A bankruptcy is never fun. But studying what happens as a company approaches a financial crisis is an important and useful exercise in securities analysis. Eastman Kodak’s Chapter 11 filing illustrates many general characteristics, as well as one or two novel twists. Here’s what I see:
a close-in look
–bankruptcy fears feed on themselves. One day a senior analyst at my first job told me about a research report he wrote on a small magazine publishing company. He pointed out gently deteriorating subscriber trends and opined that–unless they were reversed within a year or eighteen months–the company could be out of business. He called the publisher two months later and found out the company was closing its doors for good. Why? The CEO told my colleague that advertisers had read his report, concluded it made no sense doing business with a dying firm and stopped placing ads. Cash flows dried up, the company began to bleed red ink and was forced to cease publication.
Maybe my former colleague’s report was that influential, maybe not. But something did happen to accelerate the magazine company’s decline–a loss of market confidence.
On paper, a firm might appear to have plenty of time to fix current financial problems, but the situation can change dramatically and very quickly if business partners decide to defend themselves against a possible Chapter 11 filing.
What can happen?
working capital issues
End users will likely worry that bankruptcy will mean the end to a product line, or at least a cessation of operating supplies, repair parts and service. Warranties, too. So they’ll hesitate to buy. Anticipating a falloff in demand, wholesalers and retailers may no longer want to carry the products. And they certainly won’t be in any rush to pay the manufacturers for units they have in stock–no matter what terms they’ve agreed to.
Suppliers, knowing that trade creditors have little clout in bankruptcy proceedings, may ask for payment in advance before they’ll ship raw materials.
In theory, these supplier and customer actions should show up on the balance sheet in expanding receivables and shrinking payables, or maybe a buildup in finished goods inventory. In practice, however, my experience is that they’re almost impossible to detect.
–drawing down a bank credit line. Contrary to what people commonly believe, a bank’s commitment to offer long-term finance can be very fragile thing. For money already borrowed, restrictive clauses (covenants) in the loan agreements can easily mandate that if the borrower’s financial condition falls below specified levels, bad stuff will happen–say, the entire principal becomes due immediately, or the borrower has to devote all of its cash flow to repayment.
The same thing applies to unborrowed money, except that the line can be reduced or cancelled outright if the bank sees deterioration in the financials a company periodically submits as a condition of keeping the credit line open. When Kodak suddenly borrowed its entire $160 million credit line (see my post), it signaled to Wall Street that it was worried about this possibility.
–fraudulent conveyance. This is a new one for me. Kodak had been supporting its turnaround efforts in recent years despite by selling patents. According to newspaper reports, lawyers for potential buyers warned of a legal risk were Kodak to enter Chapter 11 soon after a purchase. In that event, lawyers for the creditors could sue to reclaim the patents, arguing the sales price was too low (the fraudulent conveyance). If this tactic were successful, the pre-bankruptcy buyer would have to give up the patents. But it wouldn’t get its money back. It would become an unsecured creditor of Kodak–at the end of the line of those hoping to be paid by the bankruptcy court. If bankruptcy is imminent, why take the risk?
–foot-dragging in litigation. Kodak has also been suing tech companies for violating its intellectual property rights. After its Chapter 11 filing, Kodak complained that the other parties had been dragging out settlement talks, ostensibly in hopes of getting better terms from the bankruptcy court. Maybe so, but what’s so surprising about that?
–resigning directors. Shortly before Kodak’s bankruptcy filing, three independent (that is, not company employees) directors resigned. This isn’t an everyday occurrence. It’s almost never a good sign. In this case, it signaled to me that Kodak had made a very important decision that these directors not only disagreed with but wanted to forcefully distance themselves from.
stepping back a bit
From the Kodak case, I think an analyst can develop a useful checklist of possible bankruptcy symptoms. I have one further, Kodak-specific comment though:
why printers?
I’ve followed printer companies in the US and Asia off and on for the better part of twenty years. My take is that printers, both corporate and personal, are a very mature, brutally competitive, commodity business, whose heyday was three decades ago. Corporate customers play one supplier off against another to get discount services. Retail customers buy machines for well below the cost of making them, while the printer companies hope to eventually earn a profit through ink sales (I understand this may not exactly be the Kodak model, but that in itself is another potential worry).
In my view, this is an industry to get out of, not get into. My questions about Kodak’s strategic direction would make me less willing to back the company, not more–and I suspect I’m not alone in this view. That alone would make business partners quicker to adopt defensive measures than they ordinarily would.
