Tesla unsecured debt: recovery tops out at ~30c (if you’re lucky)

I’m dusting off the cleats (yes, it’s been a while), as I’ve had a large number of incoming questions regarding what happens to Tesla (TSLA) unsecured debt if or when they file for bankruptcy. This will not be a post about the long list of existential risks facing TSLA at the moment: there will be no commentary about how fundamentally flawed the business is; how they play fast and (very) loose with accounting rules, securities laws and their customers’ lives; how they’ve seen more executive turnover than the first class lounge at London Heathrow; nor how they’ve been running the business on the fumes of fumes for at least the last couple of quarters. For more on any/all of these topics, and a lot more, feel free to mosey on over to Twitter and follow $TSLAQ; or read some excellent blog posts here or here, for example.

Rather, since I consider a TSLA balance sheet restructuring basically a fait accompli at this point, to me the more interesting question than ‘where does the equity go?’ (answer: zero) is what happens to the unsecured creditors. As of the Dec’18 10-K, there was about $5.8bn of unsecured debt with full recourse to the TSLA balance sheet, and today the cheapest of these unsecured bonds trades around 88c on the dollar (the 5.3% ’23 long bond); note also that this category of debt includes the converts trading above par, due to convertible option value even though the strike price is still well out of the money.

I don’t want to spoil the lede, and I should disclose at the outset that I am (significantly) short TSLA stock in various forms (cash equity as well as via put options). But in terms of risk/reward, shorting the bonds may be even more attractive than shorting the common, because – as we shall discuss – I think ultimate TSLA recovery on unsecured debt will be very low (max 33c, likely much lower); you can generally get more leverage on credit shorts than equity shorts (for institutional clients, at least, via CDS); and the payoff on even outright bond shorts is much more asymmetric than shorting the stock (even if TSLA doesn’t file, it is most unlikely TSLA credit improves much in the next 1+ years so the likelihood of a large loss as TSLA credit reprices massively tighter is in my view remote).

Additionally, while not too complicated, TSLA’s cap structure is not exactly clean – so I hope by unpacking it here to demonstrate at least some of the thought process around credit analysis (in particular recovery analysis) and how it can be helpful in guiding not just bond but also equity investment decisions. With that out of the way, let’s dive in…

Step 1) Start with the Balance Sheet

Pretty simple really – any analysis of what creditors (of any stripe) will get depends on what the assets are, right? (Actually its more complicated than this, but let’s work with this standing assumption for now).

As of Dec-18, TSLA’s assets looked like this (the left side), and then on the right, adjusted ONLY for the repaid convert ($920mm that matured Mar-1). We will make other adjustments as we go, but here’s what it looks like for now:

Screenshot 2019-03-04 21.12.19

OK, so ~$30bn in gross assets and ~$29bn adjusted for the convert repayment. Sounds like a lot, doesn’t it? Hmm…hold that thought 🙂

2) Isolate assets associated with leases, as well as collateralized against non-recourse loans

Of course, a large portion of TSLA’s assets have been financed by leases – clearly these assets are ‘spoken for’ and unsecured creditors will have no recourse to them (similarly, lessors have no recourse beyond them). At the same time, TSLA has incurred a large amount of so-called ‘non-recourse debt’ (a lot of it related to the SolarCity takeover), which is simply a fancy way of saying certain assets on its consolidated balance sheet have been financed by loans secured against only those assets. Since we want to figure out what’s left for the guys at the bottom of the totem pole, we need to remove all this stuff.

This is where it gets a little tricky. TSLA’s disclosures are not perfect (!) and I have had to make some simplifying assumptions. You can dig through the devilish details in the below table, or you can just rely on the summary of how I have treated most of these obligations:

  • short-term and long-term restricted cash are in effect completely consumed by some combination of short-term and long-term build-to-suit (BTS) leases, as well as short-term and long-term residual value guarantees;
  • SolarCity related asset-backed securities are collateralized at a 70% average LTV (this is within the range of 65-80% disclosed, occasionally, for some of the transactions, but not all of them);
  • The Automotive Asset Backed Notes have only a small amount of overcollateralization (I assume LTV 90%) – this is based on some isolated ABN documentation I have seen suggesting around a 10% O/C cushion.

The below chart summarizes the treatment of all the various leases and non-recourse lending that consumes a good portion of TSLA’s assets, already. Apologies if it’s a little confusing/messy, but the overall takeaway is TSLA has already pledged $5.1bn of consolidated assets against its non-recourse obligations and lease liabilities:

Screenshot 2019-03-04 21.25.31

Double-checking this number, page 123 of the 10-K suggests the co has pledged $5.2bn of assets thus far, so I think we are on the right track:

Screenshot 2019-03-04 21.26.38

3) Isolate assets associated with secured (recourse) debt

While TSLA has a ton of secured, non-recourse debt, it doesn’t have much secured recourse debt. This makes this part relatively straightforward. There are really only two obligations, one very significant (the Credit Agreement backed by inventories, receivables, and some PP&E, known in the business as an asset-backed loan, or ABL), and one small other obligation.

Again, the precise over-collateralization on the ABL is not public (since the loan docs disclose 85% of ‘eligible’ asset classes ‘less reserves’ is the borrowing base, without making it clear what those reserves are, for example, but given the quality of those underlying assets – inventory, mostly, recovery of which even in clean bankruptcies is still really low, 50% or lower – I think estimating a 70% LTV on the outstanding balance is reasonable if not generous. Hence:

Screenshot 2019-03-04 21.34.02

4) Remove all collateralized assets from existing gross asset side of Balance Sheet

Now we need to put it all together. We simply subtract – from the relevant asset categories, based upon 10-K disclosures as well as reasonable judgement – the collateralized (‘spoken for’) assets, from the gross totals presented in the consolidated accounts. See below for my attempt at this, with some clarifying comments. I have included the original Dec’18 asset side of the balance sheet for ease of comparison. The key number to focus on – at the bottom in yellow – is that post this process of elimination, TSLA’s apparently generous $30bn in gross assets is really only $18bn once existing secured claimants of various types have been removed:

Screenshot 2019-03-04 21.40.52

5) Haircutting remaining assets for value in recovery

OK, we are about half way there. Next thing to do is to think through what values the remaining assets may have to creditors. This is the part of the analysis that becomes much more subjective and variable depending on the ultimate form of restructuring (is it a pre-pack filing? Will the business continue as a going concern or not? Will it be liquidated or not? etc). I have personal views as to how this restructuring is likely to play out (to be discussed later), but for the moment I want to emphasize that even if the ultimate form of restructuring is, say, more favorable to TSLA creditors, they will all necessarily apply some conservatism (read: haircuts) to expected asset values in and around any bankruptcy/restructuring process, and by definition unsecured bonds should trade down to/or below (to allow for a risky return to market participants) levels implied by this inherent conservatism. So, the analysis is important and valid, even if by nature imprecise.

That said, you can see below the haircuts I have made to various categories. Some of these haircuts are fairly obvious (intangible assets aren’t worth anything to creditors; recovery rates on inventories and captive non-land PP&E (for example machinery and leasehold improvements would in principle be very low). NOTE ALSO that I have taken a further $1bn out of existing cash – this is NOT because I think the Dec-18 reported cash number is bogus (although I do), but is simply my estimate for the gross cash burn likely to be reported in 1Q (mostly operational, and through restructuring cost, not W/C build), so I think this is a defensible adjustment and may end up being conservative.

As you can see, even the $18bn gross available to unsecured creditors could end up being more like $9.5bn, or less, post recovery impairments to stated asset values on the last balance sheet:

Screenshot 2019-03-04 21.52.55

6) Estimating unsecured claims…

OK so we’ve figured out the asset side (‘assets available to unsecured creditors’), but what about the creditor claims themselves?

Again, this is an area where the form of the restructuring could have large implications for ultimate recovery. For example, in any kind of ongoing-business situation, trade claimants (accounts payable, accrued expenses, a few others) would effectively be treated senior to all other claimants simply by the fact that unless they get paid the company will go into liquidation. In the below I do NOT assume that is the case – in other words my base case assumption is all unsecured claimants get treated equally, after administrative claims, as would be the case in a liquidation. As we shall see, this is likely an assumption that FAVORS non-trade unsecured creditors in this case (ie, bondholders), but in any case I will expand on my reasoning for this in a little more length in a moment.

For now, we simply need to tot up all the remaining balance sheet liabilities that are neither leases, nor non-recourse debt, nor secured recourse debt. Then – and this is very important – we need to estimate the off balance sheet liabilities that become unsecured claimants post filing. Again, another area of huge judgement required (estimating the liability related to all the shareholder lawsuits re ‘Funding Secured’, for example), but once again, I have tried to be as ‘pro-creditor’ as possible in my approach. Even so, the following large items make it onto the unsecured claimants list:

  • trade claims (about $6bn);
  • customer deposits ($0.8bn) – yes this is simply an unsecured claim (gulp);
  • unsecured debt ($5.8bn left post recent convert repayment);
  • Panasonic purchase obligations ($13.2bn under ‘binding and enforceable contracts’, clearly the massive elephant in the room);
  • Other purchase obligations ($2.4bn);
  • My estimates for the NPV of the Buffalo Gigafactory breakage cost ($200mm) and legal liabilities ($500mm) – both of these numbers probably end up higher.

NOTE I have not attempted to ‘true up’ the warranty provision or make any other grand assumptions re the state of the numbers, today; rather I am simply trying to assess where the numbers naturally fall as they currently stand, and see what that says about recovery value before anything (else) goes wrong.

As a result, we get something like this:

Screenshot 2019-03-04 22.03.29

Hence, my conclusion that unsecured recovery tops out at 33c and in reality is likely to be much, much lower. Perhaps it’s worth expanding on why that may be the case.

If you’ve been following closely thus far, you can see that the residual assets available to the unsecured class are essentially cash, then SolarCity assets and then PP&E. First, the easy part: even if we thought the $3.7bn cash balance (pre convert repayment) was ever real, the chances of that being there when or if they file (given how Musk is barrelling the company right over the cliff) is, let’s say, quite low. And as for the fixed assets – as a general rule, recovery values on fixed plant tend to undershoot on the downside. Simply put, hard assets like buildings and special purpose machines are not worth anywhere near as much to a new buyer as they are to an ongoing business. Finally, when it comes to the SolarCity assets, since SC was such a liberal user of asset backed financing when it was a going concern, I find it hard to believe there is much ‘real’ (read – to a third party) asset value in the un-collateralized assets today. If there were, I believe they would have already been siphoned off for additional liquidity by now…

Liquidation or DIP+Restructuring?

…Which leads us to a further point about why, to my mind, this is more likely to be a liquidation scenario than a going-concern restructuring. In order to restructure and keep the business is operation, TSLA, once it files, will need a MASSIVE debtor-in-possession (DIP) financing – maybe $3-5bn, by my estimate, simply to fund ongoing operations. This may not be impossible to conceive, but consider the following:

  • TSLA runs massively negative working capital ($1.5bn or so currently by my estimate) and has $6bn of trade claimants, today. Also, many of those creditors have given back large rebates to TSLA simply to allow them to survive until now; many of them have not been paid on time, ever. How much of that DIP goes straight out the door to keep the lights on – $2bn? $3bn? Why wouldn’t cash on delivery conditions exist for any go-forward business post-restructuring without a massive decrease in credit extended by suppliers?
  • DIPs are generally only provided when management remains in charge. I find it hard to believe Musk & co will be entrusted to run the company if/when it files (especially if there are fraud implications, which also seem highly likely). That necessarily makes it harder to get a DIP;
  • Keep in mind that Musk and co still run the company today and by the time it actually files, even if this is just in a couple of quarters, the liquidity/asset quality/brand quality of whatever is left is, judging by current events, likely to be exponentially worse and thus less salvageable (from the perspective of any potential new credit provider);
  • While not impossible it is generally harder to get a DIP in cases where there may have been malfeasance/fraud (in TSLA’s case, this could crop up in a multitude of different ways);
  • A DIP would have to prime the other secured lenders (currently the banks backing the ABL). While if these same lenders provided the DIP (as often happens) this may be doable, consider that – as we have discussed at length – there aren’t really many other assets left to the estate worth collateralizing that gives the ABL lenders reasonable security that their position is not being made worse than a liquidation (where they would most certainly be made whole);
  • A large DIP probably only accompanies a search for a buyer of part/all of TSLA. That means financing is contingent upon a third-party being willing to underwrite, say, the value of TSLA’s brand – such as it is post the price cut abomination that Musk unfurled last week – but at the same time likely means an end to the Model 3 (which essentially is what killed the company). However to my mind there are very few ways to keep the company going and viable as a brand, without continuing to service/repair/warranty the 250k+ Model 3 lemons on the road (imagine the brand damage of that approach…). But what third-party buyer is going to be willing to underwrite that open-ended, multi-year expense?

None of this is to say a DIP, and a sale or recapitalization as a going concern is impossible (hell, Enron and Worldcom both got DIPs) – just that in this particular case I think it is clearly not the base case outcome.

But the overriding takeaway is simply this: even if you think it DOES remain an operating concern and they DO get DIP financing then the unsecured recovery will most certainly be a lot lower – since something like $3-5bn of super-senior secured financing will come in ahead of the unsecureds; and that new cash likely makes its way, mostly straight out the door to other unsecured creditors (trade claims) before the bondholders (and maybe Panasonic, for that matter – yet another reason why the DIP solution may not be forthcoming). Meaning, of course, if somehow a DIP does get done, unsecured recovery will be much, much lower than the 33c best case this exercise has suggested.

Disclosure: short TSLA everything (stock, straight bonds, converts, the lot).

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Bracell: a pretty juicy merger arb play

I don’t often pursue merger arbitrage (the practice of buying stocks with announced takeovers pending, and/or shorting the shares of the acquiror, hoping to capture the spread to the deal price if/when the deal closes). I am not an expert in the space, and oftentimes the returns don’t justify (to me) the real risk that deals can fall through. But every now and then there is an exceptional case, and Bracell (1768.HK) looks like one such opportunity.

Bracell is an interesting small-cap stock. While listed in HK, the company has most all its production facilities and assets in Brazil; even more interestingly, it is majority owned (85%) by an Indonesian tycoon, Sukanto Tanoto – who also controls one of Bracell’s key customers (this is not normally a good thing, but bear with me).

Bracell manufactures dissolving wood pulp (DWP), a naturally occurring fiber used in a variety of applications. The higher grades (“specialty grade pulp”) are used for cigarette filters, eyeglass frames, pharmaceutical tablets, cords in tires, and the like. The lower grades (“rayon grade pulp” or “commodity viscose”) are a feedstock for the textile industry. As you can imagine, specialty grade commands a higher price and margin, while the commodity grade is of lower value, more competitive, and possesses much lower margins.

Both commodity and specialty pulp markets are quite competitive – there are at least five or six large-ish players globally – but Bracell possesses two key structural advantages. Firstly it is fully integrated, owning all its own forestry assets (trees are the key raw material input as you might expect) – this is necessarily an advantage when it comes to input costs. Secondly, these forests are entirely located in Brazil – a double advantage both because of the recent weakness of the local currency (BRL) versus most all export markets for DWP, and also because of the nature of the trees grown there. South American eucalyptus trees grow to maturity in ~8yrs, versus the 30yrs for North American hardwood used by a number of Bracell’s competitors, meaning Bracell has a long-term cost advantage as the effective yield of a eucalyptus plantation is so much better. Thirdly Bracell has an off-take agreement with an affiliate of its major shareholder, to sell as much commodity product as it needs to to maintain full utilization of its facilities (at the moment ~25-30% of its tonnage goes towards specialty, the balance towards commodity grades). This provides a further layer of operational security in times of low utilization.

It should be no surprise then that Bracell is effectively the low-cost competitor in the space, and can profitably produce specialty grades of DWP at prices ~$200/t cheaper than its North American rivals (Rayonier, Tembec, etc). With specialty grade prices around $1200/t, this is a massive cost advantage.

This is all by way of background. The key takeaway is that within this market, Bracell possesses a number of quasi-structural advantages that look likely to persist in the medium term.

Recent events and the opportunistic bid for the company

This brings us to recent events. For much of the past year, Bracell stock drifted along unnoticed in the $0.9-1 range, despite solid operational results and high cash flows. In early June, however, the company announced 1H profit (to be fully reported in August) would post 100-150% higher year-over-year, a function of the lower BRL, price stabilization in specialty pulp, continued cost discipline and (in my view) further customer wins due to their cost advantage. The stock immediately took off, rallying from ~$1 to the $1.5-1.6 range – a level that still looked very cheap on fundamentals (as we shall discuss).

At this point the company announced that the majority shareholder had bid to acquire the remaining public float (just ~15% of the outstanding), sending the stock spiking to $2 as arbitrageurs piled in, before settling back to $1.6-1.65 once the offer price (just $1.78) became known. This is effectively a ‘take-under’, given where the stock was trading pre-price announcement.

So this is where we stand today (mid-July). The stock is currently at $1.62; there is a $1.78 bid on the table from the current 85% shareholder. The company has hired Morgan Stanley to evaluate the offer, and according to HK Takeover rules, there is a requirement for 75% of MINORITY shareholders to approve the bid, and ALSO for <10% of shareholders to veto the deal outright. While not insurmountable, these are reasonable protections for minority shareholders, in my view.

It is worth considering now how cheap this $1.78/share bid is. Last fiscal year (Dec’15), Bracell generated ~$172mm of FCF, which equates to ~39c per HK share – or a LTM FCF multiple of just 4.5x. You would be hard pressed to buy a dying, heavily levered business at <5x cash flow. Bracell is quite the opposite – it is the low-cost producer in a commoditizing industry, possesses very little leverage today (~0.8x EBITDA), and will be effectively net debt free by year end 2016. You could easily argue a 10x FCF multiple for this business is too cheap, even absent an acquisition premium.

Of course, we also know 2016 earnings numbers will be better than 2015 (due to the 1H profit guidance). In the below abbreviated CF statement, I assume a decent step-up in cash taxes, capex spend, AND no working capital benefit but still think Bracell will throw off at least another ~30c per share (or ~$133mm) in FCF:

bracell1

The majority owner is thus offering to pick up the remaining shares in what could become an industry leader at 5-6x FCF with no leverage…clearly very opportunistic, to say the least

Heads I win, tails…I win more?

This brings us to the source of the opportunity. As we sit today, I estimate the following three possible outcomes:

  • minority shareholders simply don’t care that they are being expropriated – they vote the deal through. As such you receive $1.78 for the $1.62 paid today, likely in <6 months (this is not a complex deal), thus ~22% annualized return or better. Not bad at all.
  • MS suggests the bid is too cheap, and, fearing losing the shareholder vote, the majority owner raises the bid. I estimate fair value much closer to $3 than $1.78 for this asset, but even a nominal bump in deal price would lead to significant returns. For example, 7x FCF would equate to ~5.5x EBITDA, which looks cheap versus comparables but is not as egregious as the current price. That alone would increase gross returns (vs $1.62 current) to 35.8%, and, if the deal closes in <9months (again, very conservative, it should be faster than this), to 48% annualized returns. Again – not too shabby.
  • MS suggests the bid is wayyyy too cheap, and the majority shareholder drops the bid. While this seems a fairly bad outcome, I really don’t think the stock has that far to fall. Recall this business is already trading at 4.2x LTM FCF and ~5.5x current year FCF, with no net debt from end-2016. It also pays a ~2.5% dividend which will surely be raised if the takeover doesn’t go through, AND it was trading in the $1.5-1.6 range BEFORE the takeover bid was announced. Finally, since the majority owner owns 85% of the issue, there simply isn’t much stock for arbs to dump if the deal breaks (frankly I think most of them bailed once the deal price was announced). Adding it all up, I don’t think the stock price falls that much if the deal breaks (5% or so?) and if it did I would buy more.

We must also consider the motives of the major shareholder. As of today, the entire market cap is $715mm (USD), and the EV is ~$850mm. At deal price, the implied EV is $923mm (looking at LTM numbers), or $785mm looking out to year 2016 end (due to the FCF generation). Of this EV the major shareholder already has $668mm invested (his 85% stake at $1.78) thus leaving only ~$118mm of ‘value’ being paid out to minorities. Increasing his bid by say 25% thus only amounts to an incremental ~$30mm being paid out, or just ~3.8% of EV at current deal price and <5% of the value of his stake at deal price. This does not seem like a large incremental amount to pay to achieve closure for this valuable asset, in my view.

Really the main limiting factor here is liquidity (the stock trades ~$200-300k USD per day, or less), and then timing (it is as yet unclear when the vote will be, though I anticipate it will be ❤ months). However for smaller funds/private investors, the risk/reward looks compelling.

Disclosure: long 1768.HK

Capital structure arbitrage: the curious case of Peabody Energy

Peabody Energy (BTU) is a coal company. As most anyone who hasn’t had their head in the sand the past couple years will tell you, it is a terrible time to be a coal miner (see here or here for some background – this post is less about the problems facing coal and more an exploration of one company’s cap structure). The travails in the industry were naturally reflected in the capital markets, and 2015 was something of an annus horribilis for the sector, with three large-scale bankruptcies – Arch Coal, Walter Energy, and Patriot Coal. BTU has managed to scrape by – for now – but as the subsequent discussion will show, it is merely a matter of time before Peabody too joins its compatriots in the restructuring bin.

The impetus for this post was a quick look at BTU’s capital structure. In evaluating potential investments I always try to think about how the various pieces of a company’s cap structure – 1st lien debt, 2nd lien debt, unsecureds, equity, etc – fit together. People often say valuing a stock is more art than science, and that may be true for the equity piece, but looking at the whole enterprise is much more akin to solving a jigsaw puzzle. We can argue about the ‘right’ valuation for the whole entity, but the values ascribed to each piece of the piece must at least be consistent with each other. If the value of the equity portion is meaningfully out of whack vis-a-vis the bonds (or vice versa), we can try to profit by buying/selling the different pieces until they are back inline (this is ‘capital structure arbitrage’).

With this in mind, take a look at BTU’s capital structure – perhaps one of the most egregiously mispriced I have seen in quite a while. The below cap table summarizes BTU as of mid-Feb (I have used some estimates where data is not available). Note I am using 2016E consensus EBITDA ($350m) to calculate leverage through the cap structure:

btu

There are a few things going on here but the most important takeaways are as follows:

  • BTU is massively levered: 6x levered through the 1st liens alone is well in excess of 1st lien revolver covenants (<4.5x levered on a LTM basis), suggesting covenants will be breached imminently (next few quarters or earlier);
  • ALL of BTU debt trades at HUGE discounts to par: the 1st lien paper trades at 37c on the dollar, while even the 2nd liens trade at just 8c on the dollar. These are insanely low levels for a going concern, and clearly imply a very high likelihood of full impairment on everything junior to the 1st lien paper. Indeed, the 2nd liens have a 5pt coupon payment due in merely a couple of days, yet trade at 8pts – implying to me a very high likelihood of that coupon being skipped (and thus BTU falling into default)
  • Implied equity/credit valuation disparity is massive: given the market-price discounts of the debt, the bond market is effectively telling you the company is worth ~$900-$1bn (treating the 1st/2nd lien paper as senior to non-debt obligations like asset retirement and pensions). Alternatively, treating 1st/2nd liens as pari-passu with non-debt obligations would imply an EV of ~$2.5bn at current debt prices. Meanwhile the equity is telling you the EV of Peabody is ~$8.7bn today. It is also worth noting that the value implied by the equity at current suggests an EV/EBITDA multiple of 25x – which, even on a trough EBITDA number, is ~15-18 TURNS higher than normalized multiples for a coal company

Of course, it is not unusual for so-called ‘stub’ equities of highly-levered companies like BTU to trade with ‘option value’ even though bankruptcy, restructuring, or otherwise equity-destroying events loom large down the road. But the BTU situation is different – not just because the equity valuation is particularly egregrious, relative to the debt, but because there are a number of imminent catalysts that suggest not just equity but most of the unsecured debt portion of the cap structure could be wiped out, pronto. To wit:

  1. Cash burn: As horrible as the above picture is, it is merely a static shot as of Feb’16 and does not consider the ongoing cash burn BTU is suffering. Consensus EBITDA for 2016 is ~$350m. Against this BTU is guiding for $130m capex, is on the hook for $450m in interest payments; owes another $250m to the US government for land rights; and owes another $75m in cash related to legacy Patriot Coal obligations. This suggests cash burn of ~$550m in 2016, with all liquidity already drawn down and precious little in asset sales (more below) likely to offset. This also doesn’t include any lost liquidity if BTU’s self-bonding obligations are deemed less credible and the government demands cash collateral posted against asset retirement obligations (this discussion is ongoing).
  2. Structure of the leverage: more worrying for equity holders is the structure of the outstanding debt. Of BTU’s outstanding debt, ~71% (~$5.5bn out of $7.7bn) is below the first lien level; of the ~$450m in interest payments going out the door in 2016, only ~$71mm relates to 1st lien debt, or just 16% of 2016’s interest bill. This means, of course, that the vast majority of cash out the door goes simply to maintain 2nd lien and lower creditors – though the 1st lien covenants are the ones that need re-negotiation for BTU to survive the near term. Simply put, there is no incentive for BTU 1st lien lenders to waive/renegotiate covenants only to see BTU’s dwindling cash cushion be wiped out in a matter of quarters – and then see the company need super-senior debtor-in-possession (DIP) financing when bankruptcy finally arrives down the road. This makes it infinitely more likely that 1st lien lenders will exercise their rights to tip the company sooner rather than later (which Franklin Resources, one of the principal lenders, is apparently already pushing for)
  3. Failed asset sales: while BTU is fully tapped out on their credit lines (another bad sign – disclosed at 4Q earnings), they are trying to sell some assets in NM and CO to Bowie Resource Partners for $358m. While this would not be enough to even make a dent in overall leverage, it would nevertheless buy the company time. Unfortunately for BTU, credit markets seized up at the wrong time, and Bowie has thus far been unable to raise the necessary funding to consummate the transaction. Indeed, BTU disclosed in a NT-10K filing in late Feb that if they were unable to close the Bowie transaction, they would be forced to include a ‘going concern’ notice in their 10-K (due by mid-March, so, imminently) which would be classified as an event of default in their credit agreement. This would provide the 1st lien lenders the breach required to accelerate and tip the company (and even if it didn’t, a breach of the 1st lien leverage covenant in a quarter or two would serve the same purpose). At this point, it seems highly unlikely BTU will be able to close this transaction in the next week or so as they need.
  4. Upcoming interest payments: BTU has two large upcoming interest payments on Mar 15th (the 2nd lien 10% ’22s, and the 6.5% ’20s unsecureds) which cumulatively amount to $71m – a large amount of liquidity for BTU given their prospective 2016 needs and dwindling cash sources. Again – I find it highly unlikely that the company would choose to pay these large coupons on subordinated debt (indeed, the market prices of the debt suggest they get skipped) while they are negotiating with senior lenders for relief. As per point 3 – skipping the payment (assuming the grace period was also violated) would constitute an event of default and – under cross-default provisions – allow the 1st lien lenders to accelerate on the company.

All in all, then, I am very much at a loss as to why the equity has continued to trade at such generous (relative) levels – particularly in the last couple of weeks, when it has more than doubled. Clearly the rally in all manner of ‘junky’, levered, commodity equities (CHK, FCX, etc) has helped, though the situation at BTU seems pretty clear-cut. Indeed, were it not for the day to day volatility of the stock, you could quite easily structure a short equity/long bond trade (probably vs the cheapest unsecured instrument) that leaves you well covered in most all scenarios, even where the equity survives in some highly diluted form.

However, it is my contention that the current dynamics – which have seen the stock squeeze aggressively and bonds barely move – are symptomatic of cap arb players who already the trade on getting carried out of the trade just as the finish line has come into sight. This – along with my distinct bearish bias in this case (ie, I think this ends in bankruptcy pretty soon with zero equity recovery) means this is one cap structure play I am expressing purely through owning short-dated downside puts. I expect a resolution in the very near term (next month or so, allowing for 30 day grace period on potential skipped Mar’15 coupon payments).

Disclosure: short BTU stock (via Apr/May low strike puts), no position in bonds

TimkenSteel: imminent dilution is the only way out

When it comes to looking at stocks, I’m a big believer in looking at the business from a credit perspective as a window onto equity valuation. What terms are the lenders extracting for credit and how are creditors protected? What are creditors worried about and how do they think they will get paid back? What view do the lenders (and not the company’s execs) have of the company’s liquidity? Since the imperatives of stock-owners and creditors are so different, this divergent perspective can be illuminating when analyzing distressed/semi-distressed companies in times of change.

TimkenSteel (TMST) is a perfect example of how creditors can tighten the screws, to the likely near-term detriment of equity-holders. TMST is a specialty steel company that makes steel bars used in a variety of industrial end-markets such as automotive, oil & gas, agriculture, construction, etc. As you can probably guess, anything ‘oil & gas’, or ‘industrial’-related has been under unrelenting pressure the last 1.5 years as the great commodity and US oil booms have unraveled. Since, at year-end 2014, TMST derived at least 40% of sales from oil & gas (and of that at least two-thirds related specifically to growth capex, not maintenance), it should come as no surprise that sales, margins, EBITDA, and the stock have all fallen off a cliff. EBITDA – after peaking at ~$277m in 2011 – posted $222m in 2014 then promptly cratered to negative $34m last year. This explains why the stock has done this:

 

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I first encountered TMST mid-last year, after reading this great bearish take on the company and initiating a modest short position (around $30) upon doing further work. Back then the story was one of relatively over-valuation as much as fundamental deterioration. I covered far too early at $18 or so, and the stock kept following the steel market and US rig count lower, trading as low as <$4 on bankruptcy fears before the latest earnings release (late January) provided a bit of respite.

TMST reappeared on my watchlist after a report crossed the tape last week suggesting the company had hired PricewaterhouseCoopers to explore financing options. This struck me as a strange move, given this was clearly not the pursuing of ‘strategic alternatives’ (code for trying to sell the company), and normally financing options are handled by investment bankers, not accountancy firms. While this didn’t smell exactly of imminent bankruptcy – there are generally specialist bankruptcy restructuring advisers hired for that – something didn’t seem quite right with the announcement, so I decided to take another, deeper look at the credit.

A few things jumped out at me straight away. First off: the company renegotiated its credit agreement in December – but without putting out a clarifying press release to detail the new terms. While this is not exactly required (they DID file the required SEC disclosures), often-times – and especially when the new terms are more favorable – the company will trumpet as much to the public. In this case, unless you were an intrepid and dedicated reader of all the company’s SEC 8-K filings, you would have missed this important info until the CEO mentioned it in passing – again, in very muted fashion and without detailing terms – in the press release announcing full-year 2015 results on January 28.

In any case – the company needed to amend its credit facility because it was about to violate its interest coverage covenants on the old revolver. In return for tearing up the interest coverage (and minimum capitalization) covenants, the banks rewrote the credit facility to look like this:

  • $300m asset-backed revolver, subject to a ‘borrowing base’
  • LIBOR + 125-225bps rate (along with 0.4% commitment fee on unused balances)
  • borrowing base governs availability  – simplifies basically to 85% of eligible receivables + 70% of eligible inventory + 85% of eligible equipment, less reserves (which are at lenders’ discretion)
  • company must maintain $22.5m minimum availability, stepping up to $30m minimum availability from end-June 2016 AND must have availability of $100m for AT LEAST ONE DAY prior to end-July 2016
  • After July 2017, fixed charge coverage ratio covenant kicks in (FCCR must be >1:1 in the LTM period from July’17)
  • Mandated max capex levels in 2016 ($45m) and 2017 ($50m)

There’s a fair bit to chew on here. But first – as of Dec 30, 2015, the company disclosed they had $200m of total debt, and $84m of total available liquidity – which, since they have $42.4m of cash, implies just $41.6m of availability on the revolver left. Now, we know that of the $200m in total debt, $18m are revenue refunding bonds unrelated to the revolver. Working backwards, then, we get an implied drawn revolver balance of $182m ($200m total debt less $18m revenue refunding bonds) and thus an implied current borrowing base of $224m (drawn revolver balance plus remaining revolver availability of $42m).

It’s important to recognize that the stated maximum availability under the revolver – $300m – is really only of secondary importance, given actual availability is governed by the borrowing base (currently $224m as discussed) – and that this in turn is a function of the company’s receivables, inventories, and equipment asset categories. As the company’s working capital and net assets contract – due to shrinking sales and lower capex – so too does the company’s liquidity.

Now let’s return to the terms governing the borrowing base calculation. Recall that the simplified calculation is: Borrowing Base = 85% x eligible receivables + 70% x eligible inventory + 85% x eligible equipment, MINUS reserves. Looking at TMST’s current situation: year end receivables were $81m (so 85% = $69m); year end inventories were $172m (so 70% = $120m), and year end equipment was ~$515m (so 85% = $438m). Sum this all up and you get $627m – and yet the current borrowing base is only $224m. What gives?

Well, we do not know the precise calculation of ‘reserves’ which are used to provide the lenders with a margin of safety; nor do we know exactly which receivables, inventories, and equipment are ‘eligible’ (though the credit agreement gives a ton of guidelines). Suffice to say the lenders here have a ton of discretion and tend to err on the conservative side, always – after all, it is their capital at risk. My own intuition suggests there are minimal reserves held against receivables, substantially more against inventories (where 70% is really not a huge discount in this environment), and much, much more against equipment (the resale value of which would be FAR lower than 85% of book in the current market).

If I were to haircut these asset categories in bankruptcy (which is ultimately what creditors to distressed companies need to contemplate), I would use an 85% rate for receivables but probably more like a 50% rate for inventories and a very low recovery assumption for any used equipment – maybe 10%. This rough methodology would yield ~$207m as a theoretical asset base for lending purposes, which is not materially off from where the current borrowing base is ($224m), suggesting banks are applying similar discounts.

Thus – the first important takeaway is that the lenders are applying fairly draconian discounts to the company’s stated asset values. This alone suggests a pretty skeptical stance from the lenders towards the company.

Unfortunately for TMST, it gets worse. As mentioned, TMST as of year-end only has ~$42m of revolver availability left. This is a big problem given a couple of the other conditions of the amended facility – namely, the minimum availability covenants. To recap, TMST must maintain minimum availability of $30m AFTER end-June, having experienced AT LEAST ONE DAY of minimum availability north of $100m.

Of course, TMST is barely in a position to meet the $30m minimum availability covenant upcoming, so the $100m one day availability covenant is simply beyond the realm. We will come to a FCF bridge shortly and explain exactly how much cash TMST needs. But cash burn aside –  these minimum availability covenants, as structured, provide further insight into what the banks are thinking: they want TMST to find alternative liquidity sources, and pronto. Indeed, the ONLY reason to specifically include the one-day observation of a much larger liquidity requirement is to force the company to find another source of funds (or allow the banks to accelerate immediately if they can’t).

The Fixed Charge Coverage Ratio test that kicks in from next July is similar in this regard. In order to even approach, let alone meet, this requirement, TMST would need positive EBIT in the LTM period up to July 2017; yet EBIT was negative $108mm last year and analyst consensus is for another negative $107mm this year, and then another negative $20mm in 2017. Barring an absolutely miraculous turnaround in the oil & gas and industrial steel markets, it is wildly unlikely TMST will even sniff passing the FCCR test and thus would lose complete access to the revolver. Of course, the banks knew this when they amended the loan docs (just last December, after all) and thus the conclusion is the same – the banks are effectively demanding TMST find alternative funding in large enough size to either repay the revolver or at least to assuage the banks to accept amended terms next July.

How much cash does TMST need?

To summarize so far: banks structured the amended revolver very carefully, to a) limit their maximum exposure by applying punitive haircuts to company assets in determining the borrowing base; b) force the company to find alternative funding in the very near term to avoid tripping availability covenants; and c) ensure that these alternative funds are not ‘stop-gap’ capital and substantial enough to allow either a full bank exit, or a substantial reduction in bank risk exposure, by mid 2017.

We can now begin to think about how much cash TMST needs. While this is something of a moving target, let’s frame the discussion by looking at potential cash burn in 2016.

A rough estimate of free cash flow (FCF) is generally given by the formula FCF = EBITDA – capex – cash interest – cash taxes – cash pension contributions +/- change in working capital. See below for my estimates in each category:

  • EBITDA: analyst consensus is -$28m, but the company has guided to -$15m in 1Q alone so the street is expecting sequential improvement over the year. Since rig count and industrial end-markets have done nothing but roll over further in the last couple of months, even -$28m may be a stretch. But let’s assume the lower end of consensus for now and thus EBITDA of -$20m for 2016;
  • Capex: the company guided to $45m at the last earnings report; this is also the maximum amount mandated under the new credit agreement. At ~5% of sales (vs 10% 2yrs ago) this is likely bare minimum maintenance level or even below;
  • Cash interest: should be $6-7m, applying loan costs to end-2015 balance, commitment fees to unused portion, and not charging much for incremental interest on additional cash burn;
  • Cash taxes + cash pension payments: assume zero for both given no profits and company stated they would not pay a cash contribution towards the pension deficit ($114m) this year;
  • Change in working capital: this one is a little tricky. Working capital was a massive source of cash for the company last year (+$119m) as the balance sheet shrunk and the company did everything it could to tighten its cash conversion cycle. While I do think working capital remains a source of cash (at least for a couple more quarters), I am skeptical TMST can generate anywhere close to this amount again in 2016. For one, with TMST’s rapidly declining credit quality, I don’t anticipate payable days – which tightened from 31 to 21 over the course of 2015 – rebound much. Meanwhile receivables outstanding have been cut in half – from $167m to $81m – in a year and are at the best levels the company has ever enjoyed (36 days sales in 4Q ’15). That just leaves inventories, which, like receivables, have already been tightened a lot in absolute terms ($294m -> $172m since end-2014) and in a weak environment may turn a bit slower. In any case, given a stabilizing sales picture (I assume), even further improvement in inventory days would make only marginal impact, at least in terms of affecting the company’s near-term liquidity. Eg, as the table below shows – further improvement in the cash conversion cycle (CCC) from 88 to 84 days in 1Q only releases another $5m cash at street consensus revenue estimates:

tmst1.jpg

Putting it all together – TMST should burn at least ~$73m in 2016 BEFORE working capital in 2016.

But we need to think not just about total cash burn in 2016, but the progression of cashflows over the year (since the key liquidity tests under the credit agreement stipulates having $100m available at some point before July ends). A simple linear approach would suggest half, or ~$36m, will be burnt in 1H. This is probably too generous, since analyst consensus numbers are already predicated on a 2H recovery. But let’s give the company the benefit of the doubt here for a moment.

Under these assumptions, then, how much cash does TMST need before July? The below table summarizes my thought process:

tmst2

To unpack it a little further – if at some point TMST needs to have $100m available on its revolver, then it needs to reduce the amount drawn on that revolver to $100m below the borrowing base. Since we know the borrowing base is currently $224m, this implies max outstanding at that point in time of $124mm. But since the company already had $182m outstanding, AND will burn another $33m in 1H 2016, that implies needed cash – to cover debt reduction and cash burn – of $91m. Two notes: this is pre-working capital, which again remains the wild-card (ie, how much benefit does the company get?). And secondly – it is highly unlikely the borrowing base remains static; indeed it will likely shrink as the asset base reduces, thereby partially or fully offsetting any working capital benefit I am not including here.

$91m may not sound like a lot, but the company’s current market cap (at $7.3/share) is only $323mm, so we are already talking ~28% of current market value at spot; of course in any dilution scenario, shares would likely be offered at a meaningful discount, thereby increasing dilution to current owners. And this doesn’t get the company through the rest of the year, nor even begin to contemplate refinancing the revolver in 2017.

This last point brings the discussion full circle. Any near-term financing designed to get the company into compliance with the pre-July availability covenants will have to also address, or provide a step towards, addressing the the upcoming Fixed Charge covenant in July 2017. From the company’s perspective, it would make no sense to issue a small amount of equity (or second lien debt), then have to come back to the market in <6 months to try to raise more capital to either refi or partially delever and convince the banks to amend the revolver (again).

I believe it is far more likely that TMST engaged PwC to try to rightsize the capital structure once and for all, in advance of the July availability test but also in such a way as to make the FCCR test next July not an overhanging issue.

Why equity and not debt? Why won’t banks ‘amend and pretend’?

At this point you may ask, ‘why would TMST issue equity and not more debt’? Well, a few reasons:

  1. They can’t issue more first lien debt due to negative pledges on the existing revolver (pretty standard, really, the banks don’t want more debt diluting their collateral package and currently they have a call on all company assets);
  2. The high yield market is closed: I shudder to think what debt capital markets desks would say if TMST – a negative EBITDA, oil & gas capex related, industrial name burning cash – called them up and wanted to do a second lien bond deal in the current environment (let alone an unsecured). Suffice to say, the window is closed and is unlikely to be open for companies like TMST at any point in the next few months;
  3. Equity is permanent capital and is the only solution (other than asset sales, again a non-starter in this market) that delevers the company. Deleveraging is important because it is far more likely banks agree to amend/waive the FCCR covenant next year if the amount of debt (and thus the banks’ risk) has been reduced to a reasonable level;
  4. The company still has a meaningful market cap ($323m) relative to the size of its enterprise value ($481m), meaning deleverage through equity sale in the market is a realistic (though not painless) option

Against this, you would have to consider management – which was buying back stock as recently as a year ago – would really have to swallow their pride to go down this road. But as they say – beggars can’t be choosers.

What is ‘reasonable’ leverage on a go-forward basis?

This of course begs the question – how much delevering would be required to assuage worried banks come next July? Well, EBITDA was $275m a few years ago and is currently running substantially negative, so it is anyone’s guess what ‘normalized’ EBITDA for a highly cyclical, boom/bust name like this is. Bloomberg consensus for 2017 gets to $51m, and then jumps to $145m in 2018. This last number seems a bit aggressive to me – especially as the company clearly benefited from a once-in-a-generation bull market in commodity capex. Let’s assume $100m is where the company could get to on a normalized, sustainable basis, at least for now.

At the moment, the company is carrying $200m of gross debt. As discussed, I think they burn at least $73m in 2016, probably more; and it is not likely they will generate any FCF in 2017 at this stage either. To that we must add $117m in pension deficit (which is effectively debt as it needs to be periodically funded) – and I wouldn’t bet against that number going up, given how interest rates have tightened so much while plan assets are probably getting killed. Putting it all together, I could envisage TMST exiting 2016 with close to $400m of adjusted gross debt, implying 4x gross leverage (and ~3.5x net) on what I think is a generous ‘normalized’ EBITDA assumption of $100m.

To be frank – this is simply too much for this kind of highly volatile, capex intensive, cyclical business, especially at this point in the cycle and currently still burning a ton of cash – even if you did believe the company could get back to $100m EBITDA in 2.5 years. 2x gross leverage (and <1x net) would be more palatable (thinking like a bank) and would help assuage doubtful bankers to amend/waive covenants next July. But again – that would dictate a very chunky equity offering (around $200m – assuming such size could get done). Without such a move I just don’t see how the company can extract much leeway from a banking group that seems pretty fixed in ‘self-preservation’ mode (and not in ‘save TimkenSteel’ mode).

Summary: TMST is between a rock and a hard place

I don’t mean to be too negative: a bankruptcy filing, while definitely a possibility, is not my base case outcome at this stage. But I do envisage a substantial (30-40% of market cap? or more?) dilution in the very near-term – whether by public offering or third-party allotment to key stakeholders, or both, and likely at a meaningful discount to where we currently trade. Such a move will be deeply unpalatable to management who were buying back stock as recently as a year ago and remain key backers of the company – but without it, I simply don’t see how they will be able to jump through the hoops assigned for them by their increasingly skeptical banks. In this scenario, I would not be surprised to see TMST retest the recent lows or at least get close, as shareholders wake up to the dilutive implications of right-sizing this currently sinking ship.

Disclosure: short TMST. All data is from company filings, Bloomberg consensus and/or my estimates.

Extra Disclosure: TMST trades like Conor McGregor fights – violently and without mercy. (up and down). Extra special ‘big boy’ risk is involved if you traffic in this name.

 

In defense of aircraft leasing (and especially Aercap)

January was a rough month for stocks in general, with major global averages falling 5-10% and all manner of sectors (oil & gas, REITs, MLPs, etc) punished far more than that. While there have likely been a lot of babies thrown out with the collective bathwater, one under-performing sector that has especially piqued my interest has been aircraft leasing. There are only four major listed pure-play aircraft leasing companies on US exchanges (AER, AL, AYR, and FLY), making this a small and often misunderstood sub-segment of the broader financials universe. See below for performance this month (in percent):

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Aercap (AER), the largest listed player and a close second in terms of global scale to GE’s aircraft leasing business, is one of my largest holdings, so this move has been painful to say the least.

That aside, there have been a number of (often-conflicting) narratives concerning the current business environment for lessors, all of which have weighed on the stocks near-term. To name a few:

  • aircraft valuations, especially for older wide-bodies, are under pressure (cf. recent analyst notes, lessor commentary in the last month, and Delta CEO’s claim a few months ago that there was a ‘bubble’ in wide-body aircraft);
  • Boeing’s recent production cuts to the 747 cargo plane and also the old-gen 777, suggesting lower demand;
  • emerging market pain will cause distress amongst EM airlines (in particular, China exposure is thought to be problematic);
  • low oil prices are bad for the lessors since they decrease demand from airlines to upgrade to newer, fuel-efficient aircraft.

Since the lessors now trade for ~25-35% below book value – which, as we shall see, is likely understated in any case – Mr Market is suggesting that a combination of these factors will cause an imminent and material impairment to the carrying value of the lessors’ fleets.

On the other hand, I think the market is too fixated on a couple of isolated and perhaps temporary signs of weakness in the market – ie, tepid demand for new Boeing wide-bodies – and is completely missing the bigger picture (that aircraft leasing is healthy and in a solid go-forward position). Here’s how I get there.

Aircraft leasing: two major ways you can lose (assuming you do indeed lose)

Much like other leasing businesses, there are really only two main ways a lessor can take a large loss: either one or more of its clients goes out of business (or otherwise gets into enough financial trouble that it breaks its leases); or, aircraft held without a lease cannot find a new lessee and need to be written down in value as a result. It is important to recognize that as long as a client is current on lease payments, it would be extremely rare to impair the value of the leased asset (think of car leases as an equivalent example).

This of course means there is and should be a reasonably high correlation between lessor impairments and the health of their clients – the global aviation industry. This is where one of the major tenets of the bear case – that low oil prices are bad for lessors due to a decrease in demand for newer, fuel-efficient aircraft – simply falls apart. The vast majority of the global airline industry is in high cotton; in fact the IATA forecasts that 2016 will be the most profitable year on record for the industry (following on from 2015, which was also the then-most profitable year). Outside of a couple of problematic jurisdictions – Russia, Brazil, and Malaysia, for example – the global aviation industry has never been more profitable.

As you might expect, record profits are prompting many airlines to grow their fleets and expand into new routes – this has caused pressure on yields (‘passenger revenue per available seat mile’, or PRASM), since the addition of capacity generally forces prices down (especially when coupled with lower fuel and healthier airlines competing for share). This may be an issue for airlines’ profit margins on a per-unit basis (though overall profit dollars are clearly still rising). But it is very difficult to reconcile record profits and higher growth at the major airline clients with meaningfully lower aircraft valuations – for the simple reason that there are no major bankruptcies that would cause a flood of un-utilized planes to hit the market. A case in point: AER’s plane utilization currently is 99.3%, and has not dipped below 97.5% since 2005 (from AER Sep’15 investor day presentation):

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However, it would still be theoretically possible for lessors to take losses on aircraft coming off lease, if there was not enough extant demand for them to sign new leases at rates that preserved the then-values of the aircraft. This appears to be something of a concern within certain segments of the market, in particular for older Boeing wide-body aircraft. We will look at specific exposures for Aercap in particular shortly, but for now it is important to recognize that leases are generally long-term agreements spanning 10-20 years – often, the majority of an aircraft’s life usable life. Lessors take special care to place and lease aircraft in such a way that large chunks of their fleets do not come off lease at the same time, potentially pressuring residual values. As a result, the idea that a large portion of a given lessors’ fleet could or should be impaired imminently stretches credulity.

Take Aercap, for example. As of end-2014 (the last full year of reported data), an average lease term on a new lease came to 144 months (ie, 12 years), while even re-leases came to 7.5 years. The company also was active in extending current leases with clients, with the average term on extensions amounting to 4 years. In terms of lease expirations, AER discloses that total planes rolling off lease amount to 176 planes in 2016 and 172 planes in 2017 – this amounts to ~14% of their total fleet. Again – this was as of Dec’14, so it is highly likely that a number of these planes to be rolled off have already been re-leased or extended, given current utilization rate is still 99%+.

But even so, digging a little deeper: the Boeing wide-body proportion of AER’s total fleet is ~22%, but the number of Boeing wide-body aircraft rolling off in 2016 and 2017 are only 10 and 20 respectively. This constitutes ~5-10% of total lease roll-offs in either year, or, more importantly, around 1-2% of the total fleet (by aircraft number) or maybe 2-4% of the total fleet by weighted book value. The point is simply that even assuming a) the number of Boeing wide-bodies rolling off in the next two years is this high, and b) it is impossible to re-lease these planes globally at all, and c) a full impairment of these assets is necessary – then even in that case the impact to AER’s net book value is likely only a couple of percentage points.

In reality, even this assessment is too bearish. For one – the average age of AER’s fleet is ~7 years, meaning old-tech, less-fuel efficient planes should actually see higher residual demand than in previous roll-offs due to the much higher operating leverage they provide at lower fuel prices. Hence, I expect secondary demand for these kinds of planes, absent near-term volatility, to be solid. Secondly – an independent valuation of AER’s fleet, conducted about a year ago, suggest the net book value of the fleet added an additional ~30% to stated book values as recorded in AER accounts. See below from AER’s investor day last September:

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While valuations have undoubtedly come off since then, it nevertheless accords AER a huge buffer against potential impairments in that a good portion of the true value of the fleet has not yet made it into AER’s state book value. As a check on this number, bears may want to consider AER’s long-term track record of trading aircraft: since 2006, AER has sold over 400 planes at an average gain of $1.6m per plane.

Explaining the pessimism

AER now trades at ~70% of (understated) book value whilst generating 15%+ sustainable RoEs, has the best order book in the industry, the most scale and customer diversification in the industry, and has de-levered to the point where it likely gets an investment grade rating in the next 1-2 quarters. Most interestingly, there is a massive disconnect between where the equity trades – a large discount to book, and <2x operating cash flows – and the credit – where benchmark 5yr senior unsecured paper trades just under par and exhibits little if any distress. In my experience, the credit market usually gets it right.

While I have been talking most entirely about Aercap, there is a level of pessimism here regarding the industry that seems far too short-sighted, and I am at a loss as to why these values exist in the market today (this explains why I have been buying!). Boeing’s announced production cuts reflect either weakness in the cargo market (which is almost totally peripheral to AER, and of minimal importance to the lessors generally), or in the pre next-gen delivery schedule for the 777. Indeed, at the same time as cutting the 777 production schedule, Boeing increased the production rate for their narrow-body offerings, suggesting the 777 production cut could simply be an issue of clients not wanting to buy ahead of new tech offerings to be launched from 2020. You could even conceivably argue that OEM supply-side discipline in cutting production is a good thing and supportive of valuations. As I have previously argued, the effective duopoly in aircraft manufacturing is beneficial to the maintenance of such production discipline because ultimately Boeing/Airbus are the biggest losers if they over-produce and flood the market.

Ultimately, I think much of the recent price action can be explained by technicals. AER is a well-owned hedge fund stock, and has signficantly under-performed the more-expensive, less-diversified but less-owned Aircastle (AYR) by ~12% in the last month alone (see above). Not only that, AER has perceived greater wide-body exposure than some peers as well as a larger China business (around 10% of the fleet is in China, though the CEO made pointed comments China’s secular growth outlook for air travel is unchanged). But as this discussion suggests, I view the majority of issues facing the company and indeed the sector as transitory, and the recent weakness as the reaction of the fearful rather than the prescient. At ~$30, the stock could retrace 50% and still look cheap (near 1x 2016 book and 7.3x EPS) – so I have been sizeably adding to my long position.

Disclosure: long AER

Behavioral investing case study: short Chipotle

Regular readers will be aware that I have something of a penchant for investing/trading not just with a view to the underlying fundamentals, but also occasionally in advance of behavioral changes that can affect those fundamentals and thus move a given stock. In this vein, I shorted Lumber Liquidators (LL) earlier this year, purely on the basis of a massive consumer shift away from LL product after the damning 60 Minutes allegations of carcinogens in some of their laminates. Guilty or not, I reasoned, the cost of remaining a LL customer was, for the ordinary consumer, simply not worth the risk of buying even at discounted prices. LL stock is now $15.

With regard to the power of ‘behavioral investing’ the current situation regarding Chipotle Mexican Grill (CMG), the ubiquitous and heretofore incredibly successful Mexican fast food restaurant chain, is another case in point. CMG has been a massive multi-year investment winner, is (or was, until very recently) a core holding of growth investment managers, and has a large and growing base of dedicated consumers across the United States. Operational excellence – CMG had mastered the art of serving customers faster than any other QSR chain – and secular growth potential (due to the increasing Hispanic population) had led to long-term above double-digit growth in sales and EPS, and the stock enjoyed a huge multi-year run. Ten years ago, the stock was $50; a month ago it was over $700.

Much of this thesis has changed in the last couple months, however. The first warning shot came with the 3Q report, where CMG reported comp store sales growth fell below 3% (+2.6%) vs +4.2% in 2Q. Positive comps in a difficult environment are nothing to sneeze at, to be sure, but it has become clear in recent quarters that CMG is running up against the natural limits of comp sales increases, having enjoyed heady comp store growth for so, so long. Sure, the company is still guiding to opening ~200 stores a year, providing for ~10%+ sales growth (current store count is ~1700) assuming flat comps. But with the stock trading in mid-October at ~40x earnings, low-single digit comp growth was taken negatively, and the stock fell below $700, to ~$675.

More recent newsflow has been much worse, and directly relates to the opportunity now. In early November, CMG announced they were shutting 43 stores in Portland and Washington state, due to the outbreak of the E.Coli virus amongst a number of people who had eaten at Chipotle restaurants in those states. CMG stock fell further – to $610 – though it initially appeared that the damage could be limited to a local supplier to restaurants in Washington and Oregon.

But despite subsequently re-opening these stores, by last week, it had become clear that E.Coli cases had spread to nine states, including the Mid-West and East Coast (casting doubt upon a whole new batch of regional suppliers, or indeed something specific to CMG’s supply chain processes). Worse, after the close Friday, CMG reported that consumers were abandoning the chain en masse: comp sales – predicted to be +3% just a month earlier – posted -20% in the days following the 43 restaurant closure, before moderating to -16% in the back end of November. As a result, the company pulled its 2016 comp view (for low-mid single digit comp increases) and, to my mind, it now appears highly likely comp sales will meaningfully decline in 2016. It was in the after-market on Friday – with the stock already down 30%+ from the highs – that I shorted CMG, at $525.

The behavioral calculus here is pretty simple: why would anyone in their right mind eat at Chipotle in the near-term? E.Coli is a very nasty virus, and can be deadly; and it is quite clear this is not an isolated outbreak anymore (nine states, over 50 hospitalizations). Consumers are clearly voting with their feet, and thinking logically, the cost to a consumer for not eating Chipotle (and say, going to Qdoba instead) is zero, while the penalty for not changing your behavior could be very severe. It is almost a given, then, that comps will turn meaningfully negative in the short/medium-term.

I would also be wary of banking on a quick rebound in comps, even if the situation appears to be brought under control. As mentioned above, there are very low to non-existent switching costs here and there are a plethora of other similar options in most US locations (Taco Bell, Qdoba, El Pollo Loco, Chuy’s, etc). Furthermore, food scandals in particular capture the public imagination and provide plenty of scary headlines for 24 hour news channels, which, combined with the low switching costs mentioned, could keep CMG demand quite low for the forseeable future. And finally, even if no other cases of E.Coli are reported, it seems quite likely some of the victims will have viable cases to press for damages from CMG, especially if ongoing investigations reveal meaningful fault on the part of CMG’s processes (not inconceivable given how widespread the problems have become).

None of this should be life-threatening to CMG as a company. But the beauty of this situation is CMG is still priced not just for growth but for high growth. Consider: at $560 (Friday close), CMG trades at 30x next years consensus EPS, and 15x EV/EBITDA, despite just 11% expected sales growth, and 9% EPS growth. I would argue that these numbers must continue to come down, especially in light of the recent disclosures that the company is seeing recent comp sales in the -16-20% range. But even before the E.Coli scandal. this was a rapidly maturing growth stock that somehow garnered the kind of lofty multiple deserved by a mid-life growth story with a long, long run-way still ahead of it. As anyone who has followed retail or restaurant chains from Michael Kors (KORS) to El Pollo Loco (LOCO) will tell you, generally speaking you do not want to be left holding a richly-priced growth stock when the growth disappears – and E.Coli scare aside, CMG could be confronting that exact point now. The E.Coli situation may just catalyze and clarify the downside in the nearer-term.

To my mind, current consensus models about a 10-11% sales hike from new stores and a flat to low single digit hike from comp sales next year, all with some margin compression (50bps or so at the GM level) to get you to ~9% EPS growth. To me, this is wildly optimistic and I would expect both much lower comps, as well as a slower pace of store openings, as the company struggles to get to grips with the E.Coli fallout. In a scenario where comps drop modestly (5%?), store openings slow to ~7% unit growth, there is some margin compression due to discounting (but not counting the announced ‘one-time’ costs to clean up the supply chain),  it is not hard to see CMG posting flat to +5% EPS growth next year, or say ~~$17-17.5 vs current consensus of $18.6.

This may not seem like a huge delta but in reality I would not be surprised to see consensus fall to year-on-year earnings declines. Putting even just a 25x multiple on say $17 of earnings – still a huge premium to the growth rate – suggests a $425 stock, or another ~20%+ downside from here, and frankly I don’t think 25x is the right multiple anyway (hint: it should be lower). The upside risk case is fairly moot given E.Coli newsflow should remain negative and even if it doesn’t, the behavioral thesis suggests consumers will really take their time coming back to the stores – which in any case were running at much slower comp rates than historically, despite the cheap stock.

Adding it all up, and CMG looks like another good ‘behaviorable’ risk/reward trade on the short side.

Disclosure: short CMG

Square – does one good idea make a viable business?

Square (SQ), the San Francisco-based upstart payments processor, is an intriguing company on a number of levels: for one, it’s CEO, Jack Dorsey, invented Twitter, has had numerous profiles appear in respected publications like The New Yorker and Wired, and has even been compared to his erstwhile idol, Steve Jobs. But aside from the ‘Dorsey effect’, Square has been ‘through the ringer’ as a private company and is going public at an interesting time in its corporate evolution. All this piqued my interest so I decided to take a closer look at the company.

Square burst onto the start-up scene in 2010 with a good, or perhaps even great, answer to an unmet need: how could small businesses (often mobile) accept payment by credit card? The original Square dongle – a small white appendage you plug into the headphone jack of an iPhone – immediately took off with small businesses across the US due its combination of form (sleek and sexy), functionality (easy to sign up and use), and cost (original dongles were given away free to build share; processing fees were and are set lower than the comp as well). The visual similarities, along with the innovative yet simple solution to a pressing need, initially drew the Jobs comparisons.

Those comparisons were short-sighted, however, for a few reasons, but mostly because Steve Jobs would never sell a premium product at a discount to market – in fact he was famous for making the best possible product and letting consumers come to his product on his terms. Dorsey, of course, did not have this luxury: payment processing margins are so thin (around 1% net of each transaction, after paying fees to the credit cards, and before provisioning for operating costs) that he could not simply build the coolest product and hope the customer would show up at his door. Instead, he would need to seek out the customer (via loss-leading dongle giveaways), build scale, then hope to up-sell ancillary services (POS systems, invoice/receipt management, tax-related services, credit provision, etc) to build profitability later. Along the way, Square would hope to transition – or at least grow exposure to – much higher-volume enterprise (read: big business) users, since small businesses of course process many fewer transactions, are harder to scale (a new client win counts for relatively little) and are smaller targets for add-on upselling.

Win share with low-value customers, build relevance, transition from low-value to high-value customers once demonstrating a value proposition, then make money – not a bad model, as far as it goes (except perhaps the part about starting with low-value customers). Of course, note that success is dependent not just on growing low-end share but ALSO upon transition the offering up the value chain. The fundamental issue for Square today is that, four years in, it has become painfully clear that no matter how much the small-business segment has been a success, growing share with larger payers has been, all told, a failure – and it is thus extremely unclear whether the model will ever profitably scale. Square’s experience with Starbucks is a telling example.

When Square first announced its deal (2012) to provide POS solutions and process all card transactions at Starbucks’ 7000+ US outlets, it seemed like a massive win. Square was moving beyond small business and into the enterprise; it could push out ancillary products (Square Wallet, etc) to Starbucks users as well as hopefully to Starbucks corporate; and Starbucks even took an equity stake in the company.

But fast forward just three years and Square’s S-1 (pre-IPO) document depicts promising opportunity gone awry. Square cumulatively lost ~$80mm on Starbucks transaction processing alone (ie, not counting the operating expenses to support the business), while Starbucks has opted to move to another payments process from October this year. The problems were various: transaction volumes at Starbucks basically stopped growing this year – implying  consumers simply didn’t care to use the product – while Square was unable to up-sell ancillary products either to Starbucks customers (eg, the failure and eventual shut-down of Square Wallet, a Paypal/Venmo/Google Wallet competitor) or to the company. Subsequently, various articles have suggested Square only won the business back in 2012 by severely under-cutting the then-processor (Bank of America) on price – not exactly a sustainable way to profitably win new business.

The financial implications as reported by Square are also troubling. In the IPO offering docs, Square takes the somewhat aggressive approach of removing all the Starbucks related business from their ‘Adjusted’ revenue and EBITDA metrics. This effectively treats the Starbucks experiment as a discontinued operation, which it is, given the service will stop from October this year. But the adjustment of Square’s financial reporting to remove Starbucks numbers also gives the impression that this experiment – despite being ~15% of Square’s total transaction revenues in 2014 and 1H 2015 – is immaterial to Square’s on-going operations and prospects, which I believe is severely misleading. After all, earlier in the S-1, Square proudly trotted out the below ‘GPV’ (Gross Purchasing Volume, a measure of the $ value of all transactions processed by Square) chart, suggesting a successful transition to larger merchants was an ongoing part of the Square growth story:

Capture

Looking at the financials, it is clear that Starbucks represents most all of the ‘>$500k annualized GPV’ exposure (and likely a good chunk of the ‘$125k-$500k’ range as well), since they accounted for 15% of transaction revenues and at lower-than-average take-rates (thus implying higher % exposure of GPV). As such, the spectacular failure of the Starbuck deal demonstrates both that go-forward Square will be, once again, most entirely a small-business focused payment processor; and that the company cannot make money serving enterprise clients. Both of these deductions suggest serious concerns over the ultimate scalability of the model.

At this point, you are probably wondering why Square hasn’t caught on with enterprise clients or larger consumer-facing businesses (despite the Starbucks debacle). After all – if it is such a hit with smaller businesses, surely the offering has something going for it? But recall that Square’s initial market-share gains were a function of a) unmet needs; b) winning share on price; and c) ease/efficiency of use. Of these three factors, you could argue only in the last instance does Square hold an advantage when it comes to larger enterprises (if you believe Square’s POS interface, and back-end offerings are more efficient than the comp), though even this is debatable. But as for points a) and b): clearly the corporate market is highly competitive (Micros, NCR, First Data, a number of banks, and even the likes of Paypal now are all here), and Square cannot waltz in and offer a solution to an unmet need because, frankly, the need is being met. As for b): the Starbucks disaster clearly demonstrated how competing purely on price for larger-scale business worked neither for Square nor the client. That is not to say it will never work, and Square won’t win any share – but certainly we should deduce that the chances of Square being able to replicate its initial and ongoing success with small businesses amongst larger enterprises – in the face of furious competition with more experienced, cashed-up players – is much, much lower.

Competition is coming to the small business market

The challenges Square appears to be facing vis-a-vis large enterprises are tough enough; but the coming threat to its bread-and-butter business of serving small businesses could be existential. As discussed, Square is winning in small businesses mostly because they were a first mover to an unmet need – but they are no longer the only player in town. Both Paypal and Verifone (amongst others) have already released competing dongles designed for mobile small businesses; others, like Google could soon follow. I will be the first to admit the Paypal and Verifone dongles don’t look very cool but both companies have significantly greater financial resources than Square,  and Paypal especially is on a growth mission to prove its relevance and defend its dominant share in another vertical (P2P payments) by expanding turf. Furthermore it has been an aggressive acquirer of ancillary services like Venmo and Xoom – both far superior offerings to Square’s nascent ‘Square Cash’ money-sending app (and we already mentioned the abject failure of Square Wallet). Suffice to say that the small-business payment processing space, though still likely to grow rapidly, may become much more price competitive going forward.

The other corollary of this trend would be the need for Square to spend much more in advertising dollars to defend or win share – a problem when the business is already having trouble scaling, and advertising dollars were actually cut in 2Q’15 to make incremental operating losses seem less bad (likely to try to juice numbers for the IPO). As Square says in its S-1:

Nearly half of our sellers find us and sign up, rather than us finding them. This is the result of building services that deliver value and that sellers eagerly recommend.

While of course it is great to have a killer product that customers eagerly recommend, sentences like the above read to me as code for increasing marketing spend as the company grows beyond its initial core of early adopters – especially in the face of new and fierce competition. This does not bode well for trying to scale operating margins.

The future of payments is…Apple Pay or die?

I specifically haven’t talked much about where the payments industry is heading, frankly because I am not an industry expert. But even a few very broad strokes suggest a problematic outlook for Square. We already know Square is facing Herculean challenges in entering the large-enterprise space against entrenched, capital-rich competitors. But even looking at changes coming to the point of sale (POS), it is difficult to see how Square can maintain a value proposition in the far future.

Take Apple Pay, for example. At the moment this is basically a function that allows you to swipe your iPhone in front of a NFC (near field communication) terminal at CVS and pay for your groceries (via a link to your debit/credit card, etc) without dipping your card. That is to say, at the moment, the payment architecture (whereby payment processor routes the transaction through the credit card network, receives approval/denial from the issuer, and routes it back) does not change – the consumer simply does not dip the card. This allows room for payment processors, like Square but including the behemoths like First Data, etc, the ability to take a fee for processing the transaction.

But if Apple Pay goes mainstream (as I and many think it will) and the technology improves slightly to allow for ‘phone-to-phone’ NFC payments (this was already speculated a year ago and in my view happens in the near-term), all of a sudden it becomes much more murky for payment processors. Of course, such a move immediately obviates the need for a physical dongle: this immediately puts Square’s main hardware offering (and key network building-block) atop the technology dustbin. As already discussed, since Square is an entirely small-business focused processor, this move alone likely hits them harder than any of its competitors as all of a sudden their core user-base will no longer need their Square dongle and hence a good chunk of their transaction revenue could dry up.

But taking this one step further, it is not a huge leap to think that Apple – already possessing many hundreds of millions of customer accounts and having built its own physical ‘network’ through the dispersion of hundreds of millions of iPhones-cum-payment terminals – will just become a payment processor itself. This puts the entire payment processing industry in Apple’s headlamps – not the place you generally want to be, given their resources and track record. (As an aside: the credit card companies, who provide value because they can price the credit risk of their customers, probably have more survivability in this scenario, but will still probably see price pressure from such a development).

Other issues – fraud costs a function of under-investment?

This is all pretty scary stuff, and we haven’t even gotten to the pricing of the shares! Actually, since the price hasn’t been set, I will skip an in-depth analysis of the ‘right’ valuation for Square and suffice by saying that a very high multiple of revenues (maybe 9-10x, assuming it comes at a premium to the $6bn valuation achieved in the last private financing round late last year) for a high-growth yet high-loss, high-cash burn, minimally-scaling business with demonstrated failure beyond its unprofitable core market and existential threats probably just a couple of years out, is fairly crazy. The only thing this IPO will do is make Paypal (PYPL) look exceedingly cheap at ~4x sales, low double digit EBITDA multiples for a much-better positioned company (already fully scaled and dominant in its core vertical) churning out 20% operating margins and 20% top line growth today.

What is actually more interesting is a couple of line items in the S-1 that may not be noticed by many but I think could be important: namely, “Transaction and advance losses“, as well as net capex spend in recent years. “Transaction and advance losses” is a line in operating expenses that the company describes as:

We are exposed to transaction losses due to chargebacks as a result of fraud or uncollectibility. Examples of transaction losses include chargebacks for unauthorized credit card use and inability to collect on disputes between buyers and sellers over the delivery of goods or services…For the year ended December 31, 2014, our transaction and advance losses accounted for approximately 0.1% of GPV.

These losses have been small in % GPV terms as the company chooses to emphasize – but when reflected as a % of either gross (ie, before paying fees to credit cards, banks) or net transaction revenues, these losses are concerning (4.6% of gross, and 15.7% of net transaction revenues, respectively, in 1H 2015).

Clearly 16% of your net transaction revenue – when gross margins (even excluding Starbucks) are only ~35% – is highly problematic. And thinking about it another way – on a gross basis, this scale of fraud-related loss – around 5% – is strange given this is roughly what American Express provisions for credit losses – but Square is of course not a credit provider, it is just processing the transactions. To have this level of fraud-related losses hit them is fairly inexplicable and I think speaks to under-investment in necessary fraud-prevention software, human support, fail-safe transaction oversight, etc – itself a function of how capital-poor the company has been for much of the last couple of years. There could also be a corollary to Square’s ease-of-use business model: the company promises transactions clear for merchants in 24 hours, which limits the window in which they can catch potentially fraudulent transactions and thus save themselves from these kinds of losses.

This brings me to Square’s capex, or rather lack of it. Square has spent a pitifully low amount on capex in recent years: just $29mm in 2014, and only $20mm in 1H 2015. This equates to 3-4% of revenues, while direct competitors like Paypal are spending 8-10% of revenues (on a much larger revenue base) and of course behemoths like Apple, Google, have limitless resources. It is just really tough to see how Square can even attempt to keep up with the Joneses at this level of capex intensity. Simply put – they won’t.

Why IPO now?

All this leads back to the most important question: why IPO now? There have been persistent sale rumors regarding Square in the last year or so – apparently they were going to be sold to Apple for $3bn last December, though Dorsey turned that down and instead Apple focused on Apple Pay, while Square did another funding round at $6bn implied. Retrospectively, that move is looking more and more to me like Dorsey won the battle but lost the war.

Frankly, the company as currently constituted – one good idea and great product, a number of product failures and unproven new ventures, highly cash consumptive, large market opportunity but increasing competition and existential threats around the corner, and very limited cash resources – would fit much better within the fold of a larger, cashed-up organization like an Apple or a Google than fighting on its own in the unforgiving public markets (my guess is this is what happens down the line, assuming they maintain relevance). Which of course begs the question, ‘Why IPO?’, and the pertinent answer is most likely ‘dumb money’ – that is to say, strategic acquirers had no interest in paying nosebleed valuations but the unknowing public presumably will (but not you, dear reader!).

It will be interesting to see how Square prices and trades: the IPO market has been quite tough, given recent volatility (First Data repriced their IPO and it traded poorly), and Square will be a ‘pie in the sky’ speculative offering. But even if it defies the gloomy backdrop and trades well, this is another hot tech IPO that, like so many others (Etsy, Groupon, etc) is more likely to end in tears. Caveat emptor.

Disclosure: no positions (but may go long PYPL short Square post-IPO)