Wednesday, January 07, 2009

2009 - A Different World for Business

A recent article focused on satellite radio and the merger of XM and Sirius. In an interview with CEO Mel Karmazin, he said:

Ironically, one rationale for the merger was the expectation that the combined company could borrow money more cheaply. “The bankers who covered the deal believed that one of the synergies of the merger was the ability to refinance at a lower level,” says Mr. Karmazin. Consider this: five years ago, Sirius, with 300,000 subscribers and no hint that Mr. Stern would be gracing its channel lineup, borrowed money at 2.5 percent interest. Those days are long gone. “Warren Buffett managed to get a 10 percent coupon from G.E. and Goldman Sachs,” says Mr. Karmazin, speaking of the interest rate that Mr. Buffett, the Omaha investing legend, was promised for his recent investments in both companies. “So if you are Sirius XM, what should the coupon be?”

Thus the Sirius / XM stock ticker, which peaked at $9 in 2005, now trades at 12 cents. Approximately $3B in debt is outstanding for the company; since they are not cash flow positive to any significant degree and raising money through stock offerings is extremely difficult when you are a penny stock, their balance sheet is killing the company, and possibly the entire satellite radio industry as a result.

There are two keys to this analysis - 1) the interest rate on a START UP industry which was inherently risky was only 2.5%, amazingly low (stupidly low, because the bankers are going to get burned if the company goes under) 2) at almost any price no one is willing to finance risky companies today - the liquidity is gone and the markets are essentially frozen. As Mr. Karmazin notes above, a rough guess would be that they would have to pay maybe 20% interest rates to roll their debts, which would mean that interest alone (no principal) would be $600M on $3B in debt, for a company with marginal cash flow in the first place (they currently pay around $60M+ in interest expense today).

On what seems to be an unrelated note, let's look at the consulting company BearingPoint. BearingPoint is a management consulting company spun off from the former KPMG (one of the "Big Six" consulting firms, now "Big Four") with a long history. I have a lot of personal experience and contacts with this firm.

As of the end of Q3 2008 (9/30/08), the consulting firm had approximately 15,000 employees, the vast majority of whom are consultants that bill at an average rate of about $140 / hour (estimates based on Q3 financials, assuming about 80% utilization). These employees are experienced (probably average 8-10 years of work experience) and many have advanced degrees (virtually all have bachelor's degrees).

And what is this company worth, a company employing so many smart people at such high billing rates? Virtually nothing. The stock ticker has been de-listed and now they trade on the pink sheets.

Their value has been destroyed because of their balance sheet. At the time they went public, they used a lot of the IPO cash proceeds to buy out CISCO's share of a joint venture, and then they added what seemed to be a modest amount of debt later (part of it is reasonable because they picked up Arthur Andersen's former consulting unit cheaply when that firm imploded under investigation). However, almost any amount of debt is crushing when a company generates only a modest amount of cash flow. Like the satellite radio industry, Bearingpoint likely assumed that they'd be able to "roll over" their borrowings in a liquid market at a reasonable rate.

While both of these companies have had problems and made management missteps (satellite radio in paying so much for talent, Bearingpoint in having financial reporting problems and a difficult IPO), they are both relatively sound businesses that in past years would have been able to refinance and climb out of their balance sheet troubles. But in the current market, both face a difficult if not dire situation.

Pretty much anyone with small or declining cash flows (which represents MANY companies) that has debt payments coming due or a need to refinance is in a VERY bad situation right now. Unlike private home borrowers, who can seemingly always refinance at very low long term rates (about 5% for a 30 year loan) due to government intervention with Fannie and Freddie, businesses in similar situations face interest rates up to 20% if they can find any kind of lender at all. Even the companies that received Federal bailout funds are unlikely to pour more good money after bad into further loans to companies like satellite radio and consulting. And even if those companies received 20% loans, they'd soon be out of business anyways due to the crushing debt burden of servicing such rates.

It is a new world order. If a business requires cash or needs refinancing, their equity share holders better prepare to be savagely hit if not completely wiped out.

Cross posted at Chicago Boyz

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