Second Acts

After bankruptcy, companies often teeter between encore and final curtain call.

Just a year ago, executives at Pillowtex Corp. thought they could finally look forward to a good night’s sleep. Following an arduous bankruptcy process, lenders to the $1 billion maker of Fieldcrest towels and sheets had agreed to slice its $1.1 billion debt load to $205 million and leave the company with access to more than $100 million in exit financing. With Wal-Mart as its biggest customer and substantial backing from Oaktree Capital Management, the former Fortune 500 company seemed to have a bright future.

“This marks the beginning of a new chapter in this company’s history,” promised then-president Tony Williams upon the court confirmation of the confirmation of the reorganization plan in May 2002. Indeed, during its 18 months in bankruptcy, Pillowtex had managed to close six plants, shed about half of its assets, and aim for a $9 million profit by the end of 2002. In 2001, by comparison, the Kannapolis, North Carolina­based company had lost $200 million.

Yet soon after its fresh start, Pillowtex was in trouble again. Asian competitors had stolen market share and kept prices in the industry low, resulting in another $26 million in losses. By September, CFO Michael Harmon was renegotiating with lenders to ease the company’s loan covenants and avoid a technical default. By March 2003, he had to repeat the process. Now, absent a buyer or additional waivers, another bankruptcy filing is a strong possibility, Pillowtex concedes in its most recent 10-K.

This is not an unusual story. One-third of the companies that emerged from the last great wave of bankruptcies in the early 1990s have had to restructure or refile within five years, according to an analysis by Boston College finance professor Edith Hotchkiss. Preliminary results for the current crop of companies emerging from bankruptcy show similar trends. “Overall, we still see a 20 to 30 percent failure rate for large public companies,” says UCLA Law School professor Lynn M. LoPucki. With a record number of companies emerging from court protection in 2002, and more to come in 2003, more implosions may be on the horizon.

Among the next crop of emergers will be the three largest bankruptcies on record — WorldCom, Enron, and Conseco. But discerning which companies will make it and which will implode is not an exact science. “Any company that has just gone through a bankruptcy is still in a very delicate condition, somewhat like someone who has just suffered a severe heart attack. They might be out of bed, they might even be back at work, but they’re not 100 percent yet,” says Bettina Whyte, president of the American Bankruptcy Institute and principal at New York­ based turnaround and crisis-management firm AlixPartners LLC.

In fact, it’s very hard to gauge the health of a company that has just emerged from Chapter 11. For one thing, it can take up to two years for a company to recover from a bankruptcy and fully implement the necessary restructurings. Moreover, historical factors such as a company’s asset size or the speed of its initial demise provide few clues about its ability to generate profits after bankruptcy. There’s also the possibility that emerging from bankruptcy simply signals a failure to attract a buyer, not financial stability; many of the 600-plus companies that have filed for Chapter 11 in the past three years have come from industries in desperate need of consolidation, such as telecommunications, airlines, steel, and textiles.

Reasons To Relapse

Gathering historical clues about relapses is difficult, because much about bankruptcy has changed since the last Chapter 11 boom, when 125 companies filed between 1990 and 1993. In particular, the average number of days a company spends under bankruptcy protection has decreased from 741 in 1990 to 367 in 2002, due in large part to the rise of prepackaged or prenegotiated cases, according to LoPucki’s Bankruptcy Research Database. In addition, more companies are opting to sell off their major assets within the protection of Chapter 11, and then dissolve.

What hasn’t changed, however, is the major warning signal for a relapse; namely, too much debt. Former bondholders tend to press for too much debt, experts say, because they stand a better chance of recouping their losses with notes than with new equity. But steep interest payments or a rapid amortization schedule can hamstring efforts to rebuild operations. In the end, debt “may be the straw that breaks the camel’s back, especially if your projections are too rosy, or you were expecting the economy to rebound in the fourth quarter last year,” says New Jersey­based bankruptcy attorney Richard Tilton.

Not only can debt siphon funds away from growth, it may be an obstacle to obtaining additional capital. That was the case at Pittsford, New York­based Mpower Communications Corp., a local telephone and Internet service provider that came out of bankruptcy with 10 percent of its original $650 million debt load last July. “We got through the bankruptcy quickly, but emerged with a plan that was still in need of cash,” says CFO Gregg Clevenger. Potential investors balked, though, at $51 million in secured debt due in October 2004.

“They were saying, if you need $35 million to $50 million to fund the business and you have $50 million coming due in 18 months, what I’m really doing is giving you money to pay your debt,” recalls Clevenger. Mpower was finally able to buy the 2004 noteholders out at a discount and sell assets for cash to fund the repurchase, a process that was completed nearly nine months after its Chapter 11 exit.

Unfortunately, even bondholders that take equity tend not to be model investors. “When you emerge and have creditors who have taken stock in lieu of debt, they don’t behave like normal investors,” says Carter Pate, U.S. managing partner at PricewaterhouseCoopers. “Instead of thinking of capital appreciation, they’re looking at capital retrieval.”

Motient Corp. CEO Walt Purnell agrees. His Reston, Virginia-based wireless company exited Chapter 11 last year with only 6 percent of its former debt and a revenue stream that had started to increase. When Motient’s growth prospects were slowed by the subsequent bankruptcies of two of its top resellers, Purnell turned to his new investor group, which is largely composed of former bondholders.

“Bondholders tend to be pretty conservative people; they hammer you all the time to cut costs because they always think something terrible is going to happen,” says Purnell. He was able to win another $12.5 million credit facility from the group, announced in January, but only at the price of deep internal cuts, including a 29 percent workforce reduction.

Customer Concerns

The optimal source of financing, say experts, is a third-party equity investor that is willing to make a long-term commitment and take part in managing the company. Such backing has proven to yield higher rates of success, according to Hotchkiss, because it both imposes discipline on the company to make radical changes and sends a signal “that at least someone is willing to take a bet on the company and stick with it.”

Given those indicators, McLeodUSA Inc. is on firm footing. The midwestern telephone company left Chapter 11 in April 2002 with about $3 billion of its original $4 billion in debt erased and access to up to $160 million in exit financing. Its annual interest payments were sliced by about 90 percent, from $365 million to less than $50 million. The company has also enjoyed the ongoing backing of buyout firm Forstmann Little, which now holds nearly 60 percent of McLeodUSA’s equity after investing nearly $1.2 billion in the company.

But investors are not the only ones skeptical of a bankrupt company’s future. Even in industries where defaults are common, “customers and employees get very nervous,” says Chris A. Davis, who led Cedar Rapids, Iowa-based McLeodUSA through the process as chief operating and financial officer and now chairman and CEO. So nervous, in fact, that Davis, current CFO Ken Burckhardt, and their team took pains to contact customers with phone calls and letters to let them know the company’s future plans as they began a strategic overhaul that involved selling $1 billion worth of assets and focusing on only the most profitable customers. They also put a significant portion of the creditor-approved $146 million capital-expenditure budget to work on speeding installation times, improving billing accuracy, and fixing network failure points.

Postbankruptcy, McLeodUSA also made an investment in employee training of around $2.5 million. “We made a decision that anyone who touched the customer or the network had to meet new ‘star quality’ standards,” says Davis, which are aimed at improving the quality of customer service. That led to a companywide skill assessment and certification process, which served “as a vehicle to motivate the workforce” as well as a boon for customers, she says.

These efforts seem to have paid off. Only 1 customer of the top 100 McLeodUSA had hoped to keep left during the bankruptcy process, says Davis. Meanwhile, employee turnover has decreased as much as 75 percent, from levels exceeding 100 percent per year in such departments as customer service and sales. “It’s an intangible return,” says Burckhardt, “but at the end of the day, it’s the employees who are going to make us successful.”

Wary vendors can also affect a company’s efforts to get back on track. Troy, Michigan-based Lason Corp., a document-management firm, is heavily dependent on temporary staffing firms when big projects come along. Since its bankruptcy filing last year, though, credit terms shrank from as many as 45 days to as few as 7, and “we have lost any sort of favorable pricing, since our vendors want to make back the money they didn’t get while we were in Chapter 11,” says CFO Doug Kearney.

As a result of that filing, which let the company shed 36 of the 76 companies it acquired between 1996 and 1999 and avoid $80 million in earnout payments, Kearney estimates Lason is paying 5 to 10 percent more for staffing services. Meanwhile, lease rates for new properties are “insane,” at 18 to 20 percent, according to Kearney, and letters of credit now require 100 percent collateral plus 15 percent in fees, up from the 1 percent in fees the company typically paid prebankruptcy. The heightened costs mean “your hands are tied” when it comes to managing expenses, says Kearney, with no end in sight. “Maybe things will change when we have 18 months of financial performance behind us, but I expect we’ll be fighting these issues for a while.”

On The Bright Side

Despite the pitfalls, bankruptcy often remains the best hope to reposition a viable company for long-term growth. “If a firm is worth more alive than dead, or liquidated, you can maximize returns to all constituencies if you just give it some breathing room,” says Stuart Gilson, a professor at Harvard Business School. His research shows that companies that attempt reorganization outside of bankruptcy court are 50 percent more likely to fail than those that go into Chapter 11. Why? Bankruptcy proceedings require agreement among a smaller majority of investors than most out-of-court deals, meaning more creditors can be forced into forgiving debt.

In fact, simply going through the bankruptcy process often creates brighter prospects, say CFOs who have done it. “Once we stopped paying interest, we had plenty of [cash] to run the business,” says Chiquita Brands International Inc. CFO James Riley. Two years ago, Cincinnati-based Chiquita filed for bankruptcy protection after an $84 million bond payment came due against a cash balance of less than $70 million. The company’s problem — namely, an oversized debt load geared to an expansion plan that had been squashed by European Union trade restrictions — “was fixable,” and well served by the relief Chapter 11 afforded, says Riley, who joined as CFO in January 2001.

Since most of the debt was at the holding company, Chiquita’s 400 operating units were untouched, meaning vendors and creditors were paid in the ordinary course of business, says Riley. Customers stuck with the company. Along with swapping $861 million in debt plus accrued interest for a $250 million new bond issue and 95.5 percent of the new equity, Chiquita was able to write down a profit-draining unit in Panama without violating loan covenants, thanks to “fresh-start” accounting.

Still, 2002 was a tough year for Chiquita, due to global competition depressing banana prices as well as the costs associated with the restructuring. The company ended the year with a fourth-quarter EBITDA that was 72 percent below the previous year’s figures. While last quarter saw a healthy profit, Moody’s Investors Service analyst Helen Calvelli cautions that the EU may strike again, with a decision expected in 2006 that could curb Chiquita’s long-term sales prospects.

Tell It To The Judge

Chiquita’s mixed results illustrate the difficulty of assessing postbankruptcy success, particularly in a recession. “You would like to see profits almost immediately after emergence, if you haven’t already,” says Whyte. “But when whole industries are in trouble, a lot of these benchmarks are hard to talk about.” Most companies will argue that their sales figures have been depressed by the recession. And stock prices may not be fair indicators, given the state of the equity markets and the abnormal sell-offs a stock may experience if former bondholders cash out en masse.

But some experts say the vagaries begin in the very plans that get companies out of bankruptcy. “To get a plan confirmed, CFOs make unrealistic assumptions about sales levels, or expenses, or the amount of money needed for capital improvements. That creates a picture of profitability, which makes a confirmable plan,” says Tilton. “But too many unrealistic expectations are a recipe for disaster.”

Indeed, in Pillowtex’s case, sales actually outperformed projections in the latter half of 2002, but nearly every category of expenses was also higher than expected. That’s hardly surprising, though, says Hotchkiss, whose research has focused on documenting the differences between projections and reality. In one study, actual profits underperformed projections made at the time of the bankruptcy by a median 80 percent a year after emergence.

The estimated market value for a company, which determines the mix of postbankruptcy debt and equity, is also suspect, since it is the product of negotiations rather than market forces, says Hotchkiss. According to a paper she worked on with Gilson, the equity values estimated by management were overstated by as much as 250 percent and understated by as much as 20 percent, compared with the actual market price. (A higher opening price may be advantageous for creditors that want to cash out quickly, while a lower opening price may be better for options-holders.)

Creditors, of course, bear some blame. Some companies arrive in Chapter 11 beyond resuscitation, thanks to bankers trying to delay write-offs. “In many cases, it’s a delay-and-pray strategy, where bankers say, ‘I’m going to delay foreclosing and hope they keep struggling along,’” says Hugh Larratt-Smith, a principal at Manhattan-based turnaround firm Trimingham Americas Inc.

On the other hand, the influx of distressed-debt buyers, too, has created pressure on companies to emerge quickly so those investors can then sell off their stakes at a gain. “Distressed investing has become the flavor of the month for a lot of hedge funds. We’re seeing a lot of people stepping in just because they’re awash in capital.”

That doesn’t excuse judges for approving overly optimistic plans, says LoPucki. “What causes the failures is that courts are not saying no to bad reorganization plans,” he says. If judges forced companies to be more rigorous about proving they had cut enough debt, he contends, fewer companies would fail. But because courts must compete for cases, judges have little incentive to be tough. “They can’t just do what they think is right; they have to do what their customers want,” he says, like allowing a company to pay prepetition debt to vendors while in Chapter 11 and exit with high debt levels.

The Need To Get Tougher

So what can CFOs do to promote success? “The challenge for a CFO is to stand firm” in hammering out reorganization plans, and point out the risks that come with budgeting with faulty assumptions, says Tilton. “CFOs need to take a longer time horizon than other participants. They need to look past the confirming of the plan and out two years or so.”

That’s a tough charge, though, since most CFOs say burned bondholders generally hold the power in such negotiations. “Senior lenders had an opportunity to force the company to do whatever they wanted,” says Lason’s Kearney. He counts himself fortunate that the lenders agreed to take equity, knowing that “they’re not paid to take risks; they’re there to get paid back.”

The challenge may be even more difficult in light of personal incentives that do little to deter CFOs from rubber-stamping poor plans. “Unfortunately, we see a lot of situations where CFOs are [encouraged] with big retention bonuses to get the company out of bankruptcy faster than they really should,” says Larratt-Smith. However, he adds, “strong CFOs won’t ever allow themselves to be swayed by that, because they also know that there’s nothing worse on your résumé than a Chapter 22.”

And once out of bankruptcy, CFOs must step into their classic role: the naysayer. CFOs “need to be the voice of reason for a company that is often not yet back on terra firma,” says Whyte. “They’re the guardians of the bank. And if the cash is not watched closely, the company could find itself back on the road to bankruptcy in a very short time.”

Sidebar: Sold-Out Performances

Companies rarely officially liquidate through a Chapter 7 filing, considered a clear sign of failure by most bankruptcy experts. These days, though, many are effectively opting to liquidate by selling off major assets within bankruptcy protection, à la Comdisco, Budget, and TWA, and then dissolve.

Why the shift? The strategy used to be impractical, since judges required a formal plan of reorganization and creditors’ approval before allowing the deals. Since the mid-1990s, though, judges have been using a provision of the federal bankruptcy code known as section 363 to push the sales through without the process. Including those so-called 363 sales, liquidations have risen from an historical 5 percent of cases to nearly 50 percent in 2002, according to UCLA Law School professor Lynn M. LoPucki.

While the lack of input from creditors raises the problem of sweetheart deals between managers and buyers (see “What’s Wrong with this Picture?” January), some say the asset sales make better economic sense than reorganizations. “A buyer brings fresh financing, fresh ideas, and new energy,” says bankruptcy attorney Richard Tilton. “For a lot of companies, that may be the best way to preserve asset values — and jobs.”

Sidebar: Coming Attractions

WorldCom

WorldCom (now MCI) — filed July 2002, hoping to emerge by September 2003.

The Plan: The telecom giant expects to retain most core assets, cut liabilities from $42.5 billion to $12 billion, and grow profits by more than 300 percent over the next two years while boosting revenues by about 12 percent, to $27.8 billion by 2005. Estimated enterprise value: $12 billion.

The Prognosis: Skeptics note that revenues are generally declining within the industry, and that low capex spending during bankruptcy may hurt it. But few believe the company will fail again. “WorldCom is setting itself up to be a great growth company,” says Vik Grover, vice president at Kaufman Brothers. It is the “best-positioned M&A candidate” in the industry, with Verizon a likely buyer within the next two years.

Enron

Enron filed December 2001, has until June 30 to file a reorganization plan.

The Plan: After trying to sell off major assets as a single entity, Enron switched gears and announced plans to form both an international energy company and a domestic pipeline operating company. It will continue to shop around unrelated properties. With its fourth deadline extension, a more-detailed plan is due to the court by the end of this month.

The Prognosis: The intangibles that drove Enron’s onetime $80 billion market value will be hard to re-create. And deriving value from current assets may be no easier, if its initial asset sale is any indicator: UBS Warburg took Enron’s trading operations (which accounted for 90 percent of revenue) in January 2002 for nothing but the promise of future profit-sharing. “We’re not expecting much to come of Enron — they’re pretty much done,” confides one turnaround expert.

Conseco

Conseco filed December 2002, on track to emerge in June 2003.

The Plan: Last year Conseco sold off its finance unit (which filed separately for Chapter 11) and is seeking to emerge as an insurance-only company. Its plan, approved in March, calls for slimming down debt from $6 billion to $1.4 billion and growing revenue slowly, from $4.38 billion to $4.43 billion in 2005, while turning a profit. Estimated market value: $3.8 billion.

The Prognosis: A $7.8 billion loss in 2002 and a court battle with Donald Trump over ownership rights to the jointly held General Motors building in New York haven’t helped. However, Standard & Poor’s director Jon Reichert is “pleasantly surprised” at bankruptcy’s impact on insurance sales, down only about 2 percent last year. His main concern? Steep interest payments.

Epilogue
How companies fare after bankruptcy.
Company (when exited Chapter 11) What Happened Next Stock Price
Comdisco (8/02) After selling its IT-services division to Sungard in 2001, decided to liquidate and pay off creditors by 2005. So far, has sold $2 billion in assets and redeemed over $1 billion in debt. $165 OTC
Covad Communications (12/01) The Internet service provider emerged with $1.4 billion less debt, but operating cash flows have stayed negative, at $74 million in 2002. $1.27 OTC
Finova Group (8/01) The former financial-services group is in the process of liquidating assets. Having sold about $800 million so far, finally turned a profit in 2003. $.16 OTC
ICG Communications (10/02) Debt dropped from $2.8 billion to $303 million, but the Internet and phone company will need $70 million over the next two years to cover remaining obligations, according to its exit plan. Now planning to lay off up to 20 percent of its workforce. $5 OTC
Loews Cineplex (3/02) Acquired by Toronto-based investment firm Onex, the theater chain is now private, but filed to go public and issue more bonds last August. NA
Rand-McNally (4/03) After reducing debt by $250 million during its two months in bankruptcy, the mapmaker was taken private by Leonard Green & Partners. NA
Sunbeam (12/02) Now American Household, creditors including Bank of America, Wachovia, and Morgan Stanley took control of the home-appliances maker after its second Chapter 11 filing in 2001. NA
Vencor (4/01) Core operations have turned profitable since Vencor, now Kindred Healthcare, emerged. However, it’s hampered by reduced Medicare payments and professional-liability costs. $17.97
Nasdaq
Washington Group International (1/02) Despite filing for bankruptcy twice in six years, the construction giant wiped out all of its debt and generated a profit last year. Future looks solid, with more than $1 billion in new contracts. $20.15
Nasdaq
Williams Communications Group; now Wiltel (10/02) Bankruptcy took the telecom giant’s debt from $5 billion to under $600 million. With a $250 million cash balance and negative cash flow, some analysts expect to see it in Chapter 11 again. $10.60
Nasdaq

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