Friday Workout

Cut Price Gym Subs; Build Back EBITDA; Red Flags Flying High

By Chris Haffenden | Editor | chris@9fin.com

Prospective investors, whether actual buyers of businesses, or those funding them via the bond or loan markets, must be able to rely on accurate and complete information to make their assessment. There are many ways to value a company, but the most popular are via earnings multiples and discounted cash flow models. But can you rely on the underlying financial reporting for your assumptions? What happens if adjustment after adjustment is baked in to boost or diminish value? 

Admittedly, the pandemic has posed greater difficulties in valuing businesses. I can see the rationale of trying to assess what a business could look like post pandemic, by stripping out short-term negative impacts. The term EBITDAC grew out of this. But it’s unclear when and even if these businesses will return to their 2019 performance levels- these figures shouldn’t be taken as a given. Furthermore, by making these adjustments, is it masking the true financial state and resilience of companies in the present? For new issues, this is compounded by more creative uses of EBITDA and add backs to earnings. 

This week brought these questions into sharp relief – for restructuring and primary. 

Cut Price Gym Subs

It is a cliche, but the saying is a good one: “the real value of a company is only what someone else is willing to pay for it”. In the case of Virgin Active, the troubled gym operator, however, creditors could only rely on a heavily adjusted desktop valuation for their payouts under a UK Restructuring Plan. The company failed to undertake a market testing exercise, much to their landlord’s chagrin.

Haircuts to valuations and their assumptions were a hot topic in the contested sanction hearing. 

Initial desktop valuation multiples were haircutted significantly, from a 9x FY22 EBITDA solvent sale valuation in a Deloitte Christmas Eve report, to the eventual 3.9x multiple in their relevant alternative report – used to develop the Restructuring Plan. 

Conveniently the valuation could be based on the relevant alternative - an accelerated sale under a funded administration. This meant that value broke in the senior secured debt, around £39m underwater, equating to recoveries of 84.6p in the pound. 

PwC for the landlords argued a 5.2x multiple (based on the ‘updated case valuation’) is more appropriate, giving surplus value of £72m with value breaking in the unsecured. Longer term, they saw significant future value, accruing to shareholders in return for a ‘marginal’ contribution. 

Valuations were already conservative there was no need to apply a 30-50% discount for a distressed sale, said PwC. Grant Thornton’s analysis for the company had other regional businesses trading at 5.6x to 8.9x. Town Sports in the US is being restructured via a distressed sale at 5.2x, noted PwC. 

Pure Gym bondholders (valued at 10x) and 20x levered might be getting hot sweats here. 

As we outlined in our analysis, Justice Snowden was at times dismissive in his judgment as to landlord arguments. He set down a marker for future valuation challenges saying: “it would be most unfortunate if Part 26A plans were to become the subject of frequent interlocutory disputes.” 

The landmark judgment is worrisome not just for landlords, but for all unsecured creditors. 

Courts are likely to be commercial in their interpretation of proposals, attaching little weight to the number of classes voting against, if they are deemed to be out-of-the-money. Worse still, the courts appear to be willing to allow those in the money to divide up the pie and apportion future value as they like. 

The relevant alternative is deemed the ‘most likely’ option at the time of the submission of the restructuring plan. Alternative scenarios, the conduct of directors leading up to the plan, and the lack of information given for landlords to properly consider what was being offered, were given short shrift by Snowden in his judgment

Virgin Active is close to running out of money, but would senior lenders really object to say £50m injected ahead of them on a super senior basis, to avoid an administration, and a 15% haircut? Surely, the gym operator is in a better position to assess its prospects after all of its clubs reopen with a couple of months performance to see how many members return? 

Those interested in whether the landlord arguments on if their payouts were correct under the relative alternative, should check out the future of the Chiswick Park gym. Downgraded from Category A to Category B, its payout was reduced under the plan from £1m to just £7,000. Late during the Sanction hearing, it was disclosed that Mischon de Reya, lawyers for Chiswick Park, started forfeiture proceedings, confident they could secure a better outcome than under the restructuring plan.

But Justice Snowden viewed this as a stunt and dismissed it as it wasn’t submitted as evidence. My latest 9fin deal prediction is that the Chiswick Park site will become a Nuffield Health by year end. 

Build Back EBITDA

I’ve been editing QuickTakes from our legal analysts for over six-months now, seeing increasing latitude granted to borrowers on their add backs to earnings. 

Here is a recent example (company name and some details redacted):

EBITDA can be calculated with uncapped EBITDA “run-rate” adjustments, including for revenue increases and contracted pricing as well as cost savings/synergies, without any time limit on realising such synergies. As we noted, for this company EBITDA includes                of add backs (30%), more than half of which               is in relation to ‘Cost saving adjustments.’ 

A “super grower” provision is present, meaning that fixed baskets receive a permanent uplift to the highest level reached by the corresponding EBITDA grower. 

Is this the EBITDA equivalent of CDO squared?

Regular readers will remember our incredulity on the add backs assigned to Coty’s latest issuance. Covenant adjusted EBITDA is $1,282.1 million vs $201.9 million Adjusted EBITDA), as we describe in further detail here. “Covenant EBITDA add backs include uncapped cost savings/synergies subject to a 24-month time limit, as well as “extraordinary, unusual or non-recurring items” (Coty relied on this latter category to add back “extraordinary and unusual” COVID-19 losses, including a $500m “estimated contribution impact of lost revenues and earnings”).

Arguably, Douglas paved the way for Coty. It’s stressed refinancing in April came up with a new term ‘management adjusted EBITDA.’ This contained sizable Covid-19 (€68.9m) and Store Optimization Program (€87.7m) effects for the first half of the financial year. 

This week, the German beauty retailer reported Q221 results. On an unadjusted basis it posted a small negative EBITDA figure for the quarter - not that you would know from this helpful slide. 

But it wasn’t all bad, in a small victory for accounting standards, the company noted that the figure is no longer adjusted for credit card fees (less than €10m).

If you thought management adjusted EBITDA (Douglas) and covenanted adjusted EBITDA (Coty) were interesting concepts, this week a new one emerged: “Average Transaction EBITDA.” 

For Cedarici, add backs are once again “uncapped, subject to no time limit and include cost savings, operating expense reductions, operating improvements, etc. EBITDA of €87m is adjusted to €156m. On the aggressive side, but unfortunately not out of kilter with the market. 

But there is a twist, Cedarici can add back the excess, if greater than zero of (x) Average Transaction EBITDA, over (y) Transaction EBITDA for such period.‘Average Transaction EBITDA’ means ‘the amount (determined by the Issuers in good faith) that Transaction EBITDA for such period would be if Capital Markets Volume for such period was equal to Average Capital Markets Volume.’

This allows a business heavily reliant on capital markets volumes to smooth its EBITDA for covenant purposes. With weak asset and value leakage protections, what is there to stop the sponsor from taking a dividend in a poor year? 

Sometimes it can be hard to know which EBITDA metric to work off. 

For those who like variety, Intralot competitor Inspired Entertainment decided to use five. 9fin analysts had a neat solution for the cap table. Skittles, we are open to sponsorship opportunities!

Back to EBITDAC, this one below is impressive.

Our latest quiz, which company is this? 

I will give you a clue, its closest peer, recently announced a full-blown restructuring. 

Red Flags Flying High

As Howard Schilit writes in Financial Shenanigans, “in many ways capital markets are designed to circulate good news…Corporate issuers are incentivised to announce good news, sell-side firms to spread such news, and investors to believe it. This dynamic is part of what occasionally creates asset bubbles and boom/bust cycles. Investors who can remain objective and sceptical, while the herds echo and amplify each other’s excitement have a better chance of profiting from the more blatant disconnects from reality.” 

One of the things we are keen on at 9fin, is to be forensic in our analysis and use our tech and AI to spot potential red flags and look for signs of irrational exuberance.

Last week, we looked at concerns over governance and related party transactions at Grenke, which short seller Viceroy Research highlighted a number of similarities with Steinhoff’s fraud. 

Frequent management changes are often cited as another big red flag, especially for companies with aggressive accounting policies. Kantar (which deserves an honourable mention in our add-backs section), saw its chief executive leave at the end of April after just four months in the job, with reports saying that he wasn’t a good fit, with Sky News saying unnamed Kantar sources as saying his consumer marketing background was at odds with the culture of the data-driven research company. Another adjustment fetishist Douglas has now gone through four CFOs in five years, with the new incumbent from Hugo Boss starting in June. 

Another red flag is frequent changes in auditing firms or using little known small accountancy firms, GreensillSteinhoffMadoff, would have failed this test. 

This LinkedIn post gives plenty more red flags to look for. Let us know your favourite signs.

Selected 9fin coverage

Intralot’s conference call on Monday was eagerly awaited, less so on business performance, but more on what was happening to its restructuring plans, with little news since the announcement of an aggressive proposal outlined in January developed with an ad hoc group of 2021 SUNs. As reported, there were doubts about deliverability amid likely legal challenges from 2024 holders. 

When questioned on the perceived lack of progress on the restructuring, management said they are very actively working to deliver a deal. There is a lot of work going on in the background, including documentation, which Intralot is seeking to deliver in the most efficient way. “We have the tools available and path to deliver.” When asked about engagement with an ad hoc group of 2024 holders, management said there have been a lot of discussions between all groups and we are committed to a deal for all stakeholders. This is a very complex deal, we are looking for the best common denominator, they added, declining to comment on the timeline. 

Virgin Active wasn’t the only important ruling in the courts this week. Just 24 hours earlier, New Look landlords lost their CVA challenge

The ad hoc group of New Look Category B landlords claimed the CVA was not one arrangement, but a series of multi-linked arrangements. Without the support of unimpaired SSN noteholders the CVA would have failed, they argued. The shift by New Look to turnover rents fundamentally re-writes the bargain between the company and the landlords, with rents set below market value, they say, citing New Look’s financial projections. Lease break rights under the plan were unworkable given their limited timeframe, and termination rights should be offered on a rolling basis, they submitted.  

Justice Zacaroli disagreed: “I do not think that the differences were such as to mean that the Compromised Landlords were unfairly prejudiced by reason of the SSN Holders’ vote securing the statutory majority at the meeting. Albeit in different ways, both the SSN Holders and the Compromised Landlords were substantially impaired by the CVA, and there was more to unite than divide them in ensuring that New Look avoided a formal insolvency process which would have resulted in a significantly worse recovery for the SSN Holders and virtually no recovery for the Compromised Landlords.”

In a consequentials hearing this morning, Justice Zacaroli, however granted the New Look landlord's permission to appeal against his ruling earlier this week. Zacaroli said in his reasoning that there are issues wider than this case and it is clearly not a one-off.

In brief 

We were surprised by the surge in Amigo Loans share price earlier this week, given the severe challenges facing the guarantor lender. News that the FCA would oppose their scheme of arrangement at sanction hearing stage sent the shares crashing. Strange given that it was disclosed in materials at the convening hearing. Another reason for a 9fin subscription?

The Spanish Government has announced changes in the ICO programme to provide guarantees to support businesses during Covid-19. The programme has been extended until December 2022, with another €3bn of loans to be made available. 

Spanish sports media broadcaster Mediapro has formally requested a €230m bailout from SEPI after its Chinese owner decided against putting in further funds. Local media reports have disclosed that creditors have hired Houlihan Lokey and Latham & Watkins as advisors, with the company advised by Rothschild and Allen & Overy. 

Virgin Active unsecured creditors look away now, Hertz’s competitive bidding with rival hedge funds to provide funding for a reorganisation plan has seen the implied enterprise value rise from just over $3bn to $7.43bn under the winning Knighthead, Certares and Apollo bid. Bloomberg suggests equity holders will get a recovery of $8 per share, well above the much-derided aborted equity raise last summer.

What we are reading/watching this week

The National Rifle Association bankruptcy filing is surely one of the oddest filings in recent years. Friday Workout’s spiritual American Cousin Petition has an entertaining take on the saga

While Labour licks its wounds in the council and mayoral elections, with many saying Brexit remained a factor, statistics on first quarter trade with the EU barely registeredwith the press. 

This week markets got spooked by a huge miss to the upside on CPI data. But is this temporary? Barrons says don’t be fooled by April’s inflation jump

But Wolf Richter believes that the latest figures are just the start, believing that the inflation is a lot worse than previously reported, and there is more room to catch-up

For those who miss markets trading on maniacal comments from a stable genius, Elon Musk has stepped up to the mike. Dogecoin took a beating on his Saturday Night Diveappearance. Realising that he might have alienated a chunk of his fan investor base, he said he might accept Dogecoin in payment for his cars. Then to round off the week, he announced that Tesla would no longer accept Bitcoin on environmental concerns. 

Over in the UK, viewing figures for Parliament TV surged past Channel 5 during weekday afternoons with Lex Greensill and David Cameron being grilled in front of a select committee. The FT has a good summary of Lex’s testimony here

Yesterday, it was the turn of former Prime Minister David Cameron. I was left with the impression that Labour’s Angela Eagle would have had a better chance of skewering Virgin Active’s witnesses after her impressive performance on the select committee.

Her opening line was disarming: “Mr Cameron, I’ve read your 56 messages, they are more like stalking than lobbying.” But she then got into her stride

Did you ever call yourself a director of Greensill? Cameron said there was a letter that referred to a “fellow director”, but that was a mistake. Are you aware of the concept of a shadow director?

Boom, as a source close to 9fin would say.