Saturday, February 04, 2017

Mr. Barrios and the Two Hundred Million Dollars

Mr. Barrios and the Two Hundred Million Dollars by @mookieghana
On Monday, December 12, shortly after the New York Stock Exchange closed, World Wrestling Entertainment sent out a press release. WWE was announcing their “intention to offer, subject to market conditions and other factors, $175 million aggregate principal amount of convertible senior notes due [in] 2023 in a private placement to qualified institutional buyers.” This was a staggeringly large transaction. A few hours later, WWE increased the offer and “upsized” the offering to $200 million in convertible notes.

The sales to the initial purchasers was expected to settle by that Friday, December 16, 2016. In the end, WWE expected the “to result in approximately $193.4 million in net proceeds to WWE after deducting the initial purchasers’ discount and estimated offering expenses payable by WWE (assuming no exercise of the initial purchasers’ option).”

Notably, these convertible notes were “unsecured, senior obligations of WWE” with 3.375% annual interest and semi-annually payments starting June 15, 2017. The maturity date for the notes is December 15, 2023 “unless earlier repurchased or converted” whereas WWE could settle “in cash, shares of WWE Class A common stock or a combination thereof, at WWE’s election.”

What is WWE going to do with 193 million dollars? According to the press release, the company was expecting “to use a portion of the net proceeds of the offering of the notes to support the execution of the company’s long-term growth strategy and for general corporate purposes.” That doesn’t tell us much at all.

The decision to use convertible senior notes was unusual and noteworthy.

WWE Chief Financial Officer and Chief Strategy Officer George Barrios joined the WWE in 2008. The hallmark of his tenure has been the series of appearances at various media and banking investor conferences. At first, Mr. Barrios extolled the virtues of WWE’s upcoming domestic television rights renewal. Later, he moved to pitching the future of media with the over-the-top media WWE Network. Each time he presents a similar “investor presentation” with a financial and corporate summary of WWE’s customer-facing strategy.

On January 6, 2017, Mr. Barrios spoke at the 19th Annual Needham Growth Conference in New York City. In addition to Mr. Barrios’ usual investor presentation, he briefly mentioned raising $200 million of convertible debt for purposes “supporting execution of long-term strategy”.

While the company hasn’t released their 2016 results yet, current revenue trends suggests that WWE probably finished the year with north of $700 million in net revenue and around $80 million in profits (adjusted operating income before depreciation and amortisation). UFC had an exceptional year with a sky-high sale price to WME-IMG ($4 billion) on a similar amount of revenue. Significantly, UFC is generating higher profits than WWE in recent years, but also had taken on an enormous amount of debt ($1.8 billion from the WME-IMG sale).

Unlike UFC, WWE has historically had very little debt. In 2015, its debt balance was a paltry $21.6 million was related to the company’s 2013 purchase of a Bombardier Global 5000 aircraft. WWE also had a $200 million unsecured revolving credit facility (that was untapped) and $35 million secured revolving credit facility for the purposes of Film production. Why would WWE suddenly decide to take on $200 million in debt in December 2016?

One reason could be WWE’s cash generated from operating activities versus their free cash flow.

(*) In October 2014, WWE took a $50.0 million advance payment related to their domestic television rights distribution agreement with NBC Universal.

In recent years, WWE has paid $36 million annually in dividends to shareholders. This includes about $20 million paid annually to the four Class B shareholders who are, by design, only Vince, Linda, and their family. The WWE annual report makes clear that the Class B shareholder are limited to “Vincent McMahon, Linda McMahon, any descendant of either of them, any entity which is wholly owned and is controlled by any combination of such persons or any trust, all the beneficiaries of which are any combination of such persons.”

Ideally, a company pays their dividends not just from their cash generated from operating activities, but from their free cash flow (cash generated from operations minus capital expenditures). The challenge is that free cash flow for WWE has only been able to cover the WWE dividends one time in the past five years (2014).

Could the $200 million in convertible debt be part of Barrios’ strategy to fix their pernickety free cash flow issue? Or is it a side effect from attending so many investors conferences? Does the company have a specific acquisition target – a competitor in the over-the-top streaming space (like FloSports) or in professional wrestling (like New Japan Pro Wrestling)? Anything is possible, but so far, WWE hasn’t dropped any meaningful clues.


Need additional information about WWE's Convertible Notes offering?
 Read this terrific primer from @sirmartingale


WWE is looking to raise capital to finance a new growth opportunity(ies).

They can do so through:
(a) issuing new shares of stock
(b) borrowing money to be repaid with interest (issuing debt/bonds/notes)
(c) a combination of both.

Issuing new shares of stock is not preferred because doing so will decrease ("dilute") the value of stock already owned. That is, the same total equity value of the company divided by a larger number of shares outstanding equals a lower price per share.

The company, then wanting to issue notes, looks to do so cheaply (meaning, with as low an interest rate as possible). Because there is an expectation of future growth resulting from the usage of new capital, the company utilizes option (c): the convertible note.

A convertible note allows an investor the choice to receive a predetermined number of shares of stock in place of the debt it is owed from the note (the investor converts the debt into equity). This gives the investor the ability to participate in the potential future growth/upside of the company if the stock price goes "high enough." In exchange for this benefit, the investor is induced to lend its money to WWE at a lower interest rate than if the investor lent the money without the benefit.

As part of this offering to raise capital, WWE did three things:

(1) issued convertible notes to a select group of private investment banks,
(2) executed "convertible note hedge transactions" with affiliates of some of those private investors, (3) executed warrants with the investors.

The convertible notes

WWE issued convertible notes that allows the investor to receive 40 shares (rounding down for simplicity) for every $1000 of debt. This implies a value per share of $25. If the stock price exceeds $25 in the future, then it is "high enough" to convert the bond. For reference, the stock price at the time of this offering was $19.93, so there is a need for the stock to appreciate by over $5 a share to have conversion make sense. That's not a small amount. If the stock never hits that level, the investor will not convert, but is still owed the original $1000 (plus interest) it lent to WWE. On the other hand, if the stock price reaches, say, $30, the investor can convert the notes and receive 40 shares of stock worth $1200 (40 x $30) by only giving up the $1000 it is owed. The investor is, in effect, only paying $25 for something worth $30 - profit for the investor.

A quick aside: When a company is unable to repay its debt obligations under a note issuance, the company defaults. When that happens, the holder of an unconverted convertible note is much more likely to recover some of its losses than if the holder converted the note to shares, since the stock will be worthless, and noteholders have a much higher priority when a company's assets are liquidated to satisfy debts.

The convertible note hedge transactions A drawback for the company is that when an investor converts the debt, the shares given to the investor are newly issued shares of stock. Recall that newly issued shares dilute the value of existing shares. To counteract this effect, WWE entered into what is referred to as "convertible note hedge transactions." This is a fancy way of saying that when an investor chooses to convert the note - that is, "buy" 40 shares of stock at $25 a piece - WWE will choose to purchase the same number of already existing shares at the same price. The conversion increases the number of shares outstanding by 40, and WWE's purchase (similar to a share buyback) reduces the number of shares outstanding by 40. The net effect is that the number of outstanding shares remains unchanged, preventing dilution. These transactions are executed with affiliates of the original investors, and WWE pays these affiliates a fee/premium to have this option.

The warrants
When a company issues convertible notes, it sometimes needs to offer extra inducement to investors in order to receive the desired low and favorable interest rate. This inducement may come in the form of warrants. Warrants, when issued in conjunction with convertible notes, give the investors the option to purchase shares of stock in the event the company significantly exceeds expectations (moreso than the already high expectations associated with the convertible notes). In the case of WWE's offering, this option will be exercised when the stock price exceeds $32 a share (rounding up), which represents a 60% appreciation from the stock price at the time of the offering. So, for example, if the stock price hits $40 a share, the investor will gladly exercise the option to pay $32 for something that is actually worth $8 more. The investors must pay WWE a fee/premium for this option. However, the amount of that fee is dependent upon the estimated probability of WWE's stock price appreciating that much over the next seven years. That probability will be minuscule no matter what sophisticated mathematical model you use, and so too, will be that fee. But that probability is not zero, and in fact, is perceived to be high enough to induce the investors to accept the long-shot bet.

When an investor buys shares of stock under an exercised warrant, it is buying newly issued stock. This again creates dilution, but there is no additional transactions in place to counteract the dilution. WWE may use the money it receives from the share purchases to "buyback" already existing shares to counteract the dilution. Or, it may use that money to fund new growth opportunities.

No comments: