Disruption from the Vantage Point of the Disrupted
Freemium Briefing - 9/26/18
Read Time = 5.2 a$$-kicking minutes
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On Sunday, our Members read about the disruptive potential of direct-to-consumer home fitness companies, the frenzy over the newly issued Refinitiv loans and bonds, Neiman Marcus, Lannett Company Inc., haves and have nots in fracking, and more. Your competitor is a Member. He/she is now far more interesting than you in the marketplace. Marinate on that.
🗞News of the Week (2 Reads)🗞
1. BREAKING NEWS: SHORT SEARS HOLDING CORP.
We’re old enough to remember when Sears Holding Corp. ($SHLD) was last rumored to file for bankruptcy. In 2017. 2016. 2015. 2014. 2013. 2012. 2011. 2010 (the last year it turned a profit). This thing is like “Karl” in Die Hard.Or this lady:It just won’t die.
So this week’s reports that Sears’ CEO Eddie Lampert “Urges Immediate Action to Stave Off Bankruptcy” were met with, shall we say, a collective yawn. Lampert has been performing financial sleight-of-hand for years, all the while the five-year SHLD stock chart looks like this:
This is what the Twitterati had to say about this: [ ].
Yes, that blank space is intentional. We’ve never seen Twitter so quiet. Grandma was like, “Sears? Sears? I last shopped in Sears when I was prom shopping…in 1956.” Mom was like, “I once bought you a Barbie at Sears…in 1989.” Some millennial somewhere was probably like, “Sears? What’s a Sears, brah?”
Just kidding: nobody is talking about Sears. That would imply mindshare. 🔥
Lack of mindshare notwithstanding, the company, despite a wave of closures over the years (including 46 unprofitable stores slated for closure in November ‘18), consists of 820 stores (including KMart). As of 2017, the company had 140,000 employees. Thats Toys R Us x 4.5. The company also has approximately $5.5 billion of debt, $1.1 billion of pension and post-retirement benefits, declining revenues, negative (yet improving) same store sales percentages, negative gross margin, and increasing net losses.
Source: SHLD Q2 Earnings Release Presentation, September 13, 2018
It also had $941mm of cash available as of the end of Q2 2018.
On Sunday, Lampert filed a Schedule 13D with the SEC outlining his proposal to save Sears in advance of a $134 debt payment due on October 15. High level, the proposal was…
“…to the Board requesting Holdings to consider liability management transactions, real estate transactions and asset sales intended to extend near-term debt maturities, reduce long-term debt, eliminate associated cash interest obligations and obtain additional liquidity.”
The proposed liability management transactions…provide for exchange offers to eligible holders of second lien debt…and eligible holders of unsecured debt…. These potential exchange offers together could save Holdings approximately $33 million per year in cash interest and eliminate approximately $1.1 billion in debt.
More specifically, the proposal calls for, among other options, ‘19 and ‘20 second lien debtholders and ‘19 unsecured noteholders to swap into zero-coupon mandatorily convertible secured debt (no yield, baby?)(read the 13D link above for more detail). It also calls for the sale of $3.25 billion worth of real estate and assets, including Sears Home Services and Kenmore.
After all of this time, why now? Per Bloomberg:
Lampert and ESL acted after watching other retailers including Toys “R” Us Inc. and Bon-Ton Stores Inc. wind up in liquidation, according to people with knowledge of the plan. The aim is to get something done out of court to preserve value for shareholders, since they don’t usually fare well in bankruptcy proceedings, said the people, who weren’t authorized to comment publicly and asked not to be identified.
There’s something strangely poetic about Lampert and ESL using the ghosts of Toys R Us and BonTon past to coerce creditors into an exchange transaction now.
Anyway, Twitter may have been quiet, but naysayers abound.
“It seems the next natural iteration of all the financial engineering the company has been engaging in over the last few years,” Bloomberg Intelligence analyst Noel Hebert said. “For non-bank creditors not named Eddie Lampert, there is a bit of prisoner’s dilemma -- maybe something more tomorrow, or the near certainty of very little today.”
“This is simply storing up trouble for the future,” according to a note from Neil Saunders, managing director of research firm GlobalData Retail. “Sears is focusing on financial maneuvers and missing the wider point that sales remain on a downward trajectory,” he wrote. “Even in a strong consumer economy, customers are still drifting away to other brands and retailers.”
From the Washington Post:
“Eddie Lampert is seeking permission from himself to keep Sears on life-support while he continues to drain every last remaining drop of blood from its corpse,” said Mark Cohen, director of retail studies at Columbia Business School and the former chief executive of Sears Canada. “The operation is a failure, and there is no plan to turn that around."
From the Wall Street Journal:
“Given Lampert’s shuffling of Sears assets in ways some creditors suspect was more to his benefit than theirs, there is a chance they will hesitate to let him reorganize unless it is under the watchful eye of a bankruptcy judge,” said Erik Gordon, a University of Michigan business school professor.
Ugh. Wake us up when its finally over. Even Karl eventually died.
2. What to Make of the Credit Cycle. Part 15. (Long Div Recaps)
On Sunday in “What to Make of the Credit Cycle. Part 14. (Long Blackstone; Short Refinitiv),” we provided our colorful take on the fervent (and 2x over-subscribed) demand for the $13.5 billion Thomson Reuters’ Refinitiv loan and bond issuance. Our take was framed from the perspective of the high yield trader and was meant to provide some insight into the machinations that occur behind the scenes at a high yield fund. But what does this deal mean for private equity firms and leveraged buyouts?
Spoiler alert: all good things.
The rousing results are likely to boost secondary pricing and will intensify pressure on primary pricing and other terms and conditions, after investors won a reprieve in the summer from aggressive transactions amid a surge in supply.
The SMi100, an index that tracks the 100 most widely held loans, stands at 98.73, the highest point since February. About 42% of US loans are now trading above par, according to LPC data. Average US high-yield bonds, meanwhile, have rallied sharply over the past couple of weeks to Treasuries plus 325bp, or just 3bp off post-crisis lows, according to ICE BAML data. (emphasis added)
Private equity firms likely smell blood in the water. More from Reuters:
The successes could also herald a more aggressive underwriting era as private equity firms squeeze arranging banks harder, which could open the door to another round of opportunistic repricings, refinancings and dividend recapitalizations that allow sponsors to take advantage of weak documentation.
“The next stuff behind the scenes is going to be punchy,” the global debt head said.
Ah, dividend recapitalizations. We miss those.
While the results are undeniably good for private equity firms, they may not be good for investors who are increasingly nervous about aggressive deals as an economic downturn draws closer at the end of an unusually long economic cycle.
With Refinitiv, Akzo and Envision, technical factors – primarily huge demand and a small visible pipeline of deals – overwhelmed any specific credit concerns and fears about aggressive documentation that allow sponsors to extract dividends quickly or make transformative asset sales and acquisitions without investors’ consent.
The three jumbo loans, each of which are capital-stretching, represent half of the forward calendar, which is already looking thinner. Worries about future supply encouraged investors to join the big, liquid deals in droves, particularly as new money carve-outs have previously proved to be particularly profitable.
…likely distress among indebted borrowers may spread into the wider economy as central banks raise interest rates. It’s not just the total debt, but the fact that investors seem less and less concerned about protecting themselves against losses, the BIS said.
Yes, indeed. The return of covenant-lite debt has been well documented.
And the borrower-favorable market has been well documented.
“When there’s tons of liquidity, lenders don’t value covenants and they’re willing to lend at very high leverage values,” said Douglas Diamond, a finance professor at the University of Chicago Booth School of Business. “If you get a negative shock after that, you’ve now got a very vulnerable sector. The crisis won’t happen tomorrow but the vulnerability is there.”
The BIS report identified other concerns, including the prospect of fire sales by loan funds if ratings downgrades push some of their investments into junk. Diamond said there’s potential for such leveraged mutual funds to cause havoc.
“The borrowing that they do is usually from a bank,” he said in an interview. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank -- not necessarily the same bank. So the risk would ultimately get back to bank balance sheets.”
But high yield mutual funds aren’t the only vehicles driving this meshugas. Don’t forget about CLOs, which, as we discussed in “💥The CLO Market is Going Bananas💥,” are in full-on volume mode. Relating to factors driving demand for borrower-friendly paper, Alexandra Scaggs wrote in Barron’s:
Another is the robust demand for floating-rate debt such as leveraged loans to protect against Federal Reserve rate increases. Funds investing in loans have seen $14.4 billion of inflows this year, according to EPFR, following on $16 billion of inflows in 2017 and $11 billion in 2016. It is not clear the scramble for floating-rate securities will stop any time soon, as the Fed is expected to raise rates four times in the next 12 months, according to Bloomberg data. The demand for loans has also been fueled by the rise of the market for collateralized loan obligations, securitized products that hold pools of loans as collateral and pay their investors the interest collected from those loans in order of tranche quality.
Canada Pension Plan Investment Board (CPPIB) announced today it is partnering with Sound Point Capital Management to invest in CLO equity https://t.co/VqAjQ7lGKYSeptember 24, 2018
In a separate segment on Sunday, we snarked about over-the-transom strategic-alternatives pitch deck” and banker boredom. Distressed and high yield investors are, no doubt, equally if not more bored. Aside from Q1, 2018 has been a barren wasteland for restructuring and bankruptcy professionals looking for things to do. Long bitching come bonus time.
But all of this flippant high yield activity has to come home to roost at some point. The question, as always, remains “when?”
😎Notice of Appearance😎
Your firm, Davis Polk, appears to do a lot of international restructuring work. With turmoil in emerging markets lately, what are some things that distressed investors should be focused on? A previous commentator highlighted US-denominated debt in a strong dollar environment...
I would highlight the recent retreat from globalism and the increase in nationalism happening around the world. Knock-on effects of a trade war with China will show up in many other countries. Take South Korea as an example. There has been plenty of press coverage asserting that South Korea would be one of the big losers in a trade war as a large supplier of products to China that then get exported to the US. Less well covered is that rising nationalism in China may continue to put independent downward pressure on South Korean businesses operating in China. The combination could create a tipping point for at-risk companies.
More generally, increasing nationalism could hurt the value of foreign IP in countries where consumers associate that IP with “disfavored” countries. Distressed investors relying on foreign IP of US companies to sell at high valuations beware.
Dovetailing off of the previous question, what is one notable trend that you expect to see in Q4 of this year that not enough people are talking about? What about the beginning of 2019?
I don’t know about Q4 or the beginning of 2019, but not enough people are talking about batteries. Every year, computers get smaller and faster. Every year, Amazon can deliver more products almost instantaneously. Yet every year, my smartphone battery gets worse. Five years ago, my phone could go several days between charges, now my new phone doesn’t even make it a full day. The lack of disruption in the battery industry is troubling. Whichever company figures out how to disrupt the battery industry is going to chase Apple and Amazon to a trillion dollar market cap.
In fact, I think this could make an interesting regular coverage piece in Petition. You are great at spotting disruption in an industry. I especially enjoy your retail coverage showing the story is more complicated than an “Amazon effect.” But you are missing an opportunity to showcase the disturbing lack of disruption over time in certain industries. Where is my my battery 2.0?
PETITION Response: Perhaps you had one of those faulty Apple batteries? Did you get it swapped out? In any event, yes, batteries are a big deal. Tesla’s valuation is a testament to that. Do you value it as a car company or as a battery company? The stock market seems to be stuck in a perpetual catatonic state of confusion on the subject.
What is the best piece of advice that you’ve been given in your career?
When I was a junior associate, a mentor told me that the most precious asset a lawyer possesses is his or her reputation. It is very true advice, especially in our small restructuring community. A reputation takes a career to build and can be squandered in a moment.
What is the best book you’ve read that’s helped guide you in your career?
“Oh, the Places You’ll Go!” by Dr. Seuss. The book has a deep message. Life will not always go the way you would like, but you should never give up. You should keep working hard and focus on controlling the things within your control. The genius of Dr. Seuss is that he delivers an important message in a way that my young children can understand and want to hear again (and again . . . and again). If only more lawyers could draft that way!
We have compiled a list of a$$-kicking resources on the topics of restructuring, tech, finance, investing, and disruption. 💥You can find it here💥. Two books we’re excited to add to the list include Bethany McLean’s “Saudi America” and Gary Shteyngart’s “Lake Success.” The former is about the U.S. as a world oil superpower and the latter is apparently about how hedge funders are d-bags.
SSG Capital Advisors, LLC (“SSG”) is an independent boutique investment bank that specializes in mergers and acquisitions, financial advisory, restructurings, private placements and valuations for middle-market companies and their stakeholders. It is looking for an Investment Banking Analyst or Associate to join its suburban Philadelphia office. For more information or to submit your resume and contact information, please email SSG at firstname.lastname@example.org.
Young Conaway seeks motivated junior-level attorneys with approximately one to three years of transferable experience to join its Bankruptcy and Restructuring Practice Group. Associates will work closely with firm attorneys, co-counsel, and clients to provide guidance, advice, and litigation support in both in- and out-of-court complex corporate restructurings. Delaware bar admission is preferred, but candidates willing to take the 2019 Delaware Bar Exam will also be considered. Interested applicants should submit their cover letter, resume, undergraduate and law school transcripts, and a writing sample to Margaret Whiteman Greecher, Director of Recruiting and Associate Development, at email@example.com.
PETITION is looking for a unicorn who wants to help build something from scratch. We are a revenue generating startup with a lot of vision for what comes next. If you have a background in finance, law, or consulting and want to be a utility player helping us build out our content, sales/marketing infrastructure, partnerships, ops, and whatever else we conjure up in our big domes, ping us. All inquiries will be handled on a strictly confidentialbasis. Preference will be given to MEMBERS. How else can you be educated about what we’re doing and how we’re doing it if you’re only seeing part of the picture?!
If your firm has job opportunities, please email us at firstname.lastname@example.org.
Nothing in this email is intended to serve as financial or legal advice. Do your own research, you lazy rascals.