Continuing a discussion from a recent show focused on crafts retailer The Michaels Companies (NASDAQ:MIK), our podcast hosts tackle two important red flags: significant private equity ownership, and the company's rather significant debt load. Click below to listen to a detailed breakdown of these two risks.

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This video was recorded on Oct. 1, 2019.

Nick Sciple: There are a few red flags -- maybe pink flags -- that might say that this company has some value trap characteristics to it. We've talked about its high leverage. One issue we haven't dived into deeply is that major private equity shareholding. First off, Asit, when you see a company that has nearly half of its stock held by private equity holders, what are the first things that come to your mind? What are the light bulbs that go off that you should start looking at when you see a company like this?

Asit Sharma: The first light bulbs that go off in my mind are, why does this company have a partial float of shares that's public? Maybe I'm a cynic, but often, that can mean that the private equity company has looked for a way to get its share. It's made an investment in a struggling company. Most of the time, it's encumbered the balance sheet. It'll take control of a private company, leverage it to the hilt, and then gradually seek ways to get their returns, which can mean selling off divisions, it can mean doing an IPO for a certain portion of the shares. And then, once part of the company is traded publicly, to continue to exert this control over management, to call the shots in a fashion manner that benefits the private equity company -- and this is not anything illegal. It's often spelled right out in those IPO documents as a risk, "We still will retain as major shareholders XYZ Private Equity Company, and we owe them through all these side arrangements related-party transactions." I have a set of antennae that just shoot up when I hear that a company which is controlled by private equity is going to offer some shares to the public.

Now, that doesn't mean that it can't benefit both the public and the private holders; but you have to do your homework in cases like this.

Sciple: Exactly. Michaels, as you mentioned, it is no different. They disclosed in their 10-K that Bain Capital and Blackstone owned approximately 46% of the stock outstanding, and, quote, "They will be able to strongly influence or effectively control our decisions, and their interests may conflict with yours, the individual shareholder, and that of the company."

We talked earlier about the heavy debt burden of Michaels, and about its free cash flow. Given its high debt burden, we had discussed before the show that if I were managing capital for this business -- a lot of concern and pressure on the valuation that is hurting their net income has been the cost it takes to service this debt, to pay that interest over time. So, it would seem to be prudent to take some of that free cash flow and pump it into paying down debt. However, when you look at the capital allocation decisions of the company, in recent years, they have been buying back $200 million to $300 million in stock over that time. As we've mentioned, the stock has declined markedly over that period of time, noting that those buybacks maybe weren't the best investment. When you see the company pushing funds toward buybacks, when we think maybe it'd be more prudent to use that toward debt service, does that contribute to those little feelings, with antennas being up about, maybe the private equity folks are helping push the company to buy shares back from them?

Sharma: Yeah, a little bit. Obviously, reduced float out in the marketplace theoretically will at some point in time increase the value those shares as they get scarce. But, for that to happen, there's got to be demand. But, on the flip side of the coin, so many companies buy back their shares in the hope that it helps prop the share price up. You'll see various corporations get into a rut of allocating a lot of cash because their stock keeps declining year after year. And they watch successful companies buy back shares, and it becomes this self-fulfilling prophecy. You're using precious capital that maybe should be invested back into the company to buy back shares. It's not helping the stock price, and then poor financial results because of lack of investment cause the stock to depreciate further, so you feel more inclined to try to pump the share price up by buying back shares. I'm positive it could potentially equally be a missed cue by management. But, sure, there's the suspicion that the private equity hands are directing the company to reduce that float because, again, that theoretically increases their percentage of ownership over time.

There have been companies that have cycled both public and private. Dell is a great example of a company that's gone through public, private, public iterations. I'm not ascribing any motive to either of these companies, if they want to again take this private. However, you have to wonder at the logic of a struggling company which is not using every last penny to try to reinvest in the business. We'll talk about that as we discuss whether this is a value trap or not.

Sciple: On the topic of debt, another pink flag -- in the most recent quarter, Michaels rolled some of its debt. It had some notes coming due, I believe it was this year, and they rolled that debt out to 2027. When you talk about their leverage, when they rolled that debt, I think the interest rate on that debt had been 3% or 5%. When they rolled that debt, they now have a rate of around 8.5%, maybe higher than that, for these new notes. Given that high interest rate, does that concern you? In today's environment, getting that high of an interest rate, particularly with free cash flow as strong as it appears to be with this company, what are the bankers seeing that we're not seeing in this case, Asit?

Sharma: Bankers tend to evaluate companies in a few different ways. They do what's called spreading the financials. All that means is, they throw the numbers up on an Excel spreadsheet. They pay attention to how the numbers look on a strictly GAAP earnings basis. They compare that, ultimately, to cash flows. The cash flows look OK, as we've discussed. But when you flip over to this look from GAAP, it doesn't look as great. The interest coverage, like, how many times does this cash flow cover interest expense? As I noted before, it's meager. That scares the bankers. It's a less credit-worthy profile that Michaels is presenting on a GAAP basis to the lending public. That's why these notes -- a blend of what you're talking about and this latest refinancing, but let's just round here. They had $500 million in senior notes that were at a previous interest rate just under 6%, so already a high interest rate. That was refinanced at 8%. That's going to cost them an additional $10.6 million in interest a year. Without getting into too fine of numbers here, roughly about 25% of operating income is being swallowed up by interest expense every quarter. That's something that, when the bank turns its ratios and decides how much risk it can take, it just doesn't look so great.

Now, that's not to say that the lending public doesn't believe in Michaels. It has an asset-based lending facility on its inventory and accounts receivable that will allow it to borrow $600 million to $700 million when it needs to, and it periodically taps into that and pays that back during the year, oftentimes before the holiday season, when it's ramping up inventory. It does have sources, access to capital. But, it has to concern shareholders a little bit. How come this debt is staying on the books? Again, we're talking about decades. Wouldn't it be a good idea to try to pay some of this down, rather than buying back stock?

Nick, this is something that you and I both agree on -- the company has some methods by which it can reduce this debt burden. I'm going to go ahead and spell out one of them: why not close some underperforming stores? We've seen over the past few years so many chains which are in deep trouble -- let's say J.C. Penney, Sears, I mentioned Forever 21, which actually didn't quite make it -- the practice is to start closing underperforming stores when you're in serious trouble. Now, Michaels is not in serious trouble. They're pretty stable. They run a profit every year. But they just need to reduce this leverage somewhat. I think it would be a good trimming exercise for the company to do this.

I'll give you one example of a company that successfully went through this. This is Dine Brands Global, which owns both IHOP and the Applebee's franchise. A couple years ago, Dine Brands decided enough was enough, and they closed a good portion -- in the high teens percentage -- of that company store base. That had the effect of improving cash flow, it improved comparable sales, because the bad-performing stores were taken out of that comparable sales space. I think this would be a great exercise to free up cash flow, to remove some of the drag on that income from underperforming stores. The reason the company probably hasn't done it is because it's not in enough trouble, and it's always hard to make that move until the very last minute.

Nick, what about you? Do you see that this is possibly a big hurdle for someone who sees the company as a value play, this whole debt burden?

Sciple: It's tough. Given the free cash flow yield and what it looks like from a value perspective, buying back stock doesn't look manifestly like a bad strategy; however, the market has not rewarded that behavior over time. If I were management, and I was in this position, I would want to try a different approach. As you had mentioned, it's been a significant drag on their net income, their debt service. This is debt they've been carrying for a large number of years. The fact that they're generating what appear to be stable results is not being rewarded by their lenders. They're having to pay higher rates. At this point in time, the prudent move from my perspective would be to adopt a different strategy, try to pay down that debt load. Clearly, what appears to be the concern of the market at this time is that they have such a high debt load burdening the company. To take some of those concerns away from the market would seem to be the appropriate approach. However, management hasn't done that to date. They have noted that there is a new interim CEO in place. Perhaps that's the step to make. Again, to your point on closing stores, it's not urgent to do that this time'; but, the strategy that you've been trying so far clearly has not been rewarded by the market. What could it hurt at this point? That's my perspective on it.

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