liquidity and balance sheet analysis - learnfrombarryprework · liquidity and balance sheet...
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© Barry M Frohlinger, Inc. copyright 1981 - 2017 0
Liquidity and Balance Sheet Analysis• Liquidity is the ability to meet short term financial obligations:
• By having cash on hand in excess of short term financial claims [plus unused revolvers]• Or Generating Cash Flow from Operations
• Measurement of Liquidity– Balance Sheet [Static]– Cash Flow [Dynamic]– Seasonality– Access to Credit [unused availability]– Financial Flexibility
• related to a firm’s overall financial structure and if financials allows the firm enough flexibility to take advantage of unforeseen events.
• The tools for analyzing Liquidity are:– Static
• Determine the length of the cash cycle and Operating Working Capital [WC need]– Dynamic
• Find the Cash Flow from Operations• Capital Expenditures• Dividends
– Calculate– Free Cash Flow [CFO - CapX – Dividends] and also the long run– Funds Flow less Mandatory Cap X less Dividends
– Credit• [Cash and Unused Revolvers]/Sales
© Barry M Frohlinger, Inc. copyright 1981 - 2017 1
A typical balance sheet: assets
2015 ASSETS
Cash $204 Accounts Receivable - Trade 16,931 Inventory 1,984 TOTAL CURRENT ASSETS 19,119 Gross Fixed Assets 4,129 less: Accumulated Depreciation (1,200) Net Fixed Assets 2,929 Other Assets 764 Intangibles 45,431 less: Accumulated Amortization (0) Net Intangible Assets 45,431 TOTAL ASSETS $68,243
Liquid assets
Net property plant & equipment
Goodwill & Identifiable Intangibles
Trading assets
© Barry M Frohlinger, Inc. copyright 1981 - 2017 2
A typical balance sheet: Financing [liabilities and net worth]
Equity capital
2015 LIABILITIES
Notes Payable $0 Current Maturity Long-Term Debt 7,600 Accounts Payable - Trade 7,130 Accrued Liabilities 563 TOTAL CURRENT LIABILITIES 15,293 Long Term Debt 12,400 Subordinated Debt 8,400 TOTAL LIABILITIES $36,039
NET WORTH Common Stock $1,000 Paid In Capital 12,541 Retained Earnings 18,609 NET WORTH $32,150
TOTAL LIABILITIES & NET WORTH $68,243
Subordinated debt
Senior debt
Working Liabilities
© Barry M Frohlinger, Inc. copyright 1981 - 2017 3
What is Operating Working Capital [WC need or WCR] and Working Capital?
© Barry M Frohlinger, Inc. copyright 1981 - 2017 4
8 Types of C&I Balance Sheets, Asset ProfilesA B C D A1 B1 C1 D1
Operating Working Capital
[need]
Low High Low High Low High Low High
Non Current Assets
High High Low Low High High High High
PPE High High Low Low High High Low Low
Intangible Low Low Low Low High High High High
Example
Need for Capital
Need for WC
Need for Operating Profit
Need for CFO
© Barry M Frohlinger, Inc. copyright 1981 - 2017 5
Operating Working Capital
Co A Co B Co C Co D
Working capital requirement
200 300 450 -100
Revenue 1,000 2,000 1,500 1,000
Ratio
.05
.12
.20
© Barry M Frohlinger, Inc. copyright 1981 - 2017 6
Non Current Assets
Co A Co B Co C Co D
WC need 100 240 240 1,500
PPE, net 100 900 100 400
Intangibles 100 100 900 400
Total Assets 1,200 1,200 1,200 4,000
Revenue 2,000 2,000 2,000 5,000
WC Need Capital/Sales .05 .12 .12 .30
PPE/Sales .05 .45 .05 .08
Intangibles/Sales .05 .05 .45 .08
NCA/Total Assets 17% 83% 83% 20%
PPE/NCA 50% 90% 10% 50%
NCA/Sales .10 .50 .50 .16Total Capital Need/Sales [60%] .15 .62 .62 .46
© Barry M Frohlinger, Inc. copyright 1981 - 2017 7
Non Current Assets
PPE/Sales 15% 35% 80%Intangibles/Sales 10% 30% 60%WCR/Sales 5% 12% 20%
Total 20% 50% 100%
Sales 10,000 10,000 10,000
OP
OPM
IC
RROIC
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Earning Profile and Asset Profile
8
A BWCR 1,000 5,500PPE 1,800 9,500Intangibles 1,000 15,000
Revenue 10,000 15,000Op Profit 1,000 2,250OPM 10% 15%
WCR/Revenue 0.10 0.37PPE/Revenue 0.18 0.63Intangibles/Revenue 0.10 1.00
IC 3,800 30,000IC/Revenue 0.38 2.00RROIC 17.1% 4.9%
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Balance Sheets
9
transport retailer utility distributionhome
builder techfarm
equipment auto auto tech distributor distributorFed Ex JC Penney Southern Fastenal Pulte Apple Amazon Deere GM Ford Oracle Wesco HD Supply
OpWC 1,100 - 1,550 1,000 2,900 (15,000) (10,800) 31,300 15,100 37,000 (4,300) 1,250 1,400 NCA 19,600 5,400 54,400 510 195 21,000 15,500 6,450 55,100 39,100 39,100 2,500 3,900 PPE 17,300 5,300 48,400 500 45 15,000 11,000 5,500 26,000 24,100 3,000 200 400 Intangibles 2,300 100 6,000 10 150 6,000 4,500 950 29,100 15,000 36,100 2,300 3,500
revenue 43,000 13,000 16,500 3,100 4,700 230,000 75,000 38,000 155,000 134,000 37,000 7,500 9,000 op profit 3,200 - 4,400 670 240 70,000 740 6,300 5,600 5,300 13,600 480 536 OPM 7.4% 0.0% 26.7% 21.6% 5.1% 30.4% 1.0% 16.6% 3.6% 4.0% 36.8% 6.4% 6.0%
OPWC/Sales 2.6% 0.0% 9.4% 32.3% 61.7% -6.5% -14.4% 82.4% 9.7% 27.6% -11.6% 16.7% 15.6%PPE/Sales 40.2% 40.8% 293.3% 16.1% 1.0% 6.5% 14.7% 14.5% 16.8% 18.0% 8.1% 2.7% 4.4%Intangibles/Sales 5.3% 0.8% 36.4% 0.3% 3.2% 2.6% 6.0% 2.5% 18.8% 11.2% 97.6% 30.7% 38.9%Sales/PPE 2.5 2.5 0.3 6.2 104.4 15.3 6.8 6.9 6.0 5.6 12.3 37.5 22.5NCA/Sales 45.6% 41.5% 329.7% 16.5% 4.1% 9.1% 20.7% 17.0% 35.5% 29.2% 105.7% 33.3% 43.3%PPE 88% 98% 89% 98% 23% 71% 71% 85% 47% 62% 8% 8% 10%Intangibles 12% 2% 11% 2% 77% 29% 29% 15% 53% 38% 92% 92% 90%
IC 20,700 5,400 55,950 1,510 3,095 6,000 4,700 37,750 70,200 76,100 34,800 3,750 5,300 Sales/IC 2.08 2.41 0.29 2.05 1.52 38.33 15.96 1.01 2.21 1.76 1.06 2.00 1.70
RROIC 10.0% 0.0% 5.1% 28.8% 5.0% 758.3% 10.2% 10.8% 5.2% 4.5% 25.4% 8.3% 6.6%pretax RROIC 15.5% 0.0% 7.9% 44.4% 7.8% 1166.7% 15.7% 16.7% 8.0% 7.0% 39.1% 12.8% 10.1%
© Barry M Frohlinger, Inc. copyright 1981 - 2017 10
LiquidityBalance Sheet Management
Acc Receivable in Days AR/Sales *360 [or 365]
Inventory in Days Inv/CGS * 360 [or 365]Acc Payables in Days AP/CGS *360 [or 365]
Trade Cycle in Days AR days + Inv days
Cash Cycle in Days Trade Cycle less AP daysTrading Assets All CA less cash/mkt sec
Spontaneous Financing All CL less st debt & div payable
Operating Working Capital TA - Spon Finance
^ In OPWC
OPWC/SalesWorking Capital Capital less NCA
PPE [net]/Sales
Intangibles/SalesNCA/Total Assets
PPE[net]/NCA
Net Operating Assets [IC]/Sales
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Omnicom, April 2016
• Advertising giant Omnicom Group Inc. announced the pricing of its public offering of $1.4 billion 10-year senior notes. The notes will bear an interest rate of 3.60% per annum, and will mature on Apr 15, 2026.
• As the second biggest global advertising and marketing service agency group, Omnicom has an extensive geographic footprint, high client retention and a huge, diverse customer base. Despite slackening global economic growth, Moody's expects Omnicom to grow at a moderate pace in 2016. The company also has an edge over the traditional single-channel media firms and can navigate technology driven shifts more quickly and efficiently.
• Moody's has assigned a Baa1 rating to the issue, along with a stable outlook. • Omnicom intends to use the net proceeds from the offering for general corporate purposes, like working capital needs, acquisitions, fixed asset
expenditures, debt refinancing and stock repurchases. The proceeds will likely be used for the retirement of the company's existing 5.9% senior notes worth $1 billion, which will mature on Apr 15, 2016.
• The note issuance will extend the company's maturity profile while decreasing its cash interest costs by about $10-$15 million annually.
11
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Omnicom
12
Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17Revenue 4,153 3,499 3,885 3,791 4,241 3,587 3,790
Cash 2,620 1,750 1,537 1,969 3,022 2,485 1,874 AR 7,221 6,321 6,423 6,489 7,511 6,797 7,143 Other Working Assets 2,140 2,474 2,354 2,374 2,189 2,446 2,488 TCA 11,981 10,545 10,314 10,832 12,722 11,728 11,505 PPE 693 690 683 679 675 678 687 Intangibles 9,100 9,445 9,525 9,490 9,423 9,489 9,574 Other NC Assets 337 387 413 401 345 342 397 Total Assets 22,111 21,067 20,935 21,402 23,165 22,237 22,163
STDebt 5 39 12 25 29 29 19 CPLTD 1,000 1,000 - - - - -Acc Payables 9,812 8,406 8,507 8,817 10,477 9,454 9,849 Other Working Liabilities 3,401 3,494 3,022 3,119 3,505 3,587 2,996 TCL 14,218 12,939 11,541 11,961 14,011 13,070 12,864 LT Debt 3,564 3,613 5,022 5,007 4,920 4,915 4,930 Other LT Liabilities 1,270 1,404 1,375 1,378 1,372 1,396 1,320 Total Equity 3,058 3,111 2,997 3,056 2,862 2,856 3,049 Total 22,110 21,067 20,935 21,402 23,165 22,237 22,163
WC R -3,852 -3,105 -2,752 -3,073 -4,282 -3,798 -3,214 WC -2,237 -2,394 -1,227 -1,129 -1,289 -1,342 -1,359
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Omnicom
13
Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17
WC/Revenue -23% -22% -18% -20% -25% -26% -21%
PPE/Revenue 4% 5% 4% 4% 4% 5% 5%
Intangibles/Revenue 55% 67% 61% 63% 56% 66% 63%
© Barry M Frohlinger, Inc. copyright 1981 - 2017 14
Peer Comparison [BS Management]
• Compare Avon to its peers and be prepared to comment on Balance Sheet Management
© Barry M Frohlinger, Inc. copyright 1981 - 2017 15
Apple
APPLE 6/30/12ASSETS:Current assets:Cash and and securities 27,654 Accounts receivable 7,657 Inventories 1,122 Deferred tax assets 2,309 Vendor non-trade receivables 6,641 Other current assets 6,560 Total current assets 51,943
Long-term marketable securities 89,567 Property, plant and equipment, net 10,487 Goodwill 1,132 Acquired intangible assets, net 4,329 Other assets 5,438
Total assets 162,896
LIABILITIES AND SHAREHOLDERS' EQUITY:Current liabilities:Accounts payable 16,808 Accrued expenses 10,430 Deferred revenue 5,822
Total current liabilities 33,060
Deferred revenue - non-current 2,530 Other non-current liabilities 15,560
Total liabilities 51,150
Shareholders' equity:Total shareholders' equity 111,746
Total liabilities and shareholders' equity 162,896
Revenue [9months ended 6/30/2012] 120,542
WC need (8,771) WC 18,883 Need for Capital 12,615
© Barry M Frohlinger, Inc. copyright 1981 - 2017 16
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Carnival 2017
WCR
WC
Implications to Liquidity
Recommendations
17
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Sales Growth
18
2017 2018
Revenue 10,000
EBITDA 1,000
Funds Flow 700
Cash Flow from Operations
2017 2018
cash
acc receivables 1,000
inventory 800
prepaids 100
stdebt
acc payables 800
accruals 900
tax payable 100Non cash WC [WC need]
Sales Growth 10%
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Sales Growth
19
2017 2018
Revenue 10,000
EBITDA 600
Funds Flow 400
Cash Flow from Operations
2017 2018
cash
acc receivables 2,000
inventory 900
prepaids 100
stdebt
acc payables 300
accruals 300
tax payable 100Non cash WC [WC need]
Sales Growth 10%
© Barry M Frohlinger, Inc. copyright 1981 - 2017 20
Cash Flow Patterns
Positive OPWC Zero OPWC Negative OPWC
© Barry M Frohlinger, Inc. copyright 1981 - 2017 21
Static Liquidity Scenarios
Working Capital
Operating Working Capital
negative zero positive
negative 1 2 3
zero 4 5 6
positive 7 8 9
© Barry M Frohlinger, Inc. copyright 1981 - 2017 22
Cash Flows
• Characteristics of companies with Good Cash Flow– Stable earnings [operating profit]
• Little cyclicality, low fixed costs– Short cash cycle – Limited Capital Expenditures– Reasonable financial decisions
• Dividends and debt levels
© Barry M Frohlinger, Inc. copyright 1981 - 2017 23
Cash Flow Drivers
High Cash Flow Low Cash Flow
Profit High Low
Growth ? ? ?
Cash Cycle Short [Negative] Long
Capital Intensive Not Very
Dividend Policy None High
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Cash Flow Analysis
Short Run Long RunEBITDA
Funds Flow
^ WC need
CFOps
Cap X
Maintenance CapX
Other Core “Investing” FlowsDividends
“Share repurchase”
Cash Flow for Debt RepaymentCPLTD
Total Debt24
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Share repurchase
Shares issued upon exercise of options
Total Proceeds
Average Exercise Price
Average Price for Share Repurchased during year
Difference
25
© Barry M Frohlinger, Inc. copyright 1981 - 2017 26
Sources of liquidity
Internal External
Immediate
• Surplus cash [above operating requirements], including marketable securities
• Committed Unused Bank facilities
Near-Term • Surplus assets• Operating efficiencies
• Debt Issuance
Longer-term • Operating assets• Strategic changes
• M & A
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Liquidity Ratio
27
[Cash plus unused committed revolver]/revenue
In addition, Liquidity Position is
[Unrestricted Cash plus unused committed revolver] less [short term debt plus CPLTD]
© Barry M Frohlinger, Inc. copyright 1981 - 2017 28
Uses of liquidity
Uses of Liquidity
• Operations• Capital Spending• Dividends• Buying Shares Avoid Dilution• Debt repayments• Unexpected Claims, disasters, regulatory• Share repurchases
© Barry M Frohlinger, Inc. copyright 1981 - 2017 29
Liquidity Profile
• Running out of cash is a key reason for default
• How much cash does the firm have– Is it restricted?
– How much unused bank facility?
• Are the bank facilities committed or revocable?
– Do the banks in the facility make sense?
• Does liquidity make sense compared to peers, business risks and trend?
• Liquidity comes from – Unrestricted Cash, Unused Committed Bank Facilities, Prudent Debt Structure
© Barry M Frohlinger, Inc. copyright 1981 - 2017 30
Ways Out ContinuumWhat does deteriorating performance mean for the company?
Strong Credit Profile. Ample Liquidity
Weakening Credit Profile. Adequate Liquidity
Deteriorated Credit Profile. Low Liquidity
Further deteriorated Credit Profile. Low Liquidity
No Liquidity. Inability to pay debt in the short term
No Liquidity. Inability to pay debt at all
Refinance
Refinance in high yield market
ABF
Asset Sales
Voluntary Bankruptcy
Insolvency
© Barry M Frohlinger, Inc. copyright 1981 - 2017 31
Cash Flow Profiles
Business Management Financing Choices
Operating Decisions
Asset Management
Decisions
Financing Choices
Dividend Decisions
Revenues & Managing Expenses
Managing Working Capital
& NCA
Debt and Equity Choice
Managing Dividend Payout
Profit Margins B/S Management
Capital Structure Decisions Payout Ratios
Cash Flow Profiles, Management
© Barry M Frohlinger, Inc. copyright 1981 - 2017 32
Cash Flow Analytics, GAAP, Equity, Credit
• Revenue– CGS and SGA– depreciation
• Operating EBIT– Tax on
Operating EBIT• OPAT
– Depreciation• EBIDA
– Changes in Working Capital Needs
• Net Unleveraged Operating Cash Flow
– CapX• Free Cash Flow to
Firm
• Revenue– CGS and SGA
• EBITDAs– Interest and Tax
Expense• Funds Flow [Gross
Cash Flow]– Changes in
Working Capital Needs
• Net Operating Cash Flow
– Cap X – Cash Dividends– Shares?
• Free Cash Flow to repay debt
• Revenue– CGS– SGA– Depreciation– Interest and Tax
• Net Income– Depreciation– Changes in Working
Capital Needs• Net Operating Cash
Flow• Net Investing CF• Net Financing CF• Change in Cash
© Barry M Frohlinger, Inc. copyright 1981 - 2017 33
Appropriate Capital StructuresDoes the Current Capital Structure make sense?
• Mature / Stable [CP [with backup], bonds]• Cyclical [Cash, large revolver and long-term bonds]• Leveraged / Acquisition [Revolver, TLA & TLB, senior or sub Notes]
• [Term loan 3-4X EBITDA plus 1-2X EBITDA plus revolver]• TLA [3 – 5 years, senior secured, 75% of forecasted FCF]• TLB [1% amortization, maturity 1 yr after TLA]• Second lien loan [bullet maturity, maturity 1 yr after TLB]• Bridge Loan may be used to fund, repaid with term loans
• Volatile / High Tech [Low leverage and significant cash] • Start-up[Equity]• Seasonal/ [line of credit with a cleanup]• High Risk/High Growth [convertibles] • Declining [ABF, through a borrowing base]
© Barry M Frohlinger, Inc. copyright 1981 - 2017 34
Cash Flow Adequacy
YesCaution
NoExtreme Caution
Is there a liquidity hurdle?What is the hurdle? Does the firm have enough cash on hand?
the CFO – CapX – Dividends positive?
YES NO
YesCaution
No
© Barry M Frohlinger, Inc. copyright 1981 - 2017 35
Maturity Profile [Towers of Debt]Financial Flexibility
0
10
20
30
40
50
60
70
1 2 3 4 5 6 7 8
Cash Flow
Maturity
© Barry M Frohlinger, Inc. copyright 1981 - 2017 36
Maturity Profile [Towers of Debt]Financial Flexibility
0
50
100
150
200
250
300
1 2 3 4 5 6 7 8
Cash Flow
Maturity
© Barry M Frohlinger, Inc. copyright 1981 - 2017 37
Maturity Profile [Towers of Debt]Financial Flexibility
0
50
100
150
200
250
1 2 3 4 5 6 7 8
Cash Flow
Maturity
© Barry M Frohlinger, Inc. copyright 1981 - 2017 38
Maturity Profile [Towers of Debt]Financial Flexibility
0
50
100
150
200
250
1 2 3 4 5 6 7 8
Cash Flow
Maturity
© Barry M Frohlinger, Inc. copyright 1981 - 2017 39
Maturity Profile [Towers of Debt]Financial Flexibility
0
50
100
150
200
250
300
350
1 2 3 4 5 6 7 8
Cash Flow
Maturity
© Barry M Frohlinger, Inc. copyright 1981 - 2017 40
Debt Structuring
• Cash Flow Lending
• “A riskier way to lend to safer companies”
• Company Profile– Good Margins– Stable/Predictable Cash Flows– Identifiable Intangible Assets
• Debt Capacity– General
• Senior Debt/EBITDA of max 3X• Total Debt/EBITDA of max 4.5X
• Asset Based Lending
“A safer way to lend to riskier companies”
• Company Profile– Low Margin – Volatile or Cyclical Cash Flows– Real Hard Assets
• Debt Capacity– 70% of AR– 40% of Inventory– 60% of PPE
© Barry M Frohlinger, Inc. copyright 1981 - 2017 41
Solvency [Long term]
• Measurement of Capital Structure/Solvency• Capital Structure & Solvency [also called leverage] identifies
– the source of a firm's financing– owners vs. creditors.
• Leverage refers to the use of creditor financing. – Leverage refers to the fact that using debt [versus equity] will "amplify"
either profits or losses in relation to the equity of the firm.
© Barry M Frohlinger, Inc. copyright 1981 - 2017 42
Rating Agency View of Ratios
• Ratios are helpful in broadly defining a company's position relative to rating categories.
• Key industrial financial ratios are adjusted for unusual items and to capitalize operating leases.
© Barry M Frohlinger, Inc. copyright 1981 - 2017 43
Ratio Medians
AAA AA A BBB BB B CCC EBIT interest coverage 24.8 19.5 8.0 4.7 2.2 1.2 [0.1]
EBITDA interest coverage 27.5 24.6 10.7 6.8 3.5 1.9 0.7 Funds from operations/total debt 203% 80% 48% 36% 22% 12% 3%
Free operating cash flow/total debt 128% 45% 25% 17% 8% 3% [3%] Pretax return on capital 28% 27% 18% 13% 11% 8% 1%
EBITDA/sales 23% 24% 18% 16% 15% 15% 9% Long term debt/capital 0% 21% 34% 40% 54% 73% 78%
Total debt/capitalization 5% 36% 43% 47% 58% 75% 92% Debt/EBITDA 0.8 1.2 1.8 3.0 3.8 4.5 4.8
EBITDA/Assets 29% 24% 19% 15% 14% 11% 4% Number of companies 2 24 121 224 279 264 56
© Barry M Frohlinger, Inc. copyright 1981 - 2017 44
Ratio Medians
1 EBIT interest coverage EBIT, including equity income Gross Interest Expense plus capitalized interest
2 EBITDA interest coverage EBITDA, including distributed equity income
Gross Interest Expense plus capitalized interest
3 Funds Flow/Total Debt Funds Flow All Debt
4 Free Operating Cash Flow/Total Debt
CFO - Cap X All Debt
5 Pretax Return on Capital EBIT All debt + Equity+ Non Controlling Interest
6 Operating EBITDA margin Operating EBITDA Sales
7 Long Term Debt/Capital Long Term Debt Long Term Debt + Equity + Non Controlling Interest
8 Total Debt/Capital All Debt All debt + Equity+ Non Controlling Interest
9 Total Debt/EBITDA All debt EBITDA, including distributed equity income
Need to adjust for operating leases & securitization. Must consider other debt like liabilities, pension etc and unconsolidated businesses. Also must consider deferred tax assets and liabilities and other assets [intangibles].
© Barry M Frohlinger, Inc. copyright 1981 - 2017 45
Capital Structure
• TNW has re-emerged as a key capital measure– This was the norm in the 1970s and in small and mid sized corporates
– Adjusting Equity for
• Goodwill
• Identifiable intangibles
• Deferred Tax Assets
© Barry M Frohlinger, Inc. copyright 1981 - 2017 46
Debt Ratings
• Ratings are influenced by:– Financial Results– Business Risks– Company Size [Scale]– Projections
• Ratings are capped by– Size [Country]
• When considering ratings, make sure you consider the firm’s beta– Industry– Operating Leverage– Financial Leverage
© Barry M Frohlinger, Inc. copyright 1981 - 2017 47
Risk Framework
Financial Risk Profile
Business Risk Profile Minimal Modest Intermediate Significant Aggressive High Lev
Excellent AAA AA A A- BBB
Strong AA A A- BBB BB BB-
Satisfactory A- BBB+ BBB BB+ BB- B
Fair BB+ BB BB- B-
Weak BB BB- B+ B-
Vulnerable B+ B CCC+
© Barry M Frohlinger, Inc. copyright 1981 - 2017 48
Financial Leverage
Unleveraged Firm
Sales 1,000
Cost of Sales 300
Selling 500
Operating Profit 200
Interest 0
Tax 70
Net Income 130
Assets 1,000
Debt 0
Equity 1,000
Outstanding Shares 100
EPS
Share Price
Operating Profit Margin 20%
NI Margin 13%
ROE 13%
Leveraged Firm
Sales 1,000
Cost of Sales 300
Selling 500
Operating Profit 200
Interest 20
Tax 63
Net Income 117
Assets 1,000
Debt 400
Equity 600
Outstanding Shares 60
EPS
Share Price
Operating Profit Margin 20%
NI Margin 11.7%
ROE 19.5%
© Barry M Frohlinger, Inc. copyright 1981 - 2017 49
Off Balance Sheet
• Lease
• A/R securitization vehicles [not a cash flow loan]
• Pension underfunding may be debt– Gross size of defined benefit pensions is risk
• Litigation
• Purchase Commitments
• Backlog
• L/C
• Contingent guarantees
• Liabilities from affiliates
• Any put events
• If in doubt, put it back on the Balance Sheet [at least footnote]
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Lease Adjustment
• Convert Op Lease to on Balance Sheet debt– 8* rent
• Adjust Debt and Adjust EBITDA to EBITDAR
50
Interest DepreciationRentDebt
EBITEBITDAInterestFunds FlowTotal DebtTotal Capital
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Leasing
Total DebtEBITDA
FFTotal Debt
EBITDA
Interest
EBIT
Interest
Total Debt
Capitalization
51
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Pension Adjustment
Leasing PensionDebt Underfunded*(1-t)EBITDA Non operating
pension cost
52
© Barry M Frohlinger, Inc. copyright 1981 - 2017 53
Peer Comparison [Capital Structure]
• Compare Avon to its peers and be prepared to comment on Capital Structure.
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Company Snapshot, Make sure all these profiles are considered
54
Analysis KSF/Credit Implication Recommendation
Business Risk Profile Recommendation
Earnings Profile Recommendation
Asset Profile Recommendation
Liquidity Profile Recommendation
Cash Flow Profile
Capital Structure Profile Recommendation
Debt Instrument Profile Recommendation
Debt Maturity Profile Recommendation
Financial Profile
Legal Structure Profile Recommendation
Cash Flow Projection Profile
© Barry M Frohlinger, Inc. copyright 1981 - 2017 55
The business cycle
• Seasonal and Cyclical businesses
© Barry M Frohlinger, Inc. copyright 1981 - 2017 56
Seasonality in retailers and manufacturers
Toys R Us Quarterly
Sales
16% 17% 19%
48%
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
Fedder's Air
Conditioner Sales
27%
35%
20%18%
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Economies grow unevenly
57
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
1977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016
Change in GDP Recession
1977-2016 average
© Barry M Frohlinger, Inc. copyright 1981 - 2017 58
Sales & Earnings
• What happens in a recession to a procyclical business
– Sales?
– Earnings?
– Cash Flow from Operations?
© Barry M Frohlinger, Inc. copyright 1981 - 2017 59
Financial Analytics
• Does the time of year affect Avon’s business? [Is the business seasonal?]
• Is Avon cyclical [does the economy affect Avon’s business?]
© Barry M Frohlinger, Inc. copyright 1981 - 2017 60
Seasonality
4th 20
14 3 2 1
4th 20
13 3 2 1
4th 20
12 3 2 1
4th 20
11 3rd 2nd 1s
t
4th 20
10 3rd 2nd 1s
t
4th 20
09 3rd 2nd 1s
t
4th 20
08 3rd 2nd 1s
t
4th 20
07 3rd 2nd 1s
t
4th 20
06 3rd 2nd 1s
t
4th 20
05 3rd 2nd 1s
t
4th 20
04 3rd 2nd 1s
t
4th 2
003 3rd 2n
d
AR Inventory
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Credit
• What is enterprise value?
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Enterprise Value
Book Value Fair Value [market survey]
Cash
Operating Assets
Total Assets
Supplier Financing
Debt Financing
Min Int Financing
Equity
Total Financing
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Enterprise Value
Peers Avon
Peer Multiple
Operating EBITDA - Avon
Peer Multiple
Enterprise Value by Comparable CompaniesEnterprise Value by Market Survey
Debt/EV
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The Balance Sheet Capital Appropriateness?
Balance Sheet
Cash AR + Inv
PPE
Payables
Debt
EquityResources
Identifiable Intangibles
Goodwill
Deferred Tax Assets
NCI
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Balance Sheet ProfilesStructuringWC [need] intensive [Distributor]
Seasonal and/or permanentLeveraged [ABF]
Tangible Fixed AssetsIntangibles
Identifiable, PatentsUnidentifiable [Goodwill, on Balance Sheet]Enterprise ValueContracts [Off Balance Sheet]
Separable [Diversified] businessesSeparable [Granular] businesses
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Cash Flow Profile
qMature, Stable Cash FlowqHighqLow
qCyclical Cash FlowqVolatile Cash FlowqRapid Growth Cash FlowqDeclining Cash FlowqIncreasing Cash Flow
qSustainableqUnsustainable
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Financial ProfileNot just quantitativeWhat is the Client’s Financial Policy
• How are the financial policies balanced between stockholders and creditors?– Risks in the Financial Policy– Balancing the Cost of Capital– Financing Decisions for Growth?
• Very strong credit metrics will always be maintained• Creditors share in proceeds from asset sales• Some debt financing of share purchases and/or acquisitions• Some ratings migration possible with acquisitions• Material debt financed acquisitions• Modest cushion for creditors
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Legal Structure Profile
• Most large companies are structured with the parent as a holding company.• This is not an issue in ratings
– as long as there is no impediment that restricts access to cash.• Process:
– Identify the Legal Structure– Are there any critical issues in the choice of the legal structure?– Are any of the Opco’s regulated?– Are there any restrictions on intercompany cash flows?– What are the intercompany cash flows on a deconsolidated basis?
• The Parent company is better diversified than the operating companies• The Parent company usually has less debt• However,
– Parent debt is effectively [structurally] subordinate– Double Leverage exists at the parent company
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Subordination
Parent Sub Eliminate ConsolidatedCash 10 10Op Assets 1,000 1,000Investment 600 0 -600 0
Suppliers 0 200 200Debt 210Equity 600
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© Barry M Frohlinger, Inc. copyright 1981 - 2017
Subordination [double leverage]
Parent Sub Eliminate ConsolidatedCash 10 10Op Assets 1,000 1,000Investment 600 0 -600 0
Suppliers 0 200 200Debt 210Equity 600
70
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Subordination
• Priority of claims• Debt and lien subordination
– Debt subordination involves an agreement to turn over to “senior debt” holders everything received from the borrower
– Lien subordination requires turnover to first lien creditors the proceeds of shared collateral
– Lenders prefer debt subordination
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Subordination
• Contractual Subordination and Structural Subordination – Contractual Subordination
• A creditor waives rights in favor of other creditors– Right to payment– Right to declare a default– Financial covenants
» Fewer or Looser• Effective Subordination
– Having secured debt makes the unsecured lender effectively subordinate • Statutory Subordination
– When a firm is in bankruptcy, certain creditors will be given seniortyincluding
• Employees wages, property tax and loans made after bankruptcy
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Subordination:Contractual and Structural
• Holding Company• Consolidated Debt/EBITDA 1.9X• 4% Senior Notes • Commercial Paper
• Operating Company• Debt/EBITDA 0.2X• Bank Loan
Pepsico, Inc.
Pepsi Bottling Group, Inc.
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Subordination:Contractual and Structural
• Holding Company• Consolidated Debt/EBITDA 7X• 12% Senior Notes
• Operating Company• Debt/EBITDA 5X• Bank Loan BB-• Senior Sub Debt
Sterling Chemical Holdings, Inc.
Sterling Chemical, Inc.
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Contractual subordination
• A creditor waives rights in favor of other creditors– Right to payment– Right to declare a default
• Financial covenants– Fewer– Looser
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Structural subordination
• Legal structure– Parent holding company owns operating subsidiary
• Economic structure– Operating subsidiary owns productive assets and generates cash– Holding company owns stock of operating subsidiary
• Operating company creditors– Direct claim on operating assets and cash flows
• Holding company creditors– No direct claim on operating assets and cash flows– Structurally subordinated to operating company creditors
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Structural subordination
Holding Company
OperatingSubsidiary
AssetsCashFlow
Creditors
Creditors
CashOwnership
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Guarantees
Parent Hold Co
SubsidiaryOP Co
Guarantee
Ownership
Downstream
Parent Hold Co
SubsidiaryOP Co
Upstream
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Legal Structure Profile
• All debt at Parent Company• All debt at OpCo• Debt at Parent and Op Co• Debt at parent and OPCo, with OPCo guarantee of parent debt• OpCo is ring fenced• Debt at parent and OPCo, with parent support of OpCo debt• Debt at parent and OPCo, with OPCo not wholly owned• Parent debt with Captive Finance Sub, with debt
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Case 1, Standard CaseInvestment Grade Issuer
Operating Company A [100% owned]No Debt at Operating Company
Operating Company B [100% owned]No Debt at Operating Company
Parent CompanyAll debt at the parent level
What is the relationship between the debt rating of the parent and the debt rating of the operating [group] companies [parent borrows and advances funds to the operating companies]?
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Case 2, Operating Company debt
Operating Company A [100% owned]Debt at Operating Company
Operating Company B [100% owned]Debt at Operating Company
Operating Company C [100% owned]Debt at Operating Company
Parent CompanyVery little debt at Parent level
What is the relationship between the debt rating of the parent and the debt rating of the operating [group] companies?
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Case 3, Debt at both levels
Operating Company [100% owned]Debt at Operating Company
Parent Company [Holding Company]Debt at Parent level
What is the relationship between debt rating of the parent and the operating [group] company?
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Case 4, Guarantees
Operating Company A [100% owned]Debt at Operating Company
Operating Company B [100% owned]Debt at Operating Company
Operating Company C [100% owned]Debt at Operating Company
Parent CompanyDebt at the parent level
What is the relationship between the debt rating of the parent and the operating [group] companies
[parent borrows and operating companies borrow and operating companies guarantee the debt of the parent-upstream]?
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Case 5, Ring fence
Operating Company A [100% owned]Ring Fenced by covenants or reg
Debt at Operating Company
Operating Company B [100% owned]Debt at Operating Company
Parent CompanyDebt at the parent level
What is the relationship between the debt rating of the parent and the operating [group] companies [parent borrows and and operating companies borrow and at least one of the
operating companies is ring fenced by covenants or regulation]?
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Case 6, Parent support
Operating Company A [100% owned]Debt at Operating Company
Operating Company B [100% owned]Debt at Operating Company
Parent CompanyDebt at the parent level
Parent supports [not guarantees] operating company debt
What is the relationship between the debt rating of the parent and the operating [group] companies [parent borrows and and operating companies borrow and supports, but not
guarantees, the debt of the operating companies]?
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Case 7, Minority Interest
Operating Company A [85% owned]Debt at Operating Company
Operating Company B [82% owned]Debt at Operating Company
Parent CompanyDebt at the parent level
What is the relationship between debt rating of the parent and the operating [group] companies [parent borrows and and operating companies borrow
and minority interest [non controlling interest] exists at the operating companies]?
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Case 8, Captive Finance
Captive Finance Sub [100% owned]Debt at Capitve Finance Company
Parent Company, operating companyDebt at the parent level
What is the relationship between debt rating at parent and the finance company [parent company borrows and is also an operating company, finance company also borrows]?
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Debt Instrument Profile: TranchesAdding tranches increases debt capacity; However, lower tranches are less likely to get repaid in a distressed situationContractual Subordination
First lien Senior secured debt Generally for smaller firms or non investment grade firms, although some investment grade industries issue some senior secured debt
Second Lien Senior Secured debt
Commercial paper Investment Grade
Short term bank borrowings, seasonal
Senior Unsecured debt, Notes or Revolver
Subordinated debt Limited or no value available during distress
Subordinated zero coupon or PIK debt Limited or no value available during distress
Junior Subordinated debt Limited or no value available during distress
Preferrred Stock Limited or no value available during distress
Common Equity Limited or no value available during distress
© Barry M Frohlinger, Inc. copyright 1981 - 2017
Debt Sizing
Revolver Term LoanSize Peak useage plus
contingency plus availability for LC
Function of EBITDAForecasted FCF for debt repayment [50%]
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Debt
Liquidity Capital Leveraged Capital
Product Line and/or Revolver
Revolverand/or Term
Senior Debt and Sub Debt/Convertible Debt
90
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Debt
Product Key Issues
Line of Credit Uncommitted, no covenants, Sr unsecured
Revolver Committed, 364 – 5 years, Senior [secured for NIG], Covenants
TLA 1 – 7 years, Senior [secured for NIG], Covenants
TLB. TLC 1 year after TLA, NIG borrowers
91
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Risk
• Credit Risk• Credit risk is the probability that a borrower will fail to make required
payments of principal and interest over the life of the loan
• Default Risk• The possibility that a borrower will default by failing to repay principal and interest• and the bank MAY suffer a loss.
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Risk
• Lenders mitigate risk using several methods:– Risk-based pricing:
• Lenders generally charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing.
– Covenants – Guarantees– Collateral– Credit derivatives – Tightening
• Tightness is defined as the distance between the threshold and the initial value of a covenant ratio.
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Default risk, The possibility that a borrower will defaultby failing to repay principal and interest in a timely mannerand the bank MAY suffer a loss.
Probabilityof
Default[borrower]
Losson
Default[structure]
DefaultRisk=x
Exposure at
Defaultx Maturityx
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The drivers of default
Probabilityof
Default
Financial [Liquidity,Leverage]
Internal[Management/Operations]
External[Demand, Competition]
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The drivers of loss
Losson
DefaultStructural Priority
Asset Values
Legal Priority
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Forecasting
• The only function of forecasting is to make astrology look respectable.
97
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Covenants
• What is a covenant?
• Covenants – promises made in a legal agreement• Affirmative covenants – a promise to do something• Negative covenants – a promise not to do something• Financial covenants
– Based on financial statement measures
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Covenants
• Unlike investment grade, where debt covenants are typically loose or non-existent– leveraged finance transactions often have covenants that are
designed to restrict an issuer’s behavior. – The purpose is generally to prevent the issuer from over-extending
itself or taking on additional risk that would increase the likelihood of its failing to repay the debt.
• Covenants can affect ratings in various ways:– Sometimes a covenant may affect the issuer’s overall credit rating
one way, and have a different impact on a particular instrument’s rating.
– Alternatively, it may affect an issuer’s likelihood of default differently than it does the likelihood of recovery in the event of default.
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Earnings or Balance Sheet
• Borrowers with high profitability and low earnings volatility generally have – interest coverage and/or debt to EBITDA covenants. – These ratios, are informative for stable, profitable firms.
• In contrast, borrowers with low profitability and high volatility earnings are– likely to have net worth covenants.
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Earnings or Balance Sheet
• Equity [more than earnings] is informative about credit risk for poorly performing, volatile firms.
• Leverage covenants are more likely to be included for borrowers with revolvers.
• Leverage is particularly relevant to the credit risk profile of borrowers with revolvers – because they can draw down additional debt easily.
• Finally, borrowers with high levels of working capital needs are likely to have current ratio covenants.
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Negative and Financial Covenants
• Negative covenants require an action by the borrower to be violated– while financial ratio covenants are often violated due to poor
operating performance. • Many treat these two covenant types as substitutes that serve
complementary roles: – negative covenants prevent borrower actions that explicitly
decrease the value to lenders, while financial ratio covenants limit the costs of
• adverse actions that are not controlled by negative covenants and
• increases in credit risk unrelated to borrower action (e.g. poor operating performance driven by economy or industry shocks).
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Reason for covenants
• Risk plays an important role in debt contracting.• At loan inception, the lender estimates the expected credit risk of the borrower
over the life of the loan. • Without provisions to control increases in credit risk, the lender prices the
expected outcome in the interest rate of the loan. • Both lender and borrower suffer when the expected credit risk of the borrower is
high: the lender with increased risk over the life of the loan, and the borrower with a high interest rate. – A covenant that allows action by the lender when credit risk increases above
a specified level is valuable to the lender because they will no longer be left bearing the full cost of the risk increase. The borrower should be compensated with a lower interest rate for consenting to a covenant in the contract.
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Decrease Default Risk
• Some covenants may decrease default risk, for a specific instrument– In evaluating the impact of covenants, one of the first questions is:
• Will this covenant require the company to behave significantly differently absent the covenant?
– For example, suppose a company noted for acquisitions agreed to a term loan that limited it to tight controls on leverage, acquisitions and other actions that would otherwise cause the credit to deteriorate
– Those well-covenanted debt holders are serious about enforcing their covenants» even to the point of demanding payment while the company was still
healthy rather than letting management degrade its own credit» we might conclude that the default risk profile was now better
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Increase Default Risk
• Some covenants may increase default risk: Covenants can be a two-edged sword. – In the previous example, covenants that force a company to be its “better self” and
behave more prudently than it normally would can lessen the firm’s chances of default and possibly improve its credit rating.
– But covenants that are drawn so tightly that they restrict an issuer’s room to maneuver or cause it to default too readily can have the opposite effect.
– They may end up decreasing the firm’s financial flexibility and creating operational “cliffs” that put its ongoing financial security in jeopardy over relatively minor “misses” in its business execution.
– Covenants like this, if severe enough, could actually decrease the issuer rating.
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Covenants
Investment Grade Cross Over Non Investment Grade
Rating Scale AAA to A- BBB+ to BBB- BB+ and below
Financial Covenants One Two More than two
Financial Covenants Earnings based Balance Sheet based
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Covenants
Investment Grade Cross Over Non Investment Grade
Financial Covenants Earnings Balance Sheet
EBITDA/Interest EBITDA/InterestNet Debt/EBITDA
Debt/Cap
Light Harsh and Tight, Negative:Dividends, M&A, Share Repurchase
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Structure
Make sure revolvers expire before towers of debt
Do not structure debt on top of existing towers
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Priority: Intercreditor rights Se
cure
dUn
secu
red
SeniorSubordinated
Subordinated debt
Senior debt
Senior secured debt
Junior subordinated debt
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Secured debt
• Lender takes assets of borrower as collateral• A perfected security interest• Any type of asset
– Cash, securities, receivables, inventory– Equipment, buildings, land, intangibles– Stock [shares] of other firms
• Gives lien holder the right to– Interest in bankruptcy– Higher recoveries in reorganization– Proceeds from sale of assets
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Collateral value depends on the asset and the market for it
Illiq
uid
Liqu
id
Commodity [stable]Special purpose
High OLV
Low OLV
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Borrowing base
• The sum of the loanable values of assets in which the Bank has a perfected security interest
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A borrowing base limits loans to collateral value
Gross value– Ineligible items= Eligible value* Advance rate= Borrowing base Outstandings
may not exceed the borrowing
base
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Eligibility adjusts value for…
Eligible Accounts ReceivableGross accounts receivable
– Accounts 91 or 121 days past due– Government accounts– Customer deposits– Inter-company accounts receivable= Eligible accounts receivable
Eligible InventoryInventory– Excess and obsolete– Reserve for shrinkage– Consigned or under third-party control– Supplies= Eligible inventory
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Advance rates adjust value for…
Accounts Receivable• Write-offs of doubtful accounts• Returns• Price adjustments• Billing errors• Rebates• Collection costs
Inventory• Orderly liquidation value of
– Raw materials– Work in process– Finished goods
• Liquidation costs
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Typical advance rates
• Against eligible accounts receivable– 60 – 85%
• Against eligible inventory– Raw materials: 20 – 60%– Work in process: 0 – 30%– Finished goods: 20 – 70%
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Covenants
• What is the purpose?
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Covenants
• Business risk• Financial risk
– collateral helps to manage financial risk• Collateral Risk
– How will we be repaid in the event of a default?
– What is the appraised value, volatility and salability of the collateral?
• Structure risk – Have we properly boxed the risks with the appropriate covenants and
term?
• Reporting Risk• Funding risk• Position Risk
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Using covenants to manage risk
Business Risk Limit Acquisitions or MergersSale of assetsChange of business or control
Financial risk Minimum interest or fixed charge coverageMinimum Net Worth or Tangible NWMaximum financial leverageMaximum CapX, Max dividends and/or share repurchases
Structure risk Negative pledge and Sale LeasebackSubsidiary guarantiesMax Subsidiary debt [useful for loans to Holding Companies]Subsidiary Restricted Payments [limited, useful for Holdco loans]Restrict payments [dividends, share repurchase, investments in unrestricted subs or repay junior debt]
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Using loan terms to manage risk
Reporting risk Financial statements IAW GAAPCovenant calculations IAW GAAPAudit and inspection rightsNo Changes in accounting policy
Collateral Risk Certified borrowing base calculationsCollateral accessNo Sale of assetsInsurance
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Using loan terms to manage risk
Funding risk GAAP condition precedentNo material adverse change
Position Risk Default on breach on GAAPLegal Entity decisionAudit and inspection rights
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Credit Structure - Term
JOB AID: CREDIT STRUCTURE - TERM CASH FLOWS are the driving force in determining the length and repayment schedule of the loan. Availability is generally linked to the purpose of the loan but may also be affected by your assessment of the "soft issues" (character, management ability, and information quality).
ISSUE TERM (Length of Loan, Repayment Schedule, and Drawdown or Availability)
Purpose of the Loan
Working Capital: Businesses frequently borrow to finance a portion of their working capital needs (accounts receivable and inventory). Seasonal working capital loans are expected to be fully repaid in the liquid portion of the company's season. Non-seasonal working capital loans are repaid from operating cash flow or these are asset protection loans. Working capital loans are typically revolving up to the full amount of the facility and for rapidly growing companies, revolvers may be as long as three years with a term loan conversion feature. Term Loan: Businesses frequently borrow to finance fixed assets with these loans repaid through surplus operating cash flow. Bridge Loans: Bridge loans are generally short term loans borrowed to finance some type of long term investment. The bridge loan enables the company to complete the transaction, quantify its total borrowing requirements, and provides time to arrange the long term financing.
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CREDIT STRUCTURE - TERM (Continued)
ISSUE TERM (Length of Loan, Repayment Schedule, and Drawdown or Availability)
Business, Economic and Country Risk
High business, economic or country risk usually manifests itself in low, unpredictable cash flows and uncertain asset values
Management Without strong management's character, lending is very high risk
Information Quality
Other things being equal, if you are uncomfortable with the amount and/or reliability of the information provided, then you should opt for a shorter-term loan with a well-defined repayment schedule and tie availability to the purpose of the loan
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CREDIT STRUCTURE - COLLATERAL
It is often desirable to take collateral. This gives the bank some control over the company and provides an extra measure of financial security for the loan. Collateral is absolutely required when cash flows are weak or you have any doubts about management or information quality. In these situations, collateral is vital to give you direct access to the second way out. Guidelines for Taking Collateral
If possible, take assets that are independent of the primary source of repayment. Take the most liquid assets available that have a predictable value. Make sure that the life of the asset exceeds the life of the loan
ISSUE COLLATERAL REQUIREMENTS Structure of the Borrower
The structure of the borrower is not an issue when the collateral is owned by the entity to whom the loan is made. It can become an issue if the assets that collateralize the loan are not owned directly by the borrower. When this is the case, there are potential fraudulent conveyance problems. To avoid fraudulent conveyance, the borrower must give some form of consideration to the entity providing the collateral or it must be clear that the support given will not make the entity insolvent.
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The Negative Pledge
• Agreement whereby borrower [pledgor] promises not to place a lien on pledgor’s property
• Double negative pledge– Contains a negative pledge– Also, agreement to abstain from offering others a negative pledge
• Springing Lien• Springing Maturity
– “Springing maturity” provisions are a tweak that may undercut the stability of revolvers. These provisions exist to allow a revolver to mature earlier, given certain circumstances.
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Covenants [Bond vs. Bank]
• It is all but impossible to passively default on bond covenants.• Bond covenants limit “incurrence” not “maintenance”• Incurrence covenants only tested when the borrower takes an action
– generally require that if the issuer takes an action (paying a dividend, making an acquisition, issuing more debt), it would need to still be in compliance.
• For instance, an issuer that has an incurrence test that limits its debt to 5x cash flow would only be able to take on more debt if, on a pro forma basis, it was still within this constraint.
– If not it would have breached the covenant and be in technical default on the loan. – If, on the other hand, an issuer found itself above this 5x threshold simply because
its earnings had deteriorated, it would not violate the covenant.– Maintenance covenants are generally monitored quarterly
• Covenant - Lite loan structures have only incurrence covenants
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Covenants [Bond vs. Bank]
• Maintenance covenants are far more restrictive.
• This is because they require an issuer to meet certain financial tests every quarter, whether or not it takes an action. So, in the case above, had the 5x leverage maximum been a maintenance rather than incurrence test, the issuer would need to pass it each quarter, and would be in violation if either its earnings eroded or its debt level increased.
• For lenders, clearly, maintenance tests are preferable because it allows them to take action earlier if an issuer experiences financial distress. What’s more, the lenders may be able to wrest some concessions from an issuer that is in violation of covenants (a fee, incremental spread, or additional collateral) in exchange for a waiver.
• Conversely, issuers prefer incurrence covenants precisely because they are less stringent.
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Set covenants to the company’s forecasttoo much flex and this is not a warning sign
Minimum EBIT to Interest
Covenant 2.1 2.3 2.5 2.9 3.6 4.1 5.2
Forecast 2.7 2.9 3.1 3.6 4.5 5.1 6.5
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
80% of forecast
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CREDIT STRUCTURE -COVENANTS
In general, covenants are intended to control certain actions of the borrower. When they fail to do so, they can then serve as trigger mechanisms that enable the lender either to accelerate repayment or to renegotiate the loan. Covenants - no matter how strict -will not make a bad credit good.
COVENANTS PURPOSE OF COVENANT COVENANTS PURPOSE OF COVENANT Prohibition on Additional Borrowings: Avoids further claims on cash flow or assets. Change of Business: Merger or Sale of Business: Mandatory Prepayments: Borrower will prepay the loan if cash flow exceeds agreed on levels
To reduce principal outstanding
Divided Restriction: Conserves borrower's cash flow Interest Coverage: In highly leveraged transactions, it is common to see interest coverage computed as EBITDA to interest expense[or cash interest].
Interest coverage ratios are earnings related measures of performance and are extremely sensitive to a deterioration in operating earnings.
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CREDIT STRUCTURE - COVENANTS
F Debt Service Coverage: Debt service coverage can be defined in a number of ways. These include Funds Flow less the increase in operating working capital or Funds Flow less capital expenditures (for a capital intensive company) divided by the principal to be repaid. Other variations on this ratio include EBITDA divided by principal and interest or EBITDA less the change in OPWC less Cap X divided by interest and principal.
Debt service coverage ratios are intended to measure the borrower's ability to generate cash flow to pay interest plus principal repayments. Like interest coverage ratios, this measure is sensitive to a deterioration in the borrower's operating performance.
A Due on Sale Clause: If company sells certain material assets the loan must be retired using proceeds of that sale.
N Negative Pledge: Company may not pledge any or specific assets to other creditors.
Reduces company's borrowing capacity by eliminating further secured borrowings.
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CREDIT STRUCTURE -COVENANTS
N Restrictions on Guarantees: Maintains net asset value; preserves future cash flow F Liquidity: The most common
ratio used to address liquidity is the current ratio (current assets divided by current liabilities).
Liquidity covenants are designed to prevent a borrower from relying on short term debt to finance long term uses, thereby creating a liquidity issue. The current ratio and the absolute dollar amount of working capital are found most often. Current Ratio is good for a growing company and working capital for a seasonal company.
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CREDIT STRUCTURE - COVENANTS
F Leverage: Balance Sheet leverage [used for higher risk borrowers] can be defined various ways. A common calculation is total borrowed funds to net worth (or tangible net worth), or more commonly total borrowed funds to total borrower funds plus equity [including quasi equity financings]. Often total borrowed funds are defined to include off balance sheet financing, such as operating leases, or securitizations. Additionally, these ratios are often defined to include material non-consolidated vehicles. These ratios can also be defined to distinguish between senior and junior positions. When this is the case, the ratio is defined as senior borrowings divided by senior debt plus subordinated debt plus equity (or tangible equity). In addition, the creditor can choose between net worth reported on financial statements or tangible net worth. Tangible net worth can be defined in many ways. Common adjustments exclude related party assets (intracompany investments, loans and advances; loans to affiliates; and loans to owners) goodwill, intangibles, deferred charges or deferred tax assets.
Leverage ratios indirectly specify the maintenance of a relationship between the debt and the assets of the firm. Generally speaking, lenders are willing to accept high leverage in businesses where cash flow generation is high and relatively predictable and asset values are relatively stable. Less leverage is permitted when cash flows are low and unpredictable and asset values are less certain.
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CREDIT STRUCTURE -COVENANTS
F Minimum Tangible Net Worth: This covenant seeks to maintain a minimum level of equity in the
business so that shareholders have some level of capital at risk. By specifying a minimum level of tangible net worth this covenant also seeks to maintain a minimum level of net assets that are available to absorb unanticipated adverse events.
Cross Default Clause: If the borrower is in default on specified agreements (usually it is all credit agreements but there may be some instances where it would be limited), then it is an event of default on the agreement.
This covenant links your credit structure agreement with other creditors so that if the borrower defaults on any agreement, then you will have the opportunity to participate in any loan restructuring.
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Covenants
• Financial covenants fall into four types:• Coverage
– EBITDA/Interest– (EBITDA-CapX)/Interest– Fixed Charge Coverage [EBITDAR-CapX]/[Rent+interest+mandatory principal and pfd dividends]
• Leverage– Senior Debt/EBITDA– Total Debt/EBITDA– Debt/Capitalization
• Liquidity– Current Ratio or Working Capital
• Activity [not common]– Days on hand
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Covenants
• Material covenants:– Interest Coverage
• long run perspective– Minimum Cash Flows
• short run perspective– Debt/EBITDA– Current ratio (good for fast growing companies)– Minimum Working Capital (seasonal companies)– Total Debt/Equity (equity cushion to absorb business risk)– Total Debt/Tangible net worth (when significant, but doubtful intangibles)– Total Debt/Effective Net Worth (including liabilities which have equity character, e.g. sub
debt or quasi equity or deferred tax liabilities)– Dividend and/or Treasury Stock Repurchase restriction or limits– Capital expenditure limits and/or operating lease limits– Sale of assets restriction or limit – Acquisition and/or Divestment prohibition or limits
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Tranching
• Tranching is a type of subordination– Shorter maturities get repaid earlier– Investors in longer maturities get paid for incremental risk– Tranching usually does not impact credit ratings
• No impact on recovery in bankruptcy• Benefits of subordinated and tranched structures
– Maximize debt capacity– Stagger Maturities– Access different pools of capital– Achieve lower pricing
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Notching
• Notching is a technique designed to rate various debt issues of the issuer
– Issues may have a different rating than the issuer– This is a technique for firms with lower credit ratings
• Subordination– Contractual and Structural may have an impact– Collateral may have an impact
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Notching
• Process for Notching Loans– Determine an issuer rating [risk or default] – Calculate Valuation
• Scenario 1: Going Concern– Driven on EBITDA or Cash Flow
• Scenario 2: Liquidation Analysis of Balance Sheet– Allocate Value to priority parties
• Based upon collateral and/or structure
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Notching
• Process for Notching Loans– Determine an issuer rating– Calculate Valuation
– Allocate Enterprise Value to• Administrative and Priority Claims may capture 10% of value • Concession Payments
– Generally up to 5% of value to shorten the bankruptcy process to junior-level obligations
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Priority: Intercreditor rights Se
cure
dUn
secu
red
SeniorSubordinated
Subordinated debt
Senior debt
Senior secured debt
Junior subordinated debt
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Notching
• Process for Notching Non Investment Grade Loans– Determine an issuer rating– Calculate Valuation– First, allocate Value to Priority Parties– Then, distribute Value by Priority
• First Priority Secured, revolver is assumed to be fully drawn• Second Priority Secured • Operating Leases
– Check legal status of leases» In some jurisdictions, half of operating leases will not be
accepted by bankruptcy court and » next years lease obligation is senior unsecured claim.
• Senior Unsecured• Subordinated Creditors
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Notching
• Recovery Rates– 90 – 100% +3– 70 – 90 % +2– 50 – 70% +1– 30 – 50 % 0– 10 – 30 % -1– 0 – 10 % -2
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Exercise assignment
• Prepare a Notching For Six Flags and Blockbuster
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Causes of Business Failure
• Management Weakness• Weak internal financial controls• Weakness in business
– Cost structure
• Weakness in strategy– Unrelated acquisitions, excessive cap X
• Inappropriate financial policies– Excessive debt, wrong currencies
• Competition
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Response to Financial Distress, Loan Workout
• The aim of loan workout is a financial restructuring with one of the following goals:
– Extend the period of time to service the debt
– Provide additional financing
– Reduce the amount of company’s debt
– Restructure the business’s operations
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Responses to Financial Distress
• Success is greatest when– Financial distress is detected as early as possible
• Because speed is a key in stemming the liquidity risk– Most loan workouts fail because the company runs out time– Value of the assets is reduced as time goes on– The longer the workout, the more additional money may be needed by
the firm• The range of available solutions is increased• The prospects for recovery are enhanced
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Keep in mind
• In bank group lending, be careful if one or more bank’s own financial health is weak:
– A weak bank may pursue very risky strategies in order to defer loan-loss provisions and/or writeoffs
– Similarly, know the objectives and motivations of the various stakeholders in a loan workout
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Characteristics of successful workouts
• Company characteristics– Large corporations
• Publicly traded• Large workforces• Socially necessary products and/or services
– Complex legal structures• Often require complex loan workouts and not simple debt rescheduling
– Large levels of debt, unsecured– Attitude of the directors
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Framework for Loan Workout
• Stabilize the business– Agreed moratorium among the creditors and providing additional short-term credit
• Gather information
• Evaluate Options
• Formulate proposal– Contingency plans
• Negotiate
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Framework for Loan Workout
• Stabilize the business– Agreed moratorium among the creditors and providing additional short-term credit
• Gather information– Appoint reporting accountants and hire lawyers– Determine cash needs and develop a financial plan– Determine the sustainability of existing financial structure– Relative recovery position of each major creditor
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Framework for Loan Workout
• Stabilize the business• Gather information• Evaluate Options
– Short or Medium term • Repayment of debt
– Full or part• Sale of assets, entire business or subsidiaries• Sale of the debt• Reduce debt, improve operating working capital, extend maturities• Inject equity • Declare insolvency
– Long run• Restructure the operations• Create joint venture• Debt for equity swap• Strategic investor• Restructure debt and/or interest payments
• Formulate proposal• Negotiate
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Risks in loan workouts
• Business risk– Is there a strong core operation?
• Structural risk– Can a restructuring be completed?
• Financial risk– Will the post restructuring level of debt make sense?
• Reputational risk– Negative publicity for the bank
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Remedial ActionsMandatory Prepayments
• Excess Cash Flow– 50% of CFO – Cap X, dividends and debt payments
• Asset Sales [100%]• Debt issuance [100%]• Equity Issuance [25 – 50%]
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Blockbuster Pt 1 Lessons Learned
• With the purchase by Viacom, Blockbuster’s operating strategy shifted to vertical integration
– This is a standard make versus buy decision– MTV and Paramount, part of the Viacom empire, would use Blockbuster for product distribution
• This initial unsuccessful strategy forced the firm to bring in John Antioco• Antioco focused on strategic alliance with the studios
– Revenue sharing, initially very compelling for the studios
• Blockbuster ”merged” with Viacom in order for Viacom to use Blockbuster’s cash flow for acquisition of Paramount.
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Blockbuster Lessons Learned
• This strategic alliance with the studios appeared compelling for the studios for “sale” of the tapes
• The attempt to convert Blockbuster to a full wholesale entertainment center also failed
• Viacom saw Blockbuster as a financing vehicle to enhance its acquisition strategy
– need for intercorporate dividends puts pressure on Blockbuster’s cash flows
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Blockbuster Warning Signs
§ Shift to DVD [Purchase of DVD]§ Popular films are often rented as many as 75 times at about $3 a rental over the first year, generating $225 -- or three
times the tape's acquisition cost.
§ New Competition§ entry barriers drop with lower DVD prices
§ Large Dividend payment during 2004§ $5 per share with a share price of $15.12
§ Blockbuster failed to identify§ changed customer behavior and channel preference
§ High fixed costs § Can the earnings support the level of debt needed for a moderately capital
intensive business?§ What is the Cash Flow Profile
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Blockbuster
• Warning Signs– Large firm rivalry
• due to large fixed costs, high operating leverage– New entrants [Netflix] have lower fixed costs– Entry barriers can disappear with a shift in distribution channel [i.e. net]
• Has the firm invested in the technology to deliver product to customers where and when needed?
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Blockbuster
• Warning Signs– Financial
• Revenue, GPM, OPM all decreased in 2005• High Cap X• Cash Flow and Liquidity Problems
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Blockbuster Part 2
• The movie rental market is forecasted to continue to grow in 2009
– while the overall industry is forecasted to decline slightly due to a low cyclical
period for new game platform releases.
• For fiscal 2008, the total media business was $48 billion, with rental
movies representing $9.9 billion.
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Blockbuster
• There are continuing channel and product shifts– primarily driven by introduction of next-generation game console release cycles
– as well as the emergence of new channels of distribution for movie entertainment, such as • mail delivery,
• vending, and • digital.
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Blockbuster
• Blockbuster's viability has been questioned for awhile. • In March 2009 there was speculation that it was set to file for bankruptcy
protection as it faced increased competition – as well as distribution of movies over the Internet and cable services.
• Blockbuster believes that:– It can cut expenses by least $200 million this year by
• renegotiating store leases and taking various other actions.– Average store lease is 2.5 years– Closing 500 stores will contribute $40 million, assuming 25% retention of customers
» Plus 500 stores will produce a one time operating working capital reduction of $26 million
– The business can be separated into domestic and international business• with a sale possible of the international business
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Blockbuster
• Blockbuster's viability has been questioned for awhile. • Current management believes the current liquidity problem has forced
them to focus on cash– They will be cutting back on CapX [$30 million]– Operating Working Capital requirements will not grow– Sale of UK and Danish businesses
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Blockbuster
• Blockbuster's viability has been questioned for awhile. • What steps can the Bank take now regarding the Revolver and Term
Loan A?
• On August 20, 2004, Blockbuster entered into $1,150 million credit facilities with a syndicate of lenders.
• The Credit Facilities provided for three facilities: • (i) a five-year $500 million revolving credit facility (“revolver”); • (ii) a five-year $100 million term loan A facility (the “Term A Loan
Facility”); and • (iii) a seven-year $550 million term loan B facility (the “Term B Loan
Facility”).
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Blockbuster
• Blockbuster's viability has been questioned for awhile.
• The revolving credit facility and Term A loan facility are scheduled to expire in August 2009. • On April 2, 2009, Blockbuster amended the revolving credit facility and Term A loan facility and Term
B loan facility – to include commitments from the lenders to
• (a) replace the existing revolving credit facility with a $250 million revolving credit facility with a maturity date of September 30, 2010 and
• (b) amend certain covenants in the revolving Term A and B loan facilities. • The banks amended the Revolver to give Blockbuster a $250 million revolving loan, maturing on Sept.
30, 2010. • But the company is not just relying on amended agreements to help it survive. • It also plans to cut expenses by least $200 million this year by renegotiating store leases and taking
various other actions.• Part of Blockbuster's troubles stem from fewer consumers heading to its stores to rent videos
– due to the rising popularity of DVD-by-mail services like Netflix. • Adding to the pain are electronic distribution systems that use
– high-speed Internet connections and television set-top boxes to pump movies into homes within seconds.
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Blockbuster
• As part of the new facility, a repayment schedule was agreed upon:
– Date Amount
• December 15, 2009 $ 25,000,000
• January 31, 2010 $ 20,000,000
• February 28, 2010 $ 20,000,000
• March 31, 2010 $ 20,000,000
• April 30, 2010 $10,000,000
• May 31, 2010 $15,000,000
• June 30, 2010 $50,000,000
• July 31, 2010 $10,000,000
• August 31, 2010 $10,000,000
• All repayments and prepayments of Revolving Loans effected on or prior to the Revolving Maturity Date will be accompanied by an exit fee equal to 3% of the aggregate principal amount
• In the event the aggregate principal amount of the Revolving Loans outstanding on April 30, 2010 shall exceed $75,000,000, the Borrower shall pay to the Revolving Lenders, a fee equal to the lesser of
– (i) 10% of the amount of such excess and (ii) $5,000,000.
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Blockbuster
• On October 1, 2009, Blockbuster issued $675 million of senior secured notes to repay all bank indebtedness
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Blockbuster Lessons Learned
• Early detection of the problem• Secured interest • Pricing to induce repayment
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2002: Blockbuster debuts Super Bowl ad starring the voices of Jim Belushi and James Woods. The company posts a $1.6 billion loss.2003: Netflix posts first profit, earning $6 million on revenues of $272 million. Redbox launches a kiosk rental service. 2004: Blockbuster enters online DVD rental market. Netflix CEO Reed Hastings tells analysts in an earnings call, “In the last sixmonths, Blockbuster has thrown everything but the kitchen sink at us.” The following day, Hastings receives a package from Blockbuster. Inside: a kitchen sink. 2005: Blockbuster launches a marketing campaign touting its new “No Late Fees” policy. Subsequently, 48 states launch investigationsinto the program, charging Blockbuster with misrepresenting its late fee policy to customers. 2006: Blockbuster surpasses its goal of two million subscribers for its online platform. Netflix reaches 6.3 million subscribers.2007: Blockbuster hires new CEO Jim Keyes, formerly of 7-Eleven. Keyes decides to roll back the company’s Total Access plans. “Clearly our spending on that one channel was exceeding our returns,” he said during a company earnings call. After losing a half-million subscribers in the third quarter, Blockbuster announces it will no longer report its subscriber count.2008: Blockbuster proposes buying struggling electronics chain Circuit City. Blockbuster soon withdraws its offer after it’s universally panned. Circuit City files for bankruptcy in November. Keyes also expresses doubt about Netflix in an interview: “I’ve been frankly confused by this fascination that everybody has with Netflix…Netflix doesn’t really have or do anything that we can’t or don’t already do ourselves.” 2009: Blockbuster rolls out Blockbuster Express, its kiosk system designed to compete with Redbox.
March 2010: Blockbuster touts 28-day exclusive window over Netflix for new releases. The company also reintroduces late fees, which had been costing the company $300 million in revenue annually.May 2010: In an interview with Fast Company, Jim Keyes is asked whether Blockbuster’s financial troubles were due in part to Netflix’s success. “No, I don’t know where that comes from,” he says. Keyes denies his company is going bankrupt. June 2010: Keyes compares Blockbuster to Apple, claiming that its On Demand service is the equivalent of the iTunes. July 2010: Blockbuster launches Droid X app. Blockbuster is de-listed from the New York Stock Exchange after shares hit all time lows.August 2010: Though ailing from a debt of $900 million, Blockbuster’s head of digital strategy explains, “We’re strategically better positioned than almost anybody out there. Never in my wildest dreams would I have aimed this high.” Blockbuster adds video games to by-mail subscription plans for no additional cost, but neglects to mention that new releases will not be available for three months. September 2010: Drowned in losses of $1.1 billion, Blockbuster plans to file for bankruptcy. The company is valued at just $24 million.
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Company Highlights
• Largest regional theme park company in the world• 30 parks located throughout North America• Unparalleled national footprint with extensive reach• Strategic Focus is:
– Increase market penetration with brand extension and marquee ad campaigns– Ride and attraction upgrades– Control costs to increase margins– Expansion of existing parks– Cross-promotional and sponsorship opportunities
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Industry
• 2000 - 2003 attendance growth was the slowest in 5 years– Rainy weather, fear of travel and a weak economy in the U.S. inhibited performance
Theme Park Industry has Underperformed Historical Results Since 2000
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Theme Park Sector Downturn
Several negative factors impacted Six Flags’ performance– Adverse weather in several key markets– Terrorism fears led to decline in school group sales
’00 – ‘04 Downturn Was Challenging for the Entire Sector
EBITDA Comparison Six Flags’ ’03-04 Performance
’03-’04(in mm’s except per cap spending) 2003 2004 GrowthAttendance 34.6 33.5 (3.2%)
Revenue $1,049 $1,039 (1.0%)
Per Capita Revenue $30.32 $31.06 2.4%
CAGR($ in millions) 2003 (’00-’03)
Six Flags (11.5%) (4.8%)
Cedar Fair 3.8% 0.6%
Disney Theme Parks (9.9%) (9.3%)
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Experienced Management
• Experienced team of theme park professionals– 25 park general managers
• Average of 18 years in the industry– Substantial operating management depth
• Decentralized management structure– Operate each park as local business
• Flat and lean corporate organization– Keep senior management close to customers– Minimize corporate overhead
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Asset Sales
Aggregate Proceeds of $345 million, 8.9x Aggregate 2003 EBITDA
Description• Highly competitive market
– Cedar Fair Flagship capital allocation to region
Rationale• $145 million
Proceeds• Cleveland Park (Sold April 2004):
– Six Flags Worlds of Adventure
• European Parks (Sold April 2004): • Weak growth profile• Currency risk• Management focus
• $200 million
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• Modest increase in attendance – Significant capital campaign – Enhanced marketing
• 2.5 – 3.0% increase in per cap spending – Continuation of in-park spending initiatives– Selective price increases– Focus on improved guest service and length of stay
• Modest increase in operating expenses offset in part by savings on insurance and advertising
Improving EBITDA Target
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Six FlagsOperations, Inc.
Organizational Structure
Six Flags, Inc.
Six Flags Theme Parks, Inc.
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Six FlagsOperations, Inc.
Organizational and Capital Structure
Six Flags, Inc.
Six Flags Theme Parks, Inc.
$1.081 billion Credit Facility $244 million W/C Revolver
$837 million Term Loan
Borrowing Group
$282mm 7 ¼% Conv Preferred Stock (PIERS)
$280mm Convertible Notesdue 2015
$588.3 of Senior Notes due 2010-14
$ 400 mill 12.25% Note due 2016
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Six Flags
• In 2004, Six Flags began to close and sell properties in an effort to help alleviate the company's growing debt. • On March 10, Six Flags sold its European parks, with the exception of the Movie World park in Madrid, Spain, to Star
Parks Group. • The Madrid park was sold back to Time Warner and renamed "Parque Warner Madrid". • In April 2004, Six Flags determined that the investment required to keep Worlds of Adventure competitive with Cedar
Point would be too great, and thus the company sold the park to Cedar Fair, the owner of Cedar Point. • These sales raised $345 million in an effort to relieve Six Flags' massive debt.
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Six Flags
• In 2005, Six Flags endured even more turmoil.
• Some of the company's largest investors
– notably Bill Gates's Cascade Investments (which owned about 11% of Six Flags) and
– Daniel Snyder's Red Zone, LLC (which owned 12%), demanded change.
• On August 17, 2005, Red Zone began a proxy battle to gain control of Six Flags' board of directors.
• Later that month, Six Flags New Orleans was severely damaged by Hurricane Katrina.
• On September 12, 2005, Six Flags Chief Executive Officer Kieran Burke announced that Six Flags Astroworld would be closed and demolished at the end of the 2005 season.
• The company cited issues such as the park's performance, and parking issues involving the Houston Texans football team, Reliant Stadium, and the Houston Livestock Show and Rodeo, leveraged with the estimated value of the property upon which the park was located.
• Company executives were expecting to receive upwards of $150 million for the real estate– but ended up receiving $77 million when the bare property (which cost $20 million to clear) was sold to a development corporation in
2006.
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Six Flags
• On November 22, 2005, Red Zone announced it had gained control of the board. • Kieran Burke was removed on December 14, 2005 and replaced by Mark Shapiro,
former Executive Vice President of Programming at ESPN. • Six Flags then named the following to the newly revamped board of directors
– former Congressman Jack Kemp, – entertainment mogul Harvey Weinstein, – and Michael Kassan, the former president of the Interpublic Group
• Even with the new management team, the sell-off would continue into 2006. • On January 27 2006, Six Flags announced the sale of the Frontier City theme park and
White Water Bay water park, both located in Oklahoma City, Oklahoma, at the conclusion of the 2006 operating season.
• At the same time, Six Flags also announced its plan to close corporate offices in Oklahoma City, moving its headquarters to New York City.
• Six Flags CEO Mark Shapiro said he expected the parks to continue operation after the sale, a lesson the company learned after its public relations debacle with the closure of Astroworld.
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Six Flags
• In June 2006, Six Flags announced it was considering closing or selling up to
six of its parks, including
– Elitch Gardens,
– Darien Lake,
– WaterWorld in Concord, California,
– Wild Waves and Enchanted Village in Federal Way, Washington,
– Splashtown in Houston, Texas
– and, Six Flags Magic Mountain.
• In addition, Six Flags also announced the sale of Wyandot Lake in Powell,
Ohio to the Columbus Zoo and Aquarium, which is located next to the park.
• Ultimately, Six Flags Magic Mountain was spared, with the remaining six
parks sold on January 11, 2007 to PARC Management for $312 million, $275
million cash and a note for $37 million.
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Six Flags
• Since 2006 the firm has undertaken the following:
– Partnering with brand names to build revenue per capita
– Adjust the strategy by investing in family offerings at the parks
– Implement a new marketing program with more spend in the early part of the
season
– Increased licensing revenue by partnering with Tatweer for Six Flags Dubailand
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Six Flags
• The company's operating cash flow had decreased by over 120 million dollars annually during the Shapiro years and in October 2008, Six Flags was warned its stock value had fallen below the required minimums to remain listed on the New York Stock Exchange.
• With the 2008-2009 global financial crisis weighing both on consumer spending and the ability to access credit facilities
– Six Flags was believed to be unable to make a payment to preferred stockholders due in August 2009.
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Six Flags
• Management saw the business as a sound one, – noting that attendance across the company's parks increased
slightly in 2008 compared to 2007.• Six Flags CEO Mark Shapiro said that the company's problem was
– the declining attendance and cash flow created by his new management initiatives.
• If not resolved, the company warned that the situation might require a Chapter 11 bankruptcy filing
– with Six Flags already retaining counsel should that occur.
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Six Flags
• For the twelve months ended 3/31/2009– EBITDA 267– Cash Interest -173– Cap X -97– Cash Tax -6– Free Cash Flow -9– Debt Amortization -9
• During April 2009– Six Flags Mexico closed due to Swine Flu– Swine Flu impacts attendance at Parks in Texas– Park attendance in the Northeast impacted by weather– Attendance down and Per Capital Guest Spend down 3% in 2009– Full year EBITDA for 2009 forecasted at $200 million– Each attendee lost cost the firm $35 in EBITDA
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Six Flags
• During January 2009, held negotiations with bondholders for out of court restructuring.
• On April 17, 2009 Six Flags commenced an offer to exchange SFI notes and PIERS into 85% and 10% of the Common Equity
– but was not accepted• $66 million of Partnership Puts were received in April 2009 and funded on
May 15, 2009– Funded through a Time Warner Loan– TW was obligated to fund through the 1998 acquisition from Time
Warner
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Six Flags, early 2009
• It is May 2009. • During 2009, Six Flags has required contractual obligations to pay in
the amount of $863 million.• Included in the payments are the Bank revolver and the PIERS.• What options/strategies can you develop to assist in the helping Six
Flags with their liquidity concern?
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Outstanding Debt
• Operating Company Six Flags Theme Parks Inc. [SFTP]– $244 million revolver– $837 million Term Loan
• Six Flags Operations [SFO]– $400 million Senior Notes
• Six Flags Inc. [SFI]– $868 million of Senior and Convertible Notes– PIERS $308 million
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Six Flags
• In April 2009, the New York Stock Exchange announced it would delist Six Flags' stock on April 20
– a decision that the company did not intend to appeal.• On June 1, 2009, Six Flags announced they would delay their $15 million debt
payment further using a 30-day grace period. • Less than two weeks later, on June 13, the firm filed for Chapter 11 bankruptcy
protection, but issued a statement that the parks would continue to operate normally while the company restructured.
• On August 21, 2009, Six Flags' Chapter 11 restructuring plan was announced in which lenders would control 92% of the company in exchange for canceling $1.13 billion in debt.
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Six Flags
• On June 13, 2009 Six Flags agrees with Lenders for a reorganization plan– Reduction of debt by $1.75 billion – Eliminate PIERS
• A new capital structure with $600 million term loan with an undrawn $150 revolver
– 275 revolver will be notes of $150– 835 term loan will get notes for $450– The 600 million loan will be LIBOR + 7% with a 5 year maturity
• Senior secured lenders will get 92% of the equity of the firm• $400 million of the SFO notes will get 7% of the equity• $868 of SFI Notes will get 1% of the Equity
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Six Flags
• The approval of this plan is pending per the decision of the presiding Bankruptcy Judge.
• One component of the restructuring was negotiating a new lease agreement with the Kentucky State Fair Board
– which owned much of the land and attractions for Six Flags Kentucky Kingdom.
– Six Flags had asked to forgo rent payments for the remaining nine years of its current lease agreement in exchange for profit-sharing from the park's operations.
– When it appeared that the offer had been rejected, Six Flags announced in February 2010 that it would not re-open the park.
– However, the Kentucky State Fair Board stated at the time that they were still open to negotiating a revised lease agreement.
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Six Flags
• However, in the nine months of bankruptcy, the capital markets became more robust
• By April 28, 2010, the company's bondholders reached an agreement on a reorganization plan the Company agreed to the following– Junior note holders, including hedge funds Stark Investments and Pentwater
Capital Management assumed control of the company. • Eliminate PIERS• Eliminate all the debt at SFI [$868 million]
– Additional Equity Offering• Equity raised of $630 million
– Refinance the entire senior secured debt with a new senior secured credit facility
– Senior note holders were paid in cash • Convert $70 million of the SFO notes into 8.625% of the equity• Repay $330 million of the SFO notes
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Six Flags
• Despite objections from some parties who stood to get nothing, the bankruptcy judge approved the plan on April 30, 2010.
• As part of the settlement, Chairman of the Board Dan Snyder was removed, while Chief Executive Officer Mark Shapiro briefly remained in his post.
• Six Flags officially emerged from bankruptcy protection on May 3, 2010• Six Flags announced plans to issue new stock• Relisted on the New York Stock Exchange.• Amid suspected disagreements regarding the future of the company with the board,
Shapiro left the company – Al Weber, Jr. was brought in as interim President and CEO.
• The company announced their corporate headquarters would move from New York City to Grand Prairie, Texas.
• Six Flags announced that Jim Reid-Anderson would replace Weber and become Chairman, President and CEO on August 13, 2010.