Fri 12/18/2020 07:00 AM
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Relevant Items:
Disclosure Statement
Plan Supplement With Exit Documents

Guitar Center’s chapter 11 plan was confirmed yesterday, Dec. 17, setting up its exit from bankruptcy potentially by the end of next week, according to statements made by debtors’ counsel at the confirmation hearing. After emergence, former equity owner Ares, prepetition unsecured noteholder Brigade, and Carlyle will each own about a third of the post-reorganized equity, pre-dilution for a management incentive plan and additional warrants reserved for Brigade. At the value of the $165 million investment according to the plan, these three funds created the reorganized company at about 6.1x estimated fiscal 2021 EBITDA. Prepetiton secured noteholders received, in addition to cash, their pro rata share of new $160 million 15% dividend preferred equity.

As a result of the plan, Guitar Center would reduce debt by $783 million resulting in a more than 5x reduction in leverage. The company said it expects to generate on average approximately $35 million in free cash flow per year from fiscal 2022 through fiscal 2024. EBITDA is expected to remain depressed in fiscal 2021 because of the Covid-19 pandemic, but management said it expects cash flow to be supported by working capital. At emergence, Guitar Center’s liquidity will be limited but is expected to grow through the forecast period.

The following analysis of reorganized Guitar Center assumes the company emerges from chapter 11 on the timeline laid out at the confirmation hearing and that no further challenges to the plan emerge. As discussed below, the plan is supported by a $165 million investment by Ares, Brigade and Carlyle, and, according to the disclosure statement, that funding would be made on the plan effective date, which is subject to the terms and conditions set forth in the investors’ new common equity commitment letters and agreement. Included in the plan is the presence of a triggering event defined as a breach by the investors failing to fund their obligations within the applicable time periods. In the event of that happening, the ad hoc group of noteholders would have the right, but not the obligation, to participate in the equity funding on substantially similar terms and conditions. It is unclear at this time if the $165 million investment has been funded by the equity investors.

Guitar Center operates two segments: Guitar Center stores and Music & Arts. The Guitar Center business offers new, used and vintage guitars, amplifiers, percussion instruments, keyboards, and live sound, DJ and recording equipment through retail stores and online, along with lessons, repair services and instrument rentals offered in its stores. The Music & Arts business specializes in rentals and sales of band and orchestra music equipment to students, parents, schools and educators. Most of the Music & Arts stores provide in-store music lessons and also sell a limited assortment of guitars, amplifiers, percussion instruments and keyboards. Guitar Center operates 296 Guitar Center stores and 229 Music & Arts stores.

Changes to Capital Structure

Through the restructuring, Guitar Center will reduce total debt by $783 million and reduce leverage by more than 5x. The restructuring includes a new $165 million investment by Ares (the prepetition equityholder), Brigade (owned 80% of the prepetition unsecured notes) and Carlyle, in exchange for 100% of the post-reorganized equity, prior to dilution. Other sources of financing for the restructuring include a $375 million exit facility, $350 million of new first lien notes, sold in an offering prior to emergence. The company’s $640 million of prepetition secured notes were partially repaid with $450 million of cash and $160 million in new preferred equity.

Brigade - which, as noted above, owned 80% of unsecured notes - funded one-third of the equity offering and, in addition to its share of the reorganized equity, also received two series of 50-year warrants, each convertible into 7.5% of the reorganized equity. One tranche would have a strike price equivalent to a market value of the reorganized equity of $165 million, and the second tranche at a strike of $264 million.
 


Guitar Center’s pro forma capital structure at exit is shown below:
 

Exit Facility

At exit, the debtors project an initial balance of $239 million drawn under reorganized Guitar Center’s $375 million committed exit ABL. According to the disclosure statement, Guitar Center is expected to borrow a further $24.3 million shortly after exit and prior to the end of fiscal 2020. In addition, Guitar Center would have $7.5 million of outstanding letters of credit. The DS also estimates a $315.2 million borrowing base at fiscal 2020 year-end.

The debtors on Dec. 10 filed a draft of the exit ABL agreement included in their amended plan supplement. Interest on the ABL would accrue at L+1.5% to L+2% based on average daily availability and subject to a LIBOR floor of 0.5%. The ABL would mature in December 2025.

New Preferred Equity

On the effective date, $160 million of new preferred equity would be issued to holders of the prepetition secured notes. Dividends on the preferred would accrue on a quarterly basis at a rate of 15% a year.

As long as initial holders of the preferred equity continue to hold at least 30% of the issuance, holders of a majority of the then-outstanding shares of the new preferred stock would have the right to nominate one nonvoting observer to the Guitar Center’s board and to any committee of the board, the term sheet states.

Terms for the new junior preferred equity in the amount of $2 million provided to unsecured noteholders were not provided in Guitar Center’s court filings.

Prepetition secured noteholders would also have the option to participate in a cash-out option for up to $30 million of the new preferred equity, whereby reorganized Guitar Center would sell the amount of preferred equity up to the $30 million cash-out cap to Carlyle in an amount equal to the face amount of such new preferred equity.

Equity Split

The holders of the post-reorganized equity are shown below, including splits when accounting for dilution from the management incentive plan and two tranches of warrants:
 

Guitar Center provided the following post-emergence organizational chart:
 

Stakeholders

As discussed above, at exit, Brigade, Ares and Carlyle would each own a third of the post-reorganized equity, prior to dilution.

It is unclear which funds would own the preferred equity at emergence. According to the first day declaration, noteholder signatories to the RSA include an ad hoc group of noteholders represented by Stroock (who in the aggregate held approximately $32.9 million of superpriority secured notes, $439.7 million of secured notes and $20.8 million of unsecured notes). To date in the cases, the ad hoc noteholder group has not filed a Rule 2019 statement disclosing its members. Signatories to the RSA, according to a disclosure reviewed by Reorg, outside of the new equity sponsors - Brigade, Ares and Carlyle - include creditors Glendon Capital Management, Mudrick Capital Management, Canyon Capital Advisors, Caspian Capital, FS Investments, Neuberger Berman Investment Advisers and Venor Capital Management. These firms could have owned the secured notes and would hold preferred securities at exit, according to the plan.

Signatories to the exit ABL agreement include Wells Fargo (administrative agent), Bank of America, JPMorgan and Citizens.

Board of Directors

The reorganized board would include 10 directors: the CEO and three each nominated by Ares, Brigade and Carlyle, “assum[ing] … relatively similar levels of common equity ownership as of the closing.” Carlyle’s director would include the chairman of the board.

The governance term sheet includes financial agreements in which each of Ares, Brigade and Carlyle would need to agree, including joint ventures / acquisitions and equity issuances.

Guitar Center filed a plan supplement on Dec. 16 detailing the members of the proposed board.

Implied Valuation

It is unclear where the rights are marked given they are controlled by three funds (Ares, Brigade and Carlyle). However, adding the $165 million investment to net debt of $755 million at emergence would imply an enterprise value of $920 million and enterprise value to EBITDA multiples of 6.3x on Reorg’s calculated LTM EBITDA of $146 million as of Aug. 1 and 6.6x Guitar Center’s estimated fiscal 2021 EBITDA of $139 million.

Financials

Recent Results

For the first half of FY 2020, Guitar Center’s consolidated net sales decreased 19.8% year over year, and Reorg-calculated EBITDA totaled $36.8 million as compared with $76.9 million in the year-earlier period, according to documents reviewed by Reorg. Reorg’s calculated EBITDA does not add back certain Covid-19-related addbacks, such as rent deferrals and compensation during shutdowns, since those costs were not permanently removed.

In the second quarter, Guitar Center’s EBITDA improved to $37.3 million from $34.2 million a year earlier, largely due to a $24.2 million reduction in SG&A.

Although revenue declined nearly 20% in the first half, gross margin fell just 1.8% as a percentage of revenue, and, in particular, gross margin percentage in its Music & Arts division increased 70 basis points. The company said that the increased selling margin was primarily due to a favorable change in sales mix, which included a larger percentage of higher-margin rental revenue and a smaller percentage of lower-margin sales to schools, which, combined, was greater than the negative impact from the decrease in higher-margin lessons revenue. Further, the company said it was able to migrate lessons to an online platform which slowed some of the revenue decline.
 

Projections

Projections included in the DS assume EBITDA reaches almost $200 million by fiscal 2024 and FCF totals roughly $40 million per year.
 

Working capital represents an outflow in most of the projection years, other than fiscal 2021, in which management expects working capital to be a source of cash primarily due to expansion of terms with vendors back to the pre-bankruptcy levels.

Guitar Center said it expects to exit bankruptcy with $64 million of liquidity, which is adjusted for the additional $15 million raised in the exit note offering. However, in the short time after emergence and before the end of fiscal 2020 (likely early February), Guitar Center expects to burn $24.3 million of FCF including $21.9 million use of cash from working capital.

The company had operated with minimal liquidity prior to filing, reporting just $76.6 million of liquidity as of Feb. 1, 2020. In fiscal 2019, Guitar Center generated $6.3 million of FCF. Guitar Center reported EBITDA of $185.1 million in 2019 and capital expenditures of $50.9 million, suggesting a use of working capital and other cash costs which lowered free cash flow. As noted above, in the projection period, other than 2021, Guitar Center expects working capital to continue to represent annual outflows.

Strategy

Following a decadeslong career at various retailers, Ron Japinga joined Guitar Center in July 2014 and has served as CEO since September 2016. Since then, Guitar Center has been on a growth trajectory - in terms of store numbers and its slate of in-store offerings, according to the first day declaration. The company’s retail store growth strategy includes increasing sales at existing Guitar Center and Music & Arts locations, and opening new locations. The company added five new Guitar Center stores and converted one outlet store to a permanent location in 2019. It also opened a new Guitar Center store in the first half of 2020. Store growth is also fundamental to the Music & Arts growth model, and the company opened 67 net new stores in 2018 and 2019, and had a net gain of one store through the first half of 2020.

The company’s forecast assumes about 29 new store openings or acquisitions a year, which would primarily be in the Music & Arts division, according to the DS.

--Mark Fischer
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