Description

Company:                Michaels (MIK)

Security:                  $2,114mn L+250 Term Loan B1 due 2023

Price:                       85c / 10% YTM / 4% CY

Summary

Michaels’ first lien senior secured Term Loan B1 maturing 2023 offers attractive absolute return (+10% yield-to-maturity) and low probability of permanent capital loss. Michaels is less impacted from coronavirus than other retail companies (apparel, or speciality products) with many Michaels stores having remained open during lockdown. Liquidity is adequate to withstand the COVID-19 shock in Q1/Q2 2020; the company has drawn $600mn on its revolving credit facility to bolster liquidity, priming the term loans, but RCF reliance will likely be temporary. Current market prices create the company at 3.5-4.0x through the Term Loan at depressed 2020 expected EBITDA (~$550mn).

 The notes offer near-term potential upside if they rerate towards other similarly rated securities. L Brands Inc senior unsecured notes of similar duration are also rated B+, for example, and trade with ~7% yield-to-maturity. Investors purchasing the notes today in the mid-80s would achieve ~15-20% annualized total return if they were to sell their position in the low-90s by the Jan 2021 coupon date, including interest (assuming 1% LIBOR floor) and scheduled amortizations.

 Description:

 The Michaels Companies is North America's largest provider of arts, crafts, framing, floral & wall décor. The Michaels Companies, Inc. owns and operates more than 1,250 Michaels flagship stores. Michaels’ equity has been written up multiple times on VIC from both the long and short side over the last few years. Nychrg’s short pitch from 2018 provides an overview of the long-term challenges facing Michaels’ business model, particularly given the company’s minimal presence in ecommerce, and private equity shareholders’ conflicts of interest. See abra399’s Dec-2019 post and messages for more recent discussion.

 Michaels’ operations have been more resilient than many discretionary retailers in recent months. Demand for arts and crafts has been supported by both children and adults spending more time at home; Michaels saw a pickup in Feb/March in children’s’ crafts as consumers prepared to stay home. The company closed stores during the recent shutdown where necessary but continued to operate out of many locations. Curbside and contactless pickup will partially offset weaker results from the shutdown. The company should see a gradual rebound once stores fully reopen given back-to-school sales, Halloween, and thanksgiving/Christmas holidays. The crafts category also tends to be less discretionary when emerging from demand shocks, which should support results relative to apparel and other specialty retailers as economic growth and consumer confidence drops; Michaels’ comparable sales was down -4.6% in 2008, stable in 2009 (+0.2%) before returning to low-single digit growth.

Situation overview:

 Michaels’ securities have been hit in recent months, alongside other retailers with meaningful debt levels. Equity market capitalization fell from >$1bn in January 2020 to ~$500mn today. The Term loans traded in the mid-to-high 90s (~5% ytm) prior to the Feb/March 2020 market decline. The TL was quoted in the low-70s before Fed action and subsequent March rebound. The Term loans have rallied in recent weeks but continue to offer attractive risk/reward potential in the mid-80s. The Term Loan at ~85 reflects general concerns over leveraged retail companies in the current environment and lingering uncertainty over the impact of tariffs. Recent rating downgrades have also likely weighed on prices; S&P downgraded the TL to B from BB- and bonds to CCC+ from B- on the expectation that traffic will fall near-term and online won’t be sufficient to offset sales declines.

Summary Financials

Revenues have been deteriorating recent years. Some analysts had been expecting particularly weak figures in Q4 2019 given tariffs and issues transitioning between seasons. However, the final quarter of 2019 showed some decent progress which may bode well for post-COVID normalized operations; transitioning between holiday seasons was smoother than Q3 and resets of certain categories were well received. eCommerce grew 30%, albeit from a low base (~5% of sales). The company exited Pat Catan and Aaron’s stores and purchased the AC Moore trademark. $317mn Q4 EBITDA brought FY2019 EBITDA to $734mn, 3.1x net leverage (~$350mn of FCF before working capital adjustments).

Investment Thesis:

The investment thesis for the 2023 Term Loans relies on Michaels’ solid near-term liquidity, favourable debt maturity schedule and attractive valuation through senior secured notes at current market levels.

Liquidity – Liquidity remains solid with over $400mn cash and $850mn revolving credit facility. Michaels proactively drew $600mn on its ABL to boost available liquidity in March.

Q1 2020 results will be released next week (June 4). Free-cash-flow burn could exceed $150mn in Q1 2020, assuming ~$600mn revenue and negative EBITDA. Up to to -40% sales decline in Q1 could still be funded with cash on hand with the RCF provides additional flexibility; most sell side analysts expect ~30-35% sales impact in Q1 under a stressed scenario. The company is cutting capex and managing working capital to support cash flow. Reducing stock buybacks, a reoccurring cash usage, will LAO preserve cash in the near-term. Levered free cash flow should still remain positive for FY2020, even assuming fairly pessimistic $400-450mn adj. EBITDA for full year 2020 (-40% YoY). Most analysts are expecting ~25% decline in EBITDA in FY2020 to approximately $550 and positive free cash flow (>$200mn).

Maturity schedule – Michaels’ adequate liquidity and lack of near-term maturities mitigate the uncertain operating environment. The nearest maturity is the company's term loan due in January 2023.  Michaels has a high probability of refinancing the Term Loan’s at or before maturity; operations should have recovered fully from the coronavirus and potential aftershocks by 2023. The company’s structural issues and encroachment by online retailers will also likely be gradual, resulting in margin pressure over the long-term; any negative impact is unlikely to materially impact refinancing prospects. Investment in the 8% 2027 senior unsecured notes (80c, ~12% yield-to-maturity), in contrast, requires more faith in the long-term prospects of the business.

 Valuation – Net leverage at face value will likely increase to above 4x in 2020 given the impact of COVID-19 and tariffs. Even at depressed 2020 levels, term loans at 85c are creating the company at ~3x enterprise value (3.5x through the senior unsecured). Management reaffirmed its target leverage ratio of 2.5x to 3.0x during the Q1 earnings call; partially repaying term loans could well be considered if FCF remains positive in 2020. Total enterprise value above $2.4bn fully covers secured debt at current market value (assuming $600mn ABL at 100); one would need to assume normalized EBITDA well below $600mn (versus roughly $700mn FY 2019) and below 4.0x EV/EBITDA multiple to project insufficient asset support at current term loan prices.

In a downside scenario, Term Loans would likely control a Chapter 11 restructuring process given size and probable position as the fulcrum security. Debt capacity would remain above $2.5bn if normalized cash EBITDA is $550mn or higher and capex is below $150mn. Even under fairly pessimistic assumptions (15% FCF yield, 10% cost of debt, >$125mn capex) secured notes should recover at least 80% in debt and near-par including post-reorg equity ownership.

Risks:

COVID-19 impact worse than expected

Tariffs impacts margins more than expected

Lack of hard assets to support valuation

Private equity shareholders act against creditors' interest 

Catalyst

Better than expected Q1 2020 results

Repayment of RCF

Partial repayment of Term Loans