M*Modal: Obsolete Technology?

I'm always intrigued when I hear of a company restructuring shortly after being sponsored by a private equity firm and getting new debt on the balance sheet. It takes a lot of due diligence, time and capital to sponsor a business, so when that business has to restructure so soon, I always wonder what the sponsors were trying to achieve and what drove their plans astray.

M*Modal is a good case study. It is a medical transcription company that was purchased by J.P. Morgan's One Equity Partners in a $1.1 billion deal in 2012. The company filed for Chapter 11 protection on March 20, 2014. Here's more:

"One Equity Partners, which J.P. Morgan has said it is spinning off as an independent firm, acquired M*Modal about 18 months ago in a $1.1 billion leveraged buyout. One Equity contributed approximately $447 million in addition to $20 million to pay down part of M*Modal's debt.

M*Modal owes about $500 million to a group of lenders led by Royal Bank of Canada,stemming from a $445 million term loan and $75 million revolving facility made in 2012. The company also owes more than $250 million in unsecured notes, for which US Bank is the trustee." WSJ

" 'The acquisition was financed with a capital structure aligned with a specific set of assumptions that are no longer relevant. As a result, there is a need to restructure the company's balance sheet to better align with changing market dynamics and refinements to our strategy,' Duncan James, M*Modal's chief executive said in a statement." Reuters

The first thing I thought of when I read the CEO's quote was fraudulent conveyance! Actual fraud would be very difficult to prove because it requires demonstration of intent to deceive the creditors. 

The M*Modal scenario could be grounds for constructive fraud, though. That is, creditors could surmise that the LBO was done at a valuation that was too high. As a result, shareholders received payment for which they surrendered less than equivalent value of stock, rendering the debtor insolvent. But, there's a safe harbor provision of the bankruptcy code that prevents constructive fraud to be used for failed LBOs: 

"The “safe harbor” of Section 546(e) provides, among other things, that a trustee may not avoid a transfer that is a “settlement payment” made pursuant to a “securities contract,” unless such transfer was made with actual intent to hinder, delay or defraud creditors. As a result, a trustee cannot avoid such a transfer under a constructive fraudulent transfer theory—i.e., that the transfer was made for less than reasonably equivalent value while the debtor was insolvent. Thus, it is fairly well settled that the Section 546(e) safe harbor prevents a trustee from avoiding payments to shareholders in connection with an LBO under a constructive fraud theory." Kevin Walsh and Joe Dunn at Mintz Levin

However, as the Lyondell case decision suggests, the safe harbor provision does not apply to fraudulent transfers under state law. 

"Notably, the claims were not asserted under any provision of the Bankruptcy Code (including Sections 544, 548 or 550), but were asserted by the Creditor Trust solely in its capacity as assignee of the creditors’ state law rights...

The Court adopted the reasoning of In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013) (“Tribune”), holding that the safe harbor in Section 546(e) does not apply to state law claims brought on behalf of individual creditors. Importantly, the Court drew no distinction between state law claims asserted by the creditors themselves (as in Tribune), or by the Creditor Trust as assignee of such claims." Kevin Walsh and Joe Dunn at Mintz Levin

So any claims of fraudulent transfers would have to be brought under state law. But the question remains: was this a case of a zealous buyout or did something happen to change the fundamentals of the company?

In the affidavit in support for the first day motions, CFO of M*Modal David Woodworth describes the crux of the problem in the following way: 

"Core Transcription Outsource Services (“TOS”)... constitutes transcription outsource labor, speech understanding, and workflow technology. In 2013, TOS accounted for more than 80% of  consolidated revenue.

Physicians generally use one of two methods to capture clinical data in a digital format: dictation or templated direct data entry through clinical documentation systems. Dictation allows physicians to use their voice to document patient interactions, which is converted into a text format for insertion into the Electronic Health Record (“EHR”). Direct data entry directly populates an EHR through templates or drop-down menus, typically with a laptop or other hardware device. The adoption of direct data entry with EHRs by the Company’s customers has proven to be highly erosive to TOS volumes."

Despite volume erosion, EBITDA margins have been steady at 21%. The company hired financial advisors in the fourth quarter of 2013 and took up cost-cutting measures. 

So, in my opinion, M*Modal doesn't seem like the story of a highly levered company that was expected to "grow into" its bloated capital structure. Rather, this appears to be a story of declining earnings due to a lack of demand for the company's products in a highly competitive marketplace, coupled with a mismatched corporate strategy. 

Can Apollo Win With D&B?

Whispers abound of the PE giant considering a bid for Dave & Busters

Bloomberg had a report last week about Apollo possibly bidding to buy Dave & Busters from Oak Hill for about $1 billion. Apollo also owns Chuck E.Cheese, a restaurant and arcade for children.

"For Apollo, the move would mean doubling down on the industry after its takeover of Chuck E. Cheese, a kid-oriented purveyor of pizza, arcade entertainment and animatronic robots. The private-equity firm gained almost 600 restaurants and arcades when it acquired the chain’s owner, CEC Entertainment Inc., in a deal valued at $1.3 billion. Dave & Buster’s also runs a chain of entertainment complexes, though it caters more to adults -- with a focus on billiards, sports and beer.

A Dave & Buster’s acquisition could lead to synergies with Chuck E. Cheese, including greater purchasing scale for food and entertainment and lower distribution costs,” said Jennifer Bartashus, an analyst at Bloomberg Industries." Bloomberg

I've always liked D&B. The games yield much higher margins than the food & beverages and comprise of slightly less than 50% of revenues. Adjusted EBITDAR margins are right around 20%, and the high cap-ex of maintaining games results in a formidable barrier to entry. Also, I think it's a concept that would do well with franchising in conservative suburban America, since it gives adults an opportunity for some wholesome fun with the pretext of an edge with its psychedelic atmosphere.

I don't know about the "synergies" between D&B and Chuck E Cheese except maybe in lower costs of purchasing games. I guess food buying costs can be lowered for both concepts for raw materials such as cheese and pastas. Either way, I think D&B by itself has high potential. 

The company has two bonds outstanding. One is a $200 mil senior note that's callable this June at $105.5 and is trading at $107. Oh, and I should mention that it's about 5x levered. 

The second is a HoldCo 0% discount note that was used to pay a dividend to equity holders. This note is currently trading at $85.13 and is callable this April at $85.45. Both of those could be good yield-to-call bonds if bought right at or below their call prices. 

Not So Fast

Franchisors may not be able to force an acceptance or rejection of real property leases with franchisee.

One of my favorite sites, "The Creditors' Rights Blog", has an interesting article about a Seventh Circuit opinion in the case of A&F Enterprises, Inc. v. IHOP Franchising, LLC.

Typically, when a company enters bankruptcy, the trustee has a certain amount of time to assume or reject an "executory contract" or a contract in which both parties still have some unfinished business to provide to the other party. For more on executory contracts, go here.

If there are inter-related franchise and real-estate contracts when a franchisee enters bankruptcy, the matter can become turbid because the franchisee now has two executory contracts with the same party, but one may not be valid without the other.

"What’s the outcome when a debtor and its franchisor are parties to inter-related agreements: a franchise agreement under which the debtor operates its business and a real property lease under which the debtor leases its business premises from the franchisor?  The matter before the Seventh Circuit had the added complexity that the real property lease before it prohibited a use of the premises for any purpose other than for the operation of an IHOP restaurant, meaning the debtor could not assume the real property lease without also assuming the franchise agreement.

 ...The Seventh Circuit indicated that a real property lease in this type of commercial agreement is subordinate to the dominant franchise agreement, with the result that a debtor’s obligation to decide on assumption or rejection of the real property lease will run concurrently with its decision to assume or reject the franchise agreement." Creditors Rights

While I think that this is a narrow issue, the opinion is interesting because it could likely be applied to small business owners contracting out their stores to operators. The decision could also be applied to McDonald's franchisees who are leasing the stores from the franchisors. Lastly, since the decision clarifies the priority of the two contracts, it can be helpful to keep it in mind while negotiating an out-of-court restructuring. 

Schaden-Fraud?

Quiznos' Owners Accuse Schadens Of Scam

The New York Post had an article yesterday about a new lawsuit that Avenue Capital and Fortress are bringing on against previous owners, Richard and Rick Schaden. Apparently, the valuation presented to Avenue and Fortress was rife with inaccurate and inflated data. Here's more from Blue MauMau:

"'The Investigation has revealed that in connection with the 2012 Restructuring there appears to have been a concerted effort by the Specified Litigation Parties to deceive other members of the Debtors' management, certain minority board members, and the Debtors' then-existing lenders. As a result of this conduct, the debtors and the Debtors' then-existing lenders-in particular Avenue and Fortress-suffered material damage."

The reorganization disclosure statement issued to the bankruptcy court details how litigation proceeds could come from suing certain former officers, board members and related parties of the debtors. Their allegations will include how the current owners were purposely misled by former management about the prospects and financial health of the company.

It states, 'Notably, projections included in the disclosures have the company nearly doubling revenue and more than doubling EBITDA by 2019.'" Blue MauMau

Oh please. Unless the Schadens actually falsified factual information, the claims don't hold much merit. These are sophisticated lenders (Oaktree, Caspian, MSDC) and I'm sure they did their own due diligence.

What does hold merit, in my view, are the allegations made by franchisees. These are worth considering, not necessarily because there was any tomfoolery related to breach of contracts (I haven't seen franchisee agreements, but I'd imagine there's language about coupons and the "hidden fees" to which the franchisees are referring), but more because they hold they key to restructuring the business.

"In the new round of lawsuits, store owners claim Quiznos continues to overcharge by forcing them to buy food at marked-up prices from a Quiznos-affiliated supplier.

"The hidden mark-ups, which are the keystone of Quiznos' scheme, have generated massive profits for Quiznos while simultaneously driving its franchisees to financial ruin," one of the lawsuits says. Most of the suits contain similar or identical language...

The lawsuits allege that Quiznos management increased the use of coupons for free and discounted food — costs that are absorbed by restaurant owners — in order to make the franchisees buy more food at marked-up prices from Quiznos' supply affiliate.Disputes between franchise companies and their franchisees are relatively common, but few have the persistence and animosity as Quiznos'.

For example, Burger King restaurant owners sued the parent company in 2009, arguing that they were losing money by being forced to sell some menu items for $1. The suit was settled 17 months later, with both sides saying they would collaborate on future pricing decisions.

Analysts say Quiznos' friction with franchisees has created a debilitating spiral of store closures and declining revenue.

'The sales decline and the heavy couponing have really made it tough for franchisees to make a profit," said Jonathan Maze, an analyst and writer for Franchise Times magazine. "Quiznos charges a lot of money (to franchisees) for its food.'" -Denver Post

Doesn't this sound a lot like Burger King, but much worse? I believe a franchised model can be incredibly powerful, but only when the franchisees feel empowered. The franchisor should work to make sure that the stores are profitable by ensuring that restaurant cogs are manageable, providing strong marketing support, helping with logistics for flailing stores and continuously investing new product innovation to drive traffic instead of coupons. I hope that the new owners (Oaktree specifically because they're good at reincarnating business models) can do this. Hint: Take a look at Wendy's! 

Food Gone Bad

I'm going to kick off my blog by discussing restaurants for a few posts because the industry is close to my heart. Between 2009 and 2011 when the high yield index experienced a deluge of new restaurant bonds, I did a thorough analysis of the sector and really enjoyed learning about it.

Let's start with Quiznos. Admittedly, I've never looked deeply into the sandwich maker's financials, but the restaurant chain has been in the news because of its recent bankruptcy filing. 

"Plummeting sales and piling debt has forced Quizno’s Corp. to file for bankruptcy protection. The Denver-based sandwich chain known for their oven toasted subs is reportedly $570 million in the red, but will continue operations during its bankruptcy process...

According to company officials, Quizno’s will attempt to implement a $400 million debt cutting plan. Just two years ago, the oven toasted sandwich chain reached an out-of-court agreement with creditors that cut its debt at the time by more than a third...

A Chapter 11 bankruptcy filing would help Quizno’s handle its leases as well as loan money to franchisees for store improvements and advertising. Although, the company is facing incredible competition as its main rival, Subway, has more than 35,000 more stores. Likewise, Subway’s $5 foot-long sandwiches have helped put a fork in Quizno’s fate.

Under Quizno’s proposed restructuring plan, first-lien lenders would receive a recovery of about 43 to 53 percent, but unsecured creditors may recover all of their claims or possibly none at all.100 percent of Quizno’s first-lien lenders voted and accepted the proposed plan. Those lenders who voted make up about 88% of the principal amount of outstanding debt. As mentioned, though, unsecured creditors may not receive anything and the largest of those unsecured include a $173.8 million second-lien financing facility."  News Channel Daily

A few things have struck me about this filing: 

1) The company itself only owns and operates 7 out of 2100 stores total! The rest are owned by franchisees. 

2) Recovery for 1st lien guys will be 43 to 53 cents on the dollar, which is much lower than historical averages of around 80 cents. And NOTHING for unsecured lenders? That's rough.

3) The company just restructured in 2012. The unsecured lenders have a claim on any proceeds from a lawsuit pertaining to the previous restructuring. 

Since the company doesn't actually own and operate most of the stores, there doesn't seem to be much of an operational turnaround story here. It's not like when Outback had to restructure so it tried to cut its raw materials costs. Quiznos, like all other franchisers, just skims off the top of the franchisees sales. Which begs the question, why have sales per individual stores taken such a nose-dive? Since the problem is spread across hundreds of franchisees, is it the business model or the value proposition to the customer? It's obviously a top-line issue because margins don't even enter the equation when it comes to franchise royalties. Was it similar to the Burger King pre-3G situation where stores haven't been remodeled forever and corporate didn't mandate it?

Additionally, I wonder what went wrong with the previous restructuring? And what was the narrative supporting such high levels of debt to begin with, especially if the cap-ex is funded by the franchisees?

I'll have to do a little more digging.