Forever 21 Turns 22

Forever 21, the store known for its trendy fashions among teens and young adults turned 22 today when the company filed for its second Chapter 11 bankruptcy since 2019.  During the 2019 bankruptcy, the company closed 150 of its 534 stores and was brought out of bankruptcy by label owner Authentic Brands and mall operators Simon Property and Brookfield Asset Management. This time, Forever 21 is not as lucky as the company has announced liquidation plans.

It Was In My Other Pocket

Have you ever been short on money and gone through your clothes, only to find a $20 bill that you had forgotten about? We are sure that you were relieved. The same thing just happened to cryptocurrency exchange FTX, which filed for bankruptcy back in November. FTX attorneys announced that the company had found $5 billion in cash, liquid cryptocurrency, and other liquid investments! Of course, it appears that there may be other pockets to check as the total value of missing customer assets is $8 billion.

Liquidity and Bankruptcy

As investors have learned, like any other investment, cryptocurrency is subject to volatility. The recent bankruptcy filing of crypto exchange FTX shows, this volatility can be extreme. For example, the Ontario Teachers' Pension plan wrote down $95 million due to the collapse. As you probably know, bankruptcy occurs when liabilities are greater than assets. However, bankruptcy can result from a finer distinction between liabilities and assets, namely liquidity. In the case of FTX, the company had $8.9 billion in liabilities and $9.6 billion in assets. So was the company forced to declare bankruptcy? Liquidity. When you look at the balance sheet, FTX had $900 million in liquid assets, $5.5 billion in less-liquid assets, and $3.2 billion in illiquid assets. Think about it like way: You owe $10,000 at the end of the week but your only asset is a $100,000 house. Yes, your assets are greater than liabilities, but you likely won't be able to sell the house and receive the cash for the sale by the end of the week, so you could be forced into bankruptcy. But FTX had other problems as well. John Ray, who was appointed to oversee the FTX bankruptcy and has overseen other large bankruptcies such as Enron, stated "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

COVID-19 Bankruptcies

As we mentioned in the textbook, financial leverage is a double edged sword. With the COVID-19 lockdowns, the economy slowed dramatically and the effect on highly leveraged companies was immediate. During 2020, 244 U.S. companies with liabilities over $50 million filed for bankruptcy. This was a 70 percent increase from 2019, and the most since 2009's 293 filings. In what may be more telling, during 2019, 62 percent of companies reported being a net investor. However, by the fall of 2020, only 52 percent of companies reported being a net investor.

Wirecard Turmoils

Creditors of German digital payment processor Wirecard, which advertised "Beyond Payments," may find that the company's debts are beyond payment. Wirecard also proved that accounting fraud is unfortunately worldwide when it filed for bankruptcy yesterday. The company said that €1.9 billion ($2.1 billion) in cash that was on its balance sheet probably never existed in the first place. Now, things have gotten bad for the company's auditors as the German shareholder association SdK announced that it had filed a criminal complaint against the company's auditor Ernst & Young (EY). SoftBank, a major investor, also announced that it planned to file against EY. In its defense, EY stated there were "clear indications that this was an elaborate and sophisticated fraud, involving multiple parties around the world at different institutions, with a deliberate aim of deception" and that "even the most robust and extended audit procedures" were not enough to uncover the fraud.

Hertz SEO

We had previously discussed the Hertz bankruptcy filing. In an indication that the current economic conditions caused by the COVID-19 lockdown are unique, Hertz is planning a secondary stock offering while in bankruptcy. An SEO in the middle of a bankruptcy filing has never been attempted before. The company has warned prospective shareholders that it is unlikely that they will receive anything in bankruptcy, and barring a rapid improvement in the company's prospects, will almost certainly be wiped out. Based on the current stock price, Hertz hopes to raise $500 million. Hertz currently owes about $2.3 billion. This is certainly an SEO we are not trying to jump in line to buy.

Oil And Gas Bankruptcies

As we discussed in the textbook, financial leverage is a double-edged sword, increasing shareholder returns in good times, but causing financial distress in downturns. Since companies in an industry tend to have similar leverage ratios, a wave of bankruptcies can occur in that industry. The high leverage in the oil and gas industry appears to be reaching a tipping point as 26 oil and gas producers have filed for bankruptcy this year, almost matching the 28 for all of 2018. There is still a way to go to match the 70 bankruptcy filings in 2016, which was caused by low oil and gas prices.

Is There Too Much Corporate Debt?

A common refrain among policy experts is that the corporate debt level is too high. In fact, from 2008 to 2018, corporate debt rose from $2.3 trillion to $5.2 trillion, debt-to-EBITDA has risen, and there has been an increase in the number of companies with junk-rated bonds. So is there really too much corporate debt? A recent article from McKinsey indicates that current debt levels may not be as dire as many would lead you to believe. For example, even though the number of companies with debt rated below BBB- has increased, it appears that the reason is not a general lowering of credit rating, but rather an increase in the overall number of rated companies and companies that previously issued unrated debt now being rated. And while the debt-to-EBITDA ratio has increased, the EBITDA-to-interest ratio for most industries has remained stable over the past 10 years.

In short, it may be that the fear of too much leverage in corporate America is overblown. However, as the article notes, companies should still undertake stress testing to exam the risks associated leverage. If you are not familiar with stress testing, it is similar to scenario analysis in capital budgeting, except we focus on the worst case analysis. Stress testing can indicate scenarios that would place a company in financial distress, allowing for prior preparation if these circumstances should arise.

Bankruptcy Contagion?

Brazilian airline Avianca Brasil filed for bankruptcy restructuring in December, which is not an unusual event. However, Avianca Brasil licenses its name from Avianca Holdings SA, a Colombian airline. Avianca Holdings is a larger company, although the companies are owned by brothers. In a recent SEC filing, Avianca Holdings stated the close association between the companies “could generally result in an overall decrease in customer confidence, any of which could lead to a significant loss of business.” Whether this loss of costumer confidence occurs to Avianca Holdings occurs is yet to be seen, but Avianca Holdings also may be forced to take on four airplanes that it subleased to Avianca Brasil.

Defaulting On Bond Covenants

Windstream Holdings, a rural telecom company, is expected to file for bankruptcy after the company recently lost a lawsuit filed by Aurelius Capital. The lawsuit stems from Windstream's 2015 spinoff of the company's Uniti Group. Aurelius filed the lawsuit arguing that the spinoff violated protective covenants in the company's bond indentures. Windstream was forced to pay Aurelius $310 million. Since the ruling legally means the company has defaulted in its debt, other bondholders can now force immediate repayment on the bonds they hold.

PG&E Files Bankruptcy

Several weeks ago, we discussed the possibility that PG&E might file for bankruptcy. Yesterday, PG&E made it official with its bankruptcy filing. PG&E listed assets of about $71 billion and liabilities of about $52 billion in its filing. The advantage of bankruptcy for PG&E is that it will slow down lawsuits that have been filed or will be filed in relation to recent wildfires in California. It is estimated that the company faces about $30 billion in claims from these wildfires. PG&E may take up to two years to emerge from bankruptcy.

Lehman's Bankruptcy Tally

The Federal Reserve Bank of New York released a final (hopefully) estimate of the cost of the Lehman Brother's 2008 bankruptcy filing and the numbers are staggering. Compensation and benefit costs amounted to $1.97 billion, professional and consulting fees were $2.56 billion, and other operating expenses were $1.37 billion, for a total of $5.9 billion! This does not include the $1.36 billion paid out for the Security Investors Protection Act (SIPA)claims. While the bankruptcy costs (excluding SIPA claims) were about $6 billion, the number appears to be in line with other bankruptcies. Research indicates that bankruptcy costs are generally 1.4% to 3.4% of a company's pre-bankruptcy value. For Lehman, which had $300 billion in assets, bankruptcy costs were about 2% of assets.

Sears Bankruptcy

Sears survived the Great Depression and two world wars, but couldn't survive internet shopping. As a result, the company was forced to file bankruptcy and now it is going to get expensive. Lehman Brothers 2008 bankruptcy cost more than $2 billion, while the Toys R Us bankruptcy in 2017 has cost $375 million to date and still counting. In the Sears bankruptcy, at least 36 lawyers are charging more than $1,000 per hour. The company has employed six law firms, three investment banks, two financial advisors, and seven others who are providing tax, real estate, and other bankruptcy services. One law firm has already billed more than $5 million in the first two weeks of bankruptcy. 

PG&E Bankruptcy?

In early November, the deadliest wildfire in California history broke out. And while the exact cause has not been determined, the California Department of Forestry and Fire Protection is investigating power lines operated by PG&E as a possible cause. PG&E was previously blamed for a fire that occurred in 2017 and had to issue bonds to pay for claims from that fire even though the state has not issued a report on the cause of that fire. In the textbook, we mentioned that at one point, Continental Airlines filed bankruptcy in order to reduce labor costs. Now, there is a possibility that PG&E may use the bankruptcy process to seek relief from possible financial claims arising from the 2018 fire.

Sears' Financial Distress Costs

We mentioned in the textbook that there are indirect financial distress costs, which, unfortunately, Sears is experiencing. Because of Sears' financial problems, suppliers are not willing to sell to Sears, or are tightening credit terms. Part of the reason is that suppliers continued to sell to Toys R Us, but then only received 20 cents on the dollar. A poll indicates that 66 percent of suppliers are demanding cash payment or payment on delivery and 26 percent were on regular terms, but not longer than 30 days. In fact, more than 200 suppliers have quit selling to Sears at all. This can create a "death spiral" as Sears cannot order goods to sell at a time when sales are already low, meaning fewer customers even go to Sears' stores. 

Netflix's Capital Structure

As we discussed in the text, the optimal capital structure for a company is the result of many interacting factors. And while we can observe capital structures in practice, it is less frequent for a company to state its target capital structure. Recently, Netflix announced that was issuing $2 billion in debt to help the company reach its optimal capital structure, which the company said should be 20 to 25 percent debt-to-market capitalization. At the current market value of equity, the company would need to issue between $22 and $30 billion of debt. What makes this debt issue really interesting is that though company is burning through cash, the announced purpose of the bond is to increase leverage.  

Bond Ratings And Mergers

A recent article in Bloomberg highlights a potential threat to the bond market. Recent years have seen a number of high-priced acquisitions funded by debt. As a result, many of these companies have dramatically increased leverage as measured by Debt/EBITDA. This has caused a drop in credit ratings, with $2.47 trillion worth of debt now rated as BBB, more than three times the 2008 level of BBB debt. Even though many of the deals are funded through debt, a common assumption is that synergies and the improved cash flow would allow the company to quickly pay down debt. But a hiccup in the economy or synergies not materializing could limit debt pay down. In the last three recessions, from 7 to 15 percent of investment grades bonds were downgraded to junk status. Given the higher amount of debt with lower credit ratings, a recession in the next couple of years could push a massive amount of corporate debt into junk territory.

Sears Bankruptcy

It appears that Sears, once the world’s largest retailer, may file for bankruptcy as soon as this weekend. One alternative being explored is a Section 363, or stalking horse, filing. In a Section 363 filing, the company would sell some of its assets, but the sale would still have to be approved by the bankruptcy court. For example, CEO Eddie Lampert has already offered $480 million for the company’s Kenmore appliance and home improvement division. If successful, the company would exit the bankruptcy with fewer assets, but less debt as well.

Debt and Taxes

A proposal to reduce the U.S. corporate tax rate from 35 percent to 20 percent also includes a provision to limit the tax deductibility of interest expense. Corporations have responded in a dramatic fashion to this proposal by repurchasing $178.5 billion worth of bonds through early October of this year. In contrast, companies repurchased only $87.3 billion of bonds for the same period last year. Of course the potential increase in interest rates could also be driving debt repurchases as companies look to lock in low coupon rates. For example, Wal-Mart issued $6 billion in new bonds to help finance an $8.5 billion repurchase. Both causes have driven debt repurchases to astounding levels.

Toys R Us Joins Retailers In Bankruptcy

With $5 billion in debt, Toys R Us becomes the second largest retailer in U.S. history to file bankruptcy, following only KMart. The bankruptcy filing is at the worst possible time for the company as it is ramping up inventory for the fourth quarter, which typically accounts for about 40 percent of the company's revenue. Overall, 2017 has been a bad year for retailers as 35 retailers have filed for bankruptcy, including Wet Seal and Radio Shack, who filed Chapter 22 bankruptcies.