More Red Flags

We’ve posted several times before about the early warning signs of financial distress, most notably about Borders and about Borders again. With the recent bankruptcy of Toys R Us, this seems like a good time to return to the subject. Spotting trouble before it becomes calamitous is more of an art than a science. The predictive algorithms haven’t been written yet, so credit foresight remains much more judgment than data-driven. That may change, but for now we stand by our early warning signs: falling revenues, growing losses, increasing working capital, rising debt, decreasing liquidity, and struggling management. But we don’t have the definitive view. A risk manager we know who works with middle-market companies has his own list, and we thought you would find it interesting. Here are his problem credit red flags. Pinky rings and airplanes Management is focused more on status and comforts and less on the business. They’re too busy trying to measure up at the country club and pampering themselves to stay on top of changing market conditions and competitive dynamics. When trouble develops, they’re slow to react. Third generation in the business Key managers get their jobs the old-fashioned way, they inherit them. When the grandchildren are in charge and the founder isn’t active enough to make up for their lack of professionalism, the business suffers. Or they’re capable enough, but there are too many of them in the company. When they can’t agree on key decisions and the founder isn’t strong enough to mediate, the business suffers. “To tell you the truth” Managers who keep insisting their telling you the truth probably aren’t — at least not the...

Measuring a Company’s Liquidity

Liquidity matters Liquidity problems lead to more bankruptcies than any other cause. For such an important issue, it’s surprising how much confusion there is defining liquidity and measuring it. In this post we’ll try to add some clarity to the discussion about what liquidity is and how to analyze it. What liquidity is One textbook describes liquidity as “The ability of a firm to meet its current obligations.” An online financial dictionary defines it as “cash to meet immediate and short-term obligations, or assets that can be quickly converted to do this.” A major corporation discusses liquidity in terms of “Access to sufficient funding to meet our business needs and financial obligations.” So which is it? The capacity, regardless of source, to meet any need, regardless of type? Cash and ready-to-sell assets available for needs emerging any time from the next few days through the next year? Financing for working capital, capital spending, debt service, and the dividend? The answer, of course, is, “all of the above.” We think the most useful way to think about liquidity is in three dimensions: internal and external sources, operating and financial needs, and predictable or unpredictable needs. Our definition includes all three aspects: liquidity is the ability to meet expected and unexpected business and financial needs from internal and external sources of funds. Sources and uses Companies get the cash they need for liquidity from a variety of sources. Internal sources are those under their direct control, meaning cash generated by their operations and assets they own. They include free cash flow, cash and investment reserves, asset sales, and operating efficiencies. Expected...

The Storm that Sank Hanjin Shipping

Last summer Hanjin Shipping failed. It was only the sixth largest container shipping company in the world, but its bankruptcy may be the first of many in an industry caught in very heavy weather of its own making.  ...

Some Time to Be Valeant

The disease, not  the cure In our last post, we talked about the tangle Valeant got into with its banks over financial reporting delays. But the company’s problems didn’t end with the banks, and the banks weren’t the only creditors affected. On April 12, Centerbridge Partners, a fund that specializes in distressed debt investing, called a financial reporting default on $1 billion of bonds. Ten days later holders of four other Valeant bonds totaling $6.4 billion piled on with their own default notices. Valeant cured all of the bond defaults when it issued certified financial statements for fiscal 2015 on April 29. But for many investors, Valeant’s reporting troubles were more than a technicality. The company has $8.6 billion in what it calls “Tranche B Term Loans.” These are delayed-maturity, floating-rate, secured loans that are popular investments for collateralized loan obligations (“CLOs”). CLOs are debt securities backed by pools of corporate loans. Valeant’s Tranche B Term Loans are the most widely held investment among CLOs. In some CLOs Valeant’s loans account for as much as 4% of total investments. Those loans traded at around 94 cents on the dollar recently. The discounted price of the loans is a problem for CLOs, which are “overcollateralized” to make sure they can service their own debt. This means the value of the loans CLOs hold must exceed the value of the bonds it has issued. If the funds sold their Valeant loans at current prices, they would cut into their overcollateralization cushion, which is already under stress from a broad decline in energy sector loan prices. Deja vu all over again Valeant got...

No Time to Be Valeant

Valeant in trouble Valeant Pharmaceuticals has been a bit of a nightmare for customers, shareholders, and debt holders lately. Its strategy of acquiring established drugs, paying with debt, and doubling prices to cover the costs has provoked a furious response from consumers and lawmakers. Its mis-reporting of a troubling relationship with a specialty pharmacy called Philidor, two SEC investigations, delays in issuing its 2015 annual report, problems with its banks and bondholders, and turmoil in senior management ranks and on the board, have led to massive drops in its share and bond prices, soaring price increases in its credit default swaps, and a brutal series of downgrades from the rating agencies. The timeline of Valeant’s troubles goes like this: 10/21/15 Short-seller Andrew Left’s Citron Research suggests Valeant is using Philidor to artificially increase revenues 10/26/15 Valeant defends its revenue accounting but announces its board is investigating the Philidor relationship 10/30/15 Valeant terminates its relationship with Philidor, which shuts down 12/29/15 Valeant CEO Michael Pearson goes on leave with pneumonia 1/1/16 Former CFO Howard Schiller becomes interim CEO 2/22/16 Valeant admits to overstating about $58 million revenue in revenues to Philidor in 2014 but says the investigation is continuing 2/28/16 Michael Pearson returns as CEO, and the company withdraws its earnings guidance for the fourth quarter of 2015 2/29/16 Valeant announces that it will not be able to meet the March 15, 2016 filing deadline for its 2015 annual report; the SEC launches a formal investigation into Valeant’s financial reporting 3/15/16 Valeant misses the deadline for delivering its annual report to its banks and bondholders 3/21/16 Valeant admits to $21 million more of...