Every week, I write on 3 interesting happenings from the world of distressed investing, in a short and digestible manner.
Here is what I found intriguing…
U.K. Supermarket Chain Morrisons, trying to be acquired by Private Equity as it is deemed to be cheap. Why do they think that and are other grocers also cheap?
Private Equity Firm Clayton, Dubilier & Rice (CD&R) offered to acquire the shares of U.K.’s 4th largest supermarket chain, Morrisons last week. As seen in the below chart, the stock has been trading in a defined range since 2019, despite the managements claim that CD&R’s $7.6B offer “significantly undervalues” the company.
The stock rose on the announcement from $179 to $236 per share.
The question for me is; why did they think Morrisons was cheap?
Let’s take a look (in USD)…
FY20; Revenue - $24B, Profit - $133.5M, FCF - $500M, Tangible Book Value - $3.9B
Market Cap… Current = $8.0B, PE Offer = $7.6B, Before Announcement = $5.2B
Some key multiples from 2020…
So you are paying x2.0 TBV and x16.0 FCF for a very stable company with highly predictable cash flows and competitive advantages derived from it’s supply chain an real estate holdings. Compare this to other like grocers & the broader index; you’ll quickly see why this PE shop really like Morrisons. However, the value is not quite as obvious with other grocers. I don’t see anything that is really cheap like Morrisons.
Despite flat revenue and declining market share over the past few years, what would CD&R do with this investment to generate an ROI?
Benefit from lax rules on UK PE firms (not so with actual grocers) and consolidate with smaller grocers
High Revenue/Store but very low gross margins so reduce amount of underperforming pricing promos and cut unprofitable products
Look to sell underperforming assets on B/S to unlock cash
Healthcare organizations are struggling in stay in business. What is Private Equity seeing in this space as a potential investment?
According to Private Equity Fund, Plutos Sama Holdings, the healthcare industry is rife with investment opportunities brought on by the COVID lockdowns. It’s ironic that a healthcare event is creating distressed situations in the very industry you’d think would benefit. However revenue losses combined with an overreliance on PE funding in the past, have created the perfect situation for distressed assets.
Plutos Sama argues; “this presents an attractive opportunity for investors that can facilitate a rational, structured and ultimately profitable re-organization”.
Healthcare firms face 3 factors that are leading to a cash crunch…
Increased administrative costs
Constant reinvestment
Shift to at-home care
Much of the money patients spend on healthcare is wasted on no-value added bureaucracy costs. The National Library of Medicine’s latest study shows that US healthcare companies spend on average +10-15% more than other first world countries on admin costs. However the expenditures needed to updates back end simplifying technologies can run well into six figures, making them out of reach for many SMB healthcare businesses. Examples like nursing homes, dental offices, regional hospitals and other private clinics all fall into this category of “attractive opportunities for investors”.
A turnaround of a healthcare firm, which would qualify as an income statement turnaround, requires a careful understanding of the expenditures needed to reduce admin fees and their impact on a cash flow forecast. An investor would only see a positive ROI, if they can ensure the company’s cash flows can handle such investments. If I were to play in this space would be as an LP, benefitting from a funds ability to consolidate smaller SMB healthcare, creating enough scale to remove back end admin costs.
The COVID pandemic has created a different set of distressed opportunities for investors; it's no longer about the balance sheet turnaround.
After the 2008 financial crisis, investors were presented a window of opportunity that lasted through 2012; rebalance the capital stack to allow assets with too high of debt burden to throw off cash flows again. According to Real Capital Analytics, this time we are under a new set of rules.
It’s no longer about the big institutional investor who just threw money at the problem. The new paradigm for distressed investing is all about rolling up your sleeves and fixing the economics of the business, which is why you’re see a decrease of 40% to 20% of institutional funds acquiring distressed assets.
This is the difference between a balance sheet vs income statement turnaround (which I go into detail in “Hack the Capital Stack”). Essentially…
Balance Sheet Turnaround - cash flow issues derive from too much debt on B/S; recapitalize balance sheet by reducing debt burden with new equity financing
Income State Turnaround - cash flow issues derive from unprofitable operations; enact a turnaround plan to fix operational issues that have put pressure on the balance sheet & cash flow statements
The way to succeed in this new paradigm is to reposition or improve the functioning of company assets. Here is a quick example to drive home the point…
Picture on Left; acquired for $1.8M
Picture on Right; sold for $4.1M ($2.1M for unit #1, $2.0M for unit #2)
Profit after re-zoning, closing & construction costs ~ $0.75M
To convert this asset from $1.8M to $4.1M required more than a rebalance of the capital stack and would be out of the mantra of many institutions. Opportunity is now for those investors who will roll up their sleeves.