A Brutal Week for Toys R Us (Short Giraffes)

The week isn't even over yet and so far it's been full of good news and bad news for Toys R Us. Who are we kidding? It was mostly bad. The good news first: the bankruptcy court granted the company additional time to (i) exclusively submit a plan of reorganization and (ii) figure out what it wants to do with its store leases. So, rather than reject its leases by mid-January, the company now has until mid-April. The benefit of this, of course, is that the company gets to take advantage of its store footprint during the crucial holiday season. The disadvantage of this, however, is that it eliminates an excuse for dogsh*t numbers in Q4 '17.

Speaking of dogsh*t numbers, the company reported Q3 '17 results. The newly enriched company CEO Dave Brandon didn't use "dogsh*t" to describe the results but he might as well have, saying "[o]ur results for the quarter were disappointing." Right after that he threw babies and smart kids (read: "learning") under the bus, highlighting those segments as particularly challenging. Here are the highlights:

• Same store sales were down 4.4%. 
• Net sales were down $89mm. 
• Gross margin was down 4% (and 5.8% in the US due to vendor tightening and a "competitive pricing strategy," otherwise known as discounting).
• SG&A was up $13mm (subsuming restructuring advisory fees...these guys have no idea what's coming on that front).
• Operating loss was $208mm.
• EBITDA was negative $97mm, a $102mm swing from the prior year period. 
• Net loss of $624mm compared to $160mm in the prior year period. 

In other words, B.R.U.T.A.L. 

Hang on though. Things can't be all bad can they? Well, in the UK there are fears of a full shutdown (firewall) and thousands of job losses. But what about Star Wars driving massive toy sales? Apparently that isn't looking like quite A New Hope either. See what we did there?

Interest Rate Increases + Tax Reform = ?!? (Short High Leverage Ratios)

Restructuring professionals have been waiting for interest rate increases for some time. Now that they're here, certain leveraged loan creditors are going to see an increase in interest expense. And just in time for a potential double whammy…

At the time of this writing, Congress has approved of the tax reform bill and President Trump is champing at the bit to sign it. Analyses are incomplete but one provision, in particular, is of note for restructuring professionals: the new limitations on deductibility of interest. Indeed, Fitch Ratings issued a press release confirming that the “impact of the deduction will be more severe on highly leveraged firms.” Choice quote: “Based on a sample of 575 leveraged loan and high-yield issuers, Fitch estimates that 37% of the issuers will lose a portion of their interest deductions under the EBITDA definition. In addition, 27% would be unable to deduct 20% or more of their interest and 10% would be unable to deduct 50% or more of their interest.” Get ready to see this in a First Day Declaration coming to a bankruptcy court near you.

Indeed, the prolific Baker McKenzie firm already has published its assessment. Choice quote, "These changes are significant to the struggling US corporation that has declining earnings.  Indeed, the path to bankruptcy for a highly-leveraged company could be accelerated as a result of an increase in its effective tax rate caused by these rules.  Moreover, the reduced allowance for deductions would mean fewer NOLs would be available for use should the company attempt a bankruptcy reorganization." There's also no grandfathering: you should read the piece. We're looking at you Tenet Healthcare (and others). Who knew tax could be so interesting?

That said, certain industries in need of relief could be potential winners. Retailers who generate profits domestically stand to benefit from the corporate tax rate reduction. On average, they pay 30.6% currently so a reduction to 21% could be meaningful. Likewise, restaurants with domestic profits would also stand to benefit (multi-nationals with a higher mix of U.S. debt to earnings could run into the deductibility issue above). These two spaces could use all the help they can get after a bumpy 2017.

Finally, tax lawyers and tax advisors are already getting busy poking holes through the thing. 

Is Charming Charlie's Bankruptcy a Canary in the Coal Mine?

Chapter 11 Filing May be Warning Sign for "Treasure Hunt" Retailers

In its December 11 issue, Barron's noted the following (firewall): "Even the companies that look immune to the impact of the internet could be at risk. Consider off-price retailers like TJX ($TJX) and Ross Stores ($ROST). Bulls have argued that the experience of digging through the racks looking for buried treasure is something that can't be replicated online -- and that, they argue, puts them at an advantage to other retailers."Acknowledging some contrarians among the analyst ranks, Barron's continues "There may even come a day when the bargain-hunting experience loses its thrill. Already, companies are creating the technology that allows shoppers to have their measurements taken at home, and then create the clothes people want without having to search for it...." 

Enter Charming Charlie Holdings Inc. The company filed for bankruptcy earlier this week, capping a bloodbath of a year for retail. For the unfamiliar, Charming Charlie is a Houston-based specialty retailer focused on colorful fashion jewelry, handbags, apparel, gifts, and beauty products. It has 350 domestic stores and a core demographic of 35-55 year-old women. The company blamed (i) "adverse macro-trends" and (ii) operational shortfalls (e.g., merchandising miscalculations, lack of inventory, an overly broad vendor base) for its underperformance and reduced sales. EBITDA declined 75% "in the last several fiscal years." 75-effing-percent! With a limited amount of money available under its revolving credit facility and even less cash on hand, "Charming Charlie is out of cash to responsibly operate its business." Ouch. Two weeks before Christmas. Rough timing.

As it relates to "merchandising miscalculations," this bit caught our eye: "Historically, Charming Charlie utilized a sophisticated inventory system to position products according to their color and theme. Merchandise is offered in as many as 26 different hues and arranged at each store according to the item’s color and theme, creating what has been referred to as a “treasure hunt” experience. While this approach initially provided Charming Charlie with a strategic benefit, and engendered significant brand loyalty, it eventually caused Charming Charlie to be saddled with excess merchandise in underperforming color offerings." Curious. 

Long time PETITION readers know that we love to discuss what we call "busted narratives." Reminder: our focus is "disruption" and not necessarily "restructuring." And we'll acknowledge upfront that we may be cherrypicking one statement in an otherwise lengthy court document. But one ongoing narrative is that off-price "treasure hunt" retailers are safe from e-commerce. We're not so sure. It stands to reason that as things become more convenient at home - with 3D-printing, Amazon Echo Show, Amazon private label (see below), free returns, etc. - retailers will continue to focus more and more on inventory management. That is, if they have inventory at all. Obviously, direct-to-consumer is the not new retail trend and newer brick-and-mortar locations supporting the likes of Bonobos, Warby Parker, etc., are merely showrooms in furtherance of brand enhancement rather than inventory and supply chain management. Indeed, Charming Charlie announced that is reducing its vendor base down from 175 to 80. As inventories are more streamlined, that strikes us as an obvious headwind to discounted "treasure hunt" retailers. After all, they benefit from inefficient inventory management. And, notably, TJX had a relatively rough quarter recently. Now, TJX isn't filing for bankruptcy anytime soon, but query whether this is a trend to watch going forward. Query whether the "off price" narrative holds. 

Some other notes on Charming Charlie while we have your attention:

• The company has also commenced the closure of ~100 of its 370 stores (350 domestic + 20 international), a meaningful reduction in its brick-and-mortar footprint. Note some carefully crafted language, "The Debtors anticipate 276 go-forward locations following the first round of store closures." Key words, "FIRST ROUND." We wouldn't be shocked if the company shutters more. That depends on the landlords, it seems...
• ...and the landlords are getting squeezed too. The company seeks "to amend lease terms to reduce occupancy costs and obtain rent abatements for the first quarter of 2018...." As Starbucks ($SBUX) and Whole Foods ($AMZN) recently discovered, there's a big difference handling leases in vs. out of bankruptcy court.
• The fashion industry has suffered a 15% downturn in fashion jewelry sales and the company experienced a disproportionate 22% decline itself. Query whether the direct-to-consumer model is helping to disproportionately batter brick-and-mortar fashion jewelers.

Toys R Us Plan to Pay Execs Makes Waves

Toys R Us' Execs Seek Hefty Bonuses, Piss People Off

Happy holidays, ya'll. You're fired. In what should be a surprise to no one, Toys R Us isn't immune to store closures. In the first instance, it plans to close 25 UK-based locations. If you think the US won't see closures and/or consolidation of Toys/Babies shops, you're smoking some serious crack (as we've said before). Indeed, the company recently filed a motion establishing procedures to extend the time to deal with its non-residential real property leases. Buckle your seat belts, landlords. 

Speaking of smoking crack, the U.S. Trustee for the Department of Justice (UST) apparently thinks the company and its advisors have been at it with the good stuff; it went full-on Demi Moore with its vigorous objection to the company's mid-November motion to pay executives up to $32mm in bonuses if "Stretch" EBITDA targets are met (and slightly less upon achievement of a "Target" EBITDA level). These numbers - on the heels of millions of dollars of pre-bankruptcy bonuses paid to the very same executives - made their way through the mainstream (and not so mainstream) media and garnered some well-deserved outrage. PETITION NOTE: All of the sudden everyone is an executive compensation expert, it seems. To be fair, it is awfully counter-intuitive that the very same professionals at the helm when the ship hit Iceberg #1 need incentives to avoid Iceberg #2. Like, "eff you, guys, good luck getting a job elsewhere after this dumpster fire of a hot mess" seems to be the general public sentiment. But therein lies the push-pull bankruptcy dynamic. Switch out management now - while credit terms are non-existent, vendor/supplier relationships are strained, customers are nonplussed, competitors are champing at the bit, etc. - and its possible that, with the absence of institutional knowledge, the company could end up in even WORSE shape and stumble towards liquidation. And so this is where the Kirkland & Ellis LLP attorneys - all SEVEN of the partners listed on their filed papers - really earn their billing rate (a point we're guessing they hammer home whilst pitching management teams); they need to convince the Judge, the UST and, here, the public, that the lofty amounts they seek approval for derive value in return. And "value," here, is unequivocally a "going concern" business that can continue to employ people and contribute to the tax base. 

But, first, the company (and Kirkland) had to deal with the Official Committee of Unsecured Creditors (UCC), a fiduciary body that represents all similarly-situated unsecured creditors in the bankruptcy process (read: most vendors, suppliers, customers, employees). Late Friday night the UCC filed its "Statement" in response to the company's motion. The statement expresses support for the company's proposed plan but ONLY after the UCC negotiated various changes to the extent and timing of the compensation sought. The UCC states, "[t]he Committee recognizes the importance of maintaining strong employee morale and ensuring that management and employees are collectively working towards the common goal of a successful holiday season and a strong and viable reorganized company." So, now, per the UCC's agreement with the company (and subject, still, to the UST and the Court), ONLY $16mm and $21mm will be payable to executives if "Target EBITDA" and "Stretch EBITDA" goals, respectively, are met. And the timing of payment has been altered as well, deferring and pinning greater amounts to the consummation of a reorganization. The UCC continues, "This feature...is particularly important to the Committee in the absence of a plan support agreement or defined business plan for the case, and in the face of the distinct business pressures imposed on retail companies in chapter 11." In other words, the UCC is worried about enriching execs only to see the company liquidate. And, given the state of retail today, they damn well should be - particularly since, we assume, the UCC has insight into how the business fared on Black Friday and Cyber Monday. Marinate on that.   

Lastly, permit us to issue you your weekly reminder that DIP Lenders justify the $3+b loan to Toys R Us on, what we now dub, a "there must be one" basis. In other words, "there must be one" bigbox toy retailer. Just like there is, you know, for sports (Dick's Sporting Goods ($DKS)) and books (Barnes & Noble ($BKS)). So, how IS the "one" doing in books? Well, BKS reported earnings this past week and it wasn't pretty. Sales were down 7.9%, comps were down 6.3% and earnings per share continued to trend deeper into the negative. But have no fear: the company has a creative and revolutionary go-forward strategy: "place a greater emphasis on books." Yup, you read that right. 

Automotive (Short the B2B Business Model)

More Signs of Upcoming Auto-Related Distress

Assuming Uber Technologies Inc. can survive its latest self-imposed issues, e.g., an unreported data breach, increased regulatory scrutiny, skittish investors in Softbank and Benchmark Capital, etc.,, it appears to be positioning itself and the automobile industry towards a brand new business model. This week Uber announced its (non-binding) agreement to purchase 24k sport utility vehicles from Volvo Cars to seed a fleet of autonomous cars. Deployment date: 2019. Yes, 2019. Anyway, in addition to the obvious and previously discussed implications for labor, this move might have bigger ramifications: a forced pivot of the automotive business model in the direction of the airline model.

What do we mean by that? Assuming a great many things (including Uber's ability to successfully deploy its sensors and software with Volvo's hardware, regulatory hurdles, etc.), this could be another blow to the model of individual car ownership, the B2C formula deployed by the OEMs for years. Hyperbole? Maybe, but if people stop buying cars (and borrow money to do so), auto companies will see significant revenue effects. And they'd have to sell more to fleet operators, i.e., Uber, Lyft, etc., much like Boeing ($BA) and Airbus ($AIR) sell to Delta ($DAL), United Airlines ($UA), etc. This could mean fewer cars on the road, all told. Which, as we've previously discussed here and here, could lead to increased pain in the auto supply chain. 

Elsewhere in auto, the Faraday Future dumpster fire is turning into a full-fledged conflagration and looks like a ripe candidate to be voluntaried into bankruptcy.

And, finally, we noted back in February that 3D-printing could have a big impact on a number of industries. Now, apparently, 3D printing is projected to have a spike in activity in 2018. Businesses sourcing it most? Manufacturing, telecom, defense, and, of course, auto. To point, Divergent 3D just raised $65mm Series B financing round to build its car frame business. Curious.

Gawker: The Gift That Keeps On Giving

The Latest in the Peter Thiel vs. Gawker Saga

Peter Thiel is fashioning himself like a Die Hard villain: impossible to put down. Right before Thanksgiving, Buzzfeed reported that Thiel had filed an objection in bankruptcy court alleging that he was boxed out from bidding on Gawker's assets. This makes for an interesting - if not circular - state of affairs.

First, a quick recap. Thief’s involvement in the Gawker matter is well known by now; his support of Hulk Hogan’s lawsuit against the digital media rag put the company (and its founder) in bankruptcy. Now the company is trying to maximize the value of the "estate" in an effort to return as much to claimants as possible. Hogan - with his massive judgment claim - happens to be a large claimant. 

In the objection filed on 11/22, Thiel argues that he could be the source of said maximized value; he would like to bid for the companies assets - including, interestingly, any and all claims that the plan administrator, Dacarba LLC, may be marketing to outsiders that could be pursued against Thiel himself. Which are, of course, assets of the estate (and were, to be clear, the bigger target of the objection). Like we said, this is a bit circular. Thiel backs Hogan. Hogan sues Gawker. Gawker goes bankrupt. Gawker's plan administrator and counsel seek to fulfill their fiduciary duties by maximizing value for the benefit of the estate and its creditors. Including claims against Thiel. Thiel seeks to buy the kit and caboodle (including claims). If he does, value goes to the estate and is used to pay…Hulk Hogan. Bankruptcy = awesome. 

The reactions to this circus were fast and furious:

• Many articulated concern about Thiel’s nefarious intent: is he interested in a Big Brother-esque cleansing of Gawker and its archive from existence? 

• Others clowned on Dacarba’s liberal reliance on Precedent Transaction Analysis and the $36mm “buy-it-now” price. We don’t, however, necessarily see an issue with it: aim high we say. After all, there isn't a tremendous amount of truly comparable precedent for well-known digital media URL addresses (and archives) being sold in bankruptcy (though we’re happy to be proven wrong). Test the market, we say. MAKE a market, we say. 

• Regarding the marketing of claims against Thiel, the market is awash in new funds pursuing litigation finance strategies and looking for yield. It’s also, no doubt, awash in folks who would love to stick it to Thiel. So, why not go for that strategy? It actually demonstrates an awareness of the current litigation (and lit finance) environment.  

Is Digital Media in Trouble?

Don't Sleep on Digital Media "Distress"

Last week we announced that we'll be rolling out our Founding Member subscription program in early '18. The response was overwhelmingly positive with many of you reaching out and essentially saying "what took you so long." That warmed our heart: thank you! We look forward to educating and entertaining you well into the future. The timing fortuitously dovetails into a general narrative about the state of digital media today. 

For instance, is it fair to characterize Mashable as a distressed asset sale? Well, the company - once valued at $250mm - is reportedly being sold to Ziff Davis, the digital media arm of J2 Global Inc., for just $50mm. So, what happened? New capital for media companies has dried up (unless, apparently, you're Axios) amidst weakness in the ad-based business model. With Google ($GOOGL) and Facebook ($FB) dominating ads to the point where even Twitter ($TWTR) and Snapchat ($SNAP) are having trouble competing, digital media brands are feeling the heat. Bloomberg highlights that at least a half dozen online media companies - from Defy Media (Screen Junkies, Made Man, Smosh) to Uproxx Media (BroBible) - are also considering sales to bigger platforms. Indeed, in an apparent attempt to de-risk, Univision is ALREADY reportedly trying to offload a stake in the Gawker sites it recently bought out of bankruptcy.

Which is not to say that bigger platforms are killing it too: the Wall Street Journal reported earlier this week that both Buzzfeed and Vice will miss internal revenue targets this year. Oath, which is Yahoo and AOL, binned 560 people this week. Of course, those in the distressed space know that one's pain is another's gain. To point, Bloomberg quotes Bryan Goldberg, founder of Bustle, saying "Small and more challenged digital media companies have been hit hard. This is a time for companies with cash flow and capital to start acquiring the more challenged digital assets." That sounds like the mindset of a distressed investor: the buyside and sellside TMT (telecom/media/technology) bankers must be licking their chops. Back to restructuring, these sorts of mandates may be decent consolation prizes for those professionals not lucky enough to be involved with the imminent bankruptcies of (MUCH larger and obviously different) media companies like Cumulus Media ($CMLS) and iHeartMedia Inc. ($IHRT), both of which are coming close to bankruptcy (footnote: click the iHeartMedia link and tell us that that headline isn't dangerous in the age of 280-characters!). For instance, Mode Media is an example of a digital media property that failed last year despite at one time having a "unicorn" valuation (based on $250mm in funding), a near IPO, and tens of thousands of users. It sold for "an undisclosed sum" (read: for parts) in an assignment for the benefit of creditors. Scout Media Inc. filed for bankruptcy in December of last year and sold in bankruptcy to an affiliate of CBS Corporation for approximately $9.5mm. Not big deals, obviously, but there are assets to be gained there. And fees to be made. 

In response, (some) digital media brands are looking more and more to subscribers and less and less to advertisers in an effort to survive. Longreads' "Member Drive," for example, drummed up $140,760 which, crucially, it'll use to pay writers for quality long-form content. Ben Thompson has turned Stratechery into a money-making subscription-only service; he told readers that they're funding his curiosity and their education. Indeed, his piece this past week on Stitch Fix ($SFIX) may have, in fact, impacted sentiment on the company's S-1 and, in turn, the company's IPO price. These are only two of many examples but, suffice it to say, the "Subscription Economy" is on the rise. 

Which is all to say that our path is clear. And we look forward to having you along for the ride. Please tell your friends and colleagues to subscribe TODAY: existing subscribers will get a preferential rate.

The US Postal Service Could Use Bankruptcy

The Mail-Carrier is a Financial Hot Mess

We here at PETITION use an e-newsletter as our primary source of direct communication with our readers. Non-subscribers can see some, but not all, of the same content on our website on a delayed basis. And of course we tweet on occasion too (follow us here). Once upon a time, however, this kind of messaging depended upon physical marketing mail. 

Not so much anymore. The U.S. Postal Service recently reportedly a deluge of negative numbers. In the nine months ended 6/30, first-class mail volume fell 4.1% YOY and marking mail volume declined 1.8%. Per the Wall Street Journal, "[T]he Postal Service's financial situation has continued to deteriorate. It has been hurt by the decline in first-class mail, its largest and most profitable business, as more communications shift online."  No. Sh*t. Sherlock. 

The situation is bad: the USPS has severely strained liquidity. The USPS reported a net loss of $2.1b for the fiscal third quarter, a nearly 25% loss YOY. It hasn't made payments to its retiree fund for five years (which basically means that retirees are financing operations) - skipping a $6.9b payment at the end of September. Retirees are owed $40b in total. Now the USPS seeks to increase the price of stamps and various shipping rates. But the Postal Regulatory Commission needs to approve such measures; it currently has a vacant Board of Governors that President Trumphasn't bothered to fill. Hard to think about the USPS during the middle of your latest golf round, we guess. #MAGA! 

Naturally, human capital costs are a big part of the problem. Decrease the high cost of employment - whether due to pensions, workers comp, wages, etc. - and this business may be more sustainable. This seems to be a pervasive theme for human capital businesses. This is why Uber, for instance, is so aggressively pursuing autonomous vehicles; it suffers from the same issue. 

And so what is the USPS looking into now to help promote economic efficiencies and curtail costs? Self-driving mail trucks, of course! A USPS-issued report notes that a semiautonomous prototype is in development now with a December delivery date (PETITION query: where the hell did the money come from?). As Wired reports, the idea is to have more efficient driving and fewer accidents, all the while allowing postal workers to perform other tasks in-truck rather than focusing on the driving 100% of the time. That way, no jobs are lost! Riiiiiiiiiiight. From Wired, "The report's authors insist they're not looking to dump human workers, and that AVs can help by trimming other costs. The agency paid about $67 million in repair and tort costs associated with vehicle crashes last year. It also shelled out $570 million for diesel fuel. If the robots perform as promised, making driving much safer and more efficient, those costs could plummet. If the USPS sticks with this plan, the jobs of the nation's 310,000 mail carriers could change, for better or worse. Once the vehicles do all the driving, the humans will be left with the sorting and the intricacies of the delivery process. Unless, of course, a robot can figure out how to do those too. And whatever the report says about protecting jobs, it's clear that the best way to cut down on employee health care costs is to cut down on employees."  Our sentiments exactly. 

Someone needs to reorganize this dumpster fire. And fast. But can the USPS even file for bankruptcy? We'll leave others to the analysis: here, Weil Gotshal & Manges LLP's Charles Persons (written four years ago and we're STILL talking about this). If only we had a President who appreciated the benefits of bankruptcy AND had a same-party-Congress to do his bidding. Hmmm.

Amazon's Disruptive Force...

...Is Industry & Asset-Class Agnostic

Scott Galloway likes to say that Amazon simply needs to make a simple product announcement and the market capitalization of an entire sector - of dozens of companies - can take a collective multi-billion dollar hit. On a seemingly weekly basis, his point plays out. Upon the announcement of the Whole Foods transaction, all of the major grocers got trounced. Upon news of Amazon building out its delivery infrastructure, United Parcel Service Inc. ($UPS) and FedEx Corporation ($FDX) got hammered. Upon news that Amazon was getting into meal kits, Blue Apron's ($APRN) stock plummeted. This week it was the pharma companies that got battered on the news that Amazon has been approved for wholesale pharmacy licenses in at least 12 states. It was a bloodbath. CVS Health ($CVS) ⬇️ . Walgreens Boots Alliance ($NAS) ⬇️ . Cardinal Health ($CAH) ⬇️ . Amerisource Bergen ($ABC) ⬇️ . Boom. (PETITION NOTE: obviously impervious - for now - are the ad duopolists, Alphabet Inc. ($GOOGL) and Facebook Inc. ($FB), both of which, despite news that Amazon did $1.12b in ad revenue this quarter, had massive bumps on Friday).* Luckily there isn't an ETF tracking doorman and home security services because if there were, that, too, would be down this week. 

What Galloway has never noted - to our knowledge, anyway - is the effect that Amazon's announcements have on the leveraged loan and bond markets. Remember that Sycamore Partners' purchase of Staples from earlier this year? You know...that measly $6.9b leveraged buyout? Yeah, well, that buyout was financed on the back of $1b of 8.5% unsecured notes (issued at par) and a $2.9b term loan.Ah...leverage. Anyway, investors who expected that the value of that paper would remain at par for longer than, say, 2 months, received an unpleasant surprise this week when Amazon announced its "Business Prime Shipping" segment. According to LCD News, the term loan and the notes traded down "sharply" on the news - each dropping several points. Looks like the "Amazon Effect" is biting investors in a variety of asset classes.

One last point: this is awesome. Maybe the future of malls really is inversely correlated to the future of (livable) warehouses. 

*Nevermind that Amazon's operating income declined 40% due to a 35% rise in operating expenses. Why, you ask, are operating expenses up? How else could Amazon be poised to have half of e-commerce sales this year?
 

Recent Feedback - The (Hard) Business of Eating

"Excellent narrative on the restaurant industry in Sunday’s Petition. Btw, I really love the snarky tone of the writing – it’s awesome!" - Managing Director, Financial Advisor. 

PETITION Response: Thank you! We love receiving feedback like this; we noted that QSRs were generally doing fine while fast casual was looking a bit shaky and casual dining was looking like total dogsh*t. Insert Restaurant Brands International Inc. ($QSR), owner of Burger King (comps up 3.6%), Tim Hortons (up 0.3%), and Popeyes (down 1.8%). It reported an earnings beat on higher revenues (and then stock traded down). Meanwhile, Chipotle Inc.($CMG) - bloodbath. No queso for you. Meanwhile, if you feel like trusting Uber with even MORE of your data, maybe THIS new credit card (which promotes 4% off UberEATS) is for you. With news that Aldi's move into the US is compressing grocery prices even further, the casual dining space looks primed for a lot more hurt. 

10/31/17 Updated: Not to belabor the point, but this story by The New York Times helps drive home the issue currently in the restaurant space. There are currently 620,000 eating establishments in the United States. 620,000. That is bananas. 

Too many restaurants? Too many brands? You think? It's a shame that so many folks are sinking their livelihoods into these businesses. We expect the chart to the right to show continued downward trends given recent reports of the likes of McDonalds ($MCD) and Shake Shack ($SHAK) automating.

The (Hard) Business of Eating

Long VC Subsidies & Facebook's Copying Skills

Generally speaking, there are four categories in the dining space. First, there are the QSRs (quick service restaurants). Your run-of-the-mill fast food spots fall into this space. For the most part, these guys are doing okay: McDonald's ($MCD) and Wendy's ($WEN), for instance, have both seen great stock performance in the TTM. Second, there's the fast casual space. Competition here is fast and furious covering all manner of ethnicities and varieties. Chipotle ($CMG) and Panera Bread are probably the two best known representatives of this category. The former has gotten SMOKED and the latter got taken private. Generally speaking, there'll be some shakeout here, but the category as a whole has been holding its own. Third, there's the fine dining space. This is a tough space to play in but there are clear cut winners and losers (Le Cirque, see below): not a lot of chains fall in to this category. And, finally, there is the casual dining category. Here is where there's been a ton of shakeout. This past week, for instance, Ruby Tuesday Inc. ($RT) - the ubiquitous casual dining restaurant loosely associated with bad New Jersey strip malls - got bailed out...uh, taken private by NRD Capital at a fraction of its once $30/share price. (There was some assumed debt, too, to be fair). Moreover, Romano's Macaroni Grill filed for chapter 11 bankruptcy. In RMG's bankruptcy papers, the company's Chief Restructuring Officer said the following, "The Debtors’ operations and financial performance have been adversely affected by a number of economic factors, but perhaps most notably by an overall downturn for the casual dining industry. The preferences of such customers have shifted to cheaper, faster alternatives. On the other end of the spectrum, there is a trend among younger customers to spend their disposable income at non-chain “experience-driven” restaurants, even if slightly more expensive." No. Bueno. See below for a more in-depth (and slightly repetitive summary) of this particular bankruptcy filing. 

Unfortunately, the restaurant world received some other (slightly under-the-radar) bad news this past week: UberEATS, Uber's food delivery service, reportedly generated 10% of the company's total global bookings in Q2 - which, extrapolated, equates to $3b in gross sales for the year. That's a lot of food delivery to a lot of people sitting at home doing the "Netflix-and-chill" thing instead of the eat-microwaved-mozzarella-sticks-at-the-local-Ruby-Tuesday-thing. Of course, this is attributable to Softbank and other venture capitalists who are subsidizing this money-losing endeavor: UberEATS is unprofitable in 75% of the cities it services. On the other hand, do you know what IS profitable? Facebook ($FB). Yeah, Facebook is profitable. And Facebook is going after this space too; it released its plans to get into the online food ordering business earlier this week. And many suspect that this may be a precursor to a foray into food delivery as well. Why? Perhaps Mark Zuckerberg saw Cowen's prediction that US food delivery would grow 79% in the next several years. Delivery or not, anything that helps make online food ordering easier and more mainstream is an obvious headwind to the casual dining spots. Given that this area is already troubled and many casual dining spots have already fallen victim to bankruptcy, there don't seem to be many indications of a near-term reversal of fortune. Headwinds for the casual dining space correlate to tailwinds for restructuring professionals. Sick? Yeah. Sad? Sure. But true. 

Gearing Up for Auto Distress

Is Another Wave of Auto-Related Bankruptcy Around the Corner?

We take this break from your regularly scheduled dosage of retail failure-porn to introduce a topic we haven't addressed yet in detail: auto-related distress.

The auto narrative appears to change by the week depending on, uh, well, generally whatever Elon Musk says/tweets, so let's take a look at what's really been happening recently and filter out the hype (note: Tesla recently failed to deliver on production, lost key execs, and fired hundreds of people on Friday...draw your own conclusions...p.s. stock still going bananas): 

• Short Interest in Auto Parts Stocks. It has increased. This piece attributes this to Amazon's new foray into the car parts business. Is that really the reason why? 
• Sales. Car and light truck sales are trending downward. Auto loans that maybe - just maybe - jacked up sales are also on the decline. Mostly because default rates are going up. Here's a chart showing auto debt climbing as a share of household liability.
• Supply Chain Distress. Last year we saw DACCO Transmission Parts Inc. file for bankruptcy. During the Summer, Takata Inc. filed for bankruptcy (on account of a massive liability, but still) and Jack Cooper Enterprises Inc., a finished-vehicle logistics/transportation provider, reached a consensual agreement with its noteholders that kept the company out of bankruptcy court. For now. Then, a little over a week ago, GST Autoleather Inc. filed for bankruptcy, citing declining auto output. Is this the canary in the coal mine? Hard to say. Literally on the same day that GST filed for bankruptcy - again,citing declining auto output - General Motors, Ford and other OEMs reported the first YOY sales increase (10%), surprising to the upside. It seems, however, that the (sales) uptick may be artificial: in part, it's attributable to (a) Hurricane Harvey damage and mass vehicle replacement; and (b) heavy vehicle discounting. On a less positive note, Ford announced that it will beslashing billions in costs to shore up its financial condition; it also announced back in September that it would slash production at five of its plants. And General Motors Co. announced earlier this week that it would be idling a Detroit factory and cutting production. Production levels, generally, are projected to decline through 2021. Obviously, reduced production levels and idled plants portend poorly for a lot of players in the auto supply chain. 
• EV Manufacturing. There is increasing interest in investing in and developing the (electric) car of the future. And that includes major luxury car manufacturers like Mercedes-Benz and Audi. These manufacturers may just be putting the nail in the coffin for upstarts like Faraday Future, which barely seems like it can get off the ground.
• EV Manufacturing - Second Order Effects. Earlier this year we covered Benedict Evans' (now famous) piece on the second-order effects of the rise of electric and autonomous cars. Others, more recently, have been raising questions about what this electric-car future will look like. While others, still, are saying chill the eff out. We, rightfully questioned what would happen once electric cars gained greater traction given the relatively small number of components therein relative to the combustion engine vehicle. To point, Bloomberg writes, "After disassembling General Motors’s Chevrolet Bolt, UBS Group AG concluded it required almost no maintenance, with the electric motor having just three moving parts compared with 133 in a four-cylinder internal combustion engine." Whoa. That's a lot of dis-intermediated parts manufacturing. UBS also projects that electric vehicles will overtake gas and diesel cars by 2038 - with a rapid ramp up succeeding a slow build. 
• Charging Points. They've doubled in Germany and a plan is in place to get more super-chargers in place by 2020. Royal Dutch Shell announced on Thursday that it agreed to buy NewMotion, one of Europe's largest EV charging companies; it plans to deploy them at existing gas stations. All of this points to bullish views about EV adoption - worldwide. And we didn't even mention China, which is voraciously trying to curb emissions/pollution and go electric. 
• Increases. Range and prices. Anything that combats "range anxiety" will help adoption. Prices, however, still have to come down for electric cars to be competitive. 
• Derivative Distress. This was interesting: folks are concerned that autonomous cars may also mean the end of public radio. Will other players that benefit from captive car audiences, e.g., iHeartMedia Inc. and Sirius, also see effects? In all of iHeartMedia's discussions (see below), what are analysts assuming about the future of car ownership? About the rise of podcasts? 

To put the cherry on top, The Washington Post had a piece just this week asking whether 2017 will mark the end of the internal combustion engine. Once you add up all of the above? Well, it becomes clearer that restructuring professionals may have to re-acquaint themselves with auto distress strategies. Maybe that dude who was once the "gaming guy" who is now the "oil and gas guy" will have enough time to become the "auto guy."

Caesars = "One of the Great Messes of Our Time"?

The Embattled Caesars Entertainment is FINALLY out of Bankruptcy

Last week we highlighted this tweet that poked fun at recent asset stripping (aka dropdown financing) strategies. Great timing, if we do say so ourselves, as Caesars Entertainment has finally emerged from bankruptcy. Not great timing? This (note our reply).

To commemorate Caesars' accomplishment, the Financial Times published this post-mortem (warning: firewall). It’s a solid read. 

A few bits we wanted to highlight:

THIS is understanding who is boss: “One hedge fund investor wondered, then, if the advice of bankers was intrinsically tainted. ‘Private equity firms cut a wide swath,’ the investor said. ‘You do not want to cross them and risk the golden goose.’”

THIS is how you advocate for your client: 

“…[A] lawyer at Paul Weiss who represented the parent Caesars company controlled by Apollo and TPG and who is the longtime outside counsel to Apollo, responded: “I have been a restructuring and bankruptcy lawyer for 28 years and I do not believe David Sambur was more difficult in the Caesars case than anyone else nor in any other transaction I have worked on. David was completely fair and responsible.’” Hahaha. What else is he going to say about his “longtime” client? “Yeah, sure, FT, he was the biggest a$$ imaginable.” Talk about not wanting to cross and risk the golden goose. P.S. Mr. Sambur is now on the board of the reorganized entity. Sounds like a solid source of recurring revenue for a loyal...uh, we mean, commercial, lawyer. 

THIS is key advice (in the comments) to in-house legal representing bondholders: “‘Baskets’. Devil in the detail [sic]”. See, e.g., J.Crew. Haha. YOU THINK?

P.S. There appears to be some healthy skepticism about Caesars' long term outlook. 

Will TOM SHOES Be Another Victim of Private Equity?

Is Blake Mycoskie's Company in Distress?

NPR’s “How I Built This” podcast featuring TOMS Shoes founder Blake Mycoskie is great. But it footnotes a big piece of the TOMS story and neglects another entirely: that Mycoskie sold 50% of the company to private equity firm, Bain Capital. And that the company has debt currently trading at distressed levels and faces a potential liquidity crisis.

Let’s take a step back. TOMS Shoes Inc. is an unequivocal success story and Blake Mycoskie is deserving of praise. He took an idea that was originally meant to be purely charitable and created a company that scaled from $300k of revenue in year one to $450mm in revenue in year seven. His "buy-one-give-one" model has resulted in millions without shoes now having shoes. And the model itself has been copied by Warby Parker, Bombas, and others, across various businesses. 

That said, for us, this tweet sparked a renewed interest in the company. Many have speculated for years that the TOMS story isn’t all rainbows and unicorns and that there are unintended consequences that emanate out of the one-for-one model. The report referenced in the tweet drives this point home. 

Why is this important now? Because the charity narrative is critical to TOMS. The company cannot afford for the public to sour on the message. Particularly since the company hasn’t been doing so hot lately. Revenue fell nearly 24% YOY in Q2 and EBITDA fell 72% YOY to $5mm. Cash is thinning and the leverage ratio is fattening. S&P downgraded the company back in August. The company's $306.5mm senior secured Term Loan is trading at distressed levels down in the mid 40s, a marked decline from the mid 70s in the beginning of ’17. And that is up from a week or so ago, when it was in the low 40s: this partnership with Apple ($AAPL) and Target ($TGT) helped pump the quote. For those who don't deal in the world of restructuring or distressed investing, a plunge of loan value by nearly 100% is, well, quite obviously a terrible sign. This means, plainly, that the market is pricing in the very real possibility that TOMS will default (and won't be able to pay back its loan in full). 

A positive? There are no near term maturities: the $80mm revolver is due in 2019 and the term loan is due in October 2020. Still, at Libor+550bps, the interest rate on the term loan is a minimum of 6.5% which is a cool $21mm in annual interest expense. And that’s before interest rates rise. The company looks like it will have trouble sustaining its capital structure and there’s no indication that the addition of new SKUs will help the company grow into it. With that interest expense, liquidity is going to get tighter. Those of you paying attention have heard this leveraged-buyout-gone-awry-lots-of-interest-expense story before: it’s the same one as Toys “R” Us, rue21, Payless Shoesource, & Gymboree. 

According to S&P, the wholesale business is feeling the trickle down effect of pervasively battered retail with inventory orders on the decline. In a thus far successful effort to maintain margin, TOMS is focusing on operational streamlining. We are guessing that some kind of financial advisor is in there (anyone know?). At a certain point, there are only so many costs you can take out of a business. Does anyone think the wholesale business is set to reverse course anytime soon given the state of retail? We don't. 

Which brings us back to NPR’s podcast. Celebrating how something is built is great and, again, we are big fans. The series has featured a variety of awesome episodes (email us for recs). But it bothered us that we weren't given the whole story. It's not sexy, we get that, but the company's debt load, interest expense, and private equity history should have been the last chapter. What comes next is to be determined. 

Uber's Carnage: the Rise of Distressed Taxis

New York City Taxi Medallions Selling at Significant Discounts

Uber's Carnage (Distressed Taxis). As taxi medallion owners continue to struggle, Evgeny Friedman's bankrupt taxi companies are establishing "market value" for the New York City taxi medallion - and it's at the low end of a recently established spectrum. The New York Times writes, "In August alone, 12 of the 21 medallion sales were part of foreclosures; the prices of all the sales ranged from $150,000 to $450,000 per medallion." Friedman's medallions sold last week to a hedge fund for $186k/each for a block of 46. As context, medallions were once worth as much as $1.3mm. Considering that there are approximately 13.8k taxis in New York City today, one observer noted that it would take Uber (or Lyft), approximately $2.6b to simply buy out the entirety of the City's fleet at that valuation - a cost of a small percentage of Uber's supposedly sizable market cap. So there you have it: "disruption," quantified.

How the Supreme Court Helped Amazon

THE LAW IS ALWAYS ONE STEP BEHIND

Since 2008 Walmart ($WMT) has paid 46x more in income tax than Amazon ($AMZN). That is a crazy stat and the link (source: Axios) is worth a read. But there's more to the Amazon tax story than that: it seems that the United States Supreme Court has contributed to the rise of Amazon and the rise of the "Amazon Effect." 

Here's the condensed version:

• In 1992, the Supreme Court ruled in favor of a mail-order vendor over the state of North Dakota in a dispute over the collection of sales taxes. The case was Quill Corp. v. North Dakota. Why? Taxing the vendor would "unduly burden interstate commerce." The Court ruled that taxation would only apply to retailers with a "physical presence" in states. 
• There's a ton of discussion about the "last mile" now - a reflection of just how much retail continues to evolve - but this ruling impacted corporate decisions in a big way for a long time: why locate a warehouse in the same state as the lion-share of customers and suffer a higher tax burden? 
• Amazon avoided having any fulfillment center in California FOR 17 YEARS to avoid sales taxes. Overstock ($OSTK) and Wayfair ($W) STILL limit their distribution centers for this reason. (Now Amazon collects in all 50 states.)
• The decision looks headed for re-evaluation. In what looks like a purposeful strategy to test the precedent, South Dakota lawmakers passed a law requiring businesses to collect state sales taxes on sales of goods over $100k - even if those businesses have no presence in SD. South Dakota's highest court held that the law violates Quill. 
• So what's next? Looks like the lawyers are primed to petition for certiorari to the Supreme Court with the hope of a reversal of Quill. A reversal could help take some cash off of corporate balance sheets (see chart below) and fill state coffers. This could help counter-balance state budget ills, including underfunded pensions (see below). On the flip side, it may stifle e-commerce startup growth which, in a stroke of irony, may actually benefit Amazon further. Don't hate the player, hate the game...or something.

That Escalated Quickly: Toys R' Us Continues to Fade...

Distressed Investors and Private Equity Owners Seemingly Surprised

People can't seem to get enough of it and so we'll lead again with...you guessed it...Toys R' Us. Let's warm you up with a brief history lesson. Last week we speculated that supplier concerns were turning a stressed situation into a distressed situation. Looks like we may have been right. And so investors who may have been caught off guard are sending CDS coverage flying through the roof in an effort to hedge the value of rapidly declining debt holdings. Speaking of investors who may be worried...CMBS anyone? Now, rumors are that Alvarez & Marsal LLCand Prime Clerk LLC have been hired by the company to complement the previous retentions of Kirkland & Ellis LLP and Lazard Ltd. The smart money seems to think that that full array of professional retentions means a bankruptcy filing is IMMINENT. Alternatively, perhaps the public's newfound awareness of that full array of professional retentions means a bankruptcy filing is imminent. These things have a way of being self-fulfilling. Especially if vendors are paying attention. And it certainly seems like they are. Meanwhile, query what this all means for Vornado Realty Trust ($VNO). Sheesh. Anyway, we're old enough to remember when there was talk of an IPO. 

Geoffrey is on the Ropes: Toys R' Us is in Trouble

Private Equity Backed Retail is in the Dumps

"No Reason to Exist" - Restructuring Banker

Big news this week was CNBC's report that Toys R' Us hired Kirkland & Ellis LLP to complement Lazard ($LAZ) in a potential restructuring transaction.* This was followed by an S&P downgrade (firewall). This is "Death by self-commoditization," someone said. Sure, that's part of it but the more obvious and immediate explanation is the $5+ billion of debt the company is carrying on its balance sheet (and the millions of dollars of annual interest payments). Which, naturally, quickly gets us to private equity: KKR ($KKR), Bain and Vornado Realty Trust ($VNO) own Toys R' Us and so some are quick to blame those PRIVATE EQUITY shops for YET ANOTHER retailer hitting the skids. Post-LBO, this company simply never could grow into its capital structure given (i) the power of the big box retailers (e.g., Walmart ($WMT) & Target ($TGT)) and (ii) headwinds confronting specialty brick-and-mortar retail today (yeah, yeah, blah, blah, Amazon). That said, the gravity of the near-term maturity, the company's current cash position, and the bond trading levels don't necessarily scream imminent bankruptcy. There must be more to this. Speculating here, but this could just be an international value grab. Alternatively, given the tremendous amount of blood in the (retail) waters, we're betting that suppliers are squeezing the company. Badly. Like very badly. And/or maybe the company is trying to scare its landlords into concessions. We mean, seriously, we're in September. And the company is talking about bankruptcy NOW? Mere months from peak (holiday) toy shopping? Strikes us as odd. Someone has an agenda here. 

On a positive note, we want to give the company some credit: it tried its best to control the narrative by releasing its list of must-have toys for the holidays on the same day the Kirkland news "leaked."

*For anyone taking notes, this is a genius stroke of business development by Lazard: pinpoint a potential distressed corporate candidate and then poach that company's Vice President of Corporate Finance. Power. Move. We dig it. 

Minimalistic Consumption by Inheritance

Much has been made about the death of retail and the "Amazon Effect." We mention it quite a bit in our awesome kick-a$$ weekly PETITION newsletters (which you can subscribe to here). But we are also on record as calling the Amazon narrative lazy. After all, there's a reason why resale apps are among the highest downloaded apps in the Itunes app store. We've noted this before: millennials have no problem buying, reselling, buying, and reselling. I mean, sh*t, we're now seeing commercials for OfferUp on television. We've noted the rise of Poshmark and other apps here and here. Perhaps there's more here than meets the eye.

Baby boomers are retiring in droves now and, along with retirement (and creaky knees), comes downsizing. Many are moving into retirement communities and ditching the two-story suburbian house they filled with decades worth of nonsense. As pointed out recently by the New York Times, millennials don't want a lot of their parents' hand-me-downs. So a lot of it is going to Goodwill. 

We expect this trend will continue for the short-term. That said, 90s clothing is back again and so it's only a matter of time before 60s and 70s vintage returns too. When that happens, those dumbass kids will regret turning away their parent's wares.