Equifax's Lehman Moment Looms

|
About: Equifax Inc. (EFX)
by: Bull & Bear Trading
Summary

Markets may be in denial about the size and scope of the liabilities that are rapidly approaching Equifax. Legal expenses have already begun draining cash from the company.

Equifax was already in a surprisingly weak financial condition prior to the emergence of its current crisis with only $400 million in cash and questionable total assets.

The liabilities that may outstrip Equifax's small cash position and total assets will likely occur against a backdrop of rising expenses and decreasing revenues, resulting in compressed cash flow.

We are reminded of the Bear Stearns moment that was followed by relative quiet ahead of the Lehman moment. Certainly, Equifax's individual corporate problems are much smaller in scale, but the analogy stands.

Investors should note that ratings agencies are often lagging market indicators rather than leading market indicators. This is because they are generally reactive and not predictive by design.

The S&P lowering of the outlook for Equifax's (NYSE:EFX) credit rating from stable to negative may be a harbinger of approaching events for the company. However, investors may want to note that this downgrade in credit has had a minimal effect upon the company's bonds so far relative to what may occur in the future. Although the first leg lower in the price of the company's stock has been severe, some investors may currently be lulled into a false sense of complacency since the downgrade and decline in the price of Equifax bonds has been muted up to this point. Be advised, ratings agencies are generally not a precursor to the full extent of future events. Investors in Equifax's securities may find themselves waking up to the news of a near-term event for the company that was not fully accounted for in the initial downgrades by agencies such as S&P and Morningstar. The message here is, as always, perform your own due diligence and make investment decisions using your own good, common sense.

Chart EFX data by YCharts

While the Equifax individual corporate crisis is obviously on a much smaller scale than the subprime mortgage crash that contributed to the nation's financial crisis, investors should note that ratings agencies were slow to implement downgrades in that situation also. Ratings agencies are often times reactive to market events rather than predictive of the future. This makes them less of a leading market indicator and more of a lagging market measure of value.

The Bear Stearns Moment Preceded The Lehman Moment

I remember the morning that news broke of Bear Stearns' failure and pointing this event out to my young son as significant. I had no idea of the extent of the systemic issues that were emerging in the U.S. investment community, but I remember telling my son that something must be wrong for an old line, revered firm like The Bear to have failed. As a stockbroker with NYSE member firm Oppenheimer & Co., I had accepted an offer of a recruiting visit to the Atlanta office of Bear Stearns in 1989. I opted to start my own research boutique and later founded and managed a small hedge fund instead, but I used the clearing services of Bear Stearns Securities Corp. for a time. Don't let me forget that The Bear had a good corporate league basketball team that I enjoyed playing on for a few games as well. I had friends who worked with the firm, so the news of Bear Stearns demise came as a shock and a disappointment.

The Bear Stearns moment should have been a full-fledged wake-up call to all that something very serious was amiss in our financial system. There were a few prudent investors who took the failure of Bear as part of their cue to reposition assets accordingly. But market psychology is an interesting study, and investors often make decisions with more emotion than we would like to admit. The graphic below may seem somewhat humorous, but there is some accuracy in the description of the emotional states that investors sometimes feel during the course of a trade. Could the current emotional state of investors in Equifax securities since the early September revelations of the cybersecurity breach be found in the range between Anxiety, Denial, and Fear? Upcoming negative events for Equifax could push these investors further down into emotional distress.

Prudent Investors Were Prepared Prior To The Lehman Moment

Knowing the future is very difficult, but those who are able to read the tea leaves in our industry can acquire and preserve wealth. The Bear Stearns moment was a clear signal to investors that there were serious underlying problems in our financial system. But it was not until several months later when Lehman Brothers failed that the full size and scope of the systemic failure of our financial system became clear.

On a much smaller scale, an analogy can be drawn to the "Equifax moment." In September 2017, investors were alerted to the fact that the company had a major cybersecurity breach that could threaten the company's existence. Markets have sold off Equifax to a degree, particularly in stocks. But the bond market has not yet reflected the extent of upcoming liabilities. And, as investors begin to quantify the enormity of the upcoming liabilities for Equifax, it is reasonable to anticipate further legs lower in the price of the company's shares.

Rather than relying upon ratings agencies or the dubious reputation of a firm like Wells Fargo (NYSE:WFC) which has issued a buy recommendation on Equifax stock on 9/22/17, let's candidly discuss the possible endgame for this troubled company.

To be succinct, the existing liabilities of Equifax, combined with the approaching wave of legal expenses, penalties, fines, and judgments, are highly likely to outstrip the company's shockingly weak cash position and total assets. Please reference Equifax's June 30, 2017, Form 10-Q for a review of the company's extremely weak financial position heading into the tsunami wave of expenses, debits, and charges that the balance sheet is about to suffer.

Cash Flow

Going forward, it is reasonable to expect a much higher level of ongoing expenses for Equifax on a quarterly basis. Increased cybersecurity measures, legal expenses, and other items occurring as a result of the security breaches are to be expected. These rising expenses are likely to occur against a backdrop of lower revenues as the company's brand has been badly damaged, and many former customers have now become plaintiffs in the many lawsuits that are emerging against Equifax.

The combination of higher expenses against lower revenues would decrease free cash flow. It is conceivable that Equifax's expenses could rise so significantly against sharply declining revenues that cash flow goes negative. The event of negative cash flow for the company remains to be seen at this time, but suffice to say that free cash flow is going to be greatly reduced going forward.

With greatly reduced free cash flow, how can Equifax's weakened financials be expected to maintain operating expenses; service its existing debt; maintain the dividend; implement additional security measures; pay rising legal expenses; and meet the obligations of the upcoming wave of fines, penalties, and judgments that could soar into the billions?

The answer to this question determines the survival or death of Equifax. Let's review the company's available cash and total assets and make an assessment of Equifax's chances for survival:

Cash


Equifax's surprisingly weak $400 million cash position is likely to be exhausted quickly by rising corporate and legal expenses as a result of the cybersecurity events that have impacted the company. If any cash can be spared from paying these ongoing expenses, then it will be needed to at least attempt payment of what is very likely to be billions in legal liabilities. This previous article by Trader's Idea Flow discusses these liabilities in more detail.

Most reasonable investors do not believe that Equifax's dwindling cash position will satisfy the rising tide of expenses and legal liabilities that the company is now beginning to experience. So, as Equifax's cash position is exhausted at the same time that cash flow is in jeopardy, the company may need to liquidate some degree of total assets to meet its obligations.

Let's review the June 30th, 2017, Form 10-Q from Equifax to assess the viability of funding what may be billions of upcoming expenses and liabilities. Since these costs are almost certain to exceed the company's decreasing cash flow and small cash position, what total assets are available for Equifax to liquidate?

Total Assets

Equifax claims only about $7 billion in total assets. Again, this is a surprisingly small number when considering the age, relevance, and scope of Equifax's reach in our economy. However, Equifax's most recent 10-Q reports only $7 billion in total assets. But wait, that's not quite accurate. A closer review of the most recent Consolidated Balance Sheets shows that an entire $4 billion of total assets comes from goodwill. Another $1.3 billion of total assets comes from intangible assets. The excerpt from the Q2'17 Form 10-Q above documents this surprisingly bad news from Equifax.

How many attorneys are going to accept payment for legal expenses from Equifax in the form of total assets liquidated from Goodwill? In fact, after the recent events and conduct of Equifax's management, how much Goodwill do you believe the company now has remaining? Can we agree that when reviewing total assets of Equifax that we must reduce its claim of $7B by subtracting the bogus claim of $4B in Goodwill? Okay, this leaves $3B in total assets.

And, how many plaintiffs are going to be willing to accept payments of judgments from the liquidation of total assets from intangible assets? What value would you now assign to the IP and IT assets at Equifax after their disastrously incompetent display of technological ineptitude? Okay, subtract another $1.3B from the dwindling total assets number of $3B. This leaves us with only $1.7B in total assets.

Our review of total assets available for Equifax to liquidate and pay the upcoming billions in liabilities that the company will be required to pay seems to be coming up way short. We are now getting pretty close to the liquidation value of office furniture, old PCs, monitors, and office plants. Do you think the City of Chicago will accept payment from Equifax consisting of a few thousand office chairs if Equifax offers to throw in a few nice fern plants into the bargain? No? Didn't think so.

Existing Debt

Existing long-term debt is $2.8B. If you are a creditor of Equifax currently, then what chances are you giving the company of continuing to meet its obligations to service its debt? The company is in a very weak financial condition with a huge amount of financial liabilities forthcoming. The negative impact of Equifax's incompetence is already siphoning cash from the balance sheet, and expenses will continue to rise sharply going forward. If you are an institution holding a debt instrument issued by Equifax, do you try to unload it at the best price possible on the open market? Or, do you examine the securities covenant for a call provision? If Equifax's debt were to be called, then expect the company to be put into receivership while a bankruptcy judge awaits the determination of legal expenses and liabilities. The small amount of Equifax total assets will be divided between creditors, plaintiffs, and attorneys demanding payment. Insolvency is the likely outcome for Equifax. It is time for markets to accept this increasing likelihood.


The above discussion of the endgame for Equifax is clearly not good news. After careful review, we regret to inform Equifax that its application for credit has been rejected. This decision is final and cannot be appealed. Tough luck.

Summary

The Bear Stearns moment was a harbinger of events to come in our nation's financial crisis. The demise of Bear Stearns was a precursor to the Lehman moment in which investors became fully aware of the size and scope of the enormous problems in our financial institutions. Analogous to the Bear Stearns moment, albeit on a much smaller scale, investors in Equifax should be cautious that the initial revelations of bad news for this company could be a precursor for further bad news. The initial leg lower in the price of Equifax shares could be followed by successive rounds of selling that could drive the price of Equifax's stock much lower.

The revelation of the Equifax cybersecurity failures and the string of mis-steps that followed have enraged the public, regulators, elected officials, and the media. This Equifax situation should not be compared with any other previous security breach. The Equifax situation is in a league of its own. Prudent investors may want to consider divestiture of any Equifax securities.

The first wave of expenses resulting from Equifax's many levels of incompetence, negligence, and malfeasance are just now beginning. These expenses and liabilities will ramp much higher in the future and could last for as long as Equifax remains solvent.

The most recent Form 10-Q for Equifax discloses a surprisingly weak financial condition that will be quickly overwhelmed by the emerging expenses and liabilities that are forthcoming. We must reasonably conclude that the dividend is in jeopardy. Rising expenses and declining revenues could cause compressed cash flow. Creditors should be on watch for a possible default on the company's debt as expenses and liabilities continue to rise.

  • A few of the sources of liabilities that are emerging: Federal, state, and municipality governments - We actually can stop right here since the legal expenses and liabilities from these entities will be huge and could cause Equifax to become insolvent.

But there are also further legal expenses and liabilities that could contribute to Equifax's insolvency:

  • Banks, credit unions, and other businesses have begun to bring civil actions against Equifax;
  • There will likely be lawsuits filed in Canada and the UK at least. There may be other international liabilities as well;
  • Consumer protection agencies and watchdog groups;
  • Consumer class action lawsuits;
  • The Securities Exchange Commission;
  • The Department of Justice;

Conclusion

Insolvency and receivership where a bankruptcy judge determines the division of remaining assets between Equifax's creditors and plaintiffs is a very possible outcome for this crisis situation.

The rising tide of lawsuits from all levels of government; consumer class actions; lawsuits from banks and credit unions; international litigation in at least the UK and Canada; penalties and fines; and the enormous legal expenses to provide some semblance of a legal defense in all of these venues is now becoming unlike anything the world has ever seen. Liabilities and expenses could soar into the tens of billions of dollars. We cannot yet quantify the enormity of these legal costs.

But what we can quantify from Equifax's 6/30/17 Form 10-Q is that the company is in a surprisingly weak financial condition prior to this crisis. Barely $400M in cash. After subtracting $4B Goodwill and $1.3B intangible assets from total assets claimed of $7B, there would only be about $1.7B in total assets. Liquidation value of these suspect assets claimed by Equifax would likely be pennies on the dollar.

This shockingly weak financial position comes against a backdrop of sharply rising expenses and an anticipated drop in revenues that will negatively impact cash flow.

The chances for Equifax to survive this debacle are slim to none, and slim was recently spotted leaving town.

Disclosure: I am/we are short EFX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.