🌧April Suffers No Fools🌧

April was a busy bankruptcy month but something tells us it won’t hold a candle to what’s coming for the industry in May. There were smatterings of small retail filings and a pair of massive oil and gas bankruptcies (Whiting Petroleum Corporation, Diamond Offshore Drilling Inc.). TMT as a category continues to hold steady with telecom set to fill a lot of restructuring firm’s coffers (Frontier Communications Corporation, Speedcast International Limited). The big winners of the month: the District of Delaware, Kirkland & Ellis LLP, A&M and FTI Consulting Inc. (tough call as they both handled mega deals), Evercore Group LLC and Moelis & Company (same), and Prime Clerk LLC which continues to monopolize the biggest deals.

⛅The Rise of the Cloud. (Long Cloud Usage. Short Debt-Laden Intermediaries).⛅

The “cloud” is such a fundamental business component today that cloud considerations inform various aspects of business planning. Look no farther than Amazon Inc. ($AMZN), Microsoft Inc. ($MSFT), Cisco Inc. ($CSCO), and Google Inc. ($GOOGL), and you’ll see cloud computing providers who are minting money on a quarterly basis for providing services that alleviate the server and storage burden of businesses across all kinds of industry verticals. Underscoring the importance of the cloud, IBM Inc. ($IBM) spent a fortune — $34 billion! — acquiring Red Hat Inc. to boost its cloud-for-business offering. Furthermore, recent IPOs have illustrated just how important cloud services are: Pinterest Inc., Snap Inc. ($SNAP), Lyft Inc. ($LYFT), and many other high-flying companies pay hundreds of millions in fixed contracts for cloud computing services that power their applications in ways that everyday end users almost certainly don’t recognize and/or appreciate.

The “cloud,” however, subsumes various other services in addition to computing/storage. There are connectivity-focused applications (provided by the likes of AT&T Inc. ($T), Comcast Corporation ($CMCSA), and others) unified cloud communications applications (i.e., Vonage Holdings Corp. ($VG)), and point solutions (e.g., Citrix Systems Inc. ($CTXS)). One could be forgiven for thinking that everything and anything touching cloud would be gold in this environment. Imagine, for instance, if one firm could serve as an intermediary linking together various cloud-based solutions for other small, medium and large businesses!! Cha Ching!! 

Apparently that’s not the case.

New York-based Fusion Connect Inc., “a provider of integrated cloud solutions, including cloud communications, cloud connectivity and business services to small, medium and large businesses” is bucking the hot cloud trend and barreling quickly towards a bankruptcy court. This begs the question: what the holy f*ck? How is that even possible?

Per a January investor presentation, this is Fusion’s cloud services revenue:

The 2018 revenue is annualized: revenue in Q3 ‘18 was actually $143.4mm with gross margins of 49.1%. Net operating income was $4mm. Yet the company lost $0.23/share. How does that work? Well, the company had $21.6mm in interest expense.

The weighted-average rate of interest across the company’s credit facilities is approximately LIBOR + 7.7%. 😬 Not exactly cheap. Compounding matters is that the debt isn’t exactly cov-lite (shocking, we know): rather, the company is subject to all kinds of affirmative and negative covenants. Yes, once upon a time, those did exist.

The company’s recent SEC reports constitute a perfect storm of bad news. On April 2, the company filed a Form 8-K indicating that (i) a recently-acquired company had material accounting deficiencies that will affect its financials and, therefore, certain of the company’s prior filings “can no longer be relied upon,” (ii) it won’t be able to file its 10-K, (iii) it failed to make a $7mm interest payment on its Tranche A and Tranche B term loan borrowings due on April 1, 2019, and (iv) due to the accounting errors, the company has tripped various covenants under the first lien credit agreement — including its fixed charge coverage ratio and its total net leverage ratio. Rounding out this horror show of news, the company disclosed that it may need to seek a chapter 11 filing (combined with a CCAA in Canada) and has hired Weil Gotshal & Manges LLP, FTI Consulting Inc. ($FTI) and Macquarie Capital USA Inc. to advise it vis-a-vis strategic options. B.Riley/FBR ($RILY) analyst Josh Nicholsimmediately downgraded the company from “buy” to “neutral” (huh?!?) with a price target of $0.75 from $9.75. Uh, okay:

This is why you should never listen to equity analysts. This is the stock chart from the past year:

Like, the stock has been nowhere near $9.75, but whatevs.

On Monday, the company filed another Form 8-K. The company and 18 of its affiliated bankrupt US debtors…uh, we mean, guarantors…entered into a forbearance agreement with lenders under the Wilmington Trust NA-agented first lien credit agreement. The lenders will forbear from exercising rights and remedies stemming from the company’s defaults until April 29. The company had to pay 200 bps for the time to try and work this all out and agree to pay a slew of lender professionals, including Greenhill & Co. Inc. ($GHL) and Davis Polk & Wardwell LLP for an ad hoc group of Tranche B term lenders, Simpson Thacher & Bartlett LLP for the lenders of Tranche A term loans and the revolving lenders, and Arnold & Porter Kaye Scholer for Wilmington Trust.

The company’s Tranche B term lenders include East West Bank, Goldman Sachs, Morgan Stanley, Onex Credit Partners, Oppenheimer Funds and a whole bunch of CLOs. The latter fact may make a debt-for-equity swap interesting (PETITION Note: most CLOs are unable to hold equity securities).

The clock is ticking on this one.

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Bankruptcy Cases Suffer from Shrinkage

FTI Consulting Inc. ($FCN) recently released a “data”-driven analysis-cum-marketing-piece* that highlights the apparent rise of “Pre-filings” — otherwise known as prepackaged, prearranged or prenegotiated chapter 11 bankruptcy cases — during the 2015-2017 period. FTI examined 300 emerged cases (via plan of reorganization) from 2011-2017 and concluded that,

“Most restructuring professionals recognize that the average duration of Chapter 11 cases has become shorter in recent years, but the contraction in average case length has been particularly striking since 2015.”

Indeed, FTI points out that…

“…nearly 66% of cases that emerged in 2016-2017 were Pre-filings compared to approximately 40% over the previous five years….”

And:

“Consequently, the average duration of Chapter 11 reorganizations fell by nearly one-half in 2016-2017 compared to 2011-2015, to 235 days from 435 days.”

Sooooo, despite the rise in Pre-filings....

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Q1 2018 Preliminary Review

Long Duopolies = Long Kirkland & Ellis & Weil Gotshal & Manges

As we think about duopolies today, Google ($GOOGL) and Facebook ($FB) come to mind. The two large companies - recent controversies notwithstanding - represent a significant amount of annual ad revenue generation and have increasingly siphoned off market share and revenue from other advertising mediums; in other words, they have dominated the advertising industry. But this isn’t the kind of duopoly that we’re focused on today.

Over last week’s brief holiday respite, we set out to examine restructuring activity in Q1 2018. We wanted to answer this question: who is dominating the restructuring industry? Well, Captain Obvious: Kirkland & Ellis LLP and Weil Gotshal & Manges LLP.

We admit: we’re not surprised by this. We’ve been paying attention. In Q1 2018, Kirkland & Ellis LLP filed EXCO Resources Inc., PES Holdings LLC, Cenveo Inc., iHeartMedia Inc., and the Toys R Us “propco.” Weil Gotshal & Manges LLP filed Fieldwood Energy LLC, Tops Holdings II Corp., Claire’s Stores Inc. and Southeastern Grocers. That’s a meaningful and significant share of the large bankruptcy filings in the quarter. The industry is definitely a two-horse race when it comes to law firms and debtor filings. If we could long these firms, we would.

But, there are some changes afoot. Quintessential creditor-side firms are encroaching on the debtor shops and vice versa. Milbank Tweed Hadley & McCloy LLP filed Remington Outdoor Company and Akin Gump Strauss Hauer & Feld LLP filed Rand Logistics Inc. and FirstEnergy Solutions Corp. In turn, Weil Gotshal & Manges LLP seems to be positioning itself to take a chunk of revenue out of other firm’s debtor-side deals where it can — by sitting in other seats at the table. Weil represents both the potential buyer and the private equity sponsors in iHeartMedia Inc. and the ad hoc first lien group in Cobalt International Energy. Said another way, while Akin and Milbank are no longer creditor-only shops, Weil is no longer a debtor-shop only.

Getting even more granular, Weil Gotshal - along with Evercore Group LLC ($EVR) and FTI Consulting Inc. ($FTI) - have dominated the beleaguered grocery space. After working on the A&P Chapter 22 (which, for all three firms, was a round trip), the trifecta secured both Tops’ and Southeastern’s chapter 11 filings.

Meanwhile, DLA Piper LLP seems to be securing a foothold in the healthcare space. It was involved in Adeptus Health last year and recently filed Orion Healthcare Corp. and 4 West Holdings LLC. This is a firm to watch as people suspect more healthcare flow on the horizon.

Southeastern Grocers = Latest Bankrupt Grocer (Long Amazon/Walmart)

Another day, another bankrupt grocer.

Yesterday, March 27 2018, Southeastern Grocers LLC, the Jacksonville Florida-based parent company of grocery chains like Bi-Lo and Winn-Dixie, filed a prepackaged bankruptcy in the District of Delaware. This filing comes mere weeks after Tops Holding II Corporation, another grocer, filed for bankruptcy in the Southern District of New York. Brutal.

In its filing papers, Southeastern noted that, as part of the chapter 11 filing, it intends to "close 94 underperforming stores," "emerge from this process likely within the next 90 days," and "continue to thrive with 582 successful stores in operation." Just goes to show what you can do when you aren’t burdened by collective bargaining agreements. In contrast to Tops.

Also unlike Tops, this case appears to be fully consensual. It appears that all relevant parties in interest have agreed that the company will (i) de-lever its balance sheet by nearly $600 million in funded liability (subject to increase to a committed $1.125 billion and exclusive of the junior secured debt described below), (ii) cut its annual interest expense by approximately $40 million, and (iii) swap the unsecured noteholders' debt for equity. The private equity sponsor, Lone Star Funds, will see its existing equity interests cancelled but will maintain upside in the form of five-year warrants that, upon exercise, would amount to 5% of the company. 

Financially, the company wasn’t a total hot mess. For the year ended December 2017, the company reflected total revenues of approximately $9,875 million and a net loss of $139 million. Presumably the $40 million cut in interest expense and the shedding of the 94 underperforming stores will help the company return to break-even, if not profitability. If not - and, frankly, in this environment, it very well may be a big "if" - we may be seeing this trifecta of professionals (Weil, Evercore, FTI Consulting) administering another Chapter 22. You know: just like A&P. To help avoid this fate, the company has secured favorable in-bankruptcy terms from its largest creditor, C&S Wholesale Grocers, which obviates the need for a DIP credit facility. C&S has also committed to provide post-chapter 11 credit up to $125 million on a junior secured basis. 

Other large creditors include Coca-Cola ($KO) and Pepsi-Cola ($PEP). Given, however, that this is a prepackaged chapter 11, they are likely to paid in full. Indeed, a letter sent to suppliers indicates exactly that:

In addition to its over-levered capital structure, the company has a curious explanation for why it ended up in bankruptcy: 

"The food retail industry, including within the Company’s market areas in the southeastern United States, is highly competitive. The Company faces stiff competition across multiple market segments, including from local, regional, national, and international supermarket retailers, convenience stores, retail drug chains, national general merchandisers and discount retailers, membership clubs, warehouse stores and “big box” retailers, and independent and specialty grocers. The Company’s in-store delicatessens and prepared food offerings face competition from restaurants and fast food chains. The Company’s primary competitors include Publix Supermarkets, Inc., Walmart, Inc., Food Lion, LLC, Ingles Markets Inc., Kroger Co., and Amazon."

"Adding to this pressure is the recent growth in consumer demand for a “gourmet” shopping experience, complete with offerings of natural, organic, and gluten-free foods. Some of the Debtors’ competitors have expanded aggressively in marketing a range of natural and organic foods, prepared foods, and quality specialty grocery items. The Debtors have been at a disadvantage to companies that have the financial flexibility to devote greater resources to sourcing, promoting, and selling the most in-demand products."

Sound familiar? Here is what Tops said when it filed for bankruptcy:

"The supermarket industry, including within the Company’s market areas in Upstate New York, Northern Pennsylvania, and Vermont, is highly competitive. The Company faces stiff competition across multiple market segments, including from local, regional, national and international supermarket retailers, convenience stores, retail drug chains, national general merchandisers and discount retailers, membership clubs, warehouse stores and “big box” retailers, and independent and specialty grocers. The Company’s in-store delicatessens and prepared food offerings face competition from restaurants and fast food chains. The Company also faces intense competition from online retail giants such as Amazon."

"Adding to this competitive pressure is the recent growth in consumer demand for a “gourmet” shopping experience, complete with offerings of natural, organic, and gluten-free foods. Some of the Debtors’ competitors have expanded aggressively in marketing a range of natural and organic foods, prepared foods, and quality specialty grocery items. The Debtors have been at a competitive disadvantage to companies that have the financial flexibility to devote greater resources to sourcing, promoting, and selling the most in-demand products."

At least Weil is consistent: we wonder whether they pitch clients now on cost efficiencies they derive from just copying and pasting verbiage from one company's papers into another...? We also wonder whether the billable hours spent drafting the First Day Declaration here are less than they were in Tops. What's your guess? 

Anyway, there's more. No "First Day Declaration" is complete without a reference to Amazon ($AMZN). Here, though, the company also notes other competitive threats — including Walmart ($WMT). In "Tops, Toys, Amazon & Owning the Robots," we said the following,

In Bentonville, Arkansas some Walmart Inc. ($WMT) employee is sitting there thinking, “Why does Amazon always get the credit and free publicity? WTF.” 

Looks like Weil and the company noticed. And Walmart got their (destructive) credit. Go $WMT! 

Other causes for the company's chapter 11 include food deflation of approximately 1.3% ("a drastic difference from the twenty-year average of 2.2% inflation"), and reductions in the Supplemental Nutrition Assistance Program (aka food stamps). And Trump wasn’t even in office yet.

Finally, in addition to the store closures, the company proposes to sell 33 stores pursuant to certain lease sale agreements it executed prior to the bankruptcy filing. 

Will this mark the end of grocery bankruptcies for the near term or are there others laying in wait? Email us: petition@petition11.com.

Busted Tech (Short Influencers, Data Scientists & Fraudulent Founders)

Congratulations to Beme for being an Inception-like failure within a failure. Little more than a year ago, the ubiquitous Casey Neistat (of "Bike Lanes" fame (video)) sold his company Beme to CNN for $25mm in what, to those who track these things, was very clearly an acqui-hire rather than a legit acquisition. Neistat and his team were meant to be a boost of steroids for CNN's burgeoning digital content plans. Instead, he's gone and Beme is officially toast. Perhaps the shortest acqui-hire of all time. 

But at least Beme wasn't a $100mm bust. So, there's that. In contrast, Primary Data, a California-based data virtualization startup crashed and burned this week after 4 years of hype, $80mm in venture capital, $20mm in venture debt, and (practically) zero minutes of actual product delivery. Apple's Steve Wozniak was the company's data scientist. Notable VCs include Litespeed Venture Partners and Accel Partners.

And then there is Loot Crate, a monthly subscription service that sends video games and other nerdy gear to customers. Per Reuters, the company is a cesspool of controversy: it is the defendant in a sexual harassment lawsuit; and it had three non-exec Board members resign in recent weeks (including the high profile Mark Suster of Upfront Ventures). Consequently, it has hired Dendera Advisory LLC, a merchant bank of sorts, to raise new funds. We guess that means that, after $18.5mm of venture capital funding and Suster running for the exits, VC is no longer an option. Meanwhile, Dendera is apparently no stranger to distressed situations; it advised Sports Direct International in its purchase of Eastern Mountain Sports and invested in Performance Sports Group. 

Getting us progressively closer - but not quite in - to bankruptcy court, is Outcome Health, a medical advertising company that deploys technology (read: uh, tv screens) to doctor's offices. The company has (apparently) avoided a chapter 11 filing after settling fraud allegations Goldman Sachs and Google Capital lobbed at the company's founders. Jones Day, Rothschild and FTI Consulting were all reportedly laying in wait for a potential bankruptcy filing. The company has several million dollars of debt. As part of the settlement, the defendants and others will infuse the company with additional liquidity.

And, finally, further busting the everybody-gets-rich-off-of-tech narrative, Practice Fusion, a medical records startup, has sold for $100mm to AllScripts Healthcare Solutions Inc. ($MDRX) at a mere fraction of the once-heralded $1.5b valuation the company reportedly enjoyed. While management - including a General Counsel making $2.2mm - are getting enriched, employees taxed on earlier exercised stock options are getting shafted hard. It's a rough story. Peter Thiel (of Gawker fame) and Kleiner Perkins Caufield & Byers were large investors. 

PETITION NOTE: Startups fail all of the time. We note it only because, eventually, interest rates will rise, the bubble will burst, venture capital money will dry up, and EVEN MORE startups and tech companies will go "bust." A number of these companies - unbeknownst to many who don't follow tech - actually have venture debt (like Primary Data above) and valuable IP. Stay tuned. And imagine how long this section will be when that all that happens.

Feature of the Week: More Earnings (Simon Property Group & Starbucks)

This past week was an earnings-fest with Amazon and Google pumping out redonkulous numbers, Vince Holding Corp. missing estimates by 10 cents, declining 26% and continuing its slide towards bankruptcy, and FTI Consulting missing estimates BADLY, declining 3% and charting -23% year-to-date (we wonder how Berkeley Research Group is doing?). While all of these reports were intriguing, we took particular interest in reports from Simon Property Group and Starbucks...

Simon Property Group

Upshot: increased net operating income, increased retail sales per square foot, and increased average base rent. The company reported a flat occupancy rate of 95.6% at Q1 end and affirmed it's previous '17 guidance (typically, the company raises guidance). Snoozefest, we know, but keep reading...

CEO David Simon had a number of choice things to say about the current state of affairs (PETITION commentary follows in italics):

• Retailers need to improve the in-store experience via technology, look and feel, and merchandising. He straight-up called his tenants to task alleging that they are overspending on the internet vs. the store fleet. He says this is reversing back and notes that pure e-commerce will need brick-and-mortar. Ironically, most recent bankrupt retailers claim that they filed for bankruptcy because they hadn't focused on their e-commerce fast enough! We can't recall one bankrupt retailer who cited too much expense associated with e-commerce as a cause for filing. He also makes no mention whatsoever of Amazon and Walmart's increased market share in clothing, the rise of mobile e-commerce, the rise of platforms, and millennials' lack of interest in shopping (and penchant for vintage clothing). 
• A lot of the current bad performance is driven by private equity leverage rather than the common theme, the internet. He expressly calls out dividend recaps. No quarrel here whatsoever and more victims of this are in the bankruptcy pipeline. 
• SPG has lowered apparel in its retail mix by 5-6%. Whether that was elective was not clear.
• Expect more discounters like TJ Maxx and HomeGoods and grocers like 365, Wegmans and Fresh Market in high end malls. Other specific new tenants include restaurants (Fig & Olive, Nobu) and several movie theater brands with the occasional Dave & Buster's thrown in for good measure. This all seems consistent with the narrative that more experiential-oriented tenants will fill these spaces. Query how long until and to what degree the pain in the grocer segment will come to roost, if at all.
• Because these long-term anchors aren't driving foot traffic and revenue to the malls, there is a lot of upside in reclaiming and redeveloping department stores for mixed use, lifetime or community-oriented activity. They are actively taking back space from unproductive retailers and they are "not putting good money in the rabbit hole," suggesting, at least, in part, that future Aeropostale-like deals are unlikely. Note, also, Aeropostale's performance shaved several basis points off performance and is likely to continue doing so through Q4. This sure sounds like a solid counter-narrative but won't this eventually boil down to a case of volume assuming the vacancy rate next quarter is lower than this quarter?
• Store closures in a market also kill internet sales for that business in-market too. Really interesting and speaks to the thesis promoted by the likes of Warby Parker that some retail presence helps scale.
• Expect improvements in technology in the mall environment. If people had an issue with Unroll.me selling their data, wait until the beacons scale! 
• The mall "traffic is there" and the retail apocalypse "narrative is way ahead of itself." Yet, he wouldn't provide traffic data noting that there aren't traffic counters in their malls. The parking trackers at their outlets, however, are up 2%. See also Starbucks below.
• The strong US dollar has had a significant impact on spending by international tourists. So has our President but we won't go there. Oh, wait, we just did. Not a political commentary: just a plain fact.
• He would not opine as to how much per capital retail needs to come out of the system. It was abstract but, as we noted last week, Vornado Trust's CEO noted somewhere between 10-30% in the next five years.

Macro narrative aside, Mr. Simon remained upbeat about SPG's quarter and guidance. But speaking of REITS, we'd be remiss if we didn't point out this doozy of a red flag piece by the WSJ, highlighting 10 retailers that S&P Global Market Intelligence has noted as at high risk of default: Sears Holding Corp. (for obvious reasons), DGSE Companies Inc. (millennials don't buy precious metals, apparently), Appliance Recycling Center of America Inc. (millennials haven't been buying homes, apparently, so no need for recycled appliances...?), The Bon-Ton Stores Inc. (specialty retailer massacre), Bebe Stores Inc. (what? nobody wants glittery hats and shirts shouting BEBE anymore?), Destination XL Group Inc. ("our financial condition is extremely healthy" says the CEO whose company has a projected net loss on $470mm of revenue), Perfumania Holdings Inc. (mall-based perfume including the foul-stench of the Trump family...also fact, just saying), Fenix Parts Inc. (doesn't Amazon have an auto parts reselling business? why, yes, as a matter of fact it does), Tailored Brands Inc. (tons of quality tuxedo options online these days), Sears Hometown and Outlet Stores Inc. (obvious).

Of SPG's top 10 anchors, Sears is #2 with 69 locations and 11.3mm square footage of space and The Bon-Ton Stores Inc. is #10 with 8 stores and 1.1mm square footage of space. Macy's is #1 with 121 stores and 23.1mm square footage. Top in-line stores? L Brands, Signet Jewelers and Ascena Retail Group - all of which are reporting rough numbers of late. Which may explain why, in the end, SPG's stock was down this week, is down for '17, and is close to its 52-week low. 

Starbucks

Starbucks is just fine from the restructuring community's perspective. With one exception: Teavana. The company indicated that it is "evaluating strategic options." Why? Good question and, quite frankly, the answer is very much at odds with what Mr. Simon says. See, Teavana is a mall-based retailer; it has 350 locations. And they're not faring well predominantly because, per Starbucks' CFO, there is dramatically reduced mall traffic. Accordingly, Teavana has been suffering from negative same store comps and operating losses "for some time" with the rate of decline over the last 6 months far worse than forecast. Now even further declines are expected. And so we did a quick check: there are 78 Teavana locations in Simon Properties which would be 22% of all Teavana locations. Is it possible that those locations are the outliers and are performing extremely well on account of steady foot traffic? Starbucks doesn't break out numbers of a per location basis. But we highly doubt it. 

Things That Caught Our Attention in the Waning Weeks of '16

It's easy for small matters to get lost in translation over the holidays and so we wanted to highlight a few developments that may have flown under the radar. 

American Apparel

The company is looking to hire FTI Consulting to provide supplementary services to its current financial advisor, Berkeley Research Group. FTI will be paid $100k to prepare the Schedules and Statement of Financial Affairs and $300k for "other services" given institutional knowledge gained from the original Chapter 11 filing (note: this is a Chapter 22). Sadly, FTI had to waive its $2mm+ claim stemming from the original filing to secure this minor mandate. Ouch. 

Choxi.com

The company and the official committee of unsecured creditors have submitted an application for CBIZ to serve as financial advisor to both concurrently. We've been around the business for a while but cannot think of any prior instances when the same financial advisor sat on both sides of the table. What are other instances of this, if any?

The Choxi.com negotiating table just got a lot more interesting.

France

Just when the unintentional comedy that is France couldn't get any funnier, the country instituted a law codifying a right to disconnect, applicable to all companies with 50 or more employees. That's right: 35 hour work weeks, 14 months a year of vacation, and now the right not to be bothered by a partner at 7 pm with a request for a memo due by 9 am even though he won't look at it until 12 pm...9 days later. The Paris office of a lot of law firms just got much more interesting.