Tesco’s in the Wrong Box

On January 8 Tesco announced more details of its plan to improve its competitive position in the UK, revive its profitability, and bolster its finances. It’s going to cut prices on popular brands, trim £250 million in operating costs, limit capital spending, stop the dividend, and sell assets. Some of the changes may already be working. The decline in UK sales is easing, with growth going from (5.4%) in the second quarter to (2.9%) in the third quarter to (0.3%) during the Christmas season. But January 8 brought more bad news as well. Moody’s downgraded Tesco’s credit rating to junk status (Ba1), and Standard & Poor’s did the same a few days later (BB+). Both agencies cited competition, profitability, and financial leverage as the reasons. Those are the risks we discussed in our January 5 blog post, “Testing Tesco.” But we think the rating agencies understate the risks. They don’t consider the difficulty of changing a company as large and as focused as Tesco. We see Tesco’s still unresolved financial reporting problems as symptoms of a damaged corporate culture that is likely to fight hard against change. The agencies don’t mention liquidity in their concerns about Tesco, but the declining trend in liquidity worries us at least as much as the increasing trend in leverage. The company’s liquidity position is at a four-year low, driven by growing current debt levels.   But our biggest worry isn’t any single risk or even the number of risks. It’s the compounding effects of Tesco’s risks, the way the company’s business and financial risks amplify one another. It’s common to think of credit risk in...

Private Equity Likes Strong Brand Names

Private Equity Funds often target companies with strong brand names in mature industries.  These companies often have strong, stable cash flows, which can be used to repay the acquisition debt.  Two transactions, both announced in February 2013, demonstrate this trend. Food behemoth H.J. Heinz Company agreed to be acquired by Brazilian PE firm 3G Capital and Warren Buffet’s Berkshire Hathaway at a total transaction value of $28.8 billion. As part of the transaction, both 3G and Berkshire invested approximately $4.1 billion to acquire common stock of the company.  Heinz is a leader in the mature condiments market with large and stable cash flow, and the potential for additional cost savings.  The transaction closed in June of 2013, and the new owners wasted no time in shaking up the HNZ management team by dismissing 11 executives and replacing them with new personnel. Dell Inc. announced a deal to sell the computer maker to founder Michael Dell and PE firm Silver Lake at a price of $13.65 per share, valuing the transaction at $24.4 billion.  The company also announced that the Board would commence a 45-day go-shop period to seek offers from other bidders. This action led to two competing offers, one from PE firm Blackstone, which offered $14.25 per share for the entire company, and one from Carl Icahn’s Icahn Enterprises, which offered $15.00 per share for a 58% stake. Blackstone eventually dropped out of the process after Dell reported declining sales, but Icahn continued to purse the transaction and offered several alternative structures to the Silver Lake deal. The Board of Directors was hesitant to pursue the Icahn deal...

99 Cents Only Stores goes Lite

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: Size (millions) % of Capitalization EBITDA Multiple(b) Revolver(a) $10 Term Loan $525 Total 1st lien debt $535 38% 3.4x Senior Notes $250 18% 1.6x Total Debt $785 55% 5.0x New Equity $536 Rollover Equity $100 Total Equity $636 45% 4.0x Total Capitalization $1,421 100% 9.0x (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...

Where are we at Suntech?

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. Structural subordination 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...

A Perfect Storm

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...