Yellow Media restated credit facility – can they survive?

As Yellow Media’s shares (preferred and common) continue their descent to zero, they did release what was in their restated credit facility (attachment).

Notably are the following:

1. Article 8 covenants are fairly obvious – the company must report annual and quarterly statements in compliance with GAAP, etc. There is a reference to budgets and projections (8.1 (c) and (d)) that will likely mean that the creditors will have material information that the public does not have. Probably the same people dumping the preferred shares well in advance of this calamity!

[8.1 (d)] (x) a breakdown of print and online revenues, (y) distributable cash flow and distribution calculations and (z) expected revenue drivers and which projections should be in a format consistent with the September, 2011 Projections.

Also 8.10 requires the company to include more guarantors to the creditor agreement which are subsidaries of the company.

2. Article 9 covenants are more restrictive. They prohibit the taking out of further debt unless if under the credit agreement, except for minor items including capital lease obligations no greater than $25M, and also other minor conditions including intra-company debt;

9.3 prevents the company from acquiring or liquidating companies without being able to satisfy the existing covenants on a pro forma basis;

9.4 requires the company to remit any proceeds above $25M in a sale to the creditors necessary to achieve compliance with covenants on a pro-forma basis;

9.5 is the salient clause – it prohibits distributions to common shareholders (except for the last 2.5 cent common dividend upcoming), but includes the following clause:

(iv) the Borrower may declare and pay dividends on the preferred shares of the Borrower existing as at the date hereof,

This would suggest, as long as the company can make its other covenants that the preferred shares will continue paying dividends.

The important covenants, the performance-related ones, are the following:

9.7 Consolidated Total Debt to Consolidated EBITDA Ratio
The Borrower will not permit the Consolidated Total Debt to Consolidated
EBITDA Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be greater than the ratio of 3.50 to 1.

9.8 Consolidated EBITDA to Consolidated Interest Expense Ratio
The Borrower will not permit the Consolidated EBITDA to Consolidated Interest
Expense Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be less than the ratio of 3.5 to 1.

9.7 is a stronger covenant than 9.8; using the first half of 2011 results as a measure of these two, the company’s ratios would be as follows:

9.7: EBITDA (12-month extrapolated, realizing this is a flawed extrapolation) $366.5M*2 = $733M, debt at June 30, 2011 is $2.39B, for a ratio of 3.26:1. There was a large amount of debt paydown for the Trader Corporation sale, but the larger risk is the EBITDA number.

9.8: EBITDA: $366.5M for the first half; $84.6M in financial charges for the first half, for a ratio of 4.33:1; the financial charges going forward will be less due to the repayment of MTN’s, but the obvious risk here is the decreasing EBITDA;

The raw math boils down to the following: Can YLO keep its head above the EBITDA water? With the Trader Corporation sale, the company will have about $1.7B in debt to worry about, which means that its ultimate concern is being able to generate about $480M in EBITDA on an annual basis (or less if it continues to pay down debt). At present when you extrapolate the trajectory that its EBITDA is declining (2009: $903M, 2010: $860M, 2011: $366.5M in the first half), can they level it off at about 40% less than its 2009-2010 run rate?

If so, the company can survive its credit facility. If not, there will be a default.

High risk, high reward.

The optimistic scenario is if they can stem the decay and be able to survive its credit facility – I would guess that the preferred shares in such a case would trade around $17-18 if there is clear evidence that this is happening. Obviously we do not see any of that evidence currently and the next quarterly report is just as likely to be brutal.

Students of history will also remember that when Nortel was going through its preliminary death throes in 2002, they were contemplating restructuring and their preferred shares went down to about $1-2 before finally coming back up again. I remember that quite distinctly although I never purchased into Nortel preferreds back then. The analogy is not appropriate to this case (different business, different situation) but what is salient is that low prices give high risk, high reward type situations – there are many scenarios where it is likely that the preferreds of YLO will go to zero, but there are plausible cases where they will rise again.

This is why you never ever put significant fractions of your portfolio into picks that are high risk like this one – keep the bets tiny. At this point it’s really tough to distinguish between investing and gambling. Just as a point of reference, if you put 2% of your portfolio into a play like this and it goes up 10-fold (which the low-probability winning scenario is for the preferred shares if the company actually manages to get its act together), that 2% position will be a 20% position at the end of the day if you do not rebalance.

Just remember the likely scenario is that the 2% goes to zero!

Got my hands bloodied up catching Yellow Media

As I alluded to in an earlier post, catching plunging knives (in this case, catching plunging share prices) will leave your hands bloodied, and indeed this has been the case with Yellow Media.

They announced this morning that they will be suspending their common share dividend and also will be reducing the size of their credit facility to $500M, of which $250M will be paid off at $25M/year from the beginning of 2012 onwards.

This caused their common stock to plummet, but oddly enough, caused their preferred shares to drop equivalently, to the tune of 50%.

PR.C shares are down to $3/share, while PR.D shares are down to $3.08/share.

By slashing the common dividend, they will save about $77M/year in cash flow.

With the common share dividend gone, it will remain an interesting decision whether the company will decide to cut preferred share dividends. PR.A will cost the company $10.7M/year, but this will be alleviated when they convert them to shares in April 2012. PR.B will cost $7.6M/year, but this will also be alleviated when the company force converts them in July 2012.

PR.C is the next drain on cashflow – $13.2M/year, and PR.D is $8.5M/year. Both of these series are cumulative and can only be called by the company at par ($25) which is obviously not going to be happening with them trading at $3 over the open market.

The debentures are trading at 32 cents and represents a $13M/year interest expense for the company – these interest payments must be maintained otherwise it will constitute a default – a 20% current yield, but how long will you see those coupon payments being paid?

The real question is: how quickly is the company’s cash flow diminishing? This “decay rate” is the critical variable in determining how financially viable the company is going forward.

The company’s preferred shares are obviously a very high risk and high reward type situation if your assumption is that they are not going bankrupt and they will be able to level off their cash flows at a positive amount.

Berkshire and commodities

Two observations – Berkshire announced that it will repurchase its own shares at no more than a 10% premium to book value. The stock went up about 8% in trading during the session to roughly this level. Book value is $163 billion, while the company has 1.649 million class “A” equivalent outstanding for a book value of about $98,850 per share. Add 10% and this gives a value of roughly $108,700 per share, not too far from the closing price.

I find this interesting simply because Warren Buffett is now a net seller of his own company and he is quite good at using his mouth to talk up or down the market when it suits his purposes – there tends to be a media aura that he is relatively altruistic. I am not convinced that Berkshire makes a compelling value as its analysis is not that easy – essentially an insurance operation with a series of fully-consolidated subsidiaries and a hodge-podge smattering of equity in various well-known companies (including Burlington Northern). When at the scale of Berkshire, the rules of engagement are considerably different since it takes forever to build and exit positions – not as easy as plugging in a market order to buy 100 shares of Microsoft.

The last time Buffett talked about buying back his own shares was when it was trading at $40,000 at the peak of the tech bubble. He graciously offered anybody that was willing to sell at that price can call him up and sell it to him at the prevailing bid on the NYSE at the time. Nobody took him up on that offer.

The other observation is commodity prices appear to have developed a “spike” on the charts. Observe the following:

Although I am hardly a technical trader, my best guess at this time is that the three commodities will head up for the rest of the week or so before declining again and “retesting” the bottom of that spike and likely trending down. There was clearly some sort of liquidation that has been occurring and the market is not that deep.

The close of the quarter

Here are a few things I am asking myself – I do not think these are unique to myself at the moment:

1. How low can 10 and 30-year bond yields go? 1.81% and 2.87% are the current yields, respectively. Why would somebody want to lend the US government money at this rate when the entity they are investing in has its only escape route in debasing its own currency?

2. How low will commodity markets go? Copper has cratered about 25% over the past two months, silver has been taken out and shot in the past week, and even gold is starting to wobble. How much pain can investors in commodities take before they start getting cold feet and bail out en-mass more than they have done currently? My suspicion is that this is the beginning.

3. What should be on my watchlist that will do the best in the event of a recovery? In the 2008-2009 crisis I concentrated heavily on corporate debt investments, but I suspect that whenever the bottom of this market is hit that investors in equities that are zero yield will fare better.

Too many questions, not enough answers. My outlook still continues to remain negative and requiring defensive action and also of the belief that we will continue to see sharp rallies and even sharper declines. There still isn’t enough panic out there. Although VIX is a quantitative measure that a good sector of the population uses, there are some other metrics out there that still show there is complacency.

There is no safety other than in cash

People looking for a safe outlet for capital in the marketplace are not going to see anything except in the form of cash and cash equivalents. Typically commodities were used for the safety outlet, but notably today we see that the S&P 500 is down about 2.8% and gold is down about 4.5%.

Notably, today is the first day where the safe haven of gold is getting compromised in a market downturn. Previously gold used to hold its own against down equity market action.

One day does not make a market, but this trend is something to watch.

Technically you also see safety in 30 and 10-year government treasury bonds (Canadian or US, take your pick), but getting a 1.8% yield for the next 10 years is quite obviously a temporary solution for capital. While this might work best for a fund manager, for an individual cash is much more practical.

Notably, the Canadian dollar got pounded over the past couple days – currency traders have seen a 4% decline in the Canadian dollar:

US dollar strength to a lesser degree has also been witnessed in other major world currencies, including the Euro and Yen.

I continue to remain very skeptical of the markets and am still in a preservation of capital mode – today is the first day in awhile that I’m looking at the dry powder keg and thinking of how I will be deploying it. But that time is not now. The only minor exception I made was in the preferred shares and debentures of Yellow Media (per my previous post) simply because the liquidation of those securities by its existing investors is a mostly independent event of the present market meltdown we are currently witnessing.

It is very difficult to be an index-beating active investor without the ability to side-step market crashes. By side-stepping crashes you can keep your capital freed up for those very brief and opportunistic time that the market is desperately asking for your capital. The market signals this to you with low prices, intense volatility, high bid-ask spreads and desperation. The last real time this happened was in late February/early March of 2009. There was a one week window of opportunity that you had where you could catch the bottom. It is very easy to identify in retrospect, but very difficult to get correct in real-time. Excessive outsized returns over a relatively short period of time (i.e. 200%+ returns on investment) can only be realized with ridiculously low entry points, which in turn requires financial nerves of steel to be the only buy hitting the “buy” button when the rest of the world is liquidating.

If your capital gets caught up in a market crash, it is a simple matter of mathematics to prove why you will not be able to gain much – in the 2008-2009 financial crisis, your average index investor was down 60% from peak to trough, which means in order to just break even you had to see a 150% return from the trough. If you can limit your damage to 10-20% of your portfolio and invest your capital at a more opportune time, it obviously will do wonders to your overall performance, just as how I nearly doubled my capital base in 2009.

A recent 21st century innovation is also that if you carefully analyze the tape, you will also see probable computer program traders that are set on a “fast liquidate” setting by relentless bid hitting. While it doesn’t have to take four years of electrical engineering education to perform a formal analysis of the trading signal, having some quantitative aptitude does assist in the process.

You can get a hint of what you are competing with simply by doing some mental work on how you would program such a trade algorithm, but Interactive Brokers conveniently has some simple algorithmic trade types that give you an idea if your mind blanks out.

It is time to do research on quality securities that will get needlessly hammered by a market downturn, but not nearly time to buy – yet.

Here’s a hint: I would not look at commodity companies.