As part of a great conversation in the comments over at The Sovereign Speculator, I prepared a list of short-sale candidates meeting the following criteria:

Total assets > 50 * tangible book
EBITDA(ttm) / EV yield less than 5%
Debt > 3 * market cap
Interest coverage ratio MRQ < 1.5

In the search of good value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. However, we must never combine those three things. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap, and if they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Remember that item about how Netflix (NFLX) and Blockbuster (BBI) stand to benefit when Movie Gallery (MOVI) files Chapter 11 and starts shutting down stores? Well, as it happens, Movie Gallery filed Chapter 11 Tuesday, in a pre-packaged reorganization plan lead by Sopris Capital Advisors.

Under the plan, existing MOVI shares would be wiped out; existing equity holders would “under certain circumstances” end up with 2% of the company’s equity. No details in the announcement about store closing plans, although it does say that customers should not be affected by the filing.

I’ll keep this short - there is more detail elsewhere on Barrons.com - but I did want to briefly point out the bullish note Monday on Netflix (NFLX) from Wedbush Morgan’s Michael Pachter.

Pachter makes a simple but compelling case that Netflix - as well as Blockbuster (BBI) - will benefit significantly from the “likely” bankruptcy of Movie Gallery (MOVI). He notes that Movie Gallery could close as many as 1,100 rental stores, leaving $600 million to $900 million in annual video rental revenue “up for grabs.”

Netflix (NFLX) shares rallied some because Wedbush Morgan analyst Michael Pachter upgraded the stock to "Hold" from "Sell" and raised his price target to $18 from $15. Part of the rationale is that Movie Gallery (MOVI)is expected to give up the ghost by the end of this calendar year. He also expects Blockbuster (BBI) to reduce marketing spending.

Yes, Movie Gallery has been parked in front of the coroners office for some time now. If they close 1,000 stores everyone will pick up a piece of a shrinking pie for a little while.

Movie Gallery chose to focus on in-store movie rentals and never pursued online rentals or downloads. In 2005, they bought out larger competitor Hollywood Video saddling them with $1 billion in debt. The company has watched their revenue dwindle in the face of competition from online rentals and struggled under their heavy debt load. Their most recent quarterly filing cites liquidity problems and doubts about continuing as a going concern.

Movie Gallery said business has deteriorated in recent months; it is considering a variety of alternatives, including the potential sale of the company.

At an investor conference Monday, Time Warner's Warner Bros. Home Entertainment Group said it is considering broader simultaneous releases of VOD and DVD movies based on successful trials with Comcast. The results of six-month trials in two markets show demand for VOD jumped 50%, while DVD sales rose 10%, and there was only a "marginal impact" on rentals. Warner Bros. president Kevin Tsujihara said studios take home 60% to 70% of revenues from sales of video on demand titles, but get only 15% to 20% for rentals. Coverage of the conference by The Hollywood Reporter said a Blockbuster spokesman reiterated his stance that studios will be cautious about cannibalizing rental and retail channels, which represent their largest revenue stream at around 70%. Tsujihara of Warner Bros. said he sees the move to VOD as "incremental", but recognizes the potential for improving profit margins over the next 12 to 24 months.

The answer has been that movie studios are afraid video-on-demand will hurt DVDs and, therefore, revenue. But a report today by Thomas Weisel analyst Gordon Hodge says that in the wake of tests, executives of Warner Bros told a conference that they're moving closer to releasing video-on-demand at the same time with DVDs. They found in markets where this has been tested, there was a 50% lift in video-on-demand sales, while DVD sales rose by 10%.

If you just look at the stock prices of the two largest, Netflix, Inc. (NFLX) and Blockbuster Inc. (BBI), its stocks are down over where it was a year ago. Let's take a closer look.

Netflix offers movie rental subscription services exclusively online and has over 6 million subscribers. The stock has a P/E of 28 and a PEG of 1.2. Its latest year over year quarterly earnings growth was up 124% on a revenue growth increase of over 36%. Its balance sheet is in decent shape with over $380 million in the bank, and it has no long term debt.

The firm said such steps may include, but are not limited to, a shareholder rights offering to raise funds from existing shareholders. The possible shareholder rights offering may serve to raise capital from existing shareholders in an effort to reduce bank and/or bond debt so that future interest expense may be lowered and/or to raise cash for general corporate purposes.

The exact terms of the deal weren’t disclosed, but the transaction is expected to close sometime in the first quarter. Like its existing debt, there will be covenants that the company must meet to maintain the debt, but the restrictions on the new debt are likely to be much less restrictive than its current arrangement.

On the Verge of Bankruptcy
The restructuring comes at a desperate time for Movie Gallery. After borrowing heavily to make an ill advised acquisition of Hollywood Video in 2005, the company soon found itself in serious trouble, as the bottom of the video store market began to fallout. With bondholders getting nervous and the fundamentals of their industry rapidly deteriorating, in early 2006, Movie Gallery was forced to convince debt owners to renegotiate the covenant terms on their debt. The move bought Movie Gallery an extra year to help figure out how to turn its firm around, but as 2006 dragged on, liquidity concerns continued to intensify for the company.

In November of last year, things got even worse. Movie Gallery was forced to delay their quarterly earnings filing for almost three months over questions on how to value their store leases. When it did release its quarterly results in late January of this year, the numbers weren’t pretty. Losses continued to accumulate, cash was dwindling down and come April 1st, Movie Gallery was going to have to either file chapter 11 or pay off $780 million to bond holders.

In the filing, Movie Gallery told investors that between cash and access to its line of credit, it was only left with $50 million in liquidity as of Oct 1st, 2006. Because of the increasing likelihood that it would miss its covenant tests in 2007, Movie Gallery was also forced to reclassify its senior credit debt from long term debt to current debt in the same filing. This move prompted analysts to warn that Movie Gallery was facing a cash crunch and could slip into bankruptcy if it couldn’t figure out a way to get a refinancing done. At the time of the filing, Movie Gallery had said that they were researching a sale/lease back transaction with bondholders or possibly a massive equity underwriting to pay off the debt.

With so many competitive threats out there, I haven’t always been so kind to the video store business model. In fact, I’ve probably been downright hostile when it comes to my outlook on the industry in part because I can read the writing on the wall about consumer shifts, but mostly because I believe that the industry’s massive debt and high fixed cost structure will make it impossible for them to maintain profitability in an industry facing revenue decline.

The industry took on so much debt are for a variety of reasons. Blockbuster’s (BBI) debt was a dirty deal for investors and even today shareholders are still suing Viacom (VIA) to try and get their money back. When Viacom first put Blockbuster on the market, they couldn’t find a private buyer. Instead of trying to run the business themselves as a distribution arm, they instead chose to spin it off to an unwitting public. As part of the deal, they forced Blockbuster to make a massive dividend payment after the spin off, which made them assume debt in order to do so. This gave Viacom time to exit their investment, let them rob Blockbuster of their credit and leave a beached bloated whale in the hands of public investors who were too dumb to tell a fish from a carcass.

Movie Gallery, which owns both the Movie Gallery and Hollywood Entertainment video store chains, is deeply in debt: as of July 2, it had long-term debt of $1.14 billion, or nearly 10x the company’s $124 million market cap. In March, the company cut a deal with its lenders to relax the financial covenants under its credit facility for four fiscal quarters. The plan announced at the time called for the company to close unprofitable stores, divest non-core assets, consolidate back-office operations and otherwise improve its financial stability.

The speculation on the Street is that the company will take some action to address the coming expiration of the loosened debt covenants; the theory is that there is news coming before year-end. Debtwire, a subscription-based service for credit market players, is reporting that there are rumors of “an imminent balance sheet fix,” triggering a rally in Movie Gallery bonds. The Debtwire story says that the company has hired Goldman Sachs to assist in a restructuring. According to the Debtwire story, the company could launch a $150 million to $200 million “second lien deal” to pay down part of its $795 million in first lien debt. The story says another possibility would be a debt-for-equity swap; that would not be a good outcome for stockholders, since it would involve a massive dilution of the current equity investors. Other rumored possibilities include some kind of transaction with Blockbuster (BBI), the leader in video retailing, or potentially with Netflix (NFLX).

Shares of the video store chain - the second-biggest after Blockbuster (BBI) - are up 45 cents today at $3.51, a gain of nearly 15%. The stock today is up for the fifth day in a row, a period in which it has gained 26%; since November 1, the stock is up 61%.

The bulletin boards have some vague postings theorizing that the company will hook up with Netflix (NFLX), but nothing that at all seems reliable.

While not providing guidance, management remains cautious about the the video rental market for the current quarter ending Sept.30th, and have now engaged Merrill Lynch to help "explore opportunities to strengthen the company's balance sheet", which is racing toward a violation of bank covenants come January. Turnaround advisory firm Alvarez & Marsal Inc. have also been engaged in an attempt by the company to plug holes into this sinking ship.

Red Robin Gourmet Burgers (RRGB) expects profit, excluding some items, of $1.74 to $1.83 a share this year. Tom Coughlin, the former Wal-Mart vice chairman who admitted to stealing thousands of dollars from the company, was sentenced to 27 months of home confinement. Coughlin had faced up to 28 years in prison and $1.35 million in fines. Coughlin said he would spend the rest of his life trying to undo the damage he had caused.

Coming Soon to Your Screen

Movielink to Offer Films Online That May Be Copied on DVDs

In a word - debt.