😎The Professionals Weigh In. Part II.😎

Pros opine on the big restructuring themes for 2022.

Source: Getty Images

Last Wednesday — after publishing thousands and thousands of words over the course of 2021 — we finally took a step back and shut the hell up (though we still had plenty to say in Sunday’s a$$-kicking paying subscribers’-only briefing).

Instead, we reached out to a variety of restructuring professionals* and asked:

✅ What would be your selection for the chapter 11 bankruptcy case of the year and why (don't shamelessly list your own)?
✅ What are 2-3 of the biggest restructuring themes to emerge out of 2021?
✅ Given all of the excitement around mass tort cases like Boy Scouts of America, Purdue Pharma and J&J, what do you think Congress will do about venue and third-party releases, if anything? What should be done?

You can see their answers here.

This week we return to our panel with questions about the future. One important note: answers were, for the most part, submitted on December 13th. Enjoy.

PETITION: Put your prediction cap on: what do you think the 2-3 big restructuring themes of 2022 will be?

Pilar Tarry: “Overall, 2022 will be in like a lamb, out like a lion. If we keep clawing back from this pandemic slowly, and all signs are it will continue to be slow, companies in the hospitality and tourism space will start to crumble. The pace of change in monetary policy will be interesting to watch. It’s like a giant game of Jenga once all the obvious pieces are out.” 

David Meyer: “Rising interest rates will not have an immediate impact on restructuring activity.  But inflation will play a larger role in the latter half of the year coupled with easing of federal assistance together with supply-chain challenges and a decrease in consumer spending. 2022 will largely mirror 2021 with acute and unforeseen situations emerging as the most likely restructuring candidates. Accelerated prepacks will become the norm, and the public announcements about the fastest in-court restructuring ever will cease.”

Brian Resnick: “First, real estate. The pandemic abruptly altered many existing real estate trends.  Nobody is really sure where things will go next but investors are placing different bets— return to work vs. hybrid work; whether remote work leads to less office space or the pandemic leads to the need for more space so employees can be sufficiently distanced; finance and tech moving to Florida and Austin; business travel as usual or zoom meetings here to stay; demand for additional workspace in suburbs and warmer remote work destinations; continued growth of residential housing prices; rising interest rates cooling that growth.  Real estate bets are usually highly-levered and not all of these predictions can turn out to be right. Next, China. The restructuring world is obviously watching Evergrande and Kaisa closely, given the more than $5 trillion in debt that Chinese developers took on during the country’s recent building boom.  Total sales among China’s largest developers have plummeted over 35% year over year.  Any restructuring of the country’s major developers could have cascading effects throughout a very large industry and national economy.  If the Chinese government allows for restructuring of these distressed businesses or does not successfully manage these economic pressures, the global reverberations can be massive. Lastly, opportunistic recapitalizations. Last year, companies with medium-term debt maturities amended and extended loans to take advantage of favorable rates and market conditions.  That trend will probably continue this coming year as companies with 2023-2024 maturities opportunistically look to recapitalize and get additional runway while the getting is good.” 

Natasha Labovitz: “I don’t think we’ve seen the end of targeted mass-tort restructurings, or the related focus on third-party releases.  As more people understand what the so-called “Texas two-step” really is (hint, it’s really no more or less than a spin-off using 21st century deal technology) I predict some of the furor will die down, but the litigation will remain.  Speaking of litigation, we’re also likely to continue to see cases that sharpen the line between what borrowers and majority groups of lenders can – and cannot – do to minority and holdout lender groups in the context of liability management.  And, I’ll go way out on a limb and say that 2022 will be a year when some checks come due for businesses whose pandemic-era borrowing dwarfs their post-pandemic business prospects.  Lenders’ patience and the era of easy money will not last forever.”

Rachel Albanese: “(1) Will there be large restructurings in 2022? When will the bubble burst? (2) More mass tort action. (3) Your guess is as good as mine!”

Matthew Dundon: “Impact of higher rates, including return of a key credit metric only analysts over 40 remember – EBITDA to interest expense; recency bias luring people into low-priced 2L and unsecured bonds and loans shortly after filings because that was the money-making trade for the past couple of years.”

George Klidonas: “Third party releases, unless the Supreme Court or Congress weigh in sooner rather than later to determine the issue. Out of court restructurings, creditor on creditor violence, and liability management litigation will likely continue, particularly if certain market conditions continue.”

Damian Schaible: “Bootstrap A&Es – As many have discussed, we have added tremendous leverage to the market and capital structures over the past couple of years, and financing documents have gotten looser and looser.  As a result, there are often no traditional triggers, so capital structures can more easily persist through poor performance with liquidity issues or maturities being the only practical limitations.  With investors currently interested in keeping money to work wherever possible and obvious uncertainty in the future with respect to how long this remains the case, sponsor portfolio companies and public companies alike are looking for ways to extend maturity runways by multiple years.  Wherever traditional refinancings can be used, they will be.  Where leverage or performance issues mean that’s not on the table, companies are engaging with existing creditors to seek maturity extensions in exchange for new junior capital and/or better documents and/or terms.  We will see this dynamic accelerate until rising rates begin to bring people to the table more naturally.

Liability Management - As you’ve often reported, docs are now looser than ever before, and when you add to that investors looking desperately for things to do, you get lots of liability management opportunities for companies that would be distressed in normal times.  We will see lots of liability management exercises in 2022 as a result.

Inflation and rising rates - It’s no longer “transient” and it’s the only thing likely to stop the music at this current all-night market rager…. Inflation is the one thing the Fed can’t really manage away, and it would lead to rising interest rates that would stop the party for a lot of severely over-levered balance sheets.  (How is that for mixing metaphors?!) Who knows if it will happen in 2022 or later, but rising rates could change the game.”

Chris Ward: “First, I could have used this as a 2021 theme as well, but the continued downturn in the restructuring industry.  It will undoubtedly change, but the start of 2022 will continue with the entire industry continuing its sabbatical.  I believe my ’21 prediction was when is the wave coming?  Unfortunately, the answer may once again be – next year. Second, scrutiny.  Whether its third-party releases, independent directors, conflicted professionals, the enhanced scrutiny on the legal profession will again be a prominent part of our practices. And, third, out of court alternatives. Given the state of the economy and liquidity available to PE firms, the biggest trend may be what happens outside of bankruptcy courts.  There are still plenty of distressed companies and there are still many deals being done.  We have seen an uptick in Article 9 sales, distressed M&A deals being done out of court, and state law alternatives like ABCs and Receiverships.  When times are tight, people want to do the deal and not have to pay the costs of a full chapter 11 process.  I think this trend will continue into ’22.”

Navin Nagrani: “First, just technically speaking  - interest rates rising in 2022 coupled with the Fed plans for tapering will generally cause market and asset valuations to come down and the cost of indecision and inaction to increase (as it relates to loans in workout). Second, I think we will see more private equity sponsor backed loans in workout amongst traditional banks and non-bank lenders (BDCs, private credit groups, SBICs, etc.). Lastly, real estate in general is a slow moving asset compared to other assets like inventory or receivables..  There are some fundamental issues going on with certain types of real estate right now like office that will eventually make its way onto the restructuring scene as rents roll over and/or debt comes due.”

Steven Korf: “Third-party releases and venue shopping will continue to be hot topics into 2022. As a healthcare advisor, I would be remiss if I didn't mention the themes we are predicting in the healthcare industry in 2022. With temporary stimulus funding drying up from the CARES Act, the financial strain on hospitals and health systems will no longer be masked. While we expect hospitals may receive limited funding from the various federal infrastructure and support packages going forward, it will only provide a short-term solution to long-term operational problems and extend the timeline for entities that would otherwise be absorbed by larger systems, file for bankruptcy, or close.”

PETITION: What is the disruptive innovation trend that you’re most curious about and why?

Natasha Labovitz: “I’m interested to see what happens next in the so-called “Great Resignation”. Is this a short-term pandemic-driven phenomenon, fueled by media hype and a very catchy name, or is it in fact a societal shift that has been long in coming, which ultimately will rebalance the economic power between employers and employees and reshape the definition of career success?”

Chris Ward: “Hybrid court hearings.  Rightfully so, much ado is made about the cost of bankruptcy. However, virtual court hearings can drastically reduce the cost of professional fees for cash strapped debtors. Hybrid hearings would allow the soccer team that some firms send to the first day hearing to stay home and virtually participate.  We are approaching two years of virtual hearings and the courts and the entire restructuring industry have not missed a beat. This trend should continue, with the caveat that some evidentiary hearings and case events must be in person to delve into the veracity of the witnesses, but this is a positive trend that benefits everyone.”

David Meyer: “Zoom and 5G/increased high-speed connectivity.  Will facilitate work-from-home trends, change the way we do business (all in favor of Zoom first-day hearings raise your hand), how we shop, how we interact with each other, and how we manage our teams and optimize our culture at our respective firms.  It is inescapable that all restructuring professionals have a different work experience than they did just a few years ago, and this is arguably most impacted at the more junior levels.  The impact is at its earliest stages and will have long-lasting consequences.”

Brian Resnick: “In recent years, particularly in 2021, direct lending has increased precipitously in number of funds (to over 700), capital (to over $300 billion) and deal size (some recent ones exceeding $2 billion).  A common direct lending unitranche structure, where a single lender (or small group) holds the debt (sometimes a single lien, first out / second out structure) without syndication, has been a major selling point for direct lenders to act more like partners invested in the borrower’s success.  This structure allows a borrower that becomes distressed to negotiate with one or a small group of lenders.  The large-scale direct lending market did not exist prior to the 2008 crash, and it will be interesting to see how direct lenders manage the next downturn.  In the current borrower’s market, lenders competing hard for deals often try to market themselves as having a collaborative and flexible client-service reputation.  If defaults start to increase, direct lending funds will have to make tough calls to balance their drive to compete for new loan origination (to deploy significant accumulated capital) with the need to minimize losses from existing portfolios.  Direct lending transactions typically (though not always) still include leverage ratio-based financial maintenance covenants, so those lenders have more ability to push for restructuring than under the “covenant-lite” term loans that have become the norm across the broadly syndicated market. Direct lending structures also often include additional powerful lender protections, like pledge rights allowing lenders to replace boards.  The documentation used in direct lending transactions has not yet been tested as extensively as for more traditional loan market structures.”

Rachel Albanese: “Activist “stonk” investors.  For example, will Macy’s cave to the recent demand to create a Tesla showroom in its flagship stores and start accepting crypto? How will AMC’s new popcorn business fare? Will any CEO of a public company actually show up at an investor conference sans pants and, more importantly, how would it affect the company’s stock?🚀 🚀 “

Damian Schaible: “SPACs…. In 2021, we saw tremendous numbers of both early stage and potentially distressed companies go public through SPACs.  I am interested to see how these companies perform longer term and what the market implications will be.  Traditionally, for companies to go public, the companies and their governance, financial reporting and other systems had to be much more mature than many SPAC companies are – the traditional IPO underwriters would want to see late stage, seasoned companies looking to go through a traditional IPO process.  There obviously isn’t a lot of debt on these companies, so it is unlikely to lead to large numbers of traditional restructurings, but I am interested to see how they operate longer term and what regulatory and litigation impacts may develop.”

Navin Nagrani: “WFH has created massive ripples in the way people work and interact with others.  What is our new normal? Decentralized finance is happening - what are the downstream implications and opportunities for restructuring professionals?”  

George Klidonas: “Although I am not necessarily certain if, how and when cryptocurrency will completely disrupt the system it was intended to, i.e., replacing fiat or government-issued currency.  But one thing is for sure.  Cryptocurrency is infiltrating our everyday life more and more, e.g., Overstock, PayPal, Etsy, Starbucks, Dallas Mavericks, and the more mainstream it becomes, the more likely we are to see disruption in both the industries it is accepted in, as well as the financial institution sector as a whole.”

Ryan Preston Dahl: “No idea what “disruptive” even means anymore.  I’m not a millennial.”

Steven Korf: “I am interested to see how Artificial Intelligence (AI) and machine learning, as well as new entrants to traditional healthcare delivery, will continue to disrupt the industry.

AI and machine learning are future disruptors that cryptocurrency analysts and Elon Musk, Disrupter-In-Chief, are suggesting will reframe life over the next decade.  Both will be backbones to support predictive modeling for global health trends, climate change, and geographic displacements, which could contribute to economic upheaval.

Large commercial corporations and private equity firms have entered the healthcare market and are providing new channels of care and disrupting current providers. While this may be painful for many existing traditional organizations, I predict that we will see improvements to the delivery of care at more cost-effective rates with the new entrants.”

Pilar Tarry: “Well if you must know, crypto.  Because I just don’t get it.  Now that Gwyneth is officially in the game though, maybe I should circle back on that.”

Matthew Dundon: “Restructuring professionals and distressed investors have no idea of the informality of – or absolute absence of – corporate organizational structures and financial records in even quite large blockchain / crypto / defi companies (or “companies” in some cases).  Failures of those entities will be extremely challenging in every sense (conceptual, execution, etc.).”

Dan Dooley: “Back to the Future Supply Chains. It’s already started but you will see significant resourcing back to North America from the Pacific Rim and especially China as the labor cost differential is not nearly as great as it was 10 years ago, the pandemic has exposed the logistics risks of over-the-ocean sourcing and the relatively new political risks with sourcing specifically in China and perhaps in Taiwan as well.”

PETITION: What are you “short” going in to 2022 and what are you “long”? 

Steven Korf: “In 2022, I’m "short" China based on the evolving but unresolved Evergrande situation (multiple defaults and the Chinese government’s recent lowering of capital ratio requirements for its banks which seems to hint at something more serious) and recent IPOs for overvalued tech and direct to consumer retail companies.

LONG: ??? I am a restructuring professional.”

Natasha Labovitz: “Short the ski season in my Southern Vermont homeland, where the lack of snow makes it feel anything like Christmas-time as I type this.  Long party dresses, airplane tickets and Broadway, as pent-up demand seems to be overcoming all fear of COVID variants.  Omicron who??”

Chris Ward: “Long – Restructuring professionals.  Conservatively, $4 TRILLION was pumped into the U.S. economy during the pandemic.  Not to mention the recent $500 MILLION infrastructure bill.  Inflation is already running rampart.  Omicron (and whatever the next variant will be) are threatening closures again.  The supply chain may never recover.  This economy will crumble faster than Kevin Spacey in House of Cards.  Like dragons in Game of Thrones, restructuring professionals will resurface and rule Westeros once again! Short your 401(k). See the foregoing.”

Brian Resnick: “Short predictability.  Major freefall chapter 11’s have become fewer and farther between, but market conditions have put pressure on the usual tools that lenders and potential acquirers use to try to keep prearranged and prepackaged cases streamlined.  Stalking horse protections are less likely to deter competing bidders when valuations can rise rapidly.   Lenders looking to use a fulcrum security to acquire a debtor will continue to face the high-class problem of payment in full as more junior creditors or even shareholders take a large share of exit ownership.  A growing number of sophisticated players are under intense pressure to find strategic advantages in a smaller number of cases, leading to increasingly creative and aggressive strategies.  Out-of-court lender-on-lender violence in liability management transactions (uptierings and drop-down financings) has become increasingly common. A “first lien” piece of paper doesn’t assure a lasting first lien position the way it used to.  More than ever, stakeholders need to look carefully around every corner to anticipate non-obvious arguments and angles that could weaken their position and leverage in a restructuring.

Long volatility and major disruption.  The world feels like it is going through the most rapid rate of change in my lifetime, in both positive and negative ways.  We’ve seen a surge in development of new potentially-transformative industries based on technologies like artificial intelligence, the metaverse, blockchain and cryptocurrencies, electric (and maybe self-driving) cars. At the same time, there is increased focus on growing wealth-disparity, social polarization, climate-based risk, inflation and other collective challenges.  Aggressive fiscal policy has so far allowed the US economy to dodge the economic shocks of the pandemic, and it is hard to predict what will disrupt the current equilibrium or when that will happen.  Upcoming efforts to tighten today’s easy money fiscal policies during a credit-fueled market boom will require the federal reserve to walk across a shaky tightrope with lots of risk for a misstep.”

Rachel Albanese: “I’m “short” low orbit “space” travel (it’s like going to The Four Corners and saying you’ve been to each state). I’m “long” DTC – not necessarily the existing brands (Allbirds!) but the concept – and malls too.”

Damian Schaible: “Short Traditional Restructurings - Until inflation and rising rates call the police on the party, there won’t be a lot of traditional restructurings.  As discussed above, sponsors and public companies will use market refis, SPACs, additional leverage, liability management and bootstrap A&Es to delay the inevitable as long as possible, and traditional equitizations will be fewer and further between.

Long Liability Management and Bootstrap A&Es — Loose docs and free flowing money will lead to more liability management and “bootstrap” amend and extend transactions to buy runway for sponsors, equity and junior debt.”

Ryan Preston Dahl: “My views on “short” remain completely unchanged since I last had the chance to chat with you fine fellas—although I do wish Mr. Springsteen a happy holiday.  In terms of 2022, I’m very long Amazon’s new “Second Age” series derived from the Lord of the Rings legendarium.  My fellow nerds in the PETITION readership know exactly what I’m talking about.”

Dan Dooley: “Short technology and the internet companies who are struggling to be cash flow positive. This bubble will burst just like the technology sector did in the year 2000 for Y2K. Long anything Mexico, which will be a big winner from the pandemic.”

David Meyer: “I am “short” on returning to the office (and business travel) returning to pre-pandemic practices.  The world has changed and there is no such thing as “a return to normal”. I am “long“ that 2022 will present further opportunities to balance the best in-person aspects of our work with the lessons learned over the last 20+ months to create a better, more enjoyable, and more efficient working environment – firms that do this well will be able to create stronger cultures that will generate sizable benefits over the long term compared to those who get left behind.”

Navin Nagrani: “‘Short’: I generally think the “metaverse” and most cryptocurrencies are in somewhat of a hype bubble - too many get rich stories/schemes.  There is no easy money over long periods of time and I think this principle will play out here as well. ‘Long’: I continue to believe that relationships and health compound with energy, intention and time just as much as money does.  I am “long” on focusing on what’s really important in 2022.”  

George Klidonas: “Short Auto Sector.  The auto sector is likely to see short term stress particularly at a time when high demand for semiconductors and global bottlenecks throw supply chains into disarray.  These supply chain constraints could lead to decreased revenues, which in turn, challenge the ability for companies to deal with funded debt (especially at a time when the industry has taken on more debt).  And it is unclear whether higher car prices can fully offset reduced sales volumes.  Beyond 2022?  The industry’s migration toward autonomous vehicles could lead to long term distress for certain players in the auto industry.  But time will tell.

Long Financial Institutions. With the Federal Reserve signaling that they are going to raise interest rates in 2022, banks and financial institutions are likely to see an increase in revenues.  And with banks sitting on a ton of cash, they are likely redeploy capital back into the system.  I believe financial institutions (e.g., retail, commercial and investment banks, as well as brokerages) and FinTech are going to be big winners in 2022 if raise start to go up.”

Pilar Tarry: “Long: Cybersecurity firms/technologies as privacy and security concerns increase with higher use of technology and living more of life online. Short: Hospitality, tourism and urban mobility. Long: E-logistics companies. Short: the ultra-short case, except where the business consequences are truly disastrous. Long: Anyone who can successfully navigate the growing divide between high and middle income countries and poor countries, and similar divisions in families here at home. Short: 2nd years, after almost two years of trying to learn how to do this work in a WFH environment, it’s not surprising they’re looking at their options.”   

🤔

* Pilar Tarry is a Managing Director at AlixPartners. Damian Schaible is a Partner at Davis Polk & Wardwell LLP. Rachael Albanese is the Vice-Chair of the Restructuring Group and a Partner at DLA Piper. Dan Dooley is a Principal and CEO at MorrisAnderson. Ryan Preston Dahl is a Partner at Ropes & Gray LLP. Chris Ward is a Partner and Practice Chair at Polsinelli. Brian Resnick is a Parter at Davis Polk & Wardwell LLP. Navin Nagrani is an Executive Vice President at Hilco Real Estate. Natasha Labovitz is a Partner and the Co-Chair of Debevoise & Plimpton’s restructuring group. Steven Korf is a Senior Managing Director at and Co-Founder of ToneyKorf Partners. Matthew Dundon is a Founder and Principal of Dundon Advisers LLC. David Meyer is a Partner and Co-Head of Vinson & Elkins’ Restructuring and Reorganization group. George Klidonas is a Partner at Latham & Watkins LLP.

👕thredUP: Resale Goes Mainstream👕

For years, PETITION has been covering the emergence of resale as a new and growing retail category (see here, here, here and here). If VCs can write self-aggrandizing social media posts whenever one of their investments goes public, surely we can take a small victory lap too. On March 3, 2021, thredUP Inc. (“thredUP”) filed its S-1 ahead of an IPO. The S-1 allowed us to dig deep into a major player in the resale market.

thredUP claims to be one of the world’s largest online resale platforms for second-hand women’s and kid’s apparel, shoes and accessories. Founded in 2009, the business currently boasts 428,000 Active Sellers and 1.24 million Active Buyers who come to the platform to find items at an up to 90% discount to their estimated retail price. thredUP claims its platform is loved by both parties; buyers love shopping value, premium and luxury brands all in one place, while sellers love the convenience of unlocking value for either themselves or the charity of their choice. thredUP sees a huge opportunity in the resale market — according to the GlobalData Market Survey, the resale market is expected to grow from $7b in ‘19 to $36b by ‘24, representing a compound annual growth rate of 39%.

How Does thredUP’s Business Work?

thredUP’s entire end-to-end chain works as follows:

A seller signs up for thredUP and orders a Clean Out Kit. She fills thredUP’s ‘Clean Out Kit’ with items from her closet that no longer spark joy:

Sellers on thredUP’s platform benefit from an extremely low touch platform: thredUP essentially does all the work. The seller’s only decision to make prior to shipping their clothing is whether they want to sell their clothing for cash, store credit, or donate the proceeds to charity. Once that decision is made, the seller fills the Clean Out Kit bag and leaves it on their doorstep for a mail carrier pick up, or drops it off at a retail or logistics partner location for shipping, free of charge. Once the items are shipped, the seller’s work is finished. thredUP’s proprietary platform manages item selection and pricing, merchandising, fulfillment, payments and customer service. thredUP uses an internal software algorithm to “predict the demand for an item and determine a listing price for it, along with setting the seller payout ratio, with the aim of optimizing sell-through, gross profit dollars and…unit economics.” Seller payout ranges from 3% to 15% for items listed at $5.00 to $19.99, and up to 80% for items listed at $200 and above. For the year ended 12/31/20, that resulted in an average seller payout of 19% of the item sale price with an average seller payout per bag of $51.70. thredUP is clearly working with small dollars, but on significant volume.

Harvard Business School covered thredUP’s origins as “a peer-to-peer online clothes sharing site for adults.” In the words of co-founder and CEO James Reinhart, “It was a great story. And a bad business…Customer adoption and use of the product wasn’t nearly what we had hoped.” In 2009, acceptance of secondhand clothing was not mainstream. In 2012, thredUP pivoted to the children’s market. Per Mr. Reinhart, “[thredUP] realized there was a huge opportunity in kids because there’s the forced obsolescence of kids’ clothing.” thredUP was able to scale the business quickly from less than 20,000 adults to more than 300,000 parents, adding at a rate of 500 to 1,000 per day. thredUP discloses in its S-1 that the company shifted again in mid-2019, de-prioritizing its product sales in favor of consignment sales. As thredUP’s S-1 indicates, consignment may be a vastly superior retail business model. Per the S-1:

“We believe that operating primarily on consignment also gives us the ability to drive stronger future margins than traditional inventory-taking business models because we incur minimal inventory risk and benefit from favorable working capital dynamics. Our buyers pay us upfront when they purchase an item. For items held on consignment, after the end of the 14-day return window for buyers, we credit our sellers’ accounts with their seller payout. Our sellers then take an average of more than 60 days to use their funds.”

In other words, thredUP presumably derives a kind of “float” benefit as well, generating interest income off of that 60-day average. In addition to those positives, thredUP preserves a degree leverage over its sellers. Once a customer ships its items to thredUP, thredUP can decide which goods will ultimately be passed through to the marketplace, and at what price they will be listed at, therefore locking in platform product quality and margin.

thredUP - A Contrarian Strategy

In a letter to potential shareholders, Mr. Reinhart outlines the criticism thredUP faced from its earliest days:

“Since the earliest days of thredUP, we have been told that our strategy was contrarian. That our commitment to cracking the hardest infrastructure, supply chain and data challenges in the service of a better customer experience was risky or could lead to failure. “Touching things” is hard. “Low price points” are hard. “Single SKUs” is just plain crazy. Yes...We are doing the hard things that meaningfully expand this opportunity and enhance our leadership position. I have been willing to be misunderstood and even underestimated in taking this approach, driven by my belief that businesses that are harder to build in the short-term can have extraordinary long-term impact.”

In its S-1, thredUP outlines various proprietary technologies and processes it utilizes to execute its “contrarian” strategy. thredUP operations are “purpose-built for “single SKU” logistics, meaning that every item processed is unique, came from or belongs to an individual seller, and is individually tracked….” As there are no barcodes on clothing, moving all these unique SKUs can only be accomplished through technology. thredUP’s technological aids cover i) visual recognition of items, ii) supply acceptance and itemization, iii) pricing and merchandising, iv) photography, and v) storage and fulfillment.

Photography is one of the largest and most expensive pain points when prepping an item for online sale. thredUP claims it “utilizes machine learning and artificial intelligence” and “software that automatically selects the optimum photo to drive buyer engagement…[a] specialized photo selection capability” which enables thredUP to produce hundreds of thousands of high-quality photos a day without a professional photographer.

As Mr. Reinhart alludes to in his letter, one key to managing thredUP’s volume is reliable distribution. thredUP has leased five different distribution centers in Arizona, Georgia, and Pennsylvania, with total capacity of 5.5 million items (the company has plans to expand that to 6.5 million by the end of 2021). On current capacity, thredUP has the ability to process more than 100,000 unique SKUs per day. thredUP’s engineering team has developed and implemented automation technology, which the company believes results in reduced labor and fixed costs while increasing storage density and throughput capacity. thredUP also claims their software matches buyers to the closest distribution center, while personalizes the assortment potential buyers they see on the marketplace to items that are physically closest to them. This geographical personalization enables buyers to find items that are lower priced (the closer the item, the lower the price) and more likely to arrive quickly. Underlying all this is thredUP’s trove of data. thredUP’s business captures large volumes of data from touch points throughout the resale process, including transactional and pricing data from brands and categories, as well as behavioral data from buyers and sellers, which is fed directly into thredUP’s pricing algorithm.

thredUP’s website is a disruptive model which dramatically improves the resale shopping experience for both buyers and sellers. thredUP believes resale is on pace to overtake the traditional thrift and donation segment by 2024. For buyers, thredUP offers depth of selection and ease of browsing. The company claims it lists an average of more than 280,000 new secondhand items each week, with 35,000 brands across 100 categories and across price points. There’s no question thredUP offers a dramatically improved shopping experience versus traditional brick & mortar thrift stores. In comparison to traditional thrift stores where buyers sift through reams of clothing, thredUP undergoes a “rigorous twelve-point quality inspection” which they believe prevents low-quality items from being listed. In the S-1, the company discloses that only 59% of the items it received from sellers were listed on the marketplace after curation and processing. thredUP offers evidence this quality inspection produces results: of thredUP’s 12% return rate for total items sold, returns due to poor item quality accounted for less than 2%.

Per thredUP’s market report, online thrifting growth estimates are dramatically outperforming both brick & mortar thrifting as well as broader retail.

The Growth of Thrifting – Illustrated

In 2019, resale grew 25x faster than the broader retail sector…

…a growth trend that was aided by COVID, as shoppers found value and entertainment in thrifting…

Secondhand retail is taking market share…

…fueled in part by celebrities who believe secondhand is the future of retail.

Thrift is now mainstream, and thredUP’s new brand image is treating it as such:

thredUP’s brand pivot along with commentary by Mr. Reinhart was featured in an October 2020 CSA article:

“The perception of thrift has changed. Consumers are not only open to shopping secondhand, but they are wearing it proudly. ThredUP’s brand evolution acknowledges this shift from stigma to status, and celebrates our community of thrifters who are thinking secondhand first.”

thredUP - What’s the Risk?

If thredUP is a retailer with uniquely positive dynamics that also plays in an ESG-positive part of the consumer market that’s growing tremendously among Millennials and Gen Z, what’s the risk in this business model?

To start, cash flow out of the gates isn’t great:

Source: PETITION LLC

On a CFO – CapEX basis, thredUP burns more than $38mm of cash per annum. Taking a look at the income statement, thredUP’s Operating Expenses have been growing at a faster rate than Sales.

Source: PETITION LLC

Part of that slowdown may be due to the company’s forced revenue mix shift towards a consignment model. But COVID certainly didn’t help. thredUP notes that gross profit dollar growth and average contribution profit per order in 2020 both were lower than company estimates as a result of its COVID-19 response, which included higher levels of discounts and incentives and higher fixed costs per order. A Glossy interview with Fashionphile founder Sarah Davis indicated that resalers weren’t immune to lockdown-driven retail woes:

“According to Sarah Davis, founder of the Neiman-Marcus-invested resale platform Fashionphile, sales dipped considerably in March, but have risen each week in April, rebounding by more than 300% so far; sales are on track to be back at pre-coronavirus levels by May. But product from sellers has slowed to a standstill for a simple reason: Sellers don’t want to bring their bags of unwanted pieces to the post office while quarantined.

“Like all resellers, we are supply-constrained,” Davis said. “When things closed down, we thought people would have nothing better to do and use the time to clean out their closets. And that’s true. But the actual process of getting the product is the much harder task. Acquiring new product came to a crashing halt when we closed our warehouse [in March], which made it impossible to receive new product and really hard to process product that had already come in. And once it was back open, it was still hard to get people to go the post office to drop things off. So people had product they wanted to get rid of, but no way to get it to us. That was the big problem to solve.”

Whether thredUP’s logistics network is truly a groundbreaking, competitive advantage is up for debate. For one, the company doesn’t own its distribution centers and cannot guarantee supply, which in a space as competitive as resale may be problematic. Ms. Davis’ comments are telling:

“Luxury resale will always be supply-constrained,” Davis said. “People will always buy a Dior bag at a reduced price; the hardest thing is keeping the supply coming. It’s honestly a miracle that we have 20,000 items on the site, but each one of them came from individual people, so we absolutely need people to keep selling to us, whether it’s individual customers or even small business resellers, which sell to us sometimes. I would bet that for any reseller right now, the seller is where their focus is.”

A core strength of companies such as Amazon.com, Inc. ($AMZN) and recent IPO Coupang Inc. ($CPNG) is their logistics networks, which serve their customers quickly and efficiently. thredUP appears to be on the verge of successfully disrupting brick and mortar thrift. However, thredUP’s competition is fierce, including publicly traded resellers such as The RealReal Inc. ($REAL) and Poshmark Inc. ($POSH). The winner in the space is likely to be the reseller that best manages the supply constraint, and is able to create a friction-free environment for buyers and sellers. Logistics is the lynch pin of the resale business.

However, thredUP’s business model does differentiate it from other resale platforms. For example, thredUP’s total active management system is ideal for sellers who want a zero touch experience. This is a sharp contrast to Poshmark, which enables a seller to effectively run their own e-commerce consignment storefront. On Poshmark, sellers upload their own photos of the items they want to sell and determine their own pricing. These sellers can also leverage social media followings to drive sales.

Regardless of which platform is in vogue, we continue to think resale is a retail trend that has legs. Every dollar that goes into retail is coming out of online fast fashion like Zara Industria de Diseño Textil, S.A. ($IDEXF) and H & M Hennes & Mauritz AB ($HM-B.ST) or brick and mortar. Resale’s mainstream acceptance is being fueled by sustainability motives and endorsed by both celebrities and trendsetting, high fashion brands. Retail platforms are engaging with resale platforms like thredUP to explore new cross-selling opportunities. These drivers are accelerating growth. In its 2018 resale report, thredUP estimated the resale market to grow at a 15% annual CAGR from 2017 - 2022. In the 2020 resale report, the resale market is now expected to grow at a 39% CAGR from 2019 - 2024. If these estimates hold up, the HBS case studies of thredUP will need to be rewritten again to incorporate the foresight of its founders and a business ahead of its time.

And the narrative that brick and mortar retail destruction starts and stops with Amazon will need to become more inclusive of other factors. Just like we’ve been arguing since our inception.

💪Virgin Active Ltd. is Looking Unfit 💪

The U.S. has been quiet and the pandemic stifled travel and so we find ourselves wistful for far flung places. There's some action there, it seems. 

Source: Getty Images

Take Britain for example. Per Bloomberg:

A record 35% of U.K. companies issued profit warnings last year, according to a report by the consulting firm EY. There was also a surge in the number of companies issuing three or more profit warnings in a 12-month period, a warning sign for insolvency.

One company, in particular, caught our eye:

I'm finally out of my Virgin Active contract 😅

— Sentosa (@Vuyixen) January 18, 2021

Looks like some lenders — namely, Lloyds Banking Group — feel similarly about Virgin Active Ltd. Per SkyNews on January 20, “Britain's biggest high street lender is to extricate itself from a syndicate of lenders to Virgin Active, the struggling gym chain set up by Sir Richard Branson's business empire.” And Lloyds wasn’t the only shop jumping ship, “City sources said on Wednesday that another of Virgin Active's seven-strong lending syndicate was also planning to offload its position, although the identity of the other bank was unclear.” The fitness chain is currently in the market for rescue financing to outlast the pandemic. Lloyds and the other unnamed aforementioned member of the lending syndicate clearly don’t seem eager to wait around for the end to come. Indeed, per SkyNews on January 30:

“Lenders to Virgin Active are preparing for a fight over the future of one of Britain's biggest gym chains as its owners draw up a radical blueprint to help it survive the pandemic. Sky News has learnt that a syndicate of roughly half a dozen banks held a beauty parade of financial advisers this week to negotiate a restructuring of the company….” (emphasis in original)

This news set the chain up for a barbell drop to the head: the company got thrashed in the market. The company’s term loan plummeted 17% recently from 88 to around 73. The company has approximately 238 clubs worldwide with a large presence in places hit particularly hard by the pandemic: South Africa (😬), Italy (😬😬) and the UK (😬😬😬).

Perhaps the lenders and the company can hold work out talks while they work out. 🙄

💥Will the Biden Administration Disrupt Private Prisons Like CoreCivic Inc?💥

🚨CoreCivic: A Stable Business with a Clouded Future🚨

As we’ve made more than abundantly clear lately, there is a relative dearth of distressed names relative to ten months ago. Bankruptcy professionals remain on the hunt, however — Daddy needs to get paid, after all — and that hunt entails digging a bit deeper for mandates. With the Biden Administration now several weeks in, we can’t help but wonder whether new policies may disrupt the status quo, potentially creating distress out of thin air. One potential area of interest is for-profit private prisons.

*****

CoreCivic Inc. ($CXW) is the nation’s largest owner of partnership correctional, detention and residential reentry facilities a/k/a ‘private prisons’. Headquartered in Nashville, Tennessee, CXW claims to be one of the largest prison operators in the United States, and believes it is the largest private owner of real estate used by U.S. government agencies. CoreCivic management also believes the company serves a public good through corrections and detention management, a network of residential reentry centers to help address America’s recidivism crisis, and government real estate solutions.

CXW operates its business through three segments: (i) Safety, (ii) Community, and (iii) Properties:

• Safety. As of Q320, CoreCivic Safety operated 49 correctional and detention facilities, 42 of which are owned, 7 of which are leased, with a total design capacity of approximately 72k beds. Management believes they own 58% and lease 39% of all privately-owned prison beds in the US. In 2019, 24% of CoreCivic’s revenue came from states and 66% from the Federal government. 51% of CXW’s revenue was derived from the Bureau of Prisons, 29% derived from the U.S. Immigration and Customs Enforcement (ICE), 17% from the US Marshals Service, and 5% from the Federal government.

• Community. In 2019, CoreCivic Community owned and operated 27 residential reentry centers with a total design capacity of approximately 5k beds.

• Properties. In 2019, through its CoreCivic Properties segment, the Company owned 57 properties for lease to third parties and used by government agencies, totaling 3.3mm sqft.

CXW’s geographic presence spans 21 states, with a predominant footprint in Colorado (14), Texas (14), Oklahoma (7), Tennessee (7), Arizona (5), Georgia (5), California (4), and New Mexico (3), among others.

Since Q116 occupancy at CXW facilities has been relatively stable but has been negatively impacted in recent quarters by COVID-19.

Near the end of Q120, in an attempt to contain the spread of COVID-19, the Federal government decided to deny entry at the United States southern border to asylum-seekers and anyone crossing the southern border without proper documentation or authority. This negatively impacted CoreCivic, as the number of people apprehended and detained by ICE declined significantly. CXW also cites in its filings that disruptions to the criminal justice system have also contributed to a sequential reduction in the US Marshals Service offender population, as the number of courts in session declined rendering prosecutions impossible. If COVID-19 border restrictions and pandemic-enforced criminal justice delays continue, CXW could see a greater negative impact on their inmate populations. Further, increased expenses associated with maintaining higher health standards during the pandemic could have a negative impact on CXW’s profitability. Now just imagine what happens if they have to offer organic food to all of their inmates too!!

Source: Getty Images

*****

Private prisons have been scrutinized by both government participants and the media over the years for an undue focus on cash flow at the expense of both their inmates and employees. A 2016 Department of Justice report found that private prisons had (i) higher violence and (ii) lack of adequate security and healthcare in comparison to federal facilities. We’re not in a position to evaluate that claim one way or another: what we can say is that CXW is a fairly stable, cash flow generating business. Revenues from 2012 – 2020 help illustrate that stability. CXW revenue grew throughout most of the Trump Administration.

CXW carries $2.1b of debt, but the capital structure is far from unsustainable. On a LTM basis, CXW does ~$1.9b of revenue, ~$374mm of EBITDA, ~$400mm of Adjusted EBITDA, and Normalized Funds from Operations (a proxy of CFO less CapEx) of $265mm. Despite Q320 revenue of $470mm and Q320 Adjusted EBITDA of $95mm down 8% and 19% year-over-year, respectively, CXW managed to print $62mm of cash flow. On an LTM basis, Net Leverage is 4.9x on an unadjusted EBITDA figure (4.5x when including adjustments). Liquidity isn’t an issue either; CoreCivic has ~$282mm of unrestricted cash on balance sheet and ~$329mm of availability under its $800mm Revolving Credit Facility. The market appreciates CXW’s strong cash flow position, moderate leverage, and ample liquidity as the bonds trade between the mid-90s and par.

Source: Company Filings

Source: Getty Images

*****

The key question for CXW is what happens to the private prison industry now that those in power are focused on shutting it down. On January 26, 2021, the Biden White House distributed a fact sheet and statement outlining the President’s vision and agenda for advancing racial equity. Included in that agenda is reforming private prisons. Per the fact sheet:

“This afternoon, President Biden will outline his vision and new elements of his agenda for advancing racial equity for Americans who have been underserved and left behind…President Biden will sign four executive actions this afternoon to advance racial equity and take first steps to root out systemic racism in housing and criminal justice…The President will sign an Executive Order to end the Department of Justice’s (DOJ) use of private prisons.” (emphasis added)

The fact sheet elaborates further:

“Reform our Incarceration System to End the Use of Private Prisons. More than two million people are currently incarcerated in the United States, and a disproportionate number of these individuals are people of color. Mass incarceration imposes significant costs on our society and communities, while private prisons profiteer off of federal prisoners in less safe conditions for prisoners and correctional officers alike. President Biden is committed to reducing mass incarceration while making our communities safer. That starts with ending DOJ’s reliance on private prisons. The Order directs the Attorney General not to renew Department of Justice contracts with privately operated criminal detention facilities.” (emphasis added)

CoreCivic’s stock fell from a pre-election high of $7.51/share on November 3rd to $6.00 on November 6th but trades at $7.96 today. It jumped nearly 5% on Monday and another 4.3% yesterday. This suggests to us two things: i) it’s possible the market has already priced the Biden Administration order into a base case forecast, and/or ii) the order won’t alter the status quo or create much of a discernible impact on CXW’s business. Said another way, restructuring professionals who go around saying “keep an eye on the private prison space” may very well be sending you on a wild goose chase.

We dug into CXW’s filings and learned that the DOJ has been directing the Federal Bureau of Prisons (BOP) to cut back on private prisons since August 2016. Per the Q320 10-Q:

“In a memorandum to the Federal Bureau of Prisons ("BOP") dated August 18, 2016, the Department of Justice ("DOJ") directed that, as each contract with privately operated prisons reaches the end of its term, the BOP should either decline to renew that contract or substantially reduce its scope in a manner consistent with law and the overall decline of the BOP's inmate population. In addition to the decline in the BOP's inmate population, the DOJ memorandum cites purported operational, programming, and cost efficiency factors as reasons for the DOJ directive.”

But a 2016 change of administration got in the way…

“On February 21, 2017, the newly appointed U.S. Attorney General issued a memorandum rescinding the DOJ's prior directive stating the memorandum changed long-standing policy and practice and impaired the BOP's ability to meet the future needs of the federal correctional system.”

Commentary from the company’s Q320 earnings call suggests that over the past 7 – 8 years, CXW’s management has been anticipating prison reform and positioned the business accordingly:

Joseph Gomes:

“Okay. And kind of big broad from the 10,000 foot…if we look at your guys' stock price with what's been going on here with the election, there is a huge portion of the investor base saying, the feeling is that with -- if Biden was to win the election, that is a huge negative for the company, just based on what's happened to the stock price here…what actually can Biden do from a regulatory standpoint in terms of changing immigration or the U.S. Marshals? I know the Bureau of Prisons has reduced its populations over time. I don't know if that gives them excess capacity, can that allow the government to transfer detainees that are currently being helped by the private sector to the Federal Bureau of Prisons? Are those facilities just not set up to handle detainees versus inmates? It's my understanding, correct me if I'm wrong, please, ICE and the U.S. Marshals own minimal amount of beds at all. So that, again, the alternatives for the federal government to house these detainees is extremely limited.

Damon Hininger, CEO of CoreCivic:

“Absolutely, Joe. Thank you for the question. So yes, let me give a little color on all three federal partners. Let me start with the Federal Bureau of Prisons. So that was…about 10 years ago…15% of our revenue...This year, on the safety side, it's going to be about 2%. So we started a conversation with our Board about 7, 8 years ago, noting that the need and the trends for the BOP was going to change because they, at that time, were going through some sensing reform and changed some policies on sensing for different criminal offenses. And so we went through a process to -- as we saw contracts come up, exploration most notably, the most recent one here, Adams County, just thinking about maybe alternatives for those facilities. So that 15% revenue from the BOP back in 2010, now it's down to 2%. So we think if there is a change in policy directed towards the BOP about utilization of the private sector, again, we think our risk is pretty minimal there just because we're down to one contract.” (emphasis added)

Further, it appears that CoreCivic benefits from the fact that neither the U.S. Marshals nor U.S. Immigration and Customs Enforcement (ICE) own any of their own facilities, and rely completely on private prison service providers such as CXW. Mr. Hininger explains the setup:

 “Going to ICE and Marshals Service…[both] those agencies are law-enforcement focused. And so Marshals Service do not have any facilities they own or they operate. So unlike the BOP, where they've got 100 facilities around the country that they own and they operate, Marshals Service doesn't have that luxury. And so they have no alternative. They either rely on us, the private sector or city and counties for space. So if they are asked to look at either buying or building a new capacity, that will be a very large capital commitment and probably would take anywhere from 5 to 10 years to happen. So obviously, it's not something they could affect overnight. And again, depending on what the leadership is within the Congress that obviously would require also some concurrence with Congress on federalizing the workforce to operate those facilities. So several different steps that also they would have to take. So we think our 40 years' work with the Marshals Service and with ICE, too, we have been able to be very closely aligned with the mission, which has changed over time, provide high quality, good solutions that are very efficient for their mission.” (emphasis added)

And from what we gather, it’s not just about having an empty prison that’s important, but also having the right ancillary facilities in the right locations. Mr. Hininger continues on the Q320 call:

“Notably, and again, it goes a little bit of question about BOP potentially providing capacity to those agencies, the capacity has to be in the right location. So for example, our city in San Diego, which is about 1.5 mile from the Southwest border, that facility has not only capacity, but it's got court rooms, it's got space for lawyers and for case managers, and that BOP doesn't have anything nearby that could support them. So our facilities are not only efficient from a design perspective, but they're very strategically located that makes the mission of both agencies, Marshals and ICE, very, very, very effective. So that's an important point on that piece.”

Lastly, Mr. Hininger describes how standard government operating procedure has turned the U.S. Marshals into price takers:

“Marshals Service…[has] to provide capacity anytime a federal judge directs into holding federal prisoner. So they -- regardless of the budget situation, U.S. attorney, if they're prosecuting someone and the judge says, this person needs to detain, and they produce this individual to the Marshals Service, they have to house that individual. They don't have the luxury to say, they don't have the dollars or maybe the policy to house that population. So they're, again, beholden to what's being directed by the Federal Judiciary….“

And despite all the negative headlines, CXW cites that ICE funding over the past 15-years and 3 different administrations has “either been flat or has grown.”  

“…again, you've got 3 different administrations, and you've had multiple changes in leadership, both on the House and the Senate side. So we think that indicator is probably a pretty good sign of kind of regardless of what the outcome here of this week's election, ICE mentioned is they have a need for capacity, they rely on the private sector or local facilities, and funding has been either stable or has grown over the last 15 years. And we have constantly shown not only a high-quality solution in strategic locations, but also we've continued to apply and advocate that ICE continue to raise the standards, have appropriate oversight so all these different reforms and improvement in standards and quality of operations we've advocated for, and we've met the bar.” (emphasis added)

CXW also appears to have a bit of a moat around its business:

“Our facilities meet what they call the performance-based national detention standards that the alternative in a public sector facility, where they house them in county jails, just oftentimes cannot meet those facilities because of physical plant limitations. So where our facilities, our newer facilities, they meet all of those standards. In many cases, the alternative use in a public sector facility just can't meet those standards because of the physical plan. And then last point…I'd make is, many of our facilities also have courts within the facilities.And…we have hundreds -- literally hundreds of ICE officials that when they get up in the morning, they report to their place of work. It's at one of our facilities that -- in the case where they have courts, is an extremely efficient -- much more efficient use of the space when -- as opposed to having to round them up from county jails and get them to court. So a lot of critical needs we provide within our real estate that's very challenging to replicate. (emphasis added)

*****

A concern for any debt-laden company with contracted revenue is how quickly the business is able to replace contract churn with newly signed business. While revenue in Q2 and Q3 2020 was primarily lower due to COVID-19 accelerating the reduction in inmate populations, CoreCivic had several facilities moved to “idle” status as states struggled to manage their prison budgets. So far, CXW management appears to be on top of the situation.

During Q320, CXW and the State of Oklahoma agreed to idle the 1,692-bed Cimarron Correctional Facility and the 390-bed Tulsa Transitional Center However, on its earnings call, CXW’s management highlighted three new contracts representing the potential for an incremental utilization of approximately 3,000 beds. The Cimarron Correctional Facility in Oklahoma, the 1,896-bed Saguaro Correctional Facility in Idaho, and the 289-bed Turley Residential Center in Tulsa all entered into new contracts with various government agencies, while utilization at the 494-bed Reentry Opportunity Center in Oklahoma City was projected to increase.

While reduced inmate population in recent quarters has been a key risk to CXW’s underlying business, commentary on the earnings calls suggests some of these contracts were below historic operating margins, and this new incremental business “approximates the average CoreCivic safety operating margin” with potential for upside as utilization scales.

The other key concern for CoreCivic is managing its debt stack. CXW’s largest maturity wall is 2023, where more than half of its funded debt comes due. Per the company’s Q320 earnings call, management is focused on debt paydown:

Damon Hininger, CEO of CoreCivic:

“Last quarter, we announced our intention to revoke our election as a real estate investment trust or REIT and convert to a taxable C corporation effective January 1, 2021. Revoking our REIT election provides us much more flexibility in how we allocate our substantial free cash flow. This was evident in our third quarter because we were able to allocate $107.2 million of net cash provided by operating activities in the quarter to debt reduction. We're paying over $100 million of net debt during the quarter, bringing our total recourse debt net of cash down to approximately $1.4 billion. We believe continued on this path of prioritizing debt reduction with a target total leverage of 2.25x to 2.75x will meaningfully improve our overall credit profile and lower our cost of capital.” (emphasis added)

While public outcry and renewed government efforts to shut down private prisons may rattle the cages, it doesn’t appear like CoreCivic’s business is going away anytime soon. CoreCivic reports its Q420 earnings at market close on February 10, 2020. We anticipate the market will be particularly focused on management’s commentary on the first few days of the Biden Administration, as well as any new contract wins or inroads.

🧦Renfro Corporation. Short Rancid Socks.🧦

Kelso & Company-owned Renfro Corporation Struggles

The pandemic has been tough on all of us but one benefit is that we no longer have to see short-pants-wearing hedge fund and investment banker DBs strut through midtown Manhattan showing off their stupid frikken “sock game.” “Oooh, I love your socks, want to party?” said no person anywhere ever. So, small victories.

Speaking of losers, North Carolina-based Renfro Corporation is a Kelso & Company-backed* manufacturer of socks and the cotton behind partner brands like Fruit of the Loom, New Balance, Dr. Scholl’s, Carhartt, and Sperry as well as its own brands KBell, Hot Sox and Copper Sole. They produce exciting threads like these:

And when they really want to get cray cray, they spice things up with … well … whatever the hell this is supposed to be:

For the record, these socks — which, we think, show fruit(?) (see what they did there?) — have zero reviews. We reckon that’s because there isn’t a human being on earth who actually bought them, let alone reviewed them. Seriously, who green lit these things? Whomever it was has, at best, zero design sensibility and, at worst, psychopathy. Just sayin'.

The company’s capital structure is looking a bit deranged too — enough so that Moody’s slapped a fierce downgrade on the company (Caa3) back in late August. The cap stack consists of:

• an $87.4mm asset-backed revolving credit facility due February ‘21;

• a $20mm senior secured priming term loan due February ‘21 (Caa1); and

• a $132mm secured first lien term loan (Caa3) due March ‘21 that bids in the low 30s.

In connection with securing the priming term loan, the company obtained an extension of a limited waiver related to going concern language in its most recently audited financial statements to October 31, 2020. So, there’s a potential catalyst on the horizon. Shortly thereafter, there are the maturities. February and March are right around the corner. 😬

Per Moody’s:

Renfro's Caa3 CFR reflects the company's weak liquidity and risks regarding the company's ability to refinance its upcoming debt maturities given recent performance challenges and high financial leverage.

As of April 2020, lease adjusted debt/EBITDAR stood at around 6.4 times, and funded debt to credit agreement EBITDA was around 5.9 times. Recent unprecedented disruptions caused by the global coronavirus pandemic will likely challenge the company's ability to significantly reduce leverage over the very near term when it needs to refinance maturing debt. The rating also incorporates the company's modest revenue scale relative to the global apparel industry, significant customer concentration, and narrow product focus. With regard to financial strategy, in Moody's view, given a low equity valuation, private equity sponsor Kelso & Company, L.P. is unlikely to provide any sponsor equity support . Supporting the rating are Renfro's well-recognized licensed brands, long-term customer relationships and the relatively stable nature of the socks business. (emphasis added)

Moody’s appears a bit forgiving here. This company had plenty of challenges to deal with before COVID heightened things. First, while the company does boast of some US-based manufacturing, a significant amount of its supply chain is dependent upon Asia which, thanks to trade conflict with China, was likely already under strain. Second, a significant amount of its business is done through Walmart Inc. ($WMT). While on one hand this is a positive given Walmart’s recent performance, y’all know how we feel about too much customer concentration. Third, there’s this from Renfro’s website:

The company’s respected name, integrity, and innovation have fostered solid, trusted relationships with the world’s biggest retailers, including Wal-Mart, Kmart, Macy’s, Costco, J.C. Penney, Sears, and Target, to name a few. It is considered the category captain by several retailers.

Call us “deranged” but now doesn’t seem to be a great time to over-index to Kmart, Macy’s Inc. ($M), J.C. Penney or Sears. The decline of the department store is obviously trouble for a lot of different “mall-adjacent” products but especially so for products that Renfro CEO Stan Jewell himself described as an "afterthought." Less foot traffic equals fewer impulse purchases of socks (that just happen to be conveniently located near cash registers). Any product that benefits from being an add-on as part of a larger shopping trip will feel the #retailapocalypse especially hard.

This is where the company’s “narrow product focus” bites. The company only makes socks and not much more. Attempts to generate revenue elsewhere didn’t go all-too-well: back in May, for instance, the state of Tennessee paid the company $8.2 million to deliver cloth masks. Renfro stepped up producing millions of made-in-America cloth masks on short notice. The reception was … a bit … cold:

It also doesn’t help that the company has upstart sock competitors nipping at its feet. Renfro is a ~$500 million player in a market orders of magnitude larger than that. Though socks on the whole are far from a growth category there is a strong shift in mix towards fashion-oriented socks. As Mr. Jewell has pointed out, maybe you "…like pizza and beer so I’m going to have pizza and beer on my socks [and] like Picasso, so I’m going to have Picasso on my socks." Or maybe you get a pair or socks with a massive middle finger on it. Does Renfro sell those? 🤔

Renfro has tried to capture some of this category. But they were a little late to the party. Companies like Stance and Bombas didn’t exist a decade ago and are now each reportedly doing hundreds of millions in revenue and, in the case of Stance, partnering with the likes of Billie Eilish and the MLB. Their growth comes at the expense of slower moving, less well funded players like Renfro. And there is also a horde of other brands (e.g., Allbirds) and generic D2C “blands” with missions to "change the rules on how socks work” funded by growth-at-all-cost venture investors focused on customer acquisition everywhere but the mall. A strong relationship with J. C. Penney won't do much to combat these headwinds. 

Renfro has a tough few months ahead of it. The work-from-home trend won’t help matters either. But, perhaps Moody’s underestimates Kelso and they’ll write another check. Crazier things have happened. But Renfro will likely have to show that they have a strategy to combat the perfect storm swirling around it.

---

*Kelso acquired the company in 2006 — an oddly hot year for the sock industry. That same year Blackstone took Gold Toe private and scooped up rival Moretz. Blackstone exited the investment in 2011 with a $350mm sale to Gildan Activewear Inc. ($GIL) in 2011.

The company is also 25% owned by Japanese conglomerate Itochu Corp. ($ITOCY), one of five companies recently invested in by Warren Buffett. Looks like Berkshire Hathaway ($BRK.A) just can’t stay away from its textile roots. 

🍿Hollywood Fails, Theater Operators Quiver (Short Movie Magic)🍿

Will Theater Pain Hurt National CineMedia Inc.?

If reality followed fiction, President Trump’s assertion that COVID-19 would magically disappear would come true at the waving of a wand. Unfortunately, magic doesn’t exist outside of the cinema and, lately, it doesn’t exist inside the cinema either.

The good news? Approximately 70% of US movie theaters are back open.

The bad news? They’re open in zombie form, key markets like NYC and LA remain shuttered, and theaters don’t exactly have a ton of inventory to exhibit. Those theaters that are open couldn’t max out revenue if they wanted to as safety restrictions include, among other things, staggered seating. And so you’ve got the same formula for theater operators as that afflicting gym operators: little-to-no revenue and increasing operating expense. AMC Entertainment Holdings, Inc. ($AMC), Cinemark Holdings, Inc. ($CNK), and Regal owner Cineworld Group plc ($CINE) are feeling it; they find themselves stuck between the government shutdowns, the COVID-19 induced movie delays and, to add insult to injury, the forced acceleration of "alternative delivery methods" that will compete on the supply side. Studios are leveraging studio weakness to better position themselves for the future too: Universal Pictures secured a smaller theatrical window so it could stream titles via its on-demand platforms earlier than they’ve historically been able to. All of this creates the perfect storm for theaters.  

Looking for a reprieve from the deluge of bad news, operators eagerly awaited the long-postponed US release of Christopher Nolan’s “Tenet.” Nolan is among, if not the, most popular directors in Hollywood today. Operators hoped that people looking to return to some form of normalcy would be jacked up to see his latest mind f*ck. Like Tom Cruise was. And Casey Neistat. And this guy who bought out an entire theater. Unfortunately, for the studio and for theaters, the film’s results were lukewarm at best. 

Hollywood execs are acting accordingly…

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💰Quantifying “The Amazon Effect”💰

In Sunday’s Members’-only edition we noted how, unlike certain other retailers that have found themselves in bankruptcy of late, Pier 1 Imports Inc. ($PIR) is almost certainly a victim of Amazon Inc. ($AMZN). Given the relative lack of debt and no private equity overlord, it seems that pundits have as clear-cut an example of “The Amazon Effect” as you can get.

This — coupled with the last few year’s of retail carnage — naturally begs a question about Amazon’s reach and market share.

Luckily, shortly before Christmas, Benedict Evans did a deep dive into Amazon’s business (using 2018 numbers). We’ll summarize it here but it’s worth a read in its entirety.

Discussing sales, Evans writes that in the US:

Amazon sold $77.5bn of products itself,

And also sold another $106bn for third parties,

Giving a total US [Gross Market Value] in round numbers of roughly $184bn. 

…$184bn sounds like a big number, but how does that compare to the competition? What market share would that give Amazon? 

The simple answer is that the US government gives a number for total ecommerce sales as an economic statistic: in 2018 the number was $522bn. Hence:

Amazon’s first party business had about 15% market share of US ecommerce

The third party business had about 20%

And the total GMV had a 35% share. 

Note the distinction he’s making between direct online sales and “third-party seller services.” The latter is Amazon’s “Marketplace,” where Amazon simply serves as an agent handling the logistics for third-party sellers.

Splitting out GMV is important because Amazon isn’t setting the price or choosing the selection for the third party Marketplace. This is especially relevant for any conversation about predatory pricing: Amazon is setting the price directly for 15% of US ecommerce, not 35%. On the other hand, some of those third party products will be competing with products that are sold and priced by Amazon, and setting their own prices accordingly. Life is complicated.

But Amazon doesn’t merely compete with online businesses and so the share numbers above aren’t entirely accurate — particularly in the context of discussions about monopolies and regulation. Amazon does compete, for instance, against physical retailers like Walmart Inc. ($WMT), Target Inc ($TGT) and Barnes & Noble Inc. ($BKS), as just some examples (and increasingly so, it seems, given the improving performance by the former two, especially). For this, you need to add in the effect of Amazon’s limited physical consumer goods stores, i.e., AmazonGo (11 stores), Amazon Books (18 stores), Amazon 4-Star (3 stores), and most importantly, WholeFoods (~470 stores). In 2018, physical stores accounted for $17.2b of net sales (for the sake of comparison, Amazon’s cloud offering, AWS, was $25.6b). And then, he notes, we need to compare the figure against total US retail (excluding auto, gasoline stations, restaurants, bars).

That leaves ‘addressable retail’ (i.e. excluding cars, car parts, gasoline stations, restaurants and bars) of $3.6tr in 2018.

Hence, Amazon US retail revenue of $200bn was about 6% of US addressable retail. 

(Incidentally, this means that $522bn total US ecommerce is about 15% of US addressable retail.) (emphasis added)

These are interesting numbers and support, in many respects, PETITION’s long-held position refuting the simplistic view that the proliferation of bankrupted retailers is the result of “The Amazon Effect.” Said another way, The Amazon Effect likely gets way more air time than it deserves. Right now anyway. Indeed, “in the USA in 2018, Amazon was a little less than two thirds of the size of Walmart.”

But:

…of course, Amazon is growing. Its US ecommerce business probably grew 20% in the last year, and so its market share of total and of addressable retail is going up. Hence, you could argue that since ecommerce is clearly going to take over a much larger share of retail, and since Amazon has a large (35-40%) share of ecommerce, Amazon’s strength in ecommerce means it will swallow everything else, even if it’s only at 5-6% today.

And this is to say nothing about how it has used data to sideswipe third-party sellers and promote its own private label brands at their expense — among other shady behavior.

Evans concludes:

I don’t think one can just assume that Amazon’s market share of online sales will be maintained indefinitely in a straight line into the future. The more that ecommerce expands beyond the original commodity categories, the more that we see new and different models and experiences proliferating. Shopify, another platform for online retail, is now at an annual run-rate of $60bn of GMV, up from nothing five years ago.

Of course, people have bet against Amazon in the past and we know how that’s worked out.

💥Achtung! Retail Poised to Fall Off a Pier💥

The holidays came and went and, for the most part, the news surrounding the consumer had been…gulp…positive? People spent money. Lots of it apparently. According to Mastercard Inc. ($MA), overall holiday sales from November 1 through Christmas Eve were up 3.4% (excluding autos). The total figure hit $880b, which exceeded Mastercard’s forecast. The question for many retailers is: “where did consumers spend?”*

Spoiler alert…

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🇨🇦Oh Canada (Short Mary Wanna)🇨🇦

If we were to be accused — and we haven’t really — of being too US-centric we would be…well…GUILTY AF. We admit it: we act like snobby Americans — like the rest of the world doesn’t really exist. Shockingly, though, it does. Who knew?😜

One thing that caught our eye recently is the apparent proliferation of cannabis-related distress in Canada — something that, due to federal law limitations, you couldn’t see…at least in court…in the United States.

On December 2nd, an Ontario-based company called AgMedica Bioscience Inc. filed a CCAA proceeding to give itself some breathing room and access much needed DIP capital. The company obtained a $7.5mm DIP credit facility from a Canadian lender, Hillmount Capital Inc., and seeks to use the bankruptcy to restructure several tranches of secured and unsecured debt.

What’s interesting is the timeline. In late 2018, everyone thought cannabis was going to be a 21st century gold rush. Canopy Growth Corporation ($CGC) was reportedly the first federally regulated and licensed cannabis producer to trade on a public exchange in Canada (artfully under the ticker “WEED”) and then went public in the United States in May 2018. The stock opened around $26/share and then rocket-shipped to as high as $52.74. It has since come WAY BACK DOWN TO EARTH and trades here:

Similarly, Tilray Corporation ($TLRY) went public in June 2018, debuting on Nasdaq at $17/share. Here is the chart since then:

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🚂Manufacturing (Short the Railroads?)🚂

We were surprised to hear certain Representatives boast about US manufacturing growth during the impeachment hearings. We stopped in our tracks: “wait, what?” As we noted on Wednesday, the ISM Manufacturing numbers tell a different story — a contraction story.

But, to be fair, there are other surveys. The recent IHS Markit index painted a different picture. This Axios piece discusses the difference between the two surveys and is worth a quick read. The ISM survey includes fewer participants and “…uses five components, each weighted evenly at 20% — new orders, production, employment, supplier deliveries and inventories.” The IHS survey “…uses a weighted average that gives greater importance to new orders (30%), output (25%) and employment (20%), and lower weighting to suppliers’ delivery times (15%) and stocks of purchases (10%).” The bottom line is that if the former is correct, the US economy may be f*cked; if the latter is more accurate, the economy is expanding.

Now, granted its a small data set but the current trucking situation (see Wednesday’s “🚛Dump Trucks🚛“) seems to reflect, at least in part, a slowdown in manufacturing (among other things, including the effect of tariffs and shipping). But what about the railroads?

In November, rail carloads declined 7.5% YOY, led primarily by coal (⬇️ 14.5%) and primary metal products (⬇️ 15.1%). Per Logistics Management:

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⚡️Update: Forever21 Inc.⚡️

Forever21 Inc. is forever filing motions to reject sh*t. On Friday, the company followed up its Store Closing Motion (which, itself, had two supplements) with its fourth rejection motion of non-residential real property leases. By our count, somewhere between 100-150 different lease (or sublease, as the case may be…looking at you Belk Inc.) counterparties have been affected now by the bankruptcy. That’s a lot of landlords and lessors looking for tenants and subtenants, respectively.

Who is bearing the brunt of this? By our count (in approximate numbers):

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💰Retail Roundup (Short Mall Traffic; Long Discounting)💰

Ah, the fourth quarter. The fourth quarter is critical for retailers as they play out the “holidays” option and hope to stave off bankruptcy. How’s that working out for them?

Per CNBC:

U.S. retail sales increased less than expected in November as Americans cut back on discretionary spending, which could see economists dialing back economic growth forecasts for the fourth quarter.

The Commerce Department said on Friday retail sales rose 0.2% last month.

Surveys had predicted a 0.5% retail sales acceleration.

Excluding automobiles, gasoline, building materials and food services, retail sales edged up 0.1% last month after rising by an unrevised 0.3% in October.

The so-called core retail sales correspond most closely with the consumer spending component of gross domestic product. Consumer spending, which accounts for more than two-thirds of U.S. economic activity, grew at a 2.9% annualized rate in the third quarter.

The breakdown is as follows:

• Auto sales ⬆️ 0.5%;

• Gasoline ⬆️ 0.7%;

• Online/Mail-Order Retail ⬆️ 0.8%;

• Electronics/Appliances ⬆️ 0.7%; and

• Furniture ⬆️ 0.1%.

On the negative side, however:

• Apparel ⬇️ 0.6%;

• Restaurants/Bars ⬇️ 0.3%; and

• Hobby/Music/Book Stores ⬇️ 0.5%.

It gets worse for apparel. The Bureau of Labor Statistics’ latest CPI report revealed weakness for November — which, significantly, includes Black Friday and Cyber Monday. 😬

Men’s and women’s apparel decreased by 0.9% and 3.6% YOY, respectively, while boys’ and girls’ apparel decreased 3.9% and 2.2%. Said another way, there’s an epidemic of markdowns/discounts. That can’t bode well for retail’s bottom line.

Indeed, several retailers acknowledged that markdowns are a significant issue. American Eagle Outfitters Inc. ($AEO) CEO Jay Schottenstein* noted “the challenging environment promotional activity increased relative to our expectations,” a theme that was reiterated by management teams at Urban Outfitters ($URBN), Francesca’s ($FRAN), Children’s Place ($PLCE) and Designer Brands ($DBI). Gamestop Corp’s ($GME) CEO George Sherman — while reporting dogsh*t numbers — noted:

“At this stage, we've entered the commoditization phase of the console cycle, where promotional pricing is driving sales. And if you're out shopping or doing store checks over Black Friday or Cyber Monday you likely saw a clear example of [those] discount stands.”

The problem is that retailers need to draw foot traffic and when your retail experience is commoditized and your product sucks sh*t, how do you do that?

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🚛Dump Trucks🚛

Manufacturing, Trucking & the Ports

We’re old enough to remember a narrative that went something like this:

• Amazon Inc. ($AMZN) is dominating retail with 2-day (now 1-day) shipping +

• Traditional brick-and-mortar retailers are converting to e-commerce +

• Digitally-native-vertical-brands are cutting out brick-and-mortar and going direct-to-consumer =

• Increased need for logistics and shipping capabilities.

Because of these developments, among others, this country — it was said — was suffering from a trucking shortage relative to the demand and so wages rose rapidly and seemingly every retailer reported that rising shipping expenses were harming the bottom line. Given this, you’d think truckers would be crushing it.

Maybe…not? At least anymore.

In August we noted the following:

ACT research reflects two straight quarters of negative sector growth and DAT reported a 50% decline in spot market loads, with no category immune to the declining trend. Van load-to-truck is down 50%, flatbed load down 74.5% and reefer load down 55.5%. Some fear this may be a leading indicator of recession. Alternatively, it may just be the short-term effects of tariffs and the acceleration of orders into earlier months to avoid them. 

Still, the trucking industry is worried. 

Van spot rates were down 18.5%, flatbed spot rates down 18.4%% and reefer spot rates down 16.8%. The word “bloodbath” is now being bandied about. Per Business Insider:

“There has been a spate of trucking companies declaring bankruptcy this year, too. The largest was New England Motor Freight, which was No. 19 in its trucking segment. Falcon Transport also shut down this year, abruptly laying off some 550 employees in April.

"We have become increasingly convinced that freight is likely to remain weak through 2019 followed by falling truckload and intermodal contract rates in 2020," the UBS analyst Thomas Wadewitz wrote to investors in a June 18 note.

Trucking's biggest companies have been slashing their outlooks. Knight-Swift and Schneider both cut their annual outlooks earlier this year.”

Will this trend continue as manufacturing numbers continue to slip?

That was a good question. And, indeed, manufacturing does continue to slip — at least according to the ISM Manufacturing PMI report:

With the foregoing context, take some more recent news:

1. Hendrickson Truck Lines Co.

The family-owned trucking company recently filed for bankruptcy in the Eastern District of California (a chapter 22, actually). The company is on the smaller side: liabilities between $10-50mm; roughly 90 trucks and 100 drivers; operations in 10 states. Per FreightWaves:

“The company said its financial problems started in January with a sharp decline in overall freight tonnage. This, combined with excess truck capacity, resulted in a 21% rate drop compared with 2018, resulting in a $400,000 per month revenue drop, according to its petition.  

Two of the carrier’s top customers, which accounted for nearly 50% of its business, switched to lower-cost providers, the company said.” (emphasis added)

The company also blamed a poor truck leasing deal for its filing.

2. Truck Orders Are Down

The Wall Street Journal recently reported:

Order books for heavy-duty truck manufacturers are thinning out as a weaker U.S. industrial economy pushes fleet operators to put the brakes on plans to expand freight-carrying capacity.

Trucking companies in November ordered 17,300 Class 8 trucks, the big rigs used in highway transport, according to a preliminary estimate from industry data provider FTR. That was down 39% from November 2018 and a 21% decrease from October, providing a weak start for what is typically the busiest season for new-equipment orders.

The orders last month were the lowest for a November in four years, and analysts said they expect a backlog at factory production lines that has been dwindling this year to pull back even more.

It continued:

Truck-equipment makers have started scaling back production and laying off workers this year as demand for new trucks has weakened.

Daimler Trucks North America LLC said in October it planned to lay off about 900 workers at two North Carolina Freightliner plants as “the market is now clearly returning to normal market levels.”

Engine-maker Cummins Inc. cut its annual revenue forecast in October and the company last month said it plans to lay off about 2,000 workers early next year. “Demand has deteriorated even faster than expected, and we need to adjust to reduce costs,” the Columbus, Ind.-based manufacturer said in a statement.

What’s going on here? Well, yes, manufacturing is down. But “global trade tensions are weighing on transportation demand.” More from the WSJ:

U.S. factory activity contracted in November for the fourth straight month, according to the Institute for Supply Management.

Freight volumes and trucking prices have been on the decline. U.S. domestic freight shipments fell 5.9% in October compared with the same month last year, while truckload linehaul rates were down 2.5% year-over-year, according to Cass Information Systems Inc., which handles freight payments for companies.

🤔

3. Trade, Declining Truck Orders, and Imports (Short the Ports?)

We’re curious: if tariffs and trade wars are trickling down to trucking, what must this mean for ports in this country? Per Transport Topics:

Three West Coast ports saw significant drop-offs in cargo volume last month, the latest indication that the United States’ long-simmering trade dispute with China is impacting operations at the nation’s ports.

The Port of Los Angeles, the nation’s busiest facility, saw a 19.1% decline in 20-foot-equivalent units (TEUs) container volume, moving 770,188 compared with 952,553 in the same period a year ago. Imports and exports were both down 19%. The drop-off also means the Los Angeles port is 90,697 TEUs behind last year’s record pace, having processed 7,861,964 TEUs through the first 10 months, compared with 7,723,159 at this point last year.

Port Executive Director Gene Seroka and other officials were in Washington on Nov. 12, and he is sounding the alarm over the damage being done to the economy because of the ongoing trade battle and the resulting tariffs on hundreds of billions of dollars worth of products.

And this, apparently, isn’t isolated to the West Coast:

Rough October at Port of NY&NJ as loaded container imports fell slightly and loaded exports dropped 2.7%. The fall's East Coast shipping surge didn't get that far.

— Paul Page (@PaulPage) December 3, 2019

Will we start seeing some port distress in the near future? Fewer trucks and fewer trains mean lower revenue. 🤔

4. Celadon Group Files for Bankruptcy

Indianapolis-based Celadon Group Inc. ($CGIPQ) is a truckload freight services provider with a global footprint. Founded in 1985, the company professes to have pioneered the commerce trail between the United States and Mexico. Thereafter, it IPO’d and used the proceeds for growth capital, expanding its freight-forwarding business with the acquisition a UK-based company and another 36 companies thereafter. Not only did these acquisitions expand its geographic footprint, but they also expanded the company’s freight capabilities, opening up revenue possibilities attached to refrigerated and flatbed transportation. In all, today the company operates a fleet of 3300 tractors and 10000 trailers with 3800 employees. Its primary focus continues to be NAFTA countries; its customers include the likes of Lowes Companies Inc. ($LOW), Philip Morris International Inc. ($PM), Walmart Inc. ($WMT), Fiat Chrysler Automobiles NV ($FCAU), Procter & Gamble Inc. (($PG) and Honda Motor Co Ltd. ($HMC).  

All of the above notwithstanding, it is now a chapter 11 debtor. Worse yet, it will, in short order, wind down and no longer be in existence. In an instant, the aforementioned 3800 employees’ livelihoods have been thrown into disarray.

Not that the signals weren’t there. The company has been in trouble for some time now. In addition to macro woes, it has a large number of self-inflicted wounds. 

Back in July, the company teetered on the brink of bankruptcy but it bought itself a short leash. On July 31, 2019, the company refinanced its term loans held by Bank of America NA ($BAC), Wells Fargo Bank NA ($WFC) and Citizens Bank NA ($CFG) with a new facility agented by Blue Torch Finance LLC* that counted Blue Torch and Luminus Partners Master Fund as lenders.** The new lenders provided $27.9mm of new term loans and, in exchange, received $8mm in original issue discount and fees. The banks, it appears, got out just in the knick of time. Indeed, the company and its lenders have been engaged in an endless stream of negotiations, concessions and waivers ever since: the credit docs have been amended ad nauseam ever since the initial transaction because the company was in constant danger of breaching its covenants.

Why so much drama? Per the company:

“The need to file these chapter 11 cases was a result of a confluence of factors including industry-wide headwinds, former management bad acts, an unsustainable degree of balance sheet leverage and an inability to address significant liquidity constraints through asset sales and other restructuring strategies. In mid-2019, the trucking freight market began to soften. The combination of a decline in overall freight tonnage and excessive truck capacity in the market led to a significant decline in freight rates, and customers began to take bids at lower freight rates. Compared to the year immediately prior, 2019 showed a steady decline in freight rates, including spot freight rates and contractual rates. In addition to declining freight rates, volumes of loads in freight have experienced decreasing numbers for a significant portion of 2019.”

Sound familiar? Well, these issues alone should have been enough to present problems but they were accentuated by the fact that the company’s prior senior management allegedly engaged in some shady a$$ sh*t. That shady a$$ sh*t ultimately led to a Deferred Prosecution Agreement and a $42.2mm fine. While only $5mm has been paid to date, that $37mm overhang is substantial.

With all of these issues piling up, the company ultimately defaulted on its revolver. Consequently, MidCap Financial Trust, the company’s revolver lender, froze lending and the company’s already-growing liquidity problem became a wee bit more problematic. With barely enough money to fund payroll and payroll taxes, the company had no choice but to file for chapter 11. To put an exclamation point on this, the company had merely $400k of cash on hand when it pulled the trigger on bankruptcy. 

So what now? The company ceased operations and will commence an orderly wind down of its businesses, preserving only Taylor Express Inc. as a going concern. Taylor Express is a NC-corporation that the company acquired in 2015; it is a dry van and dry bulk for-hire services provider, operating principally for the tire and retail industries and primarily in the South and Southeast regions of the US. To fund the cases, the debtors secured a commitment from Blue Torch for $8.25mm in DIP financing. The DIP mandates that any sale order relating to the liquidating business be entered by January 22. 

As for the employees? Well: 

Yeah, they’re understandably pissed. For starters, they were laid off en masse with no notice. One employee, on behalf of all employees, filed an Adversary Complaint alleging a violation of the WARN Act, which requires 60 days’ advance written notice of a mass layoff and/or plant closing. In response, the truckers have formed a “Celadon Closure Assistance and Jobs” group on Facebook. It has 1300 members. Per Fast Company, 

“Truckers in [a] Facebook group are posting about having 20 minutes to clear out their trucks and go. CBS also reported that some drivers “were stranded when their company gas cards were canceled.”

YIKES. All told, this is a hot mess. Per SupplyChainDive:

“’This is noteworthy because of the size of the fleet,’ Donald Broughton, the principal and managing partner at Broughton Capital, told Supply Chain Dive in an interview.  ‘It’s noteworthy because less than 10 years ago Celadon was known as one of the most active, prolific and successful at salvaging small fleets that were struggling and in trouble.’

The failure of Celadon represents the largest trucking failure this year and ‘certainly one of the largest in history,’ Broughton said.”  

“Largest [insert industry here] failure” is not an honor that anyone wants.

*Blue Torch Finance LLC was also active in another DLA Piper LLP bankruptcy, PHI Inc., as DIP lender. 

**Blue Torch hold a priority right of payment on the term loan collateral with Luminus second and revolver lender, MidCap Financial Trust, third. 

💩Retail, the Internet, China & Counterfeiting (Long Unscrupulousness).💩

This is a story about S’well. It illustrates just how vicious competition is today. And made even more vicious by (i) “signaling” and ease of discovery (lots of likes on Instagram), (ii) shady-AF Chinese manufacturers (producing legit product by day, extra off-the-truck product by night), and (iii) Amazon Inc.’s ($AMZN) failure to police third-party sellers. Choice bit:

Counterfeiting is an old game: In ancient Rome, counterfeiters knocked off authentic Roman coins. In recent decades, counterfeits of luxury products like handbags, watches, and sneakers have become commonplace. Now, though, online marketplaces like Amazon and social-media sites like Facebook and Instagram are enabling a new copycat ecosystem that’s become a hall of mirrors for both brands and shoppers. It’s never been easier for makers of knockoffs to reach consumers, project authenticity, and make money — and it’s never been harder for the real companies to regain control.

This is crazy:

…less than a year into starting the business, Kauss realized she had a big problem. Kauss and her then-boyfriend Jeff Peck (now her husband and the company’s president) were heading to S’well’s factory in China when they stopped for a couple days’ vacation in Hong Kong. Kauss saw there was a trade show and insisted on stopping by. When she arrived, it appeared that S’well had a significant presence at the show, with bottles displayed in a case and a ribbon flaunting an award it had apparently won. “A man came over to me and gave me his business card, very properly, and said he was from S’well,” she says. His card had S’well’s logo on it, with the little TM for ”trademark.”

The problem: Kauss at that point was running S’well from her apartment. It had no presence in Asia. Nor did it have a sales rep there. And it had no employees besides Kauss. She had barely gotten the company off the ground, and her bottles were being knocked off.

What. The. Hell. Read the piece. It’s long. And nuts.

But that’s not all. This is a horribly pervasive problem:

Last year, when the Government Accountability Office bought 47 consumer products like cosmetics and travel mugs online from third-party sellers on sites including Amazon.com and Walmart.com, it determined that 20 of them were fakes.

Here’s the problem from another vantage point (also very much worth reading):

I've been talking to a friend who's a cofounder at a womenswear ecommerce startup about their content strategy. I searched around to see what kind of stuff is out there about them (press mentions, reviews, etc.), and stumbled upon something odd. On a Bustle.com top ten sex toys list, it had listed a product from their brand. They do not sell sex toys. I clicked through, and it led to an Amazon site with their company’s branding. They do not sell on Amazon.

It turned out a China-based seller had “hijacked” their brand. This is apparently a regular thing.

A few days later, when visiting my friend's office, I found out that they had one staff member dedicated to monitoring Amazon for exactly these situations. There was a big spreadsheet where they tracked various culprits. There was a specific contact at Amazon they would call when they found shady stuff like this. They had a lawyer they billed, and a process in place to deal with this. It cost time and money and it was a never-ending game of whack-a-mole. It had become such an increasingly frequent problem over the past few years, yet they seemed fairly blasé about it. It was just business as usual.

I understand counterfeiting has always been a problem in retail, but this felt different. Amazon was their competitor. It had launched a private label brand that directly competed, undercutting them on price and shipping speed. Yet, Amazon also sold counterfeit items of theirs (well, Amazon “facilitated” it) and the startup bore the cost of cleaning up the trillion dollar company’s platform. I guess this was how ecommerce worked in 2019.

The article goes on to explain that this is the natural side effect of Amazon’s concerted efforts to court Chinese sellers to its platform. It explains the lack of quality control and…..

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💥Shade of the Week— “We Believe Real Models Will Become Wildly Popular in the Post WeWork Era”💥

Restoration Hardware Inc. ($RH) reported earnings this week and blew it out of the water in every possible way. Not all retail is a hot mess, apparently. When you crush it like they did — 6+% revenue increase and doubled profits — we suppose that gives you some license to sh*t on LITERALLY EVERYONE UNDER THE SUN. This is savage:

DAAAAAAAAAMMMMN. DTC DNVBS and standard brick-and-mortar retailers just got run over by the Restoration Hardware bus. And rightfully so:

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⚡️Update: PG&E Corporation ($PCG)⚡️

Per The Wall Street Journal:

PG&E Corp. has reached a settlement with victims of the wildfires that pushed California’s largest utility into bankruptcy, agreeing to pay them $13.5 billion in damages.

The pact removes a significant obstacle to PG&E’s emergence from chapter 11 protection and includes reforms meant to address criticism that the company enriched shareholders while leaving customers exposed to danger from aged, unsafe equipment.

PG&E bowed to demands for more money for fire victims and gave in to pressure from California Gov. Gavin Newsom to improve its corporate governance and implement stricter safety protocols.

The best part: the settlement is payable half in cash and half in stock. All we have to say is:

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⛽️2019 Can’t End Fast Enough for Oil & Gas (Long Pain in TX)⛽️

Some numbers: the US now produces 13mm barrels per day and exports 3mm bpd. Per Reuters:

But the outlook for 2020 comes with growing skepticism from those inside the industry - and should growth fall short, it could shift the balance of power in world supply back to the Organization of the Petroleum Exporting Countries.

An increase in U.S. crude output by 1 million bpd would satisfy nearly all of the 1.2 million bpd increase in world demand next year, the International Energy Agency expects. [IEA/M]

That would keep a lid on prices, pressure OPEC to extend production cuts and leave shale producers still trying to achieve elusive profits. As a result, most industry executives and consultants said they expect slower U.S. shale growth.

Apropos, layoffs are starting to mount in the Permian. Austerity measures are now taking hold in the Eagle Ford. Per Bloomberg:

In the wake of the oil price crash that began in 2014, new drilling in the Eagle Ford dwindled as management teams cut budgets, and output in the region is now down about 20% from pre-crash levels.

That austerity finally began to pay off this year as the Eagle Ford as a whole generated free cash flow for the first time, according to IHS Markit.

And things may only get worse.* The state of Texas is expected to double its solar electricity output next year and again the following year. This would obviously have a negative impact on natural gas demand and prices.

Nevertheless, the Trump administration intends to bring MORE drilling online! Per The Houston Chronicle, the administration…

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🥈Second Order Effects Are Real (Long #retailapocalypse Victims)🥈

We’ve spent a considerable amount of time discussing the possible and/or actual second order effects of disruption. For instance, waaaaaaay back in December 2016, we queried to what degree the scanless technology that Amazon Inc. ($AMZN) had then launched in its AmazonGo concept might affect grocers and quick service restaurants. We noted the following possibilities:

[Our] list of losers: manufacturers of conventional scanners...plastic separator bricks...cash registers...conveyer belts; landlords (maybe? - less square footage required without the cashier and self-checkout stations); print media/candy manufacturers/gift cards - all things that benefit from lines and impulse buys at checkout; human capital; people on the wrong end of income inequality.

Three years later, you don’t hear much about AmazonGo. Sure, it’s grown: there are now reportedly 20 locations with more on the way, but it hasn’t exactly taken the world by storm and caused mass disruption to either grocers or QSRs. It’s still worth watching though: the possible second order effects are countless.

An example of actual second order effects is Cenveo Inc., which filed for bankruptcy in February 2018. At the time we wrote:

…it's textbook disruption. Per the company, 

"In addition to Cenveo’s leverage issues, macroeconomic factors, including the introduction of new e-commerce, digital substitution for products, and other technologies, are transforming the industry. Consumers increasingly use the internet and other electronic media to purchase goods and services, pay bills, and obtain electronic versions of printed materials. Moreover, advertisers increasingly use the internet and other electronic media for targeted campaigns directed at specific consumer segments rather than mail campaigns." 

Ouch. To put it simply, every single time you opt-in for an electronic bank statement or purchase a comic book on your Kindle rather than from the local bookstore (if you even have a local bookstore), you're effing Cenveo.

To close the trifecta, we’ll again highlight the recent pain in the SMA space. Catalina Marketing and Acosta Inc. both became chapter 11 filers while Crossmark Holdings Inc. narrowly avoided it. Why? Because CPG companies are taking it on the chin from new and exciting direct-to-consumer e-commerce brands, among other things, and have therefore shifted marketing strategies.

So, on the topic of second order effects, imagine being in the C-suite of a company that, among other things:

• Prints signage, displays, shelf marketing and other promotional-print-material for brick-and-mortar retailers including the likes of, among others, struggling GNC Inc. ($GNC), Gap Inc. ($GPS), and GameStop Inc. (GME), all of which are shrinking their brick-and-mortar footprint;

• Creates menu boards, register toppers, ceiling danglers and more for QSRs and fast casual restaurants who are competing with food delivery services more and more every day; and

• Services consumer packaged goods companies by creating end cap promotions, shelf marketing, floor graphics and more.

Uh….YEAAAAAAAAAH. Some high risk exposure areas right there, folks.😬 And, so you’ve got to imagine that revenues of this “hypothetical” C-suiter’s company are declining, right? Particularly given that print is a highly competitive price-compressed industry?

Luckily, you don’t have to stretch the imagination too far.

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⚡️Update: Destination Maternity Inc. ($DEST)⚡️

Speaking of ugly…

In the aforementioned October CBL update, we wrote:

The last thing CBL needed — on the heals of the downgrade — was near-instantaneous bad news. It got it this week.

Yesterday, the bankruptcy court granted interim approval authorizing Destination Maternity Corporation ($DEST) to assume a consulting agreement with Gordon Brothers Retail Partners LLC. Gordon Brothers will be tasked with multiple phases of store closures. Among those implicated? CBL, of course:

CBL is landlord to DEST on 16 properties that are slated for rejection. Considering that DEST cops to being party to above-market leases, this ought to result in a real economic hit to CBL as (a) it will lose a high-paying tenant, (b) it will take time to replace those boxes, and (c) it is highly unlikely to obtain tenants at as favorable rents.

Let’s pour one out for CBL, folks. The hits just keep on coming.

On Friday, Destination Maternity filed a motion seeking approval of a stalking horse bidder for its assets. In September’s “🤔Is it a "Destination" if Nobody Goes?🤔,” we concluded:

And so we’ll have to wait and see whether Greenhill can pull a rabbit out of their hats. Unfortunately, this is looking like another dour retail story. This looks like a liquidating ABL if we’ve ever seen one.

According to the motion, Greenhill dug deep. They reached out to over 180 potential buyers, executed 50 CAs, and granted due diligence access to nearly two dozen parties.* They also conducted 8 management presentations with potential bidders. If you’ve ever wondered why investment bankers make what they make, this ought to illustrate why: it can be a lot of work trying to garner interest and herd cats. Then again, they did accept a mandate where there was a questionable likelihood that the asset value would clear the debt. 🤔

Unfortunately, the result is not — as predicted — particularly stellar. To be clear, this isn’t a reflection upon Greenhill. This was a difficult assignment in a challenging retail environment: it’s a reflection of that.

And so Marquee Brands LLC** and a contractual joint venture between Hilco Merchant Resources LLC and Gordon Brothers Retail Partners LLC (together, the “Agent”) entered into an asset purchase agreement (APA) with the debtors pursuant to which they will purchase “the Debtors’ e-commerce business, intellectual property, store-in-store operations, and the right to designate the sale of certain inventory and related assets” for an estimated $50mm (subject to adjustments). Repeat: an estimated $50mm. The Agent will liquidate the company’s inventory, fixtures and equipment and conduct store closing sales at the 235 stores where closing sales are not already in process. Said another way: the company’s retail footprint is going the way of the dodo. Clearly this isn’t credit positive for CBL and other landlords.

To refresh everyone’s recollection, here is what the company’s capital structure looked like at the time of its bankruptcy filing:

We previously noted when highlighting the aggressive milestones baked into Wells Fargo Bank’s consent to use its cash collateral:

Wells clearly wants this sucker off its books in 2019.

Rightfully so. The $50mm purchase price is subject to a $4mm holdback. In other words, the actual value transfer may be approximately $46mm. That puts the purchase price at riiiiiiiiiiiiight around Wells Fargo’s exposure. Its aggressive handling of the case appears to be warranted: this thing looks a hair away from administrative insolvency.

Apropos, the official committee for unsecured creditors — in a grasp for some sort of relevance here — filed a limited objection to the motion. The committee argued that the break-up fee (3.5%) and expense reimbursement (up to $750k) were unwarranted given the size of the bid and the lack of a going concern offer.

They were shot down. They did, however, wrestle some concessions. They apparently got the purchase price increased by $225k (in exchange for avoidance actions) and an additional $225k to be paid to 503(b)(9) admin claimants prior to Wells getting its money. A small victory but something for some creditors here.

And that ladies and gentlemen is what bankruptcy boils down to. Is there value? And if so, who gets it? Here, it’s hard to see any real winners. Not the company. Not Wells. Not CBL and the company’s other landlords. Not vendors. Or suppliers. Or employees. Or, really, even the professionals (for once). Time will tell whether Marquee can do something with this brand that makes it one of the rare winners. It’s not clear from the papers how much of the $50mm is attributable to them and, therefore, how much they’re putting at risk. Clearly nobody else was comfortable with the risk here. However you quantify it.

*At the time of filing, the numbers were 170 parties contacted and 34 executed CAs. So, there wasn’t much additional interest in the assets post-filing.

**Marquee Brands also owns BCBG which, itself, traversed the bankruptcy process not long ago.

💥Good Retail Numbers. Bad Malls.💥

⚡️Update: CBL & Associates Properties ($CBL)⚡️

We did a deep dive into Tennessee-based CBL & Associates Properties ($CBL) back in March’s “Thanos Snaps, Retail Disappears👿” and, in the context of Destination Maternity’s bankruptcy filing, followed-up in an October update. To refresh your recollection, CBL is a real estate investment trust (REIT) that invests primarily in malls based in the southeastern and midwestern US. At the time of the aforementioned “Thanos” piece, the REIT’s stock was trading at $1.90/share; its ‘23 unsecured notes were priced around $80 and its ‘24 unsecured notes around $76. In case you haven’t noticed — all Black Friday ($7.4b in online sales, $2.9b via mobile ordering) and Cyber Monday (a record $9.2b) talk about gangbusters retail sales notwithstanding — the malls haven’t particularly fared much better since Q1. To put an exclamation point on this, early reports are that brick-and-mortar stores saw an overall 6% decline in sales over Black Friday.

When it reported Q3 earnings at the end of October, CBL’s numbers weren’t pretty. Revenue fell approximately $20mm YOY, net operating income declined 5.9% YOY, and same-center mall occupancy, while up on a quarter-by-quarter basis, was down 200 basis points YOY.

On Monday, the company announced that “it is suspending all future dividends on its common stock, 7.375% Series D Cumulative Redeemable Preferred Stock and 6.625% Series E Cumulative Redeemable Preferred Stock.” The company’s CEO, Stephen Lebovitz said:

“We anticipate a decline in net operating income in 2020 as a result of heightened retailer bankruptcies, restructurings and store closings in 2019. Offsetting these declines by retaining available cash is necessary to maintain the market dominant position of our properties and to reduce debt. CBL has also made significant efforts over the past 18 months to reduce operating costs, including executive compensation and overall corporate G&A expense, as well as execution of a strategy to utilize joint venture and other structures to reduce capital expenditures. Ultimately, we believe these actions will allow the Company to return greater value to its shareholders.”

Given the above, it’s worth revisiting the alleged benefit of REITs to investors. Among them are that:

• post 1960, REITs provided small investors with an opportunity to benefit from commercial property rental streams; and

• they are, typically, high dividend payers — considering that by law, they must distribute at least 90% of their taxable income to shareholders as dividends.

WOMP. WOMP. Not so much these days, it seems. But, we bet you’re asking: how can it terminate its dividend while maintaining its REIT status? From the company:

“The Company made this determination following a review of current taxable income projections for 2019 and 2020. The Company will review taxable income on a regular basis and take measures, if necessary, to ensure that it meets the minimum distribution requirements to maintain its status as a Real Estate Investment Trust (REIT).”

Umm, that doesn’t portend well. The answer is: it may not have “taxable income.” B.R.U.T.A.L.

How did the market react?

The stock market puked on the news. The stock was down 6% with a general market drawdown, but after-hours, upon the announcement, the stock gave up an additional ~30% on Monday and closed at $1.02/share on Tuesday:

Meanwhile, the preferred stock also obviously traded down (lots of Moms and Pops chasing yield, baby yield, getting burned here), and the ‘23 unsecured notes and the ‘24 unsecured notes, at the time of this writing, last sold at $72.75 and $64.1, respectively.

The GIF above says it all about this story. And, worse yet: it may get uglier.