Synopsis: A recent amendment gives Blockbuster the breathing room to complete its operational restructuring and a runway to refinance maturing bank debt that comes due in 2010. We believe that the bank debt is worth par under either a refinancing scenario or a Chapter 11 proceeding, offering investors a weighted average IRR of nearly 40%.
BLOCKBUSTER OVERVIEW
Dallas based Blockbuster, Inc is the largest operator of movie/video game rental retail stores in the world. It currently operates 7,267 stores, comprised of 5,742 company operated and 1,525 franchised locations.
The first Blockbuster opened up in Dallas, TX in 1985. The 1000th store was opened in 1989 and Viacom purchased the entire company in 1994 for $8.4B in stock (and debt assumption). Viacom then carved-out 18% of the company in an August 1999 IPO. In October 2004, Viacom divested the remaining 82% of BBI through a leveraged transaction (the result being the levered structure we see today).
After a failed attempt to acquire Hollywood Entertainment (which was bought by Movie Gallery, which subsequently filed Chapter 11 in 2007), and a series of management missteps, investor confidence in Blockbuster was shot. Carl Icahn attempted to wrestle control of the company (winning three board seats in 2005) and a new management team was installed in June 2007; James Keynes, former CEO of 7-Eleven, was named Chairman and CEO.
Since then, Keynes has made formidable steps into fixing the mistakes of previous management. The company closed under-performing domestic stores (which still remains an important strategic initiative), rolled out new store layouts, simplified rental pricing and terms, stopped the aggressive marketing war with Netflix on the mail order business, franchised and divested a number of foreign stores, changed store designs, entered the vending business (in a partnership with NCR) and the online/on-demand market with the acquisition of Movielink. Furthermore, its DVD by mail service, Total Access, recently announced it would begin a pilot program for renting video games by mail in 2Q09 and fully commence the operation in 2H09. These results have helped stabilize comps and EBITDA margin degradation.
BLOCKBUSTER CAPITAL STRUCTURE
RECENT CREDIT FACILITY AMENDMENT
On March 19th, 2009, Blockbuster (in its 4th Quarter Result Press Release) announced that it had entered into an agreement in principal with its revolver lenders (JPM, Silverpoint and Monarch). Leading up to this, market participants were worried that the company would be unable to refinance the up-coming revolver maturity (at the time, there was ~$160M outstanding) and the company would have to seek bankruptcy protection. Consenting revolving lenders were well compensated with a one-time 8% fee for the amendment. The amendment was finalized on May 11th. Terms of the amendment are as follows:
- Rate set to LIBOR plus 10.00% (3.50% LIBOR floor)
- Maturity date extended to September 30th, 2010
- Size set to $250M (from $325M) with $52.5M available for LCs
- Amortization Schedule Set: December 15th, 2009: $25M, January 31st, 2010: $20M, February 28th, 2010: $20M, March 31st, 2010: $20M, April 30th, 2010: $10M, May 31st, 2010: $15M, June 30th, 2010: $50M, July 31st, 2010: $10M, August 31st, 2010: $10M
- 50% Excess Cash Flow Sweep established, Fixed Charge Coverage Ratio set to 1.25x up to January 3, 2010 and 1.30x thereafter
- Leverage Ratio amended to 2.75x (previously 3.00x)
- $30M Capex covenant in 2009 and $40M in 2010 (with a $10M carryover option); this is in-line with maintenance capex for the company.
- Removes “Going-Concern” default language resulting from FY2008 Auditor’s Opinion
MOVIE GALLERY BANKRUPTCY – A WINDOW TO THE FUTURE?
On October 16th, 2007, Movie Gallery filed for bankruptcy in the Eastern District of Virginia. Movie Gallery was Blockbuster’s #2 competition for in-store movie and game rental, operating a portfolio of 3,000 retail stores across the United States. Sopris Capital, as the lead creditor, converted a large portion of their second lien investment and subordinated bond investment (in tandem with a subsequent rights offering), to gain control of Movie Gallery’s equity. More important to our discussion is the fact that the first lien (Class 3 claims) was reinstated at a significantly higher rate (Eurodollar Rate + 1000, 3% points in fees).
Movie Gallery filed for one reason: Too much debt from the failed Hollywood Acquisition. Some background: In April 2005, Movie Gallery completed its acquisition of Hollywood (BBI had previously bid). Hollywood had a predominantly West Coast, urban store base, complementing the existing footprint of Movie Gallery. Unfortunately for Movie Gallery, the integration is still not completely finished. The acquisition cost Movie Gallery nearly $900M that was financed 80% in debt. The company successfully refinanced that facility in the credit heyday of early 2007. That being said, as the company’s result languished in mid 2007, the trade became incessantly tighter on their terms (LCs are very common in this industry). This caused a covenant violation at Movie Gallery, which caused more contraction in trade (including COD), forbearance was established to work a pre-pack and the company eventually filed.
Upon emergence, and using 2009 projections for the baseline, Movie Gallery was to be levered 4.0x through the first lien debt and 4.7x total. Coverage was to be 1.3x. The company needed approximately $100M in a DIP throughout the bankruptcy. We use this information in walking through a possible Blockbuster Bankruptcy below.
VALUATION AND INVESTMENT OPINION – BBI BANK DEBT
Before moving on to the Chapter 11 Going-Concern Valuation, we want to highlight our projections for cash flow for the next few quarters.
If the company is unable to refinance their debt in the first half of 2010, we expect the company to run out of cash in the 2nd quarter of 2010 or 3rd quarter of 2010 (depending on how working capital shakes out). At that point, the company, under our assumption of a 9% drop in same store comp, will be running at an LTM EBITDA level of $295M. Given where leverage is projected to be at the time (below 1.5x on a gross basis), we believe the company will have no problem refinancing their debt. Assuming a takeout in June 30th, 2010 at a price of 68.5 leads to a return of 45%.
Chapter 11 Going Concern Valuation
We assume, similar to what happened at Movie Gallery that BBI will need some sort of DIP to pay off its existing LCs and be able to conduct ordinary business properly. Based on size alone relative to Movie Gallery, we assume a $150M DIP below.
Possible upside to this model include cash generated throughout the bankruptcy (we believe banks would stay current on their interest rates) where the bond holders would not receive interest. At the current market price of ~70 cents on the dollar, the market is anticipating a 55% drop in run rate EBITDA, an asserting we do not agree with. Under this scenario, bank debt would be reinstated (or refinanced with an exit facility depending on the credit markets). We assume a 2 year bankruptcy, commencing in June 2010, and a repayment in 2012. Assuming default interest of L+575 (current rate of L+375), at a purchase price today of 68.5 leads to a return of nearly 35%.
The weighted average of these two scenarios (refinancing and Chapter 11), at a 50% expected probability of both lead us to our assumed return of 40%.
CONCLUSION
We believe that a 40% weighted average return (IRR) to investors more than compensates them for the downside risk inherent in investing in Blockbuster. While risk of technological disruption, industry secular changes, and a weaker global consumer are definitely present, management seems to have a handle on these issues and are working through them diligently. While cash constraints could derail the operational restructuring, we believe that a bankruptcy would be a net positive to bank debt lenders by diverting cash flow from junior creditors to senior creditors. The low leverage (as well as the recent amendment) gives us comfort that Blockbuster will be able to refinance its debt, albeit at a high rate. Either scenario though brings a par recovery for bank debt lenders even under the most severe of circumstances. This is a very interesting distressed debt investing case study.
Another interesting post, thanks. At some point, can you do a post on covenants in credit agreements and indentures? Clearly it wouldn't be possible to cover everything, but something like a "top 5 things I look for" in credit agreements and indentures would be interesting. Also, any pointers on where I could learn more on the subject would be helpful. Thanks again for the blog.
ReplyDeletenew to distressed debt...great blog. what are LC's?
ReplyDeleteI'm assuming Loan Covenants...
ReplyDeleteor letter of credit...
ReplyDeleteI'd recommend LSTA's "Complete Credit Agreement Guide"... Very good from basics to details..
ReplyDeleteI work on the buyside, lbo's, I'd be interested in seeing a distressed model if that is possible..
ReplyDeleteyou mean you used to work in lbo's.
ReplyDeleteThe sub notes are at 48.5 and might be worth holding. The bank debt looks more attractive on a risk reward basis. But us little guys can not buy this.
ReplyDeleteOther than that thanks for the great analysis.
I am currently long some Six Flags bonds trying to holdout. The alternative if the holdout does not work is likely a prepack in which cost of the bonds at 18 is recovered.
"The sub notes are at 48.5 and might be worth holding. The bank debt looks more attractive on a risk reward basis. But us little guys can not buy this. "
ReplyDeleteWhy is this? Why cant the "little guys" buy the bank debt, isn't there a market for it?
Bank debt is relatively illiquid and only moves in large (often well over $10+ million) chunks. The bonds on the other hand probably can move in blocks smaller than $100,000.
ReplyDeleteWondering what your thoughts are on the senior subordinated here, now that the company has refinanced $675MM and appears to have a credible plan for improving liquidity at this stage of the game. How would you think about estimating intrinsic value for this piece?
ReplyDeleteI have a full write-up on the new bonds and sub notes on the DDIC - I suggest you apply
ReplyDeleteHunter two questions:
ReplyDeleteWhat is your opinion on Fitch's (9/15/09) $537 million distressed Enterprise value estimate based on 26% EBITDA discount and 2.5x multiple?
Also where is the best place to go to read up on the MVGR bankruptcy proceedings? I've found the court dockets on Bloomberg but tough to tell which would be of value, if any, without paying the extra $ to order them.
And yes I know the point of this post was to get people to apply to the DDIC-- and that you have a full write up on the sub notes in there. I'm new to the distressed area otherwise I would do just that. At some point I would love to apply.
In lieu of that now though, I'd greatly appreciate your opinion on the above 2 questions.
Thanks!
Hunter- what are your thoughts on the sub notes given how the movie gallery bankruptcy played out? Seems like the sub holders in that case got pretty screwed in that deal, although there was more debt ahead of them in that case (and lower EBITDA).
ReplyDeleteAlso, what do you think of Fitch's $537 million EV estimate for BBI given a 2.5x multiple of 26% lower EBITDA? They are forecasting 0-10% recovery for the Sub Notes.
I would apply to the DDIC to get your opinion on the sub notes but I am knew to the distressed space and going to try and learn some more before applying. Would appreciate a response here if you're up for it.
Are you going to do a follow up piece on blockbuster. I read that blockbuster agreed to a sale of the business to secured lenders. What may the final recovery look like to secured lenders?
ReplyDelete