Almost a year ago, at a time when various folks in finance and real estate were ready to write eulogies for Realogy, I spent a few posts arguing that the rumors of Realogy’s demise were ahh… premature. My basic point then was that the bondholders of Realogy have very little incentive to push Realogy into bankruptcy:
The reason isn’t that I know something others don’t about the strength of Realogy or any such thing. The reason mostly has to do with incentives for bankers and bondholders to allow a default and the consequences of such. There is next to zero incentive for any creditor of Realogy to force the company into bankruptcy.
Realogy has next to no assets. Really. If you think about their business model, as a franchisor of service businesses, their main assets are the brand names and the people who work at their various company-owned stores or franchisees.
In the case of some of the other firms named by Crains, such as JetBlue or Hovnanian Enterprises, they own real assets that can be auctioned off or sold off to raise a fair amount of money. Airplanes and real estate are both real assets. In those cases, it might make a lot of sense for creditors to push those companies into Chapter 7 liquidation proceedings and recover their losses that way.
But Realogy’s real assets are negligible, to say the least. It owns no buildings that I know of (unlike other franchise models where the franchisor owns the franchise location and receives rent from the franchisee). All of its company owned stores are lessees of other landlords. Whether its servers, technology equipment, office equipment, and such are worth a lot is unknown, but one suspects that Realogy probably doesn’t own the equipment in its datacenters (it probably leases them from the hosting facility), and used furniture isn’t exactly going to make a huge dent in the billions owed.
A year later, the latest news from Realogy (PDF) is that it has posted $58m in profits in Q3 of 2009 on $1.2b in revenues. Critically, Realogy managed to stay in compliance with the debt-to-income ratio in its loan covenants.
Looking through some of the details, however, it appears that Realogy has really dodged a bullet this time around… but the way in which they dodged said bullet augurs a promising future.
The Bullet and the Dodging Thereof
While the Q3 results of a $58m profit were good in and of themselves, the real issue for Realogy was whether they could stay in compliance of the loan covenants. Without having the docs in front of me, I can only paint the most basic picture, but the deal is that when Apollo bought Realogy, it issued some $3b in debt. Those loans contain a trigger where Realogy promised that the total debt to income would not exceed a 5 to 1 ratio. Violate that, and the entire loan amounts can come due, which means immediate bankruptcy.
The feverish cost-cutting measures at Realogy over the past year or so have been driven, I believe, by the need to stay in compliance with this critical ratio.
In Q3 of 2009, Realogy stayed in compliance by the narrowest of margins: 4.94. to 1. For every dollar of income (which is not “net income” as we know it, but calculated according to a formula in the credit agreement), Realogy had $4.94 in loans (again, which is not “loans” but calculated).
With the closing of the $650 million second lien facility, Realogy repaid its revolving credit facility balance and reduced Senior PIK toggle notes outstanding by $221 million. Realogy entered into a private transaction that exchanged these toggle notes for $150 million of second lien financing.
The 10-Q filed by Realogy contains this information:
SENIOR TOGGLE NOTE EXCHANGE
On September 24, 2009, we and certain affiliates of Apollo entered into an agreement with a third party pursuant to which we exchanged approximately $221 million aggregate principal amount of Senior Toggle Notes held by it for $150 million aggregate principal amount of Second Lien Loans (included in the $515 million noted above). The third party also sold the balance of the Senior Toggle Notes it held for cash to an affiliate of Apollo in a privately negotiated transaction and used a portion of the cash proceeds to participate as a lender in the Second Lien Loan transaction. The transaction with the third party closed concurrently with the initial closing of the Second Lien Loans. As a result of the exchange, the Company recorded a gain on the extinguishment of debt of $75 million.
What’s interesting about this (based on a relatively cursory analysis) is that had this swap not taken place, Realogy would have violated its loan covenants and would likely be in serious trouble right now. How so?
On page 60 of the 10-Q, we present the senior secured leverage ratio calculation. Adjusted EBITDA is calculated based on reported EBITDA for the last 12 months ended September 30, 2009. At September 30, 2009, total Senior Secured Debt as defined in our credit agreement totaled $2.95 billion. That divided by Adjusted EBITDA of $597 million for the 12 months ended September 30th, results in the senior secured net debt to Adjusted EBITDA ratio of 4.94 to 1, maintaining compliance with our credit agreement.
Keep in mind that an unidentified lender to Realogy swapped $221m in Senior Toggle Notes for $150m in Second Lien Notes. The difference is $71m. Add back in that $71m to the $2.95b mentioned above, and you get $3.021b in “Senior Secured Debt” — I’m assuming that the Toggle Notes get counted as such. With $3.021b against $597m in Adjusted EBITDA, you get a ratio of 5.06 to 1: violation of the covenants.
The swap of Toggle Notes for Second Lien Notes occurred on September 24, 2009 mere six days before the close of the quarter, which is the date at which the loan-to-income ratio would be calculated.
That, my friends, is called dodging the bullet — I rather believe that Tony Hull and his team at Realogy probably deserve a lot of credit (no pun intended) for pulling this off.
The Future and the Brightness Thereof
I think the future looks rather bright for Realogy based on how they dodged this bullet. It confirms, in a way, my belief that the creditors of Realogy really have no incentive to put them into an insolvency situation. Granted, the unknown creditor who swapped $221m for $150m did get something out of the deal — the interest rate on the Second Lien Notes is 13.50%, while the Toggle Notes were at 11.00%/11.75% — but to swap first priority debt for junior priority debt is meaningful in and of itself, not to mention taking 68 cents on the dollar.
Plus, as Richard Smith mentioned during the Q3 earnings call, Apollo appears to be committed to Realogy in a fairly big way:
We are also pleased to note Apollo’s increased investment in our company through purchases of Realogy bonds with a total face value of $970 million aggregate principal amount that have a current market value in excess of $600 million. We view this, Apollo’s continued investment in Realogy, as a substantial vote of confidence in our business and our prospects.
Part of this could have been defensive — since violating the loan covenants would likely mean extinguishing Apollo’s equity position in Realogy — but putting down somewhere in the $600m range strikes me as a vote of confidence, or at least commitment.
Fact is, Realogy continues to make interest payments on its debt obligations: $318m in so far in 2009. And even while its revenues are down on a year-over-year basis, from $1.341b in Q3 of 2008 to $1.169b in Q3 of 2009, its expenses have been hammered down. Payouts to agents are down, naturally, which is to be expected, but Realogy has also cut its operating and marketing expenses by over $100m for Q3, 2009 over Q3, 2008. Result: profits for the quarter. Nice work.
No creditor is going to kill that golden goose anytime soon, unless the housing market really and truly tanks in the next couple of years and Realogy ends up missing payments and such. Instead, creditors will likely work with Realogy to keep Realogy from violating its critical loan covenants. Even if the creditors won’t play along, I feel that Apollo is going to try everything possible to keep the company from going into a bankruptcy situation.
Nothing is for certain, of course, and the housing market still is unstable, and there is likely a huge backlog of REO’s that haven’t hit the market yet (something Richard Smith mentions in the earnings call), but those are macroeconomic factors no one can control. And if the market should stabilize, then turn, Realogy still owns NRT, the #1 brokerage in the country by a wide margin, still owns some of the top brands in the business (even if they are in need of some resuscitation soon), still owns the top relocation network, and still generates over a billion and a quarter in revenues.
We can revisit this topic in the future, but looks good to me so far.
Disclosure note: I worked at Realogy for four years. I did not consult nor speak with nor got any info from Realogy (other than public press releases and filings) or any of its people for this post.