson has the top market share in premium electric guitars, selling over 170,000 guitars annually in over eighty (80) countries worldwide and selling over 40% of all electric guitars priced above $2,000.
But the company also expanded to include a "Professional Audio" segment, its musical instrument and pro-audio segment ("MI," which is positive cash flow), and a "Gibson Innovations" business ("GI"), which stems from a 2014 leveraged transaction. The latter business has been a drag on the overall enterprise, ultimately leading to breaches of certain financial covenants under the company's senior secured bank debt financing agreements. The company was forced to pay down the debt to the tune of $60 million since the Fall of 2017, a cash drain which severely accentuated liquidity issues within that business. It came to this brutal reality:
...the GI Business became trapped in a vicious cycle in which it lacked the liquidity to buy inventory and drive sales while at the same time it lacked the liquidity to rationalize its workforce to match its diminished operations.
That's rough. Even rougher is that on April 30, 2018, the GI business initiated formal liquidation proceedings under the laws of at least 8 different countries. Looks like Mr. Juszkiewicz' previous expansion "plan" was an utter disaster.
⚡️Warning: Geeky stuff to follow⚡️:
Now, the company is left with restructuring around the EBITDA- positive MI business with the hope of maximizing recovery for stakeholders. The holders of 69% of the principal amount of notes (PETITION NOTE: for the uninitiated, this satisfies the 2/3 in amount requirement of the bankruptcy code; unknown whether they satisfy the second prong of 1/2 in number) have entered into a Restructuring Support Agreement which would effectively equitize the notes and transfer ownership of MI to the noteholders. The company has also entered into a $135 DIP credit facility backstopped by an ad hoc group of noteholders to finance the company's trip through bankruptcy (the mechanic of which effectively rolls up some of the prepetition debt into the postpetition facility, giving the noteholders higher distribution priority).
The RSA envisions a transaction whereby the company will exit bankruptcy with an untapped asset-backed lending facility and enough exit financing to pay off the DIP facility. So, the noteholders will collect some nice fees for about 9 months. The lenders under the DIP facility will have the option to cover the DIP monies into equity in the reorganized company at a 20% discount to the plan's valuation.
⚡️Geeky Stuff Over. Now Back to Regularly Scheduled Snark ⚡️:
Naturally, current management has somehow convinced the new owners, i.e., the funds converting their notes into equity, that they're so invaluable that they should receive millions in "transition"-based compensation and warrants for upside preservation. Makes total sense. David Berryman, who runs Epiphone, will get a one year employment agreement paying $3.35 million, 5 year-warrants, and health benefits; Mr. Juszciewicz will get a one year "consulting agreement" paying $2.1 million, 5 year-warrants and health benefits (plus other profit-sharing incentives). It sure pays to run a company into bankruptcy these days. Naturally, they'll also get releases from any liability. Because, you know, bankruptcy!!
One final note: Thomas Lauria and White & Case LLP are listed as the 22nd highest creditor. Popping popcorn.
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