Most of my career involved managing money for a portfolio of distressed assets. The term distressed investing is pretty broad, encompassing bank debt, bonds and sometimes equities of companies that are in Chapter 11, or have the potential to file for Chapter 11 bankruptcy.
Recently, Clearwire (CLWR) stock traded down to just a hair over $1.00 a share, from well over $5 in 2011. I have been involved in Sprint since last December, and felt it was worth digging into their cousin Clearwire a tad more.
To summarize, I think that few equity holders really understand recovery process here should Clearwire file for Chapter 11. I also believe that the odds of a Clearwire bankruptcy are quite high.
Perhaps CEO John Stanton's purchase of $5mm of CLWR stock last August gives comfort to the crowd. He does have a good record of insider buying. But cash burn is a huge problem, and understanding Clearwire's legal structure is paramount to making an informed investment decision.
Overall, at $1.10 the risk reward is quite good, but only for those willing to lose 100% of your capital.
From the 10K: "We are a leading provider of fourth generation, or 4G, wireless broadband services. We build and operate next generation mobile broadband networks that provide high-speed mobile Internet and residential Internet access services in communities throughout the country. Our 4G mobile broadband network provides a connection anywhere within our coverage area."
Clearwire's prized assets include its spectrum, comprised of 46.3BB MHz-POPs in the US, and a smattering of leased spectrum in Europe, about 1.8BB MHz-POPs. The company owns more spectrum than anyone else in the mobile world, a whopping 160 MHz of spectrum in the top 100 markets in the US. 160 MHz is very wide, a big channel is 20MHz. With exploding demand for capacity, Clearwire is seen as one of the few options other carriers have to provide it to their wireless customers as smart phones continue to eat up the airways.
BB's of MHz-POPs
The spectrum owned is at the 2500 MHz level, which doesn't propagate as well as lower banded spectrum (like 700MHz). That means more towers and a costlier network to build and operate. The spectrum gets less valuable the higher you go up. I'll discuss valuation of this later and its implications for the stock.
The most important issue in looking at a name like Clearwire is determining its liquidity (cash plus debt capacity). If the company runs out of cash and cannot refinance its debt maturities or make its interest payments, then it will have to file. It's that simple.
A Chapter 11 isn't the end of the world though. It's a well structured process that enables management to continue running the business (hence the name Debtor in Possession or DIP), while at the same time allowing for the priming of existing liens (superpriority liens that is) to provide fresh capital. Aptly named DIP loans provide lending capacity to Debtors (companies in bankruptcy). They rank ahead of all pre-petition debt, ie debt outstanding before the Chapter 11 filing date.
Clearwire looks problematic. There isn't really a scenario I see where they can avoid a restructuring, barring sales of significant amounts of spectrum or rapid improvements in EBITDA. A major red flag I see for Clearwire include its selling wholesale WIMAX services to Sprint on an upfront basis. They seem desperate enough for cash today that management structured their Sprint deal to collect $600mm in 2012, and $300mm in 2013. The problem is, the revenue will be reported properly straight-line, ie $450mm per year.
Interesting that management crowed about their "positive cash flow from operations" in Q1 despite the fact that it was generated from huge deferred liabilities (ie Sprint's prepays)!
In any case, the company forecasted positive EBITDA by 2012 a couple of years ago. In Q1 this year, they burned 38mm in quarterly EBITDA, and have about $550mm in annual interest costs alone. The company has been tight-lipped about EBITDA this year, only remarking that they expect positive improvements to EBITDA. Not the same as positive EBITDA.
Here is a quick liquidity analysis. They will burn through their $1.4BB in cash pretty quickly. Interest on their debt alone is $550mm per year.
Note that their WIMAX capital expenditures ended with completion of that build-out in Q1 2011. The LTE build out will ramp up to include $600mm of capex split between 2012 and 2013. Afterward, it's primarily maintenance capex spending.
In 2015, the first lien senior secured bonds mature. But even using optimistic EBITDA numbers here, they are still $210mm short of cash by the end of next year, 2013! That is a near term concern; they will have to do something to avoid hitting the wall then.
The good news is that $600mm gets them until 2015, when the 1st lien bonds mature. Seems pretty likely that something can be done to get them out to that date. A mix of vendor financing and asset sales may be suffice.
Based on the company's Q1 conference call, they listed 4 items of potential liquidity:
- Strategic Partners
- Asset sales
- Future LTE payments from Sprint
- Capital markets
Strategic partners could be shareholders Google or Intel or Sprint providing fresh capital. Given the performance of their equity investments from 2008 however, I somehow doubt that they want to add to their losses here. But it's a possibility.
Sprint put in a pile of capital last December, but given their own liquidity problems, I don't believe they have the cash to do so again. If they did, shareholders stand to be severely diluted too. Future LTE payments are of course likely from Sprint, but that is baked into the EBITDA projections I provided in the analysis above.
Capital markets are also problematic with unsecured debt and the equity at such low levels. It simply gets too costly to the company to issue huge coupon debt, or too dilutive to issue stock at $1.10 a share as just mentioned.
In 2015 when $2.9BB of the first lien bonds mature, it's possible that they can refinance this, but then in 2017, the 2nd lien bonds also mature. It would be impossibly cost prohibitive to raise 3rd lien debt, or unsecured debt in my opinion. Refinancing the secured notes for one year doesn't help either. Plus the recently issued 1st liens of 2016 (the $300mm done in January) required a 14.75% coupon to get done.
Management on the Q1 earnings (I use the term loosely) call seemed to spend most of their time convincing listeners of the value of their spectrum holdings. I was partly convinced, but then somewhat surprised management isn't more aggressively embarking on an asset sales process, which truly seems the only option to get past 2015. Unless you believe big wholesale agreement comes along to drive EBITDA significantly higher. But those aren't likely before the LTE upgrades to be complete at the end of 2013. And will AT&T and Verizon want to lease capacity from a competitor (Sprint) owned network? And why so many questions on the call about the buildout of the network, and very little on their liquidity?
My problem with asset sales is, they need to sell a lot of spectrum to get past the 2015 bond maturity, or to at least de-lever the company enough to refinance these bonds. And I am not sure Sprint wants Clearwire to sell loads of capacity to their competitors either. They are only a 49% voting holder today, but clearly have significant influence. There is also a super-voting clause in the company's bylaws, requiring 70% of holders approve any asset sales. If Verizon buys the spectrum, then how do they wholesale capacity to them?
Here is the current capital structure (as of March 31, 2012):
Any decent distressed analyst however looks at the legal structure, which in a filling dictates the waterfall of recoveries. Naturally, lenders of assets subject to a Chapter 11 filing get first dibs on recoveries of these assets. The chart below was similar in the 10K too, but didn't show where the cash and debt resided, which is critical to bond and equity recoveries (if there are any).
The blue represents the secured debt, the green is the unsecured debt. A DIP Loan in a Chapter 11 would prime all the debt. Note that B common holders are not entitled to distributions in a liquidation. These holders however will take their share from the Class B Unitholder pot. See the waterfall below.
Common A shareholders need to understand that after paying senior secured debt, they are only entitled to 33% of the proceeds from a sale of the spectrum which resides at the Clearwire Communications LLC subsidiary. (Notice the huge minority interest booked on the company's balance sheet. That is equity ownership of Clearwire Communications LLC).
The public shareholders are the A common holders, at the top left in this chart. In the case of the B shares, there is no recovery should they not convert their Class B Clearwire Communications Units (far right) to Class B common shares.
However, the best way for Sprint to generate any return on their investment is not to convert if Clearwire files. There is in fact, no requirement for them to do so. Sprint's lawyers aren't stupid, they knew that owning a big economic interest in a subsidiary ahead of the common holders would work to their advantage in a bankruptcy. It works to the detriment of the common A holders. But at least the common B holders get no recovery in a liquidation if they keep their CC LLC units. The bylaws are an important read here.
Waterfall of Recoveries
Looking at the cash situation clearly shows that not only will Clearwire burn through its $1.4BB of cash in a couple years, they will also need another $500mm to $1.0BB to get them to 2016 (even without repaying the secured bonds).
I included in this waterfall the Present Value of the spectrum leases, which totals $1.2BB. There is a risk that in a bankruptcy, the FCC will revoke this leased spectrum, but I am no expert on spectrum ownership of public airwaves. I do recall that Nextwave Wireless fought the FCC for years after winning spectrum at auction, then failing to pay for it and filing for bankruptcy. Ultimately they were able to keep their leased spectrum, so I think Clearwire will as well, even in Chapter 11.
I provided a large range of values per MHz-POP numbers to illustrate the proper recoveries in a Chapter 11, from 10c to $1.00. That range provides recoveries from zero or $25.70 per share! I do question management's claim that this spectrum is worth $0.50 to $1.00 per MHz. AWS spectrum sold for $0.54 and $0.68 per MHz POP in a couple transactions, and it is better, lower banded spectrum at around 1900 MHz. The 2500 stuff that Clearwire owns simply has to be worth less.
So, to me $0.50 is the best case, but even that seems not terribly likely. That would equate to a $10 stock to the A shareholders. But given the sheer size and amounts of the spectrum involved, I question that they could actually sell this for a whopping $23BB. They might be able to sell 10 to 20 MHz (of their 160 MHz of spectrum) for a price like that. But selling all of for $23BB, a huge number, wouldn't happen until the airwaves really get choked up, which may not happen for who knows how long.
I think the more likely case is that such a big swath of capacity is worth perhaps $0.20 to $0.34 per MHz-POP, which is where the spectrum was originally valued in 2008. That equates to a range of $1.04 to $5.35 per Common A shareholder. Like I said, it's quite hard to predict when that value could be realized, however. Nextwave's bankruptcy took something like 7 years to get resolved!
There might be upside scenarios here in Chapter 11, most involving a creditor/equity fight against Sprint. Sprint's pricing contract in bankruptcy could be rejected (assuming it's an executory contract). If Sprint did get a sweatheart deal in pricing last Fall, then perhaps the threat of litigation to them for equitable subordination could result in a meaningful settlement. Usually such settlements involve swapping secured claims to subordinate level classes.
One meaningful example: they could be forced to swap out of their Clearwire Communications LLC units for Clearwire Corp common shares. Hard to say, but there likely would be some give up from them. They were all over the board, used to have 53% voting control, and any misconduct resulting in injury to the outside creditors and equity holders merits counterclaims.
It's hard to see this avoiding a default. Best case is some kind of asset sale, refinancing of the secured debt, or perhaps an out of court restructuring. Small asset sales, vendor financing or other capital raises of $500mm or so will get them to 2015, which is 3 years away. But at that point the gig is up.
The risk reward is heavily skewed to the upside though. I can lose a $1.10 a share, and if the spectrum is worth at least $0.20 a MHz-POP, then I'll at least get my money back. Seems a realistic valuation argument for a floor at current prices.
Perhaps the 2015 1st Lien bonds are the way to go. I do think they are covered, but generally I am not a fan of buying debt supported by asset value, but not cash flow. The same perhaps goes for the equity. Clearwire is not a stock for the faint of heart.
There will be liquidity fears to come, which could easily drive the stock to 10 or 20 or 30 cents a share, at which point I would look to establish a real position.
But even today, it's a pretty good speculative bet. If the market rebounds, the stock could easily be a quick double. But the odds of a liquidity event are very high. And that could spell trouble for the stock down the road. Trade it carefully.