Fashion Risk

Fashion is risky business. Who knows what works? In the investment circles, buying stocks or bonds of a company that sells modish products is referred to as taking on "fashion risk". Rightfully so, because many of them fail, with the most recent example being Coldwater Creek. In this post, I will use Coldwater Creek as a case study for some of the possible pitfalls for an apparel retailer and discuss strategies for convalescence.

Coldwater Creek, a specialty clothing retailer, filed for bankruptcy on April 11. According to the recent liquidation plan, all term loan, priority and secured claims will be paid in full. Unsecured claims would recover an estimated 4.43%. TheDeal.com

The retailer was once beloved by middle-class, professional women for its effortlessly chic styles. It started as a catalog company back in the 80s and soon began opening retail stores in the 90's.

"The shopping centers, located in upper-middle-class neighborhoods, cater to the company's core audience: women who earn an average of $70,000 a year and who are drawn to such Coldwater Creek staples as $79 burnished silk jackets and $65 reversible suede belts... 

(Dennis) Pence is rushing to capitalize on an emerging demographic group that retail experts have dubbed the zoomers. They are baby boomers with a zest for living" Bloomberg BusinessWeek

Fast forward to April 2014 and the Company filed for bankruptcy after attempts by the debtors to refinance the debt, recapitalize the balance sheet and even sell the enterprise outright failed. What happened?

2008 happened, and everything went downhill from there. Net sales declined approximately 32% from its peak in 2006 to $742 million in 2013. The Company has cited everything from a slow-down in traffic to merchandising issues for the steep decline in same store sales. Following the reduced revenues, the buildup in inventory and its subsequent markdowns resulted in a deterioration of margins.

James A. Bell, EVP, COO and CFO of Coldwater, stated in the Declaration in Support of First Day Motion:

"From 2011 to 2013, the Debtors attempted a targeted turnaround process, which focused on the following:  a) incorporating cross-channel discipline into product and creative functions b) establishing the foundation of product assortment architecture c) acquiring retail-centric talent d) developing and implementing a real-estate optimization program e) positioning the brand strategy to ensure focus on target customer and f) re-engineering design and product development functions." Pacer

In order to gauge what the problems could have been, I did a little digging online for reviews from customers and employees. Here are some quotes that sum up many of the issues.

"Coldwater Creek USED to be a place women could go to find elegant, classic fashions. This year (2013) in particular, they have seemed to slide down that same slippery road as JC Penneys and KMart, which has resulted in imported, tacky, frumpy-looking clothing." Customer, May 2013

"I hear CWC is trying to grow back its customer base, but I just took a look at their website. Styles are dowdy and colors are drab. With my past experience with CWC poor quality and fit, there is nothing that tempts me to try again." Customer, October 2013

"Return policy is too liberal. End the 'anything, anytime, for any reason' deal." Employee, November 2011

"People bring stuff back from 5 years ago and get money or a gift card." Employee, December 2011

"While the employee discounts are good, the quality of the products have dramatically declined over the past 3-5 years." Employee, August 2012

"They are trying to change their entire customer base and it makes it difficult for the store emplyees to help the customers that made the company so popular to begin with. Not every customer wants short sleeve tops, slim leg jeans, and shapeless tees. Bring petites back to the stores we are losing customers everyday because we are only carrying pants in the store. Same with 3X sizes for customers." Employee, August 2012

A few observations:

1.  Returns Policy- I wouldn't recommend any turnaround strategies without a through quantitative analysis of costs and benefits. That said, anecdotal information could point to where corrective actions may be necessary. Depending on the negative contribution margin due to returns, the policy may be significantly hurting profitability OR it may just be a perk that doesn't make a significant difference in the bottom line. It would be helpful to do a margin impact (since nonperforming inventory is liquidated to offset some of the cost) curve based on the difference between time of sale and time of return to see if the returns are a significant hit to profitability. 

2.  Fast Fashion- In the mid 2000's with increased globalization and textile outsourcing, the fashion game changed. Zara is often noted as the pioneer of "fast fashion", an idea that fashion should be as responsive as it is innovative. Unlike traditional fashion labels that produced two main collections a year, fast fashion concepts such as Zara, H&M and Topshop design, manufacture and deliver many collections over the year to drive traffic. The two main determinants of fast fashion are short production and lead times and highly fashionable product design. Here's more from a Wharton paper:

"Short lead times are enabled through a combination of localized production, sophisticated information systems that facilitate frequent inventory monitoring and replenishment and expedited distribution methods. 

The second component (trendy product design, Enhanced Design) is made possible by carefully monitoring consumer and industry tastes for unexpected fads and reducing design leadtimes. Benetton, for example, employs a network of "trend spotters" and designers throughout Europe and Asia, and also pays close attention to seasonal fashion shows in Europe." Cachon and Swinney, "The Value of Fast Fashion".

The benefits of quick response strategies influence consumer behavior by reducing the frequency and severity of season-ending clearances. Enhanced design capabilities result in products that are of greater value to the customer in the present time and exploit this greater willingness-to-pay by charging higher prices on trendier pieces than on basics.

In contrast to the fast fashion front-runners, Coldwater Creek explains its merchandising process in the 'Risks' section of its 10-K:

"On average, we begin the design process for apparel nine to ten months before merchandise is available to consumers, and we typically begin to make purchase commitments four to eight months in advance. These lead times make it difficult for us to respond quickly to changes in demand for our products...

Our inventory levels and merchandise assortments fluctuate seasonally, and at certain times of the year, such as during the holiday season, we maintain higher inventory levels and are particularly susceptible to risks related to demand for our merchandise. If the demand for our merchandise were to be lower than expected, causing us to hold excess inventory, we could be forced to further discount merchandise, which reduces our gross margins and negatively impacts results of operations and operating cash flows." 

Coldwater Creek 10-K. 

Essentially, the Company is making bets about what will work in fashion 4-8 months in advance. For equity holders, that is like investing in a company that buys forward contracts based on fashion trends!

I am not suggesting that an apparel designer and retailer aimed at women in their 30's to 50's ought to carry pieces trendy enough for teenagers, but it does help to be more nimble when it comes to responding to consumer demand. And in order to be more reactive to consumer demand, faster lead-times are essential.

Of course, there is a trade-off: faster lead-times and enhanced design require giving up a lot of design control and following trends in an efficient way. For example, Zara's designers work to imitate fashion, rather than innovate fashion. Only the fabrics are ordered before the season starts due to long lead times, but even those are ordered uncolored so there is flexibility on changing them right before the order. Suppliers have more autonomy in design, so they become more of strategic partners rather than just an operational necessity. Zhelyazkov, "Agile Supply Chain". 

3. Technology- As a retail grows into servicing customers through multiple channels, it's IT system becomes incredibly important. Macy's merchandising initiatives called My Macy's and Omni-Channel were initiated in 2009 as a way to delight customers at a local level and provide a a seamless shopping experience regardless of the channel. Of course, this required significant IT capacity. 

"A single platform or visual merchandising software enables retailers to also extend the reach and relationship with their product suppliers, giving them insight into the merchandising process and ensuring they are able to act more quickly and sharpen their merchandising execution."  Retail Customer Experience

"Most retailers cannot match Macy's spectrum of Omni-Channel initiatives because they have not created the multi-year master plan needed to achieve it. Many retailers have not allotted the investment required to create accurate, real-time views of inventory, order management, supply chain." Seeking Alpha

Migrating everything over to a single ERP platform from various databases can be very costly and operationally awful; just ask Levi Strauss about its SAP disaster! In addition to an ROI analysis, it would be useful to examine scenarios where such a migration could go wrong and assess the possible impact of the worst case scenario before deciding on a solution. 

Lastly, an important public service announcement: Many firms lose touch with employees on the field and their customers as they grow. It should go without saying that employees in the front lines should be empowered to voice their concerns, those opinions should be an important part decision making process, and the reasoning behind those decisions should be freely shared with the employees. "Store employees can in turn provide faster feedback when a campaign has been executed so corporate has a clear understanding of compliance, the impact an accurately executed campaign has on sales and the customer feedback from that geographic market," Retail Customer Experience. Open communication within a company goes a long way and could make the difference between success and failure.

Valuing Multiemployer Pension Liability For Investments

In my previous post, I shared some background information about multiemployer pension plans and discussed the possible impact of these plans, specifically as it relates to bankruptcy. In this post, I want to talk more about disclosures of multiemployer pension liabilities, and how these disclosures can be used for valuation purposes.

FASB Required Disclosures:

Under the previous disclosure rules set by the Financial Accounting Standards Board (FASB), employers who contributed to multiemployer plans were only required to disclose their own historical contributions. FASB's Accounting Standards Update No. 2011-09 presented a new set of disclosure requirements for public companies participating in the plans, effective December 2011.

The new rules require:

• Identifying plan information. 
• The employer’s level of participation in the plan:
• Contributions made for each period of Income Statement 
• Whether the contributions represent more than 5% of total contributions to the plan 
• The financial health of the plan:
• The most recently available funded status:
•  < 65% funded (red zone)
•  65-80% funded (yellow zone)
•  > 80% funded (green zone)
• As of the end of the most recent year presented:
• Whether a funding improvement plan or rehabilitation plan has been implemented or was pending; and
• Whether a surcharge has been paid to the plan by the employer.
• Information about when the collective bargaining agreements and when are set to expire.

The ASU notes that factors other than the amount of the employer’s contribution to a plan (e.g., the severity of the underfunded status of the plan) may need to be considered when determining whether a plan is significant. (Moody, Famiglietti & Andronico).

YRCW:

So now that we know what must be disclosed, let's look at a real-life disclosure. I've chosen YRCW which, as a less-than-truckload service provider, is comprised of 78% union workers and contributes to 32 separate multiemployer plans. The company contributed a total of $88.7 million to multiemployer pension plans in 2013, or approximately 34% of adjusted EBITDA. (YRCW 10-K)

The company contributed $52 million in both 2012 and 2013 to the Central States, Southwest and Southwest Areas Pension Fund (CSSSA), which represents the Company's largest contribution to one multiemployer plan. The disclosure looks like this (I've reorganized the exhibit to make it more visible; take a look at page 66 of the 10-K for more details).

Notice the CSSSA is in the red zone, so as an investor, I'd want to find out what that plan looks like. Since we have an EIN Number, we can look up the most recent funding data on the Department of Labor's website. Since CSSSA is a prodigious plan, we can get funding information directly from the CSSSA's site.

The 2013 Annual Report for this plan provides exactly the kind of information that we need to do one more layer of analysis on the risk pertaining to this specific plan. Here, we find out that the plan's assets were valued at $18.7 billion on a mark-to-market basis and the plan was approximately 52% funded as of 2013. The plan's total contributions by employers for 2012 were $764,042,58, of which YRCW made up 6.8% (at $52.1 million).

Estimating Future Payments

An obvious way to incorporate liabilities for multiemployer pension plans in an investment analysis is to estimate future contributions and include them as operating expenses and as part of cash flow. The less obvious part of this is figuring out what the expense ought to be.

At times, the company will provide guidance for future cash outflow expected for multiemployer  pension plans. If not, the financial statements of the funds will provide projected contributions in the coming years. You can use the percent of contributions from the previous year and total contributions projected for the upcoming year to estimate the expense.

CSSSA expects total contributions in 2014 to be approximately $632 million. Using YRCW's 2012 contribution percent of 6.8%, we can estimate YRCW's 2014 payments to be around $43 million. As an investor, you can dig a little deeper to find out if future contribution number is closer to $43 million or 2012's number of $52 million. That is, you can do a little more work to find out how many beneficiaries YRCW supports via CSSSA and what the average payment per those beneficiaries is likely to be in the next year.

Employer Risk:

Major types of risk to a particular multiemployer plan from contributing employers are:

1. Financial stability risk from contributors
2. Upcoming collective bargaining agreements 
3. Any increases in contributions required from employers 

     1. The form 5500 is required to list major employer participants and their contribution levels. From a risk perspective, it is important to look at financials of these major participants to assess the companies' ability to continue making fund contributions. In the case of CSSSA, the other big contributor (besides YRCW) is ABF Freight, which has a total of 114 pension accounts with the fund.

     2. Moreover, the form lists the expiration dates of collective bargaining agreements and the number of accounts that the agreements will impact. For example, YRC has 240 accounts for which a collective bargaining agreement expires on 3/31/2015. The negotiations leading up to the expiration date could result in volatility in the securities' prices and lead to operational risks.

     3. The notes to the financial statements of the fund will also have information about any aberration of contributions or withdrawal from the fund. In this case, the notes indicate that YRCW entered into a Contribution Deferral Agreement ("CDA") in June 2009:

"YRC’s outstanding balances under the CDA at December 31, 2012 and 2011 were $84.4 million and $90.2 million, respectively...YRCW is assumed to remain on the Distressed Employer Schedule and make Primary Schedule contribution rate increases beginning in 2015." Form 5500, 2012.

From an investment perspective, it would be important to find out what the increase in rate will mean in terms of increased cash outflow for the company. For YRCW, the Contractual Obligations Section of the 10-K tells us that that pension deferral obligations due in 0 to 4 years equals $136 million. This includes all possible pension deferral obligations, not just those due to CSSA.

The question from a modeling perspective would be: in what quarters will these cash outflows occur? Then, I would do a liquidity analysis to make sure that there would be enough cash/revolver available to fund these outflows without a detriment to interest payments.

Plan Holdings: 

An important variable to expected returns from a particular plan is the asset allocation of funds. The form 5500 gives a detailed breakdown of the assets in the fund, including cost and current value of bonds and stocks. The data is likely old by the time we get the form 5500 (The one for 2013 isn't out yet), but the funding notice is more current and has a broad asset allocation table. An incredibly persnickety investor could do his own valuation of the fund based on the asset allocation information. In general, I will just use the market values for the assets and increase the possible future liabilities if the assets in the fund look particularly risky.

A&M Valuation: 

Alvarez and Marsal had an article recently on risks associated with investing in companies with multiemployer plans. There's some useful insight in the paper concerning impact of these pension plans in M&A transactions. In terms of valuation, the article states:

"In lieu of detailed projections, we recommend that a buyer contemplating the purchase of a business that participates in a “red zone” plan consider a minimum 10 percent increase in per annum contributions as a conservative starting point; in some cases, the annual increase could be as high as 20 percent." A&M

Liens on Assets: 

This part is probably the most important for bond-holders, especially those worried about a bankruptcy. In some cases, a withdrawal or deferral liability to a multiemployer pension fund may be secured by a lien on certain assets, which would then reduce any asset value available for unsecured bondholders and equity holders.

For example, CSSSA requires that any Distressed Employer:

"Provides the Fund with first lien collateral in any and all unencumbered assets to the fullest extent it is able in order to fully secure (i) any delinquent or deferred Contribution obligations owed to the Fund, (ii) the Employer’s obligation to make current and future pension contributions to the Fund, and (iii) any future withdrawal liability potentially incurred by the Employer (with the amount of such potential withdrawal liability to be determined based on estimates to be provided by the Fund)."

So I would make sure to find out which assets are encumbered by pension liabilities and adjust my valuation accordingly.

One Last Thing: I've ignored the validity of basic assumptions of pension accounting in this case, such as the discount rates and expected rate of returns used by specific plans. You can read more about those rules and assumptions on the American Academy of Actuaries website.

Multiemployer Pension Plans, Bankruptcy and Twinkies

I've been meaning to do some research on multiemployer pension plans and how they are treated in bankruptcies, mainly because as an investor, it is difficult to value a company that participates in one of these plans. In this post, I will give a background of multiemployer pension plans, their challenges, and proposed reforms. In the next post, I will discuss liability disclosures and valuation of companies from an investment standpoint. Hostess is a good case study for this topic because we see the impact of a bankruptcy on other employers that contribute to the multiemployer pensions. 

When Hostess filed for bankruptcy in 2012, the world was aghast at the possibility losing the "golden sponge cake with creamy filling" called the Twinkie. The filing came just a few years after completing a an earlier restructuring and purchase by Ripplewood Holdings. The pastry maker cited pension and medical benefits obligations for its financial downfall. At the time, Hostess employed 18,500 employees, 83% of which were were union members. Bloomberg

Then, Apollo and Metropoulos used their resurrection stone to bring back the famed confectioner from the dead. The private equity firms won against a crowded bidding pool to acquire certain assets of Hostess in a 363 asset sale for $410 million in cash (Apollo Press Release). But even as the carb-laden sweets came back, many of the jobs did not. 

"Hostess had two main unions when it went under: About 6,600 employees were members of a bakers' union and worked at 33 bakeries nationwide, and 7,500 were drivers who belonged to the Teamsters union.

Some of the reduction in jobs is due to the new owners' different business model. Instead of using truck drivers as salesmen to deliver the product and stock the shelves of about 50,000 stores, the new company will hire outside trucking firms to deliver trailers full of the product to retail distribution centers.

Some jobs won't be coming back due to the permanent shutting of nearly 600 outlet stores the old Hostess Brands operated to sell products directly to consumers."  CNN Money. 

The Chapter 11 filing of Hostess had another unfortunate impact: multiemployer pension funds in which Hostess was involved. Here's a little more background on multiemployer pension plans: 

"Multiemployer plans are collectively-bargained pension plans that are maintained by two or more employers. In a multiemployer plan, there is joint and several financial liability between all employers in the plan." (US Chamber of Commerce). 

"When Hostess Brands Inc. went bankrupt in 2012, it triggered anxiety among employees at Ottenberg’s Bakery, a family-owned enterprise in Maryland. The companies shared a pension plan, and if Hostess couldn't pay its retirees, Ottenberg’s would have to pick up the tab." Bloomberg. 

Afraid of a domino affect (and probably the wrath of the Teamsters), the Pension Benefit Guaranty Corporation (PBGC) paid for the retirement benefits of 350 former Hostess Brands employees who were members of the Bakery and Sales Drivers Local 33 Industry Pension Fund. The remaining people covered under the Bakery and Sales Fund will be merged with another plan to protect benefits of workers in multiemployer funds. 

While this can be reminiscent of Chrysler, the important distinction is that this specific funding for the retirees isn't coming from Hostess lenders; it's coming from the PBGC which charges premiums for these kinds of guarantees. 

But it's not as if bankruptcy didn't play a role in the fate of the multiemployer plan. When a company decides to either completely or partially withdraw from a multiemployer plan, it faces withdrawal liabilities that are considered debt. (Fox Rothschild).  

"The Bankruptcy Code is wreaking havoc on multiemployer pension plans by providing an escape hatch from employer withdrawal liability, as recently highlighted by In re Hostess Brands, Inc. By taking advantage of bankruptcy courts, employers are able to discharge their Early Withdrawal Liabilities (EWL) as a debt and as a result avoid paying millions or even billions of dollars in EWL to pension plans." Villanova Law Review.

And importantly, from a debt-holder's perspective, the withdrawal liabilities are considered pari to unsecured debt. According to Marketwatch, Hostess' unsecured debt will recover between 12-42%, surely impacted by multiemployer plan claims, while bank loans will recover 27-80%. 

And then, there's the PBGC, which is also in perilous shape. Here's what The New York Times Dealbook  has to say: 

"The P.B.G.C. is supposed to be self-supporting, financing its operations with premiums paid by companies rather than tax dollars. Its single-employer program has the power to take over company pension funds before they run out of money so the assets can be used to help defray the costs. But the multiemployer program must wait until a failing plan’s investments are exhausted, so it gets nothing but bills. It now has premiums of about $110 million a year to work with. All it would take is the failure of one big plan to wipe out the whole program."

Institutional Investor also has a report on management of multiemployer funds and the Teamsters' role in pension plans. 

There's a lot of interest in overhauling the way multiemployer plans and their withdrawal liabilities work. Recently, the National Coordinating Committee for Multiemployer Plans issued a report called "Solutions not Bailouts". The reform outlined in this plan address offers remedies such as limiting withdrawal liabilities and providing the trustees with the flexibility of reducing benefits for deeply troubled plans. 

Given the all-time highs of the stock market, the underlying assets in the multiemployer funds are probably helping many of the funds to stay afloat. Hopefully, we'll have a change in the current multiemployer benefit system before stocks turn south, taking valuation of many of the funds in the same direction. 

In the meantime, it is important to think critically about investments in industries such as construction, entertainment, manufacturing, mining and transportation, which utilize the multiemployer pension plans, since their pension liabilities could be greater than expected. In my next post, I will take a closer look at assessing pension liability disclosures to help make investment decisions. 

EFH and Oncor: An Electric Ring-Fence

TXU's 2007 LBO by KKR, TPG and Goldman and its subsequent bankruptcy filing on April 29th serve as an informative case study of the evolving nature private equity investments, commodity bets, various facets of the public utilities industry, and a complex, debt laden capital structure. S&P has a great recap of the events leading up to Energy Future Holding's filing; go here to read it. Also, check out this free webinar by Chapter 11 Cases to be held on 5/8 at 1pm ET. 

What piqued my interest in this filing was the ring-fencing of Oncor, which obviated the subsidiary's need to file for Chapter 11 protection. Ring-fencing of a subsidiary is typically done by declaring a unit as a bankruptcy-remote entity (also known as Special Purpose Entity or Special Purpose Vehicle). Here's more: 

"'Bankruptcy-remote entities' have been utilized for years in commercial transactions as a means to protect a defined group of assets from being administered as property of a bankruptcy estate in the event of a bankruptcy filing by an affiliated entity." Crowell Moring

Oncor, which is regulated transmission and distribution entity that is 80% owned by EFH, was ring-fenced at the entreaty of Texas Public Utility Commission (PUC). 

"At the time of the merger of TXU Corp, EFH and Oncor made significant commitments to the Texas Public Utility Commission regarding the separateness of Oncor from EFH.  These commitments, commonly referred to as Oncor's "ringfence" are included in Oncor's governing documents as well as an order of the Public Utility Commission of Texas which carries the weight of law." Oncor Website

It seems that the strategy worked: Oncor's collateral should not be used to pay EFH's debt. But that doesn't mean that the ownership of Oncor would be unaltered. 

Post bankruptcy, some unsecured creditors including Avenue Capital, P. Schoenfeld Asset Management and GSO Capital could end up owning Energy Future Intermediate Holding Co (EFIH) and become the newly adopted parents of Oncor. A change of control like this would likely trigger a need for regulatory approval from Texas PUC to ensure that the modification would be in public interest. Moody's notes that this change of control may also come with a push for a rate concession during a public interest hearing. (Reuters)

A tax-free spin-off of EFIH, however, would not necessarily be a credit positive for Oncor. 

"EFIH is expected to have about $5.4 billion of debtor in possession first-lien senior secured debt, and is likely to carry an additional $1.9 billion of second lien DIP debt backed by its unsecured creditors. In effect, this debt means there will be little deleveraging at EFIH during the restructuring process, and Oncor, as the only unit generating any revenue or cash flows, will ultimately be looked on to provide upstream dividends and tax payments to service the debt load. That said, the EFIH second lien DIP debt is structured as a mandatory convertible, so upon emergence, the unsecured debt will convert to equity, a credit positive." Electric Light and Power

While the spin-off sounds like an overall positive event for Oncor, one has to keep in mind the possible rate renegotiating that could take place as a result of the PUC hearing. Moreover, about 26% of Oncor revenues come from Texas Competitive Electric Holdings (TCEH), an indirect subsidiary of EFH and included in the Chapter 11 filing. (Oncor 10Q) So there is some revenue risk for Oncor to the extent that TCEH has trouble during the restructuring process. That said, post EFIH bankruptcy emergence and mandatory convert of the DIP to equity, Oncor's earnings and leverage profile look strong.

What does this mean for the Oncor bonds? They're okay for a high grade investment since they really lack the juicy yields we're used to, but they could be a good alternative to cash.  The '32s and '33s are yielding over 125 bps in spread, but the dollar price is in the $130 range. I would rather be in the 5.25% '40s with spread of a little over 100.

One last thing: Don't try ring-fencing at home! (Okay, maybe you can, but get a lawyer first). Bankruptcy remote entities aren't necessarily bankruptcy proof. In 2000, Doctor's Hospital of Hyde Park, which had set up a "bankruptcy remote" vehicle called MMA to purchase the hospital's receivables, filed for Chapter 11. The Seventh Circuit disagreed with the nature of MMA's separateness, which called into question the Hospital's transfer of receivables to MMA. 

"The bankruptcy judge made clear that a court should go beyond evaluation of the documented list of “separateness factors,” and examine whether the behaviors of the related entities are consistent with their purported “separateness.” The court further noted that when analyzing whether an asset transfer is a “true sale,” courts should carefully examine the true sale case law elements to see if they have been actually satisfied by the transaction." The Insolvency Blog

Betting on Casinos, Part II

Let's Take this Online

My last post discussed how the debt at Caesars operating company relates to the entity that carries the online gaming  business. In this post, I want to talk a little more about the online gaming business and how it specifically relates to Caesars. 

The Turnaround Management Association's January 2013 issue of Journal of Corporate Renewal was dedicated to managing casinos through a restructuring. It's worth a read in its entirety for those investors or professionals interested in the gaming industry. One of the interesting things discussed in that issue is the role of the legal system in online gambling. The article explains that both the Illegal Gambling Business Act and Unlawful Internet Gambling Enforcement Act are "inapplicable if a bet is not unlawful under federal law and the law of the state from which the wager was made and received." TMA

Apparently, the politics surrounding online gaming laws are pretty obfuscatory. Internet gaming is legal in Delaware and New Jersey, and Nevada only offers poker to its online customers. 

"At least 10 states are considering legalizing Internet gaming this year. Some are further along than others. Positive sentiment has been expressed in Massachusetts and Illinois statehouses, a poker-only bill was introduced in New York and California’s poker-only legislation is slowly moving forward." Las Vegas Review-Journal

"Las Vegas Sands Corp. Chairman Sheldon Adelson — who has vowed to dip deep into his heavy wallet and spend whatever it takes kill online wagering — funded the Coalition to Stop Internet Gambling. 

Not to be outdone, MGM Resorts International, Caesars Entertainment Corp. and the American Gaming Association are paying the bills for the pro-Internet gaming Coalition for Consumer and Online Protection. 

Apparently, some lobbyists sold themselves to the highest bidder.

As reported this month by political pundit Jon Ralston, Bono initially offered to work for Adelson’s side before joining the pro-online gaming forces. Meanwhile, Dickstein Shapiro, a large law firm with a lobbying component, initially pitched its services to Caesars before signing on with Adelson." Las Vegas Review-Journal

This sounds so Godfather-ish.

Okay so near-term prospects of legalizing online gaming don't look promising. 

Let's get back to Caesars. The gaming company was acquired by Apollo and TPG in January 2008. The funding for the acquisition resulted in $21 billion of debt at Caesars Entertainment Operating Company (CEOC). Then, in October 2013, the parent company of CEOC, Caesars Entertainment Corp (CZR), formed a joint venture Caesars Acquisition Company (CACQ) to form Caesars Growth Partners (CGP). Then, CZR contributed all of the shares of Caesars Interactive Entertainment (CIE) along with other assets to CGP in exchange for $360 million of proceeds. CIE has all the internet gaming assets. Here's another version of the company's capital structure. (Caesars Exchange Offer)

In the last post, I discussed the capital structure issues with investing in CZR, namely that parent still guarantees much of the debt, giving the guaranteed debt priority over the CZR stock in case of an operating company bankruptcy. CEOC was levered around 15x at the end of 2013 (Caesars supplemental financials). But what if you wanted to invest in CACQ stock as a way to have online gaming exposure?

According to the CGP Offering Memorandum dated April 10, 2014, CACQ has 42% of economic interest in CGP, which owns CIE. CZR has 52% of economic interest in CGP. CGP owns casinos Horseshoe Baltimore, Plante Hollywood, The Quad and Harrah's New Orleans. 

CACQ expects CGP annual adjusted run-rate EBITDA to be $287-320 million; 2013 adjusted EBITDA pro-forma for the transaction was $238 million. 

Debt at CGP the end of 2013 pro-forma for the transactions was around $2 billion, mainly comprised of $1.16 billion of terms loans, which are guaranteed by CACQ and most subsidiaries, and $675 million of unsecured debt. (Offering Memorandum). 

With a 42% share in debt and EBITDA of CGP, CACQ would be levered at about 6.7x, which doesn't sound so bad. But market cap of the stock is already $1.71 billion, making enterprise value roughly $2.5 billion (add 42% of debt, subtract 42% of cash to market cap), and EV/EBITDA multiple becomes closer to 20x. WYNN and LVS are around 15x and MGM is around 12x. So using the company's projected earnings and assuming steady debt, the stock looks pretty rich.

Betting on Casinos, Part I

One of my friends sent me a Barron's article on Caesars' stock from last week and suggested that it would be a good topic to discuss. It is indeed a good topic because it involves a farrago of issues such as equity valuation, a complex capital structure and an alleged distress situation.

"Caesars (ticker: CZR), which has been gearing up for legalization, has one of the leading brands in its World Series of Poker. Yet the shares look overpriced because the debt-laden company has little going for it besides a future in online poker. Its current market value of about $2 billion assumes legalization of online poker at state and federal levels and significant profits from what is likely to be a very competitive business." Barron's

The company only issued 1% of its outstanding stock in it's IPO, and Barron's claims that volatility in stock price and the alacrity with which shares were scooped up is due to a scarcity of supply. 

Importantly, the company is encumbered by so much debt that any equity value would be elusory. 

"There appears to be little or no equity value in Caesars' core business given the ugly financials. Yet the IPO prospectus shows Caesars carved out its online business, including the World Series of Poker, into a separate unit unencumbered by debt. This means Caesars equity holders should get all the online profits; hence the investor focus." Barron's

There are two issues that I have with betting on the online gaming business for Caesars: 

1) Just because the online gaming business is in a separate unit that is unencumbered by debt does not mean that its proceeds cannot be used to pay for the debt that has a parent guarantee. 

2) I'm not sure if online gaming is as lucrative as the gaming industry would have us believe. 

I'm going to discuss the first issue in this post and the second issue in the next post. For starters, here's the organization structure according to Caesars' website in a presentation dated December 4, 2013:

Notice that the public shareholders hold shares in the Parent company, Caesars Entertainment Corp. The online gaming portion is held in a separate entity called Caesars Interactive Entertainment, as the Barron's article stated. 

"Caesars Interactive Entertainment, Inc. ("CIE"), which is a majority owned subsidiary of CGP LLC, operates an online gaming business providing for certain real money games in Nevada, New Jersey, and the United Kingdom; "play for fun" offerings in other jurisdictions; and social games on Facebook and other social media websites and mobile application platforms, such as Slotomania. CIE also owns the World Series of Poker ("WSOP") tournaments and brand, and licenses trademarks for a variety of products and businesses related to this brand." CZR 2013 10K 

So let's break down the debt level at various subsidiaries. According to the Prospectus Supplement for CZR Stock, CEOC has $15.8 billion of debt, CERP has $4.6 billion of debt and CGP has $721k of debt. Total debt on CZR's balance sheet, therefore, is a little over $19 billion. CGP has an additional $1.1 billion of debt that is associated with a recent acquisition of four properties from the Parent. 

Even though CIE does not have any debt outstanding, that does not mean that all of its earnings go to public shareholders. The reason is that the shares are issued at the Parent level or Caesars Entertainment Corporation (CZR). Moreover, of the $19 billion of debt listed on the balance sheet, at least $15 billion of that is stated in the prospectus as Guaranteed by the Parent or Guaranteed by the Parent and certain other subsidiaries. What that implies is, in the case of a bankruptcy, at least $15 billion of debt is still considered an unsecured obligation by the parent and is still ahead of the equity claims. 

Now that we know that there really is a substantial amount of debt ahead of the equity, the shares can be valued on the likelihood of the Parent being unable to meet its debtors' obligations. 

There is some real concern of Caesars being able to meet its debt obligations. Caesars' latest sale of four casinos to CGP has raised some eyebrows. 

"Caesars Entertainment Corp. (CZR)’s $2.2 billion property sale to an affiliate raises the chances the world’s most-indebted casino operator will force a restructuring of its bonds at a loss to investors.

By selling four casinos to Caesars Growth Partners LLC, the unprofitable company will receive proceeds that Chief Executive Officer Gary Loveman said will help pay down loans. That may help the company persuade those lenders to amend its credit agreements, allowing it to restructure high-cost bonds on more attractive terms, according to CreditSights Inc.

This week’s transaction means the operating unit “will have far fewer assets in Las Vegas where the market is improving -- it will be left with Atlantic City assets where the market continues to basically tank,” Kim Noland, an analyst at Gimme Credit LLC, said in an e-mail. Anticipated future steps will include a distressed-debt exchange and possibly the removal of the parent guarantee." Bloomberg

And the bondholders aren't sitting idly by. Second-lien bondholders of Caesars Entertainment Operating Co., such as Canyon Capital Advisors, Oaktree Capital Management and Appaloosa Management (which, full disclosure, is my former employer), have sent a letter to Caesars Entertainment Corp that alleges that its operating unit is insolvent and that some of its intercompany transactions constitute fraudulent transfers. 

"Still, if the second-lien bondholder group formally litigated and succeeded in court, the lenders could simply get their money back, which wouldn't be a very rewarding result.

In a worst-case scenario, however, CEOC could file for bankruptcy, in which case the new lenders' claims could be subject to a stay and could be invalidated." The Deal Pipeline

If the bondholders are right and CEOC is insolvent, files for bankruptcy or restructures, CZR could be on the hook for making its guaranteed debt as close to whole as possible. Thus, the equity value could be diminutive considering the $15 billion of debt that is guaranteed by the parent is issued by CEOC.

The other obstacle for the stock could be CGP which wholly owns CIE, the unit with the online gaming business. CGP also has a substantial amount of debt associated with it, $770 million of which is on the balance sheet and $1.1 is billion associated with acquisition of the above properties. That debt is an unsecured obligation of CGP, so if CGP has to restructure, any equity that would have been generated from CIE would also be diminished. 

Thus, I think pricing CZR stock is less of an exercise in valuing the online business and much more of an exercise in valuing CZR's subsidaries that have issued bonds with Parent guarantees. 

Bankrupt Companies and their Employees: Conscious Uncoupling

I know, the phrase "conscious uncoupling" is extremely trite by now, but even The Economist joined in on the joke, so I thought, "why not"? Plus, it's actually relevant to this post, I promise.

Brookstone, a specialty retailer of luxury gadgets like massage chairs, has filed for bankruptcy with a deal to sell its assets to Spenser Spirit. The retailer has been cutting costs for a while, however, and it appears that many of the personnel cuts have happened prior to the announcement.

"Jim Speltz, Brookstone president and CEO, said the deal would have no impact on customers, that "business will continue uninterrupted," and that all existing customer programs, including warranties, gift cards, returns and exchanges, would be honored.

The company also plans to maintain employee benefit and payroll as they currently exist, he said. Brookstone's largest creditors support the deal to salvage the retailer that has seen declining sales in recent years." NH Union Leader

Not only are the current employees being retained, but Brookstone is handing out large bonuses to some of its management team. 

"Under the proposal, four executives would earn bonuses tied to the sale price as well as the company’s cash flow. For example, if Brookstone closes the $147 million deal currently on the table, then the executives would share roughly $840,000 in bonuses, although this doesn't take the cash-flow targets into account.

Another 33 non-executive employees would share up to $1.28 million in bonuses as long as they stick with Brookstone throughout the sale process. These employees come from the company’s finance, e-commerce, human resources and other departments." WSJ Bankruptcy Beat

It looks like Brookstone is doing a decent job of transitioning its employees, which is not always the case for companies in distressed situations. Not having an acceptable transition period for the employees could impact shareholders or even sponsor private equity firms!

The WARN Act, which was codified in 1998, gives guidance for lay-offs for both healthy and stressed companies. 

"The WARN Act "provides that a business enterprise that employs 100 or more employees must provide at least 60 days advance written notice of any “plant closing” or “mass lay-off” to each employee who will be terminated.  A “plant closing” is a shutdown (permanent or temporary) that results in the loss of employment of 50 or more full-time employees at a single site of employment.  A “mass layoff” is the loss of employment of 500 or more people or the loss of employment of at least 50 employees constituting more than 33 percent of the full-time employees at a single employment site." JD Supra

Although employers must still provide notice as soon as practicable, there are three stated defenses to the 60 day notice requirement under the WARN Act:

1. "when an employer reasonably believes that advance notice would impede its active pursuit of capital or business;
2. unforeseeable business circumstances; and
3. natural disasters.

Somewhat naturally, companies seeking bankruptcy protection are often forced to abruptly terminate employees before providing the required notice.   In addition to developing the “liquidating fiduciary” principal discussed above, bankruptcy courts have examined, and often disagreed, about certain applications of the WARN Act once the “employer” is bankrupt."  JD Supra

When a company lays off workers in turbulent times, the second defense of the WARN Act may apply, in which case, the company may not have liability under the Act. However, it gets interesting if that company is owned by a private equity sponsor.

In 2000, Outboard Marine Corporation, a designer and manufacturer of outboard motors, filed for Chapter 11 protection and laid off 6,500 employees without notice. Employees filed a class action lawsuit (Vogt case) alleging violation of the WARN Act. However, since Outboard had limited assets, the plaintiffs sued the three private equity firms, Greenmarine Holdings, Quantum Industrial Partners and Quantum Industrial Holdings, along with entities that owned interest in those firms. Goodwin Proctor.

The court determined that those three private equity firms and Outboard constituted a single owner since majority of the shares and board seats were held by those private equity firms.

"The Court focused on the fact that the defendants were heavily involved in the preparations for Outboard’s bankruptcy and ultimately made the decision to file for bankruptcy and close the company’s facilities. The Court concluded that these allegations supported the plaintiffs’ contention that the three private equity firms acted as a single employer and thus could be held liable for Outboard’s failure to comply with the notice requirements of WARN." Goodwin Proctor.

When we think of distressed private equity firms instituting a turnaround of their portfolio companies, lay-offs and closings can be part and parcel of the reorganization. When implementing a personnel restructuring, sponsors need to balance being transparent about cuts and avoiding operational distractions. Moreover, restructuring professionals advising a company in distress ought to tread lightly and make sure that all of the boxes are checked when recommending downsizing. In order to avoid liability under the WARN Act, and even more importantly, to treat employees in a decent manner, a "conscious uncoupling" is crucial. 

Comedy in Tragedy: The Daily Show on GM Liabilities

I LOVE The Daily Show. Last week, Jon Stewart discussed how the post-bankruptcy GM is immune from liabilities related to accidents caused by vehicles made by pre-bankruptcy GM. The automaker's fledgling CEO Mary Bara led the recall of approximately 2.6 million vehicles with faulty ignition switches. This defect is linked to at least 13 deaths, which is especially controversial because GM has known about this since 2005. The automaker purportedly decided against fixing the problem then because it would take too long and cost too much money (WSJ). 

Here's the Daily Show clip: 

The Daily Show
Get More: Daily Show Full Episodes,Indecision Political Humor,The Daily Show on Facebook

Let's recall a teeny tiny fact about the time-frame of the initial discovery of the ignition issue: the GM and Ford downgrade from Investment Grade to High Yield! Remember that mess in 2005? GM and Ford, which were considered bellwether bonds making up the second and third largest issuers of the bond market. This was right after the Fed had raised short-term rates and GM had failed to get healthcare concessions from its unions. 

"The GM downgrade could cause disruptions in the market for junk bonds, partially because many funds that are limited to investment-grade assets will be forced to sell GM's bonds." WSJ

So cost of capital for GM went from around 5% to around 11% for corporate debt. There was a huge sell-off in the bond market and then Kerkorian started bidding for GM stock, which had languished from $40 in the beginning of 2005, at $31. 

I'm sure that GM management at the time was like, "Eh. We have to pay more than double to borrow money, our unions want way more in healthcare benefits than we can afford, and, oh, we may now have an activist shareholder hovering over our shoulders. We're selling a record number of vehicles because we started this vicious employee discount cycle to offset our dwindling market share, and we need to keep selling. Let's hold off on making changes to this ignition thing until we're super duper sure about what we're going to do." Not that it absolves anyone of wrongdoing, but it gives us some context as to the turbid morass that the company was in at the time. 

Okay, so let's get to the liabilities from ignition device defects, why, according to bankruptcy law, new GM doesn't necessarily have a legal obligation to compensate consumers for the malfunctions, and what can possibly be done about it. 

When I heard Stewart talk about GM negotiating the release of former liabilities as part of its bankruptcy plan, he made it sound as if such releases are abnormal. In fact, a Chapter 11 filing is puissant precisely because it gives the company a new life line by extricating itself, at least partially, of the heavy burdens of debt and liabilities. If you'd like to know more about the history and impact of liabilities releases on financial renewal in America, check out this ABI podcast with Harvey Miller.

When a corporation files for bankruptcy protection, a reorganization plan, which has to be approved by the judge, details recuperation of the company's assets for all stakeholders. BUT, all stakeholders aren't created equally. For example, in GM's case, if a bank lends specifically for the a new plant and the plant serves as collateral, more than likely, in a simplified case, the bank will get that plant in a bankruptcy filing. This arrangement makes the bank a secured lender. 

Then, there are unsecured lenders, those who lend to GM without having explicit collateral. There are many levels of unsecured lenders, which can get kind of complicated. But the process of a restructuring involves figuring out which lender has dibs on which assets, and then distributing those assets accordingly. 

Obviously, consumers of the product can also have claims in a bankruptcy proceeding, especially in cases such as warranties, gift certificates or pre-orders. So what happens in the case where stakeholders at the time of the bankruptcy don't know they're going to have claims? That is, they didn't know they had a faulty switch until now in a car that was purchased back before the bankruptcy filing? There is precedence for such a situation in the Epstein v. Official Committee of Unsecured Estate of Piper Aircraft. Here's a quick summary: 

"Piper has been manufacturing and distributing general aviation aircraft and spare parts throughout the United States and abroad since 1937.

On July 1, 1991, Piper filed a voluntary petition under Chapter 11 of Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Florida. Piper's plan of reorganization contemplated finding a purchaser of substantially all of its assets or obtaining investments from outside sources, with the proceeds of such transactions serving to fund distributions to creditors.

On July 12, 1993, Epstein filed a proof of claim on behalf of the Future Claimants in the approximate amount of $100,000,000. The claim was based on statistical assumptions regarding the number of persons likely to suffer, after the confirmation of a reorganization plan, personal injury or property damage caused by Piper's pre-confirmation manufacture, sale, design, distribution or support of aircraft and spare parts." 58 F. 3d 1537

The most relevant aspect of this case decision is that these Future Claimants are considered tort victims. The problem is that tort claims do not take priority over secured claims, meaning that they're in the same category as unsecured claims. LexisNexis

So, let's do a simplified hypothetical example. The bank lends GM $80 for the plant. Then, GM issues unsecured bonds that get purchased by mutual funds and insurance agencies with a notional amount of $100. Total GM debt is $180. GM files for bankruptcy and sells its plant and other assets for $100. Of that amount, $80 goes to the bank because it was a secured lender. There's only $20 left over for ALL unsecured bondholders plus any future claimants of tort cases. The trustee sets aside $10 for future claimants and distributes $10 to the rest of the unsecured holders. 

A few years later, it turns out that there are $100 of tort cases related to pre-petition design of cars. New GM pays off those victims in full. What happens? If you held an unsecured bond and 10 got cents on the dollar, you'd be pretty upset since the tort victims, whose claims were at the same level as yours, got more than you did. 

The problem here is deeper than it initially seems. If we assume that future tort victims have similar priority as unsecured claimants, then we can't justly pay them more. We also can't require the new GM to compensate the tort victims because that would be changing the rules after the deal has been done. That is, since the new GM has different shareholders, the new shareholders bought the stock assuming that they weren't liable for future claimants any more than for unsecured bondholders. Changing that would cause buyers to lose trust in the system. (Here's a Pepper Hamilton article for more). 

The current law obviously isn't the answer, however. Loyola University's Law Journal describes the issue in more detail: 

"Allowing the debtor to escape liability for wrongful prepetition conduct frustrates the goal of deterring wrongful conduct by the debtor and others in the future. Under Piper, a tortfeasor may escape financial responsibility by simply filing for the protection of the bankruptcy court."

Is there a solution? There have been many offered in the legal field. Future damages that result from pre-petition issues could be considered claims in the bankruptcy court. There can be a cap on those claims and the judge can decide on a case-by-case basis. 

Another solution may be to put an actual dollar amount estimate to future claims and considering them secured debt so that they receive a portion of what's due to the secured guys. Here, the secured debtors end up paying for the victims (you know, the lender for the plant). 

Another answer could be explicitly requiring the new shareholders to pay for the mistakes of the old GM, maybe with a cap, so that the new shareholders know what to expect. 

Lastly, there could possibly be a claw-back using the fraudulent conveyance argument from previous shareholders, which may be the most fair, but also the most difficult to prove and execute. 

See Mr. Stewart, the problem here isn't simply a matter of whether or not the injured ought to be compensated; it's a problem of who pays for it and ensuring that the decision is the most just solution available.