The term “bankruptcy” conjures bad feelings for most companies. However, there is a reason chapter 11 of the bankruptcy code exists, which is for reorganization instead of liquidation. Sometimes it is in the company’s best interest to declare chapter 11 bankruptcy to ensure long-term success. Of course, the rather unfortunate impact is that the current stockholders and some of the company’s creditors lose out. However, as an investor, it is important to determine if a company should declare bankruptcy before deciding to invest and potentially losing your investment.
Candidate for Bankruptcy
Horizon Lines (HRZ) is a perfect example of a company currently facing credit issues that I believe should declare bankruptcy to reduce its massive debt balances, to more easily reduce certain expenses, and to give the company time to build up a new line of business. I recently analyzed the company as a potential special situations investment. However, it quickly became clear to me that, even if HRZ received the refinancing it needs, it would only be a temporary band-aid. The only solution I can see for this company is bankruptcy.
HRZ is the nation’s leading Jones Act container shipping and logistics company, accounting for approximately 37% of total U.S. marine container shipments between the continental U.S. and the three non-contiguous Jones Act markets, Alaska, Hawaii, Guam, Micronesia and Puerto Rico, according to the company’s website. Under the Jones Act, enacted in 1920, domestic U.S. maritime trade is restricted to U.S. owners of U.S.-built and flagged vessels manned by predominantly U.S.-citizen crews.
The Jones Act, while not favorable in a modern global economy, protects HRZ from most competitors and is not likely to go away anytime soon. Being the largest Jones Act company further creates competitive advantages for HRZ that are costly to overcome. HRZ is the only shipping company in the world that services all U.S. territories when the originating port is also a U.S. territory. Organizations such as Wal-Mart (WMT), Costco (COST), and the U.S. Postal Service have to get their cargo to places like Hawaii and Alaska somehow, and air freight is too expensive.
Reasons for Bankruptcy
Unfortunately, despite this competitive advantage, the company has suffered negative net income for years and has only maintained positive operating cash flows recently by reducing working capital. Paying for and maintaining a fleet of vessels is costly, and debt has mounted as a result. Debt currently comprises roughly 92% of total capital and the company has even admitted it will likely violate its debt covenants in Q2 of 2011. Below are a number of the issues I found with HRZ, most of which bankruptcy would help resolve or alleviate.
- In the container transportation business, equipment flow is key for driving margins. Maximizing utilization of the containers must be a priority. However, HRZ suffers from a characteristic of the markets that it serves that simply cannot be overcome; namely, the company can ship full containers to places like Alaska, Hawaii, and Puerto Rico, but there is no possible way of shipping full containers back to the continental U.S. There simply is not enough manufacturing capability originating from those locations. Maybe mail can be, since HRZ services the USPS, but government shipping is notoriously low margin. Pacer International (PACR), a company in the intermodal transportation industry, dropped its U.S. military business because the margin realized was a mere 1%.
- To overcome the equipment flow problem for at least the Hawaii and Guam lane, which is the longest lane, HRZ had an arrangement with another shipper called Maersk whereby, after unloading the containers in Hawaii or Guam, HRZ would continue on to Asia and Maersk would take the empty containers and put on full containers for HRZ to ship back to the U.S. This arrangement allowed HRZ to increase equipment utilization and revenue for this lane. However, that arrangement expired on Dec. 31, and Maersk opted not to renew it. To replace this lost business, HRZ decided to start its own international shipping operations from Asia to the U.S. in December of 2010. The company has just started this up and it needs time to grow. This is one reason bankruptcy is the preferred option. It gives HRZ time to grow this business, a long-term strategy, without fighting the short-term demands of its credit issues.
- HRZ has 20 vessels, only 16 of which are in operation. The other four are in reserve for peak seasons or when the others are dry-docked. One of those four needs dry-docking maintenance before it can be re-used. This seems highly inefficient. Vessels are very expensive and usually require a high capacity utilization for the company to get its money’s worth. These vessels should probably be sold to reduce expenses and generate cash to pay off some debt. The current debt agreements may limit HRZ’s ability to do this. As a result, this is another reason bankruptcy would benefit the company. HRZ would be able to sell some or all of these vessels to pay down debt or at least be given more time to find a fair price for these vessels.
- The company pled guilty to anti-trust violation allegations with the DOJ for its Puerto Rico trade lane only. HRZ apparently price-fixed with its major competitor(s). The fine was originally $45M, and later reduced to $15M. As a result of this, there are 58 different class-action lawsuits from direct purchasers. This was provisionally settled for $20M plus future price concessions. That settlement is not yet finalized, but the final price concessions will reduce future margins even more. Further, some customers opted out of the class action suits and are seeking separate damages. This will result in additional costs and price concessions. Finally, there are also securities class action lawsuits from investors who lost money when the stock price dropped as a result of the revelation of the price-fixing. Again, bankruptcy would help tremendously by likely eliminating any remaining lawsuits.
- The former CEO and chairman "retired" in February 2011 with a severance of $2.3M over 25 months, along with a two-year non-compete. After leading the company to the state it was in and allowing the price-fixing, he should get nothing beyond the $96K a month he is getting. Further, the interim CEO is getting paid $90K a month or $1,080,000 annually plus benefits. For a company that loses money, that salary is not defensible. Bankruptcy court would likely force the company to reduce salaries and the severance package given to the former CEO, given the timing. Admittedly, this factor may unfortunately be preventing the company from declaring bankruptcy, since obviously no executive wants to give up his or her perks.
- 1,267 of 1,890 employees are unionized and likely very costly. With the former and new CEOs getting paid so much, the company has absolutely no leverage to negotiate a new CBA with the unions. Again, bankruptcy might help improve its CBAs.
- HRZ has 113 sales people across its markets and believes that figure to be the highest of any container shipping and logistics compant active in the company’s markets. Since HRZ is not the largest fitting that description, it clearly has higher customer acquisition and retention costs than its peers. Again, bankruptcy would force the company to take a close look at this if the threat of bankruptcy will not.
- There is something called the Capital Construction Fund that is negotiated with the U.S. government. Basically, HRZ, as a shipper, can defer taxes on all earnings that the company plans to eventually use to build vessels. However, those earnings put aside must be used to build vessels or the amount will be taxed at the highest rate -- plus interest will be applied for all the years since it was placed into the fund. The current deferred tax liability related to this is $14.8M, indicating a fund balance of $42M assuming a 35% tax rate. That is $42M in funds the company is restricted in using, from what I can tell. It seems that bankruptcy would help with at least the interest, though the taxes would likely still be due even under bankruptcy.
I understand the company can probably continue to struggle along as is, amending debt agreements at a higher and higher cost to avoid covenant defaults. However, I think it will continue to be unsuccessful with all the headwinds it is facing. A better long-term strategy by the company would be to file bankruptcy and get rid of many of these headwinds. Further, the company will also have more control over the bankruptcy process if it voluntarily declares it rather than have it forced upon it by its creditors if it violates debt covenants. The company might even be able to put together a pre-packaged deal with its creditors, which will greatly reduce lawyer and advisor fees.
There have been a number of companies in the past with great assets, which I believe HRZ to have, that had to declare bankruptcy. Those companies greatly benefited by bankruptcy and emerged from it as much stronger and more competitive companies. While I expect HRZ to declare bankruptcy or to be forced into it by its creditors, I look forward to the opportunity to possibly invest in the company when it emerges from bankruptcy.
In the interest of full disclosure, we are not shorting the company, we have no plans to short the company, nor do we recommend shorting the company.