April 27th, 2013 by Ron Carleton
99 Cents Only Stores operates a chain of over 300 “extreme value retail stores” in California, Texas, Arizona and Nevada.The company was founded in 1982, and in January 2012 it was taken private by Los Angeles private equity firm Ares Management and the Canada Pension Plan Investment Board. The new capital structure was typical of LBOs done at that time:
% of Capitalization
Total 1st lien debt
(a) The Revolver commitment was $175 million, of which only $10 was borrowed at the time of the transaction
(b) Using fiscal year 2012 pro-forma adjusted EBITDA, a reported by the company
The company’s choice of loan products shows that one of its objectives was to maintain as much operating and financial flexibility as possible:
- The revolver is an Asset Based Lending (“ABL”) facility. Compared to most secured “cash flow” revolvers, ABL facilities typically have fewer and less restrictive covenants. In fact, it is common for ABL facilities to have no financial covenants, or to have financial covenants that are only measured if the company borrows most of what is available under the borrowing base. This additional flexibility is a key advantage for ABL borrowers.
- The term facility is a Term Loan B (“TLB”). This provides the company with significant cash flow flexibility. It has amortization of only $5.25 million per year (i.e. 1% of the original principal) and a final maturity of 7 years (with a balloon payment of about $490 million). Had the company chosen a Term Loan A, the final maturity would have been shorter (i.e. only 5 years) and there would have been significant quarterly principal payments so that the loan would have been repaid in full by the maturity (without a balloon payment at the end). The TLB gives the company a longer maturity and requires only token amortization.
- The TLB is “covenant lite.” As described by the company, the TLB “includes restrictions on the Company’s ability … to incur or guarantee additional indebtedness…”
- Most loan agreements include “maintenance covenants.” For example, the company must maintain at all times leverage of no more than 5x total debt to EBITDA. If the company’s leverage goes above 5x, it is a default and the lenders can exercise their rights.
- Most bond agreements include “incurrence covenants.” For example, if the company’s leverage goes above 5x total debt to EBITDA, the company cannot take a certain action (e.g. issue more debt, pay a dividend, make an acquisition, etc.). In this case, if leverage goes above 5x, the bond is not in default unless the company also takes the prohibited action. From the borrower’s perspective, incurrence covenants are preferable to maintenance covenants – it gives them much more flexibility.
Covenant Lite Loans
During the debt market boom of the mid-2000’s, we saw the emergence of covenant lite loans. These are, typically, TLBs with incurrence covenants. The low amortization, long maturity and lax covenants give borrowers significant operational and financial flexibility, especially when compared with the typical Term Loan A. This is especially true when a covenant lite loan is paired with an ABL revolver, which also has lax covenants. This is the strategy used by 99 Cents Only Stores.
The market for covenant lite loans peaked in 2007, when almost $100 billion were issued, accounting for over 40% of all syndicated loans for non-investment grade issuers. During the credit bust of 2008-2010 very few new covenant lite loans were issued. However, starting in 2011 when the credit cycle began moving to a borrower’s market, covenant lite loans have returned. It is likely that issuance in 2013 will exceed the record set in 2007.
And the credit cycle continues …
April 14th, 2013 by Tim Delaney
Suntech isn’t who we think it is
The company known as Suntech isn’t simply Suntech at all. It’s a group of 41 different holding companies, intermediate holding companies, and operating subsidiaries tied together by common ownership. Suntech Power Holdings Company Ltd., based in the Cayman Islands, is the parent company, the ultimate owner, directly or indirectly, of all the others. Wuxi Suntech Power Company Ltd., in the Peoples Republic of China, controls the most important operating subsidiaries.
Each company in the Suntech group is a separate legal entity with its own assets and liabilities. Suntech Power Holdings’ biggest assets are its shares of three intermediate holding companies; its biggest liability is $585 million in debt held by U.S. investors and the World Bank. Wuxi Suntech’s subsidiaries own most of the plant, equipment, and inventory and generate nearly all of the cash flow; its biggest liability is $1.7 billion in debt held by Chinese banks.
Suntech’s legal complexity is more than just an opportunity for lawyers; it’s also a problem for Suntech Power Holdings’ bondholders. Even though their bonds are senior under the terms of their own indentures, they are junior to Wuxi Suntech’s bank loans. That’s because of something called structural subordination.
Structural subordination occurs when a holding company borrows money at the same time as an operating subsidiary does. Suntech Power Holdings relied on cash from Wuxi Suntech for debt service, but Wuxi Suntech had its own debt payments to make to the banks. By forcing Wuxi Suntech into bankruptcy, the banks blocked payments from Wuxi Suntech to Suntech Power Holdings and to the bondholders.
Mount Kellett Capital Management, Driehaus Capital Management, Pioneer Investment Management, and Suntech Power Holdings’ other big bondholders, have no way to get at Wuxi Suntech’s assets and cash flows because of where they are lending in Suntech’s legal structure. They’re structurally subordinated to Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and the other banks.
That means the bondholders will have to wait until the banks’ claims are satisfied before they will be paid anything. No wonder Suntech’s bond prices have been below 50 cents on the dollar lately. Bondholders are expecting to get very little at all.
The broader lesson is to know your borrower. And not just in the sense of risk factors, cash flows, management, and the usual credit concerns; but in the sense of who your borrower is and who the other borrowers are. Which company in the consolidated corporate family? What other companies are borrowing? Where is your borrower in the legal hierarchy?
How do you protect yourself against structural subordination? One way is to limit the amount of borrowing below you: have your loan agreement with the holding company limit borrowings by operating subsidiaries. Another way is to have operating subsidiaries with substantial assets and cash flows guarantee your debt. Better yet, do both.
March 31st, 2013 by Tim Delaney
Here comes the sun
In 2008, the clouds of pollution that clot the skies over China’s cities had officials there gasping for relief. They were even more troubled by the slowdown in China’s economy. Their solution was to promote solar energy, not only for clean energy production but also for exports and jobs. The government backed the solar panel industry with massive lending programs from state-controlled banks.
China’s solar module manufacturing capacity grew from less than 5 gigawatts in 2007 to just under 40 gigawatts in 2011, more than double the total in the rest of the world, and far in excess of demand. The market for solar modules was only 5 gigawatts in China and 30 gigawatts globally. The result was a collapse in panel prices worldwide.
Suntech’s power fails
For Suntech, China’s largest solar panel maker, prices fell from $3.72 per watt in 2007 to $1.51 per watt in 2011. In terms of volume, Suntech’s sales were strong, with sales in megawatts of generating power up 34% in 2011. But low prices coupled with above-market, take-or-pay supply contracts for raw materials short-circuited profits. Adjusted for special charges like asset impairments, operating profits were negative in 2011 and the first quarter of 2012.
Suntech’s free cash flow was negative in most years because of heavy investments in working capital and in plant and equipment. The company was able to offset operating losses with working capital efficiencies, and cash flow from operating activities went from ($30) million in 2010 to $93 million in 2011. But capital spending proved harder to cut; it actually increased from $276 million in 2010 to $367 million in 2011.
Suntech funded those persistent cash flow deficits with debt, driving leverage to very high levels in 2011. Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and other banks had loaned $1.7 billion to Suntech by the end of 2011, and there were $585 million in convertible bonds outstanding. On March 15, 2013, the company defaulted on its bonds, triggering a cross-default with its bank debt. On March 20, the company was forced into bankruptcy by the banks.
Disasters come from compound risks. It took a combination of speed, darkness, and shortage of lifeboats to sink the Titanic and drown 1,502 of her passengers and crew. In credit it’s usually a mix of business and financial factors that brings a company down.
In Suntech’s case, the key business risk factor was what we call an industry cycle, something we’ve blogged about earlier using shipping as an example. They are more common in mature industries, but even an emerging business like solar panels can generate one and see prices and profits fall.
The key financial risk factor was too much debt. Suntech’s interest expense was $136 million in 2011, well above the income or cash flow available to pay it without adding more debt. With the banks unwilling to make more loans, the only solution was to try to restructure Suntech’s debt in bankruptcy.
February 24th, 2013 by Tim Delaney
Office supply retailing has been a tough business lately. Demand for paper, writing materials, envelopes, and many other products is falling as people do more and more work on line. On-line stores are making big inroads, just as they have done in books, music, and consumer electronics in the U.S. and the U.K. mass merchants are also selling more and more office products.
It’s a fiercely competitive industry, with intense rivalry, demanding buyers, growing substitutes, and aggressive new entrants. Even the biggest competitor, Staples, can only manage a paltry 0.44% return on equity. It seems foolish to commit any more capital to an industry with so little potential for profit.
But the deal makes sense just because things are so grim in office supplies. It’s bad enough to be buffeted by the forces of a hyper-competitive industry, but it’s much worse to be facing such challenges from a weak competitive position.
Office Depot and OfficeMax are among the industry’s top three competitors. Office Depot has about 19% of the office supply market and OfficeMax has 16%, while Staples has 30%. Amazon, W.B. Mason, WalMart, Costco, and the other competitors have the rest.
Size matters. Companies with large market shares are generally more profitable than companies with smaller shares. They benefit from bigger economies of scale in production, marketing, distribution, and financing. They enjoy greater experience curve efficiencies, more bargaining power with customers and suppliers, and an advantage in attracting and retaining good managers.
But it’s not absolute size or ranking among the leaders that matters, it’s relative size – how much bigger or smaller a company is compared to its competitors. Staples is much bigger than either Office Depot or OfficeMax, and its size advantage is apparent in table below.
Debt to capital
|1 for 2011 in millions of U.S. dollars 2 Average over last 3 years
Staples is more than twice the size of Office Depot and three times the size of OfficeMax. Of the major independent office-supply retailers, only Staples is growing and profitable. The other two are making money, but they’re losing share and are much less profitable.
And the reason they’re losing share and struggling to make money is because Staples is so much bigger. It’s able to exploit economies of scale and the other advantages of size to undercut Office Depot and OfficeMax on pricing, or outspend them on marketing, or both.
For Office Depot and OfficeMax, the best chance they have to survive in office supplies is to close the gap in relative share with Staples. The easiest way to do that is to merge. They can trim costs by closing overlapping stores and cutting corporate overhead, and they can start exploiting their new economies of scale in purchasing, distribution, and marketing.
There’s no guaranty of success, but the merger greatly reduces the risk of failure. When conditions are tough, it’s best to deal with them from as strong a position as possible. For Office Depot and especially for OfficeMax with its high debt-to-capital ratio, the deal is a chance to reduce credit risk and raise shareholder value. Without it, both firms face an even more dangerous future.
December 11th, 2012 by Ron Carleton
1) I will think like an equity analyst. In order to properly assess the credit risk of a company, you must understand what management is thinking. Since management works for the owners of the company, not its creditors, you must think like an owner. Is there a viable business plan? What is the company’s competitive advantage? What is the company’s plan for growth? How will the company enhance returns to shareholders?
You must understand the pressures management is facing. Is the share price dropping? You can bet that management will do something to push it up, like a share buyback, special dividend, divestiture, or acquisition (or even worse, they will “manage” earnings). Is the owner (whether a private equity shop or a family) interested in selling the company? Perhaps they will defer capital projects (or, once again, “manage” earnings).
2) I will think like a debt analyst. OK, you must understand the owner’s perspective, but you must also keep in mind that what is good for the owner is not always good for creditors. For example, shareholders love high growth companies – they get higher equity valuations (and their managers often get higher compensation). But high growth often means high risk and, perhaps, low or negative cash flow. Remember, a business plan can be good and appropriate for the company, and at the same time, high risk from a credit perspective.
3) I will avoid elevator analysis. No one needs you to tell them if sales (or margins or leverage) went up or down. People can see that themselves by looking at the numbers. Your job is describe why the numbers are changing and, perhaps, give insight into how the company is likely to perform in the future. You have to have an opinion. Tell me if performance is good or bad, not just up or down.
4) I will find the elephant in the room. Too often we see people doing “checklist analysis.” There are certain things they must analyze to fill in all the boxes in their memo. Checklists can be helpful, but you have to remember to look at the big picture. That may mean identifying issues that don’t fit neatly into the boxes. Is there a big issue out there? What does management spend most of their time thinking about? What is the most likely cause of a future decline in the company’s credit quality? This might be an anticipated future sale of the company (for leveraged buyouts), the age of the owners or managers (for privately held companies), a new regulatory framework (for banks), or a new competitor (for everyone!). Don’t be so focussed on the details that you forget to look at the big picture (even if it’s not on your checklist).
5) I won’t leave the structuring to the lawyers. Too often, bankers and credit analysts are focussed on bringing in new transactions, getting them approved internally and/or getting them sold into the market. We leave covenants and other structural issues to the lawyers, or we use a “standard package” of covenants. This is a mistake. The covenants and other structural elements of the deal should be tied to the unique risks of the company. Are you worried the company might grow to fast? Or that they might take on excessive leverage or that the owners will take too much money out of the company? Structural subordination? There are covenants for all of these concerns. The right package of covenants (and the covenant levels) are different for every company.
December 3rd, 2012 by Tim Delaney
Risk culture is the way people behave about risk. But people, organizations, and risk are all complex and dynamic. It’s important to have a formal concept of risk culture, but perhaps the best way to explain it is through examples.
Dan Sparks at Goldman Sachs
In 2006, Dan Sparks was the partner in charge of mortgage trading at Goldman Sachs, and by mid-year he was troubled by growing risks in the mortgage markets. For the next six months he tried to escalate his concerns.
In Sparks’ words: ”It was tough…and I mean tough…the rigor that Goldman Sachs puts on people is unbelievable…especially when there’s a concern…I went up there to the 30th floor…five times…’We’ve got a problem…Here’s what’s going on. Here’s what I don’t understand. Here’s what I’m worried about.’ As soon as you do that…they get the risk controllers and all kinds of people involved…I mean they’re all over it.”
In December David Viniar, Chief Financial Officer, convened a meeting to discuss Sparks’ views. The decision was to “get smaller, reduce risks, and get closer to home.” As a result, Goldman ultimately gained $4 billion from hedging its mortgage exposures. For more on risk management at Goldman read Money and Power by William D. Cohan.
Madelyn Antoncic at Lehman Brothers
Madelyn Antoncic was Chief Risk Officer at Lehman Brothers from 2005 to 2007. Before joining Lehman, she’d been a mortgage trader at Goldman Sachs, head of market risk at Goldman Sachs, and head of market risk at Barclays. In 2005 she was Risk Magazine’s risk manager of the year, and in 2006 she was named one of the 100 most important women in finance.
As the mortgage market crisis began to develop in 2006, Dick Fuld, Chairman and CEO, saw an opportunity for growth. He proposed an increase in the firm’s overall risk limit from $2.3 billion to $3.3 billion. Antoncic was concerned about market conditions and argued for a an increase to only $2.7 billion.
Lehman pushed hard into leveraged finance in 2006 and 2007, regularly exceeding its own risk limits. Antoncic opposed many of the deals and the firm’s total exposure to leveraged loans, but the Executive Committee overruled her. Lehman also moved aggressively in commercial real estate lending, routinely ignoring risk limits once again.
Antoncic’s concerns grew. As she told the Financial Crisis Inquiry Commission, “At the senior level, they were trying to push so hard that the wheels started to come off.” The seniors responded by excluding her from Executive Committee meetings, and in September 2007 she was demoted to a regulatory policy position. Within a year, Lehman was bankrupt.
Measures of risk culture
It’s clear that risk culture matters for good and bad. But how is a board member or a senior manager or an outside analyst to know if a company’s risk culture is working or failing? We think the best indicators are these.
- Risk access to board
Senior risk officers have regular, unrestricted opportunities to talk to directors about risk
- Risk-adjusted compensation
Pay should be adjusted for the risk incurred and for contributions to risk management
- Risk funding
Spending on risk systems and personnel in terms of trend and relative to peers
- Business people working in risk
To advance into management, risk originators have to do a tour as risk managers
- Risk manager turnover
The percent of risk managers leaving the firm in terms of trend and relative to peer
- Risk escalation score
The number of times risk originators or risk managers formally escalate risk issues
Risk culture is too important to ignore. And if it’s important enough to matter, then it needs to be measured. We think these are metrics that would be meaningful to outside analysts, but that’s just our opinion. What do you think?
November 20th, 2012 by Tim Delaney
Consider the sad story of UBS. In 2007 it suffered $38 billion in losses on mortgage back securities, requiring a $60 billion capital infusion from the Swiss government to keep from going under.
In 2008 it paid out $19 billion to clients it had duped into buying worthless auction-rate securities. In 2009 it had to pay the U.S. government a $781 million fine for helping wealthy Americans evade taxes. In 2011 it took $2.3 billion in losses on a $12 billion trading position built up without authorization by one trader, who hid it by booking fictitious hedges.
This is more than a series of unfortunate incidents. It’s a pattern that points to terrible problems with risk and controls at one of the world’s largest and (formerly) most prestigious financial institutions. How could things go so wrong for so long at UBS?
Critics were quick to attack the firm’s risk culture: “At UBS, It’s the Culture That’s Rogue” by James B. Stewart and “Questions Arise About UBS Risk Controls” by Alistair MacDonald and Deborah Ball. Even the company acknowledged it had to improve its risk culture: “UBS 2007 Annual Report (page 10).”
And the problem ran deep. “The problem isn’t the culture,” one investment banker said, “The problem is that there wasn’t any culture. There are silos. Everyone is separate…People cut their own deals, and it’s every man for himself…People thought of themselves first, and then maybe the bank, if they thought about it at all.”
Too deep for management to fix. Sergio Ermotti, the CEO brought in to fix risk at UBS after the 2011 trading crisis, has decided on radical surgery. Over the next three years, he’s going to wind down most of the investment bank trading operations.
Of course, UBS isn’t the only firm with risk culture problems. Lehman Brothers, Citigroup, AIG, and many others have been accused of having weak risk cultures. It’s been cited as a factor in any number of financial disasters, but, strangely enough, it’s rarely been well defined.
We think the best definition of risk culture is based on one from McKinsey’s “Taking Control of Organizational Risk Culture” by Cindy Levy, Eric Lamarre, and James Twining: the norms of behavior that determine how an organization understands and acts on risk.
In a strong risk culture, the degree of risk and the appetite for it are subjected to rigorous analysis and continuous debate. Everyone from the board and the CEO to bankers and support staff takes risk very seriously and is involved in managing it. There are rewards for managing risk well, including for escalating serious risk concerns.
That’s a simple way to describe a complex topic. Risk itself is intricate and changeable. Risk culture is subtle and elusive: it’s the way people behave about risk. Perhaps the best way to explain it is to describe is through examples. We’ll do that in our next post, and discuss ways to evaluate risk culture.
November 9th, 2012 by Tim Delaney
Tesla Motors has drawn a lot of attention for its sleek, high-performing electric cars. Its Roadster has been an enviro-celebrity favorite for several years, and its new Model S sedan is getting great reviews. The company has been trying to scale up to large-scale production since 2009, raising $226 million in the stock market and $465 million in Department of Energy loans.
But there are growing concerns that Tesla might run out of cash before it can get into full production. The original plan for the Model S was to produce 5,000 in 2012, but the company recently cut that to 3,000. At that level of production, how long will it be until Tesla uses up its sources of liquidity?
Over the last four quarters, Tesla’s internal cash flow deficit was $423 million. That was mainly the result of heavy start-up costs, which caused a $159 million shortfall in cash from operating activities, and from capital spending of $412 million.
Unusually, cash flow from working capital was positive. Tesla has hardly any accounts receivable; instead, it charges customers a $5,000 deposit on each car they order. Customer deposits contributed $100 million dollars to cash flow through the last four quarters.
How has the company recharged its cash batteries? From two sources: cash reserves and loans. Tesla has drawn $109 million from cash reserves and $298 million from the Department of Energy since June 2011. That left Tesla with $211 million in cash at the end of June 2012.
As we noted in an earlier post about Kodak, “cash burn” is commonly defined as “the rate a company uses up cash.” But cash isn’t Tesla’s only source of liquidity. It had $33 million of un-borrowed Department of Energy loan commitments last June.
Combining cash with available borrowing ability, gives Tesla $244 million in liquidity at the end of its latest quarter, compared to $453 million in liquidity a year before. So Tesla has run down its liquidity by $209 million over the last four quarters, or by about $52 million a quarter. That implies Tesla has a little more than one year’s worth of liquidity left ($244 million ÷ $52 million ÷ 4) at its current rate of “liquidity burn.”
And that’s the measure we prefer. Liquidity burn is better than cash burn because it takes ready off-balance-sheet sources of funding into account. It’s a more realistic look at how much time a company has left before its sources of cash need to be recharged.
September 26th, 2012 by Ron Carleton
The Background: I was a vice president at a global bank, responsible for a diverse group of clients in North America. One of my clients was considering a major reorganization of its business and restructuring of its balance sheet, and it hired my bank as financial advisor. Since we were a lender to client and a restructuring could have impacted our position, the bank saw the conflict and (with the consent of the client) set up separate teams. Given the size of the assignment and the large potential fees, the advisory team was led by the bank’s Vice Chairman, and included the head of my department, who was my boss. My “team” (really just me and an associate) was responsible for the bank’s balance sheet – our counterparty risk and our lending position, including a large syndicated loan for which we were the agent.
The Setup: The advisory assignment went on for several months, during which I could not discuss the client with my boss or anyone else on the advisory team. This led to some strange situations, like running into people from my bank in the elevator at the client’s headquarters (a very silent ride), or sitting across the table from them in client meetings.
Finally, key elements of the restructuring began to emerge. To make it work, one large asset of the client had to be quickly and quietly sold. This is when my boss called me into his office and gave me the term sheet showing our bank buying the asset. But, since he was on the advisory team, he couldn’t buy it. It was up to me to make the purchase on behalf of the bank.
But it didn’t look right. The client (really our advisory team) provided very little information about the asset to be sold. Depending on your assumptions, it was either wildly over or under priced. And the company wanted us to buy it right away, without any disclosure to other lenders (including members of our lending syndicate) or to the public. The advisory team (via my boss) assured me that the price was fair, and that purchasing the asset would enable the rest of the client’s reorganization.
The Conflict: After reviewing all the materials and running the numbers, it still didn’t look right. I collected my materials and went to see Jim, the senior executive for North America (my boss’s boss). After running him through the situation, he agreed we shouldn’t do it. Even if the numbers made sense (which was questionable), the reputation risk was too high – the speed and secrecy wouldn’t look good to other investors or to the public.
Finally, Jim said, “let’s go see Dennis,” and with that, he was on the phone to the office of the Chairman of the bank. We collected my materials and walked down one flight of stairs to the Chairman’s conference room. There, we were met by the quickly assembled advisory team, including the Vice Chairman, internal counsel, and my boss. I remember looking around the room and thinking I was the only one in the room (including the Chairman) without my jacket on.
The Resolution: Jim presented our case. The transaction may (or may not) be the right thing for the company to do, but it was not right for us to be on the other side of the deal – the speed and secrecy, combined with our conflicting roles (i.e. advisory, lender, agent), made it too risky. It did not pass the Wall Street Journal test (would you be happy to see the details of the transaction on the front page of the Journal).
The advisory team presented the other side – the client wanted the transaction and without it, we could not complete our advisory assignment (and thus would not receive an advisory fee).
The Chairman asked some questions, got into some of the detail, and heard from more people in the room. Finally he said, “This doesn’t sound like something we want to do. What do you think Roberto?” (looking to the Vice Chairman, the leader of the advisory team). The Vice Chairman agreed. The deal was dead.
The Lessons: Do the right thing. A firm’s reputation with its clients, investors, regulators and employees takes years to build yet it can be destroyed very quickly. When something doesn’t look right, raise the red flag – bring the issue to the right people in the organization.
After the decision had been made, the Chairman had one more comment before he let us all go: “Conflicts like this large and small happen in our business every day, and you can’t bring every one of them to my office. When you get back to your desks, remember the decision we just made.” And just like that, an ethical corporate culture was reinforced from the top of the house.
September 1st, 2012 by Tim Delaney
Last October, David Einhorn, head of Greenlight Capital, a hedge fund famous for taking short positions in Lehman Brothers’ shares before Lehman failed, attacked Green Mountain Coffee Roasters’ in a presentation at an investors’ conference. It was a tour-de-force of financial analysis. Using only publicly available information, Einhorn made a strong case for unrealistic sales growth and overstated earnings.
Since then, things have only gotten worse for Green Mountain. The share price collapsed. Robert Stiller, the founder, was forced to sell shares to meet margin calls on $617 million in personal debt secured by his Green Mountain shares and had to resign the company’s chairmanship. The SEC continued with an investigation into the lack of disclosures about a key distributor.
And many of David Einhorn’s concerns remain. We’ve looked at one of the issues he raised: capitalizing operating costs. Here’s our own analysis, updated with the latest fiscal year data.
As Green Mountain reports it, sales have been growing at an striking rate, propelled by demand for its K-Cup coffee brewers and pods and by acquisitions.
After a dip in 2010, Green Mountain’s EBITDA margins expanded along with sales, peaking at nearly 18% in the fiscal year ending in September 2011.
One tactic companies use to understate expenses is to capitalize them. That is, they add current period operating costs to property, plant, and equipment — or some other asset with a life of more than a year — instead of treating them as cost of goods sold or selling, general, and administrative expenses. That spreads them out over a number of reporting periods as part of depreciation expense — or some form of amortization expense.
An increase in capitalized costs causes an increase in capital spending (“capex”). And Green Mountain’s improved profitability coincides with a big increase in capex.
Capex climbed from 6.1% of sales in 2009 to 10.7% in 2011. That may have been because the company needs to expand capacity to keep up with the growth in sales. But 10.7% seems high by Green Mountain’s past standards and in comparison with the company’ peers, whose average capex in 2011 was 4-6% of sales.
If we assume capex greater than 2009’s 6.1% of sales to be excessive, then Green Mountain may have capitalized expenses equal to 4.6% of sales in 2011. That’s $121.9 million in operating costs put on the balance sheet instead of run through the income statement (David Einhorn’s estimate of operating costs capitalized in 2011 was $103.1 million). Adjusted for these costs, reported EBITDA of $474 million falls to $352.1 million, the EBITDA margin falls from 17.9% to 13.3%, and debt to EBITDA increases from 1.2x to 1.7x.
So far there have been no serious credit consequences for Green Mountain. None of the rating agencies are considering a downgrade on Green Mountain’s $583 million in debt. The company hasn’t breached a covenant in any of it’s debt agreements.
But if these suspicions prove true and the company has to delay financial reports or restate its financial statements, that will almost certainly trigger covenant defaults. That, in turn, would lead to liquidity pressures and serious credit problems.
Of course, this is all just informed conjecture. But it’s grounds for caution, if not alarm. That’s because it’s reminiscent of another company with high growth, low costs, increasing capital outlays, and a chairman facing margin calls on his company shares — WorldCom.
June 23rd, 2012 by Tim Delaney
The shipping industry is in rough waters lately. In many categories, global capacity exceeds demand, and shipping rates and ship values have sunk to near-abyssal lows. Take the VLCC (”very large capacity carrier”) tanker business, for example.
Back in 2005 and 2006, shipping companies had every reason to be optimistic about potential demand. Asian economies were booming, and their need for oil was surging. So they ordered scores of large, new vessels.
Between 2007 and 2011, the world’s VLCC fleet grew by 10%, but demand for oil grew by only 3%. With capacity that far ahead of demand, shipping rates plunged to near-record depths. Reduced income from ships meant reduced values for ships, and vessel prices fell by 55% over the same period.
The industry got caught in a perfect storm of business cycle and industry cycle risk. The business cycle drove down demand for shipping when the United States and Europe went into recession in 2008 and 2009 and emerging economies slowed down. But even after the global economy recovered in 2010 and 2011, shipping remained trapped in a classic industry cycle.
Industry cycles occur when capacity exceeds normal, recovery-stage levels of demand. Prices plummet, and revenues fall with them. Industry cycles are different from business cycles. In business cycles revenues are demand-driven; in industry cycles they are price-driven.
There is more at work in industry cycles than the simple microeconomics of supply and demand. They have a complex set of drivers. They are most common in industries with these characteristics: commodity products or services; large economies of scale; high fixed costs; intense competition.
Commodity industries are especially likely to get caught in industry cycles. It is hard for competitors with commodity products to differentiate themselves and compete on distinctive product features, so they compete on price instead. When supply steams ahead of demand and customers begin to exploit their new bargaining power, the only course commodity producers have is to cut prices.
Many industries benefit from economies of scale in production, purchasing, distribution, and the like. Because competitors invest heavily for scale, they have a big burden of fixed costs. In periods of weak pricing, they make things even worse, cutting prices aggressively to keep sales volume above break-even levels.
A tendency for competitors to add capacity all at once makes things even worse. The companies with the newest capacity have the biggest economies of scale and the latest, most efficient technology. Afraid of being at a cost disadvantage, the other competitors add capacity too, and then total capacity sails ahead of demand and a price war ensues.
Shipping is not alone in this. There is a whole fleet of industries prone to industry cycles. Chemicals, pulp and paper, memory chips, airlines, commercial real estate, and many others share a tendency for capacity to overshoot demand and prices to fall as a result.
The risk lesson in all this is clear. Even in good times for the economy as a whole, when demand is at least recovering and at best strong, be careful. Be sure the company you are following isn’t headed for the shoals of an industry cycle.
March 30th, 2012 by Ron Carleton
We often tell our clients that a company does not file for bankruptcy on a particular day because it has too much leverage, or because it has a bad management team, or because it has a competitive disadvantage. All of these factors may eventually drive a company out of business, but the reason a company files for bankruptcy on a particular day is liquidity: they run out of cash. Therefore, it is important to measure a company’s liquidity as part of any comprehensive financial analysis (one of our favorite tools is the liquidity position).
For many companies, availability under a committed, revolving line of credit is a key source of liquidity. Here’s an example:
In 2010, Sears Canada entered into a five-year $800 million senior secured revolving credit facility. As of January 28, 2012, they had borrowed $101 million under that facility. How much additional can they borrow using that revolver?
a) $699 million
c) Something between $699 and zero
The answer is … you don’t have enough information to give an answer. According to Sears, they have $415 million available.
Here are the factors that determine how much you can borrow on a revolver:
- How much you have already borrowed. In the Sears example, it would reduce availability to $699 million
- Letter of Credit usage. Many revolvers can also be used for letters of credit. This allows companies to issue letters of credit without getting credit approval for each one individually. However, letters of credit issued under a revolver reduce borrowing availability under that revolver. In the Sears example, they had approximately $284 million of letters of credit outstanding under the revolver. When added to the $101 million of borrowings, it reduce availability under the revolver to $415 million.
- Covenants. If a company is in default under its credit agreement (for example, because it breached a covenant), it automatically blocks any additional borrowing under a revolver (because it can not satisfy the “conditions to borrowing,” one of which is an absence of default). In addition, if the borrowing itself would put the company into default (for example, by increasing leverage above the leverage covenant), the company may not borrow. In our example, Sears is not in default (but if they were, the answer would be zero). It is interesting to note that a default does not automatically require the company to repay the existing borrowings – lenders must affirmatively act to accelerate (or “call”) the loan.
- The Borrowing Base. According to Sears, “Availability under the Sears Canada Facility is determined pursuant to a borrowing base formula based on inventory and account and credit card receivables, subject to certain limitations.” So even if there were no borrowings and no letters of credit, and even if the company was in compliance with all covenants, they might not be able to borrow the full amount of the facility, because of the borrowing base.
Here’s how a borrowing base works:
- Review the company’s accounts receivable and inventory. Are there any items that are likely worthless (e.g. past due, disputed or related party receivables; obsolete or work-in-process inventory) or unable to be pledged (e.g. inventory or receivables in other countries)? These items are referred to as “ineligible” and are removed when calculating the borrowing base.
- Apply an “advance rate” or discount to the remaining “eligible” items. This discount reflects the likely decline in asset values in a stress scenario and the cost to the lender to foreclose and sell the collateral. Typical advance rates are 50% for inventory and 75% for accounts receivable.
- Once the ineligible items are excluded and the advance rate is applied to the remainder, you end up with the borrowing base amount. The revolver must, at all times, be at or lower than this number (even if it is less than the stated amount of the revolver). For Sears, the borrowing base was not a limitation (i.e. the borrowing base was larger than the commitment amount). Here’s an example of how a borrowing base might work (not Sears):
Asset based lenders (”ABL”) use a borrowing base all of the time. It is also very common among small and middle-market borrowers. It is typically not used for loans to large corporate borrowers (except if they are borrowing in the ABL market).
So how much can a company borrow under its revolver? It depends.
March 10th, 2012 by Tim Delaney
Kodak’s cash burn was a big concern among analysts in the last months before the firm’s bankruptcy in January of this year. Cash burn is a term that gets thrown around a lot when companies are in trouble, but it’s hard to find a definition for it in books on accounting or financial statement analysis.
Accountingglossary.net defines cash burn as “the rate that a company uses up cash” and calculates it as “Total Cash Change / Time Period.” We think that’s a useful approach to analyzing how a company consumes its cash, although we think we have a better way.
Our method starts with the company’s Internal Cash Flow. To calculate Internal Cash Flow, start with the company’s cash flow statement and use the values presented there. The formula is: Internal Cash Flow = Cash Flow from Operating Activities + Cash Flow from Investing Activities + All Uses of Cash in Financing Activities.
Cash flows with negative values in the cash flow statement have negative values in the formula. Uses of cash in financing activities include debt repayment, dividends, share repurchases, and any other outflow in that part of the cash flow statement.
Internal Cash Flow includes all operating and investing sources of cash and all operating, investing, and financing uses of cash. It’s cash flow before external financing, so it excludes cash from borrowings, debt issues, and equity issues.
If Internal Cash Flow is negative, the company is not generating enough cash in the period to meet all of its needs. That leaves it with only two ways to plug the cash gap: get financing or use cash reserves.
Kodak had an Internal Cash Flow deficit every year 2008 through 2011, as the chart shows. Declining revenues, growing losses, and disappearing credit from suppliers drove cash flows down year after year. The chart also shows how the company dealt with its chronic cash flow problems.
Kodak borrowed money to finance some of its Internal Cash Flow needs; for example, $412 million in 2011. But its biggest source of cash wasn’t financing; it was cash reserves. In 2011, Kodak used $777 million of its own cash to close its Internal Cash Flow gap. Over all four years, the company had a cumulative cash flow deficit of $3.8 billion, which it filled with $1.8 billion in debt and $2.0 billion from its cash reserves.
And that brings us to the meaning of cash burn. We think the best sense of the term is the amount of cash reserves the company uses to help fund an Internal Cash Flow deficit. It highlights the use of an important source of liquidity, it’s a good early warning sign of distress, and it was clearly a big negative for Kodak.
February 26th, 2012 by Tim Delaney
At a lunch meeting in July 2011 to go over his concerns about massive, unexplained fees linked to Olympus’ acquisition of Gyrus in 2008, Michael Woodford, the new President and CEO, got the first sign his job was in danger. Chairman Tsuyoshi Kikukawa and Group President Hisashi Mori were served an elegant assortment of sushi; Woodford got a tuna sandwich.
In October, Woodford was fired before he could press his inquiry any further. Since then, Olympus has been forced to take a $1.3 billion loss and see its credit rating fall two notches to BBB+. Kikukawa and Mori have lost their jobs and been arrested.
The tuna sandwich was Woodford’s own early warning, but how could an outside analyst have seen Olympus’ problems developing? We’ve blogged about the early warning signs of companies in distress before: Early Warning Signs at Borders Part 1 and Part 2. We think Olympus is a good example of our sixth sign, problems with management.
Olympus is a classic example of a recurring problem with management at troubled companies: desperate strategies. From 2008 on, as smart phones with built-in cameras grew in popularity, the company’s sales of digital cameras suffered and profits collapsed. And digital cameras were vitally important to Olympus, accounting for as much as 26% of sales but only 8% of operating profits in 2008.
What was management’s response? Unable to counter the threat from telephone cameras, Olympus made a string of senseless acquisitions, including companies in pet care, medical-waste disposal, microwave cookware, and mail order cosmetics. When it made an acquisition in a core business, Gyrus in medical equipment, it overpaid. Then Olympus sold its profitable diagnostics unit at a bargain price.
This kind of flailing acquisition and divestiture activity is a symptom of management and a board that are unable to cope with reality. Instead of taking a methodical approach to analyzing and solving the company’s problems, they panicked. The danger signs should have been clear to any analyst concerned about risk well before Michael Woodward’s dismissal set off alarms.
For more about Michael Woodford and Olympus, read The Story Behind the Olympus Scandal by Karl Taro Greenfield in Bloomberg Businessweek, February 20, 2012. For more on management’s role in troubled companies, read How the Mighty Fall by Jim Collins.
December 31st, 2011 by Tim Delaney
By the time they grew to $1.5 billion, Michael Roseman, MF Global’s Chief Risk Officer, was concerned about the firm’s positions in bonds of Italy, Spain, Portugal, Ireland and Belgium. He was worried the trade might endanger the entire firm if the financial problems in Europe got too tough. Roseman believed MF Global didn’t have enough liquidity to withstand a credit rating downgrade.
Roseman joined MF Global in 2008 to improve risk-management culture after a rogue trading incident cost the firm $140 million. As the Euro sovereign positions grew to $6 billion, they blew through trading limits that he had helped put in place before John Corzine, MF Global’s new CEO, became his boss.
It was Roseman’s job to get the directors to approve any increases in those trading limits. He made at least three separate requests to increase sovereign debt exposure. Each time, directors asked him about the risks of the trade. And each time, in spite of the fact it challenged the CEO’s pet strategy, he did what he was supposed to do: he outlined the risks as he saw them.
But Corzine insisted on maintaining the trade, even threatening to resign if the board did not back him. So Roseman was replaced, and a new risk officer, Michael Stockman, took over in March 2011. But he was not allowed to weigh in on the broader implications of the sovereign debt trades, including the risk of ratings downgrades, loss of investor confidence, and funding problems.
Which, of course, is exactly what happened. By October, MF Global had succumbed to a liquidity squeeze and filed for bankruptcy. This sad story prompts lots of questions, but for us the most interesting one is, “Could a better risk culture have protected the firm and its clients from Corzine’s bullying and blunders?”
Lack of an effective risk culture has been cited as a factor in the collapse of Bear Stearns and Lehman Brothers and troubles at many other firms. But what is risk culture? And what are the signs an outside analyst can use to tell whether a firm’s risk culture is strong or weak?
We have our own ideas, which we’ll share with you later. But first we’d like to hear from you. How do you define risk culture? How do you evaluate it? We look forward to getting your comments, and, in the meantime, happy New Year.
December 12th, 2011 by Tim Delaney
The New York Times DealBook blog just put out a fine piece on the collapse of MF Global: A Romance with Risk That Brought on a Panic by Azam Ahmed, Ben Protess, and Susanne Craig (December 11, 2012). It’s the most comprehensive summary of the events that led to the firm’s bankruptcy that we’ve seen so far. Until the investigations are done and the books are written, it’s a good source for thinking about the credit risk lessons to be learned in MF Global’s sad story.
MF Global seems to have made a lot of risk management mistakes. It took on a big dose of market risk with its $6.3 billion exposure to the European debt crisis – over the objections of its senior risk manager. With only $1.4 billion in capital, the company could barely afford to take any losses.
There may have been operational risk issues at the firm as well. About $1.2 billion of client money has gone missing, and after weeks of searching the company’s records it’s still not clear where most of it is. At best, this is a serious systems failure; at worst, it could be a lot more sinister.
But the fatal risk at MF global was a form of credit risk called counterparty risk. That’s the risk that a firm involved in a trade fails to pay what it owes. Counterparty risk is where market risk and credit risk intersect: as a company’s trading losses grow, its ability to pay decreases.
Moody’s downgraded MF global from Baa2 to Baa3 in October, citing exposure to European sovereign debt, a regulatory capital shortfall, and poor risk management. The market had been concerned about MF global for months, but the downgrade made it official. MF global was a poor counterparty.
That triggered collateral calls, with trading partners and clearing houses demanding that the firm either close out its positions or post more collateral – usually in the form of cash. The firm that cleared MF Global’s sovereign debt trades demanded $300 million in cash collateral alone. MF Global’s risk challenges suddenly became a fatal liquidity problem.
That should not have been surprising. The same thing happened to Lehman Brothers and even to Goldman Sachs. The combination of collateral demands and a runoff in repurchase financing drove Goldman’s liquidity pool from $120 billion to $57 billion in just four days after Lehman went under.
MF Global’s counterparty credit squeeze suggests the likely explanation for the missing client money: desperate to meet collateral calls, the company used client funds to try to plug the holes in its liquidity dike. That changes the nature of MF Global’s operational risk problem. It’s worse than a mistake; it’s a crime.
November 22nd, 2011 by Ron Carleton
We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.
November 6th, 2011 by Tim Delaney
There have been movies about finance before: Wall Street and Wall Street: Money Never Sleeps, for instance. There are films about the financial crisis as well: HBO’s Too Big to Fail. But the best movie about finance has to be Margin Call, just out in theaters and available on iTunes and at Amazon.
It’s a fictional account of a Wall Street firm’s effort to save itself from a massive trading loss in mortgage backed securities. The writing is crisp, compelling, and completely authentic. The characters aren’t Occupy Wall Street caricatures of evil bankers; they have real dimension. They’re callous and loyal, principled and greedy, ruthless and erudite all at once.
Best of all, Margin Call is the only movie we know that features risk and the people who manage it. And the risk managers are played by Stanley Tucci and Demi Moore! We loved it, but don’t take our word alone. According to Rotten Tomatoes, critics and audiences loved it too. So we recommend you go long on Margin Call and invest a few hours of your valuable time watching Kevin Spacey, Paul Bettany, and Jeremy Irons struggle with understanding and dealing with risk.
October 26th, 2011 by Tim Delaney
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information.
The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance.
Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength.
Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.”
Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s strategy, operating results, and finances, as well as the complexity, opportunities, and challenges management must deal with.
Effort. Being a director is hard work. Good directors spend a great deal of time and energy preparing for meetings, working on committees, and contributing to the decisions the board must make.
Board Strength at Olympus
How does the board at Olympus measure up to these standards?
Independence. Of fifteen directors on the board at Olympus, only three were outsiders. All the rest were executives of the company. It’s not clear that any of the outsiders were truly independent. In Japan, outside directors often come from subsidiaries or the company’s lead bank.
Expertise. Japanese disclosure about directors can be quite limited. But none of Olympus’ directors appear to have any top-level management experience or be seasoned deal makers.
Effort. Judging by Mr. Woodford’s account of the special board meeting at which he was fired, Olympus’ directors aren’t a very engaged or energetic bunch. Mr. Woodford was not allowed to speak, and there was no discussion. The board simply voted to approve every resolution Tsuyoshi Kikukawa, the Chairman, put before them.
It’s Not Over
The Olympus story is still unfolding. For more information on Mr. Woodford’s sudden departure, try this report in Reuters and this article in Fortune. Troubling new information about other deals with shadowy investment firms is emerging; see this article in the New York Times. And, as Japan Today reports, Mr. Kikukawa has resigned as chairman and president but remains on the board.
Whatever else develops, it’s clear that when it comes to Mr. Woodford’s dismissal, the rapid cycle of promote, praise, and pitch overboard doesn’t speak well for Olympus’ board. The company’s fumbling, contradictory explanations of the Gyrus acquisition only make management and the board look stupid or deceitful. So far, Olympus seems to be a poor example of how to govern a company. Who knows? As the story unfolds, it may prove to be an even worse one.
October 21st, 2011 by Tim Delaney
There are a number of worthwhile accounts of the firms that failed or nearly failed in the great financial market collapse of 2007-2009. Too Big to Fail by Andrew Ross Sorkin and All the Devils Are Here by Bethany Maclean and Joseph Nocera are two strong general accounts. House of Cards by William D. Cohan tells the Bear Stearns story very well, and Fatal Risk by Roddy Doyle does the same for AIG.
But the stories they tell are mainly about the personalities of the men who led those companies and the blunders they made in strategy and funding. None of them focus closely on risk management. So to correct that, we thought we’d start building a timeline of major risk management mistakes made in the run-up to the crisis.
It’s not comprehensive. It’s just a series of anecdotes drawn from books, press coverage, government reports, and other sources. Please help us build it up by contributing more stories. We’ll add them to the timeline as you do.
Sometime in 2005
Stan O’Neal, CEO at Merrill Lynch, puts Ahmass Fakahany, his Chief Administrative Officer, in charge of risk. Over the next two years, Fakahany dismantles Merrill’s risk organization, firing senior managers and moving the remaining risk managers off the trading floor. Merrill’s exposure to the mortgage market grows to $55 billion, and the company is forced to merge into Bank of America in 2008.
Citigroup demotes Richard Bowen, a senior risk manager for raising the alarm over the decline in underwriting standards in its mortgage business. His report reaches Vice-Chairman Robert Rubin, but Rubin fails to act on it. The next year, Citigroup takes over $20 billion in mortgage loan losses.
The Market Risk Committee at UBS warns of the high concentration of risk in the firm’s CDO warehouse program, which at its peak reached $50 billion. Management ignores the warning, and UBS takes $40 billion losses on its CDO portfolio in 2007 and 2008.
Joseph Cassano, head of AIG Financial Products, refuses to give Joseph St. Denis, an internal auditor, information on potential collateral calls on Financial Product’s $420 billion portfolio of credit default swaps on mortgage backed securities. St. Denis leaves the firm, but Cassano stays. Just over a year later, when collateral calls peak at $80 billion, AIG is rescued from bankruptcy by a government bailout.
Lehman Brothers removes Madelyn Antoncic, its well-regarded Chief Risk Officer, from the Executive Committee, clearing the way for the company’s disastrous Archstone-Smith acquisition in October. That drives Lehman’s commercial real estate exposures to $40 billion just as the market peaks. To avoid write-downs, Lehman tries to spin off its real estate portfolio. But that only highlights the company’s weakness, and Lehman fails in September 2008.
Oliver Wyman issues an internal report criticizing Bear Stearns’ risk management for being a low priority. CEO Alan Schwartz says the report doesn’t indicate any substantial deficiencies. Within two weeks Bear Stearns’ funding evaporates, and the firm is forced to merge into JP Morgan.