By GreatQuarter:OCC's Total Liabilities to Tangible Net Worth Bank Loan Covenant
On April 30, 2019 (FY2019 Q2-end), Optical Cable (OCC) was "not in compliance" with the Total Liabilities to Tangible Net Worth covenant in its credit agreement with Pinnacle Bank (PNFP). That was first disclosed by OCC's CFO Tracy Smith on the FY2019 Q2 quarterly conference call held at 10am on June 11, 2019:
Source: OCC FY2019 Q2 quarterly conference call
There were no live questioners on the call to ask for further elaboration on the Total Liabilities to Tangible Net Worth covenant, but further disclosure was provided in the FY2019 Q2 10-Q that was released later the same day. Note that the Total Liabilities to Tangible Net Worth covenant was barely "not in compliance", coming in at 0.96; 0.95 was the previously agreed-upon contractual requirement.
Source: OCC FY2019 Q2 10-Q
Having barely missed the previously agreed-upon contractual requirement for the Total Liabilities to Tangible Net Worth covenant on April 30, 2019, OCC was in compliance with this covenant at the end of the subsequent quarter on July 31, 2019, with a ratio of 0.93. See chart below.
Source: Chart by author; data from 10-Qs and 10-Ks' Exhibit 13.1.
At quarter-end FY2019 Q3 on July 31, 2019, OCC fell short of the previously agreed-upon contractual requirement for the Current Ratio covenant, per OCC's FY2019 Q3 10-Q: "Except as modified relative to the quarter ended July 31, 2019, the Company is required to maintain a current ratio of not less than 3.0 to 1.0.... As of July 31, 2019, the Company had a current ratio of 2.1 to 1.0. [page 10]"
While OCC did not meet the previously required 3.0 to 1.0 Current Ratio covenant at July 31, 2019, the requirement to comply with the Current Ratio covenant was suspended for July 31, 2019 "only" per the Seventh Loan Modification Agreement that was signed on September 11, 2019, included in the FY2019 Q3 10-Q filing as Exhibit 4.22.
Source: Seventh Loan Modification Agreement
The suspension of the requirement to comply with the Current Ratio covenant for July 31, 2019, was also addressed in OCC's FY2019 Q3 10-Q:
Source: OCC FY2019 Q3 10-Q
Following OCC's reported FY2019 nine-month EBITDA (adjusted for share-based compensation) of $-2.4MM, my FY2019 projected EBITDA (adjusted) is $-2.6MM. OCC would need full-year FY2019 EBITDA (adjusted) of roughly $1MM (positive) to meet the Fixed Charge Coverage Ratio covenant in the Pinnacle Bank loan agreement. Thus, absent a new loan modification agreement which modifies the Fixed Charge Coverage Ratio covenant prior to October 31, 2019, OCC's operations will not generate sufficient EBITDA (adjusted), if my projections are correct, to meet the current Fixed Charge Coverage Ratio covenant requirement of 1.25x; the calculation will be close to -2.5x, I expect (note the negative sign). If OCC violates the Fixed Charge Coverage Ratio covenant, I expect the requirement to comply with the Fixed Charge Coverage Ratio covenant to be waived, suspended, etc., with additional consideration demanded by Pinnacle Bank. Renegotiating, refinancing or paying off the Pinnacle Bank loan would be ways of avoiding a Fixed Charge Coverage Ratio covenant violation, as would an amazingly profitable FY2019 Q4. (I expect a FY2019 Q4 loss.)
Considering Pinnacle Bank chose not to extend the maturity of the revolver, rendering it a current liability, absent a refinancing, repayment, etc., I expect OCC to violate the Current Ratio covenant on October 31, 2019, to be waived, suspended, etc., with additional consideration demanded by Pinnacle Bank. My projection for the Current Ratio for FY2019 Q4 is a bit over 2x; the covenant currently requires 3x (please see table below).
Note that if Pinnacle had extended the maturity of the revolver, which would have consequently been classified as a long-term liability, not a current liability, OCC's Current Ratio would have been 3.56x, comfortably above the required 3.0x threshold.
In the table below, note the high level of cash. I expect $500K to be drawn on the revolver prior to October 31, 2019, and held as cash into November, to be used to pay down OCC's two term loans (aka the Virginia Real Estate Loan and the North Carolina Real Estate Loan) by $250K each during the month of November.
Source: Table by author, data from SEC filings, proprietary projections and calculations by author.
A new signator is the most material item in OCC's recent 10-Q: Marcus William (see Exhibit 4.22 filed with OCC's FY2019 Q3 10-Q, filed on September 16, 2019).
Source: Exhibit 4.22 from OCC's 10-Q filing for period ended July 31, 2019
A history of the signators for Pinnacle Bank of the OCC credit agreements shows a change on September 11, 2019. (As you read the table below, which covers the original loan plus seven modification agreements, note that Pinnacle Bank bought BNC â Bank of North Carolina - in 2017.)
Source: Table by author, from SEC filings and Internet searches
Pinnacle Bank's Shannon Miller, who signed the loan modification agreements from December 2016 to April 2019, has a LinkedIn page in which he describes himself as: âA relationship driven banker that continues to drive revenue, while at the same time, emphasizing a client first mindset in order to provide the best banking experience possible.â Mr. Miller appears to be everything you would want your loan officer to be â friendly, experienced, and customer-driven.
Following misses of the previously agreed-upon contractual requirements on April 30, 2019 (Total Liabilities to Tangible Net Worth covenant) and July 31, 2019 (Current Ratio covenant), the signator for Pinnacle Bank changed from Shannon Miller in Pinnacleâs local Roanoke VA office (OCC is headquartered in Roanoke VA) to Marcus William (as shown in the first exhibit of this section of this article) in Pinnacle's High Point NC office, 100 miles from Roanoke VA. Marcus William has a business Internet presence that is limited, as far as I could find, to a phone number and email. I found no LinkedIn profile that projected a friendly, customer-driven persona (I am OK with that).
Source: Pinnacle Financial Partners
Pinnacle Bank's witness for Marcus William's signing the Seventh Loan Modification Agreement was Anissa Lewis, whose LinkedIn page describes her as being in âSpecial Assets BNC Bankâ since 2011. Ms. Lewis is a witness to the signing of the loan, not the loan officer. While Ms. Lewis's LinkedIn page indicates she is in Special Assets, we cannot assume OCC's loan is.
Pinnacle's signing of the recent loan document by employees in High Point NC rather than Roanoke VA may be all that is important (unless, for example, it turns out that OCC has an excellent pre-existing relationship with Marcus William).
Source: Google Maps
Indeed, OCC's loan does not appear to fit Pinnacle's stated criteria for Special Assets, as described in Pinnacle Financial Partner's 10-K:
Source: PNFP 10-K filed with SEC
It is curious why a different loan officer in an office 100 miles away signed the September 11, 2019, loan document.
My financial projections for OCC for the remainder of FY2019, which assume status quo (i.e., no sale of the company, no placement of a large preferred issue, no large equity raise, no refinancing of existing debt, etc.), show that OCC will likely violate two covenants at October 31, 2019 (which is quarter end and fiscal year end): the Current Ratio covenant and the Fixed Charge Coverage Ratio covenant. I expect any covenant violations to be waived, suspended, etc. That would mean OCC had missed all three of its Financial Covenants during FY2019 (the Current Ratio covenant twice and the Total Liabilities to Tangible Net Worth and Fixed Charge Coverage Ratio covenants once).
Please note that the Current Ratio covenant miss on July 31, 2019 â and I project on October 31, 2019 â can be considered a Pinnacle Bank-driven breach that only occurred because Pinnacle Bank's choice to refrain from extending the revolver beyond its current expiration date of June 30, 2020, making the revolver a current liability.
OCC's FY2019 revenues will be down 19%, I project, year over year. FY2019 EPS loss will be the largest in OCC's history, ignoring FY2010 (huge goodwill impairment) and FY2001 (loss on trading securities). Furthermore, FY2019 net sales are expected to be 3% below the average for the ten-year period FY2009-FY2018. My projection for FY2020 shows OCC will incur a loss again, albeit an improvement from FY2019.
Source: Table by author; SEC filings, proprietary projections.
Personally, if I were the bank, I would not be overly worried about the loan. Finances may seem tight to the bank, but OCC has more financial flexibility than meets the eye (although in all humility I recognize the bank is privy to inside information that may have led it to a different - and more informed - conclusion), if only due to potential interest from prospective acquirers.
At Friday's close of $2.91, I am constructive with respect to OCC stock (I am long).
âOnce a covenant is breached, a great deal of the power shifts to the discretion of the bank.â
Traditionally, corporate governance is seen as resting entirely with management barring a payment default (non-payment of loan principal or interest); traditionally, following a payment default, corporate governance is seen as shifting to the lender.
In their piece Creditor Control Rights, Corporate Governance, and Firm Value, Greg Nini, David C. Smith, and Amir Sufi argue for a more nuanced view, where creditor influence increases earlier. âUnder this alternative view, creditors begin to play a more active role in corporate governance when firm performance deteriorates, but well before bankruptcy. In the âmixedâ region, the actions that creditors take to protect their return may be as important as the actions taken by equity-holders. In other words, both creditors and equity-holders play an important corporate governance role.â
Following misses of two bank loan covenant requirements, OCC seems to be in Panel B's green âMixedâ zone, according to this view.
Source: University of Virginia
The simple reason for the shift in power is the âRights and Remediesâ section of loan documents, such as in Pinnacle's April 26, 2016 credit agreement below. If an "Event of Default" - which includes financial covenant violations - âshall occur and be continuingâ, Pinnacle has the legal right to declare the revolver "terminated" and declare the two term notes âimmediately due and payableâ. While that would be highly unusual, the hypothetical and limited ability to do so provides Pinnacle with bargaining power.
(For more discussion, please see Appendix B - Event of Default.)
Source: Credit Agreement between Bank of North Carolina (bought by PNFP in 2017) and OCC dated April 26, 2016
Nini, Smith and Sufi argue that after a covenant violation, âthere is also substantial anecdotal evidence that creditors work 'behind the scenes' to affect changes in the way that the company is run and managedâ. âCreditors can offer advice to management and the board, quid pro quo, that suggest actions the company can take to maximize the chance of receiving a covenant waiver. (bold added)â
Source: University of Virginia
In Douglas G. Baird & Robert K. Rasmussen, "The Prime Directive," 75 University of Cincinnati Law Review 921 (2006), the authors argue that âPrivate debt ensures that the private lender has control over many decisions once the business becomes distressed.â For our discussion, let's replace âdistressedâ with falling short of two covenant requirements which were waived and suspended.
Source: Douglas G. Baird & Robert K. Rasmussen, "The Prime Directive," 75 University of Cincinnati Law Review 921 (2006)
âBanks, however, have information and incentives that may lead them to decisions that advance everyone's interests.â Banks are primarily interested in getting their money back, but bank interests often coincide with stockholders and other constituencies such as employees.
Source: Douglas G. Baird & Robert K. Rasmussen, "The Prime Directive," 75 University of Cincinnati Law Review 921 (2006)
OCC telegraphed a plan in their recent 10-Q, when they used the phrase âequity financingâ five times in the FY2019 Q3 10-Q, having added âor any additional credit facilities we may originateâ in FY2019 Q1 and FY2019 Q2.
Source: OCC FY2019 Q3 10-Q
Word count of âequity financingâ in recent 10-Qs and recent Annual Reports (Exhibit 13.1 filed with 10-K):
Source: Table by author, word count derived from OCC's 10-Qs and 10-Ks' Exhibit 13.1.
Certainly, OCC seems to be sending a message as to a potential plan.
Selling sufficient equity would do the trick. Refinancing the Pinnacle revolver and term loans with a credit facility from another financial institution would be fine as well.
After falling short of covenant requirements, OCC may need Pinnacle's acquiescence for any major initiative.
Equity financing is an option. I don't have an investment banking syndicate background, but my guess would be that OCC could not realistically think of selling more than one million shares, if that, and only then at a price of $2.50 (book value is about $2.90). I would expect that Ted Weschler (9.99% owner) and Anita Zucker (who possibly still owns nearly 5%) might object to being diluted so that OCC can fund ongoing operating losses. If other investors feel the way I do, Weschler and Zucker might think that, prior to an equity placement, OCC should first consider cutting management compensation, bringing in new management, and boosting its sales capabilities. And prove OCC can be profitable again, before selling more stock! If We Companyâs pulled IPO is a parallel, investors are currently in the mood to fund profits, not losses.
Neil Wilkin has not had a cozy relationship with all OCC common stock investors, at least judging by my experience of writing four research reports with no response from OCC to my phone calls, emailed questions, invitations to lunch in NYC, or stated desire to ask live questions on quarterly conference calls. (But thank you to management for answering on quarterly conference calls nearly all my emailed questions.) In my opinion, Neil Wilkin and Tracy Smith are not ideal candidates to lead a traditional equity road show.
That said, a private equity sale (either common stock or a convertible preferred stock or note) to Ted Weschler or Anita Zucker is possible, particularly if the sale came with a number of negotiated conditions: removal of the poison pill, changes in board and management, etc.
Debt financing is another option. Potential new lenders will be understandably cautious. Lenders know that the most recent Pinnacle Bank document was signed in the High Point NC office, not the local Roanoke VA office. Lenders know that Pinnacle may have reexamined all the assumptions behind all previous valuations of real estate, buildings, equipment, inventory, accounts receivable, etc. New lenders will want to get comfortable that there is not something hidden that would change their mind regarding lending to OCC.
Convertible financing is a further option, whether it be preferred stock or notes. 9.99%-owner Ted Weschler's employer, Berkshire Hathaway (BRK.A), has notably lent money and bought preferred stock in a number of troubled companies that subsequently did fine. The beauty of convertible financing is that the lender gets upside if the company does well. (Please see Appendix C.)
Selling assets might be an option, but it seems most OCC assets are currently encumbered by mortgages and liens in favor of Pinnacle Bank. Per the FY2019 Q3 10-Q,
"The [Pinnacle] Loan remains generally secured by the land and buildings at the Companyâs headquarters and manufacturing facilities located in Roanoke, Virginia and its manufacturing and office facilities located near Asheville, North Carolina and the Companyâs personal property and assets."
Roanoke County's Office of Real Estate Valuation shows a total value for OCC's real property at Concourse Drive, Roanoke VA to be $57,100 for one piece of land, $1,336,400 for another piece of land, and $6,540,500 for the main building and land, for a total of $7,934,000, representing the county's valuation this year at 100% of market value. At July 31, 2019, the associated term loan from Pinnacle Bank was $4,629,043, or 58% of appraised value.
Buncombe County Tax Department assesses OCC's two properties in Swannanoa NC, at current market value in 2017, at $2,493,600. At July 31, the associated term loan from Pinnacle Bank was $1,595,292, or 64% of appraised value. (Selling these two Swannanoa properties, and downsizing OCC's operations, could pay off the associated $1.6MM term loan and free up around $700K (reduced to reflect expenses), which presumably would pay down additional principal on other Pinnacle Bank loans. This seems to be a viable option.)
If you total OCC's real estate in VA and NC, using county appraisals of market value above, divided by all Pinnacle loans (the two term loans plus the revolver), you arrive at 88% loan to value (LTV). Note that Pinnacle Bank has liens on OCC's personal property and additional OCC assets as well. If a prospective lender is trying to get comfortable with OCC's assets, real estate is probably the easiest asset to value.
Selling the company might be the simplest and least risky option. Perhaps, the quickest as well. If lenders are concerned about management (I don't know), then selling OCC would allow a new owner to replace management, so existing management would not be a concern (if it is to a potential acquirer). If the concern instead is about the viability of assets (such as the Roanoke plant that experienced "unintended throughput constraints and inefficiencies"), then selling OCC is not such a viable option, at least at a good price.
Source: OCC FY2019 Q3 10-Q
In my opinion, OCC has not adequately addressed to the investor community the circumstances around the Roanoke plant's "unintended throughput constraints and inefficiencies". I think it would be hugely helpful if OCC included the Roanoke plant manager on the next quarterly conference call, and allowed unfettered live questions to the manager. As Rebecca Corbin writes in her The Earnings Call as a Competitive Tool/Advantage, investors often want more transparency at management levels below the CEO and CFO:
Still, considering the pluses and minuses of all the different options, I think selling the company to an acquirer is a strong probability. Because it makes sense for nearly everyone.
Pinnacle has increased bargaining power. More so because, if my projections are correct, OCC will violate two bank loan covenants on October 31, 2019, and OCC will need two waivers and/or suspensions of covenants ceteris paribus. If covenants are violated, I would expect Pinnacle to demand further consideration, beyond the higher interest rate and repayment of the term loans following the July 31, 2019, breach. If covenants are violated, I expect Pinnacle to weigh the standard considerations, including: accelerated debt repayment, additional security, increased reporting requirements to the bank from monthly to weekly, or weekly to daily, severe reduction in capital expenditures, reduction to aggregate compensation (per employee and also reduced number of employees), removal of the 15%-trigger poison pill, and at some point in the future, a Pinnacle-nominated director (suitable to both Pinnacle Bank and Ted Weschler) as lead independent director on board, with Neil Wilkin relinquishing some role. If covenants are violated, I expect Pinnacle to bargain hard for tough new covenants in the next round of negotiations.
Source: Printing Impressions, October 2011
If covenants continue to be violated, Pinnacle might encourage OCC's board to: elect a new Chairman, President and CEO and a new CFO, and then put OCC up for public auction to be acquired by the highest bidder. So long as OCC continues to fall short of covenant requirements, Pinnacle will be able to extract additional concessions. If Pinnacle is concerned about repayment of the full revolver on June 30, 2020, Pinnacle may insist on tough covenants in its quarter-end negotiations that OCC might find difficult to comply with, ensuring Pinnacle's continuing influence as the revolver's June 30, 2019, maturity date draws closer.
I imagine Pinnacle believes a viable exit would be a sale of the company to Berkshire, Belden, or a number of other potential strategic buyers. If it normally takes three months to sell a company such as OCC, and you want to allow one sale to fall through, you may want to plan for six months, or more, if one is worried that a possible recession might slow the process. June 30, 2020 will be here soon.
All that Pinnacle can do is encourage OCC to do what Pinnacle would like. OCC's board ultimately runs the company.
There may be a temptation on the part of potential acquirers to hang back and see what happens, hoping for an implosion and an opportunity to buy OCC at a severely depressed price. Not a bad strategy!
But I think in OCC's case hanging back would not work because Warren Buffett's lieutenant Ted Weschler owns 9.99% of OCC stock. (Although Weschler could sell all his holdings! Or buy more.) If anyone ends up buying OCC at a low price, it will likely be Weschler, maybe through a convertible note that provides OCC breathing room with covenants that give Weschler influence. (Hopefully all stockholders would benefit, but there are scenarios where that would not necessary be the case.)
Maybe we find out soon if Berkshire Hathaway is interested in OCC in some way.
Prior to the FY2019 Q2 and FY2019 Q3 loan covenant problems, the only way to approach OCC about an acquisition was through Neil Wilkin and the board, of which Wilkin is Chairman. Everyone in the industry knows about the Superior Essex proposal in 2006 for $6/share. (OCC stock closed Friday at $2.91).
Source: SEC filing
Five of the six board members who unanimously rejected Superior Essex's $6/share bid in August, 2006 are still on the board: Neil D. Wilkin, Jr. Randall H. Frazier, John M. Holland, Craig H. Weber, and John B. Williamson, III. Today, the board is also six, populated by those five from August 2006, plus one other. OCC has undertaken a number of initiatives in FY2019 that promise to boost future profits. Why wouldn't the board have the same reaction to a new acquisition proposal in 2019 as they did in 2006?
The difference now may be Pinnacle Bank's loans. To OCC's understandable question of whether Pinnacle Bank would extend the maturity of the revolver to allow time for initiatives to produce profitable results, rather than selling the company to an unsolicited bidder at a perceived opportunistic time and price, Pinnacle's response might be something like Jim Morrison of the Doors: âWe want the world and we want it... nowâ or at least June 30, 2020.
"We want the world, and we want it.. Now!" THE DOORS
Today, potential bidders must be sufficiently comfortable to approach OCC or Pinnacle (if that is the case). I expect, following the next covenant violations on October 31, 2019 (if my projections are correct), Pinnacle Bank to encourage OCC to announce a public bidding process, led by a newly appointed lead independent director, with Neil Wilkin relinquishing some role. OCC may not like such a suggestion, but what choice do they have, if they cannot find alternate financing? If OCC says no, Pinnacle might say: show me the money.
On the other hand, what if bidders were welcomed, surfacing interest, but no one was willing to acquire OCC after doing due diligence, even if overseen by Pinnacle? (Not my base case.)
OCC has a difficult problem. But an easy solution.
Missing Pinnacle Bank's credit agreement's covenant requirements â twice and soon to be four times (if my projections are correct) â is a problem. It must be addressed with urgency. If not, control of the situation could be nearly fully relinquished to Pinnacle Bank.
In my mind, these steps would best be taken with a sense of urgency:
- Have Neil Wilkin publicly relinquish some role to make a public statement that status quo has changed, backed by action.
- Appoint a new outside director, suitable to Pinnacle Bank and Weschler, to be lead independent director.
- Have OCC's board remove the poison pill which triggers at 15%.
- Have the lead independent director hire an investment bank.
- Have the lead independent director announce a competitive auction sale of OCC.
- Have the lead independent director run the auction.
These steps would be good for everyone, including Neil Wilkin. And Wilkin would be a hero! Wilkin could retire with the proceeds of his one million OCC shares. He could sit on boards and make donations to worthy causes in Roanoke, such as Taubman Museum of Art and Virginia Western Community College.
Neil Wilkin could be a hero or Neil Wilkin could risk losing everything if the Pinnacle Bank is not paid (not my base case). Ultimately, I expect Neil Wilkin will come around to the viewpoint that he should go out as a wealthy hero by selling OCC. I think he will come around to the view that missing payment to Pinnacle Bank could be financially and reputationally disastrous.
Seems like a clear choice. But I have been wrong before. For instance, I am confused why this has not already happened. It would be such a win-win!
The bank wants its money, not the highest stock price. Neil Wilkin (and all of us investors) want the highest stock price.
With less than nine months until the currently scheduled maturity of the Pinnacle revolver on June 30, 2020, time is getting short.
With about 7.5MM shares, and about $12MM of bank debt (Pinnacle revolver and Pinnacle terms loans, including associated Pinnacle current debt) and $1MM cash, an acquirer paying $5.00/share can buy OCC at an enterprise value (equity market capitalization plus bank debt, minus cash) half of my (I believe) conservative estimate of $100MM target for future sales. Buying a company at half of future sales is inexpensive!
Adding in potential cost savings from an acquirer rationalizing OCC's headquarters, the ultimate EBITDA multiple of a $5/share acquisition could be close to 4.0x EBITDA with OCC running in the future at $100MM in revenue.
If a better estimate of OCC's long-term sales is $120MM, I project that would lead to $12.7MM of EBITDA. Adding in potential cost savings from an acquirer rationalizing headquarters, the ultimate EBITDA multiple of a $5/share acquisition could be closer to 3.2x EBITDA with OCC running in the future at $120MM in revenue.
From best to worst case for OCC's stock price:
- OCC aggressively refocuses itself as a customer-focused sales organization. Target: $10+ in two years. My perception of this happening: 0.5%. Having missed bank covenant requirements, it is likely too late for this option.
- OCC puts itself up for sale. New outside lead independent director hires an investment bank. Issues a press release. Bids wanted. Due diligence done. $7.00 in a year if competitive bidding erupts. Chance: 20%. October 2019 might be the last chance for OCC to initiate this option.
- Non-competitive negotiated sale to a single bidder. Public announcement of auction leads ultimately to one bidder who pays $5 in one year. Chance: 50%.
- Convertible loan (preferred stock or a note) from Weschler/Berkshire Hathaway or Anita Zucker. Lots of conditions. New board seats. Change of management and exit of some board members. Leads to $5 bid in a couple years. Chance: 10%.
- Neither Weschler/Berkshire Hathaway nor Zucker rescue. Opportunistic distressed lender replaces Pinnacle. Stock languishes at $3. Chance: 10% (although this estimate might be low).
- Bankruptcy workout that takes two years. After an ugly two years, stock ultimately trades at $3. Chance: 4.5%.
- Weschler exits. OCC sells stock into an unwilling market. Opportunistic lender gets involved. Stock price: $2.50. Chance: 5%.
Source: Table by author, proprietary probabilities.
Let's round the probability weighted target price to $5.00, or even better $4.99.
There is no equity activist now. But one might think of Pinnacle Bank as an activist to preserve their loan value and optimize the bank's ultimate outcome.
While it might surprise the reader, the bankruptcy workout price (table above), which assumes a two-year exit from bankruptcy, underscores my perception that OCC has value. Even in the unlikely case that OCC were forced into bankruptcy by an unfortunate series of multiple-party mistakes, the value of OCC should endure, I expect. A stock price of $3 suggests an enterprise value (equity and debt) that is only 3.5x future $10MM EBITDA (adjusted) after OCC is operating efficiently again. For the derivation of $10MM in EBITDA (adjusted), please refer to the "Long term" column in the projected statement of operations above. (Forecasting a $3 price for OCC equity following a bankruptcy workout is another way of saying a bankruptcy makes no sense, due to the perceived value of OCC as a company.)
Note that I am not forecasting that OCC refinances their Pinnacle loan through another lender in the near term, or gets an extension on the revolver, or sells a lot of equity. If any of those possibilities were to happen in the near term, OCC's status quo would be preserved. Not the most bullish outcome for OCC stockholders, in my opinion.
A one-time violation of a bank covenant is rarely a big deal. Typically, a company communicates a concern well before the covenant violation, the bank reviews the situation and grants a waiver, and that is all. In OCC's case, the Total Liabilities to Tangible Net Worth covenant was waived for the first covenant miss on April 30, 2019 with no consideration demanded. (At the same time, Pinnacle did not extend the revolver beyond June 30, 2020, but we have no indication the lack of an extension was related to the covenant issue.)
Violating a second covenant is more noteworthy, and it could be a bigger deal. For the second violation, there might be financial consideration imposed on the borrower (if only to cover the bank's increasing costs of servicing the loan), as was the case with OCC.
What does OCC's September 11, 2019, Seventh Loan Modification Agreement mean?
- The revolving line of credit was reduced from $7.0MM to $6.5MM. But on July 31, 2019, OCC had only $5.65MM of outstanding borrowings on its Revolver. There is no immediate impact; only the availability on the Pinnacle revolver was reduced by $500K. Pro forma for the September 11, 2019 agreement to reduce the revolver by $500K aggregate, availability (undrawn available borrowing capacity) dropped from $1.35MM to $850K at July 31, 2019.
- The scheduled reduction of $500K on Pinnacle's two terms loans ($250K for each) on or before Friday, November 29, 2019 (one month after the end of OCC's fiscal year) means OCC will have to come up with the money, ceteris paribus. Absent a refinancing with Pinnacle (not my base case), new replacement financing (not my base case), major stock issuance (not my base case, but possible), asset sale (not my base case), or a use of OCC's cash (not my base case, but possible), I expect OCC will draw $500K on its revolver before October 31, 2019, when I project they will be in violation of both its Fixed Charge Coverage Ratio and its Current Ratio covenants (my base case) which would allow Pinnacle to prevent further revolver borrowing and impose more considerations. But, before the projected October 31, 2019, covenant violations, OCC should be permitted borrow against the revolver, I expect. Borrowing would be smart because it would preserve OCC's financial flexibility.
- Borrowing $500K on the revolver to repay the principal on the term loans will drop the availability on the revolver to $350K pro forma. My FY2019 Q4 projection is that OCC will show negative EBITDA of $-245K. Using adjusted (for share-based compensation) EBITDA as a proxy for cash generation/consumption, OCC will need to borrow another $245K on the revolver, leaving projected availability of $105K at October 31, 2019.
- But OCC had $1.1MM cash at July 31, 2019, so OCC could choose to use some of that cash instead. That is not my base case.
- The September 11, 2019, amendment changed the interest rate on the revolver from previous formula which resulted in a 4.52% rate to a formula that sets the current rate at 5.50%.
- Separately, the term loans pay a rate of 3.95%. By reducing the terms loans, Pinnacle shifts $500K of 3.95% borrowings on the term loans to $500K at 5.50% on the revolver (if OCC does draw as expected).
- As with the Current Ratio covenant miss on July 31, 2019, I expect Pinnacle to impose consideration and increasingly tougher terms if OCC violates one or both the Current Ratio covenant and the Fixed Charge Coverage Ratio covenant.
If OCC draws on its Pinnacle revolver before October 31, 2019, to repay $500K on its Pinnacle term loans due on November 29, 2019, which I expect, OCC will preserve its financial flexibility, probably keeping about $1MM in cash on its balance sheet following the term loan payment at the end of November. That may prove to be important in the future. At October 31, 2019, OCC will have little, if any, availability on its revolver, but if it has $1MM in cash (plus $500K to pay down the term loans on or before November 29, 2019), it can use that $1MM in cash to fund operations, obligations, etc. If this scenario is correct, OCC must draw before it triggers the next covenant violations (unless prior to October 31, 2019 OCC renegotiates the Pinnacle loans, restructures the loans via another banking institution, sells lots of stock, etc.)
Source: Seventh Loan Modification Agreement
Per the Credit Agreement dated April 26, 2016, between Bank of North Carolina (bought by Pinnacle Financial Partners, aka Pinnacle Bank, in 2017) and OCC, "if any Event of Default shall occur and be continuing", Pinnacle can declare the revolving credit facility ($5,650,000 at July 31, 2019, all of which is current) be "terminated" and declare the real estate term loans (totaling $6,224,335 at July 31, 2019, including current amounts) to be "immediately due and payable". Fortunately, such a declaration would be highly unusual.
In the credit agreement, an "Event of Default" is defined as encompassing financial covenants. An "Event of Default" can be quite different from a payment default, i.e., "The failure of the Borrower to pay any of the Obligations as and when due and payable".
Nevertheless, violating a financial covenant can, in the extreme, lead to bigger problems. My projections show that as of October 31, 2019, both the Fixed Charge Coverage Ratio and the Current Ratio covenants will be breached, barring something unexpected (sale of equity, etc.), to be waived, suspended, etc. Current requirements for OCC's financial covenants are enumerated below:
Source: Credit Agreement Between Bank of North Carolina and Optical Cable Corporation, dated April 26, 2016 updated with revised metrics shown in OCC's FY2019 Q3 10-Q
To fund OCC's cash needs over the next year, there could be a non-traditional lender. Let's say Ted Weschler still likes his equity investment in OCC. And let's say he sees fixable issues. He could lend to a nervous OCC â worried about being thrown into bankruptcy by Pinnacle in the unlikely chance everything turns out badly â and force terms such as poison pill waiver, new board members, etc.
Berkshire Hathaway â Ted Weschler's employer â has a pattern of funding stressed companies:
- 1987 Solomon Brothers
- 2008 General Electric (GE)
- 2008 Goldman Sachs (GS)
- 2008 USG (USG)
- 2009 Harley-Davidson (HOG)
- 2017 Home Capital Group (HMCBF)
Ted Weschler has filed two 13Gs with the SEC with respect to OCC. 13Gs are passive. If Ted continues to thinking passively, he might want a competitive auction, to receive the maximum return on his passive investment. But what if Ted Weschler/Berkshire Hathaway rethinks OCC and Ted Weschler/Berkshire Hathaway decides Berkshire should acquire OCC? To become an activist pushing for that outcome, all one would have to do is file a 13D.
A traditional bank is only interested in lending money and getting paid back, both interest and principal. The beauty of non-traditional lending is the lender can take more risk since the lender can craft terms - such as convertibility into stock - to capture potential upside, which makes offsetting downside risk more palatable to the lender.
Your seventh Pinnacle loan modification agreement dated September 11, 2019, signed by, and witness by, Pinnacle employees from its office in High Point NC. Have your Pinnacle loans been transferred to Pinnacle's High Point NC office? If transferred, what was the date the loan was transferred to High Point NC? Has Pinnacle Bank informed you they have assigned your loan to the Special Assets group?
What are the calculations of all Pinnacle Bank covenants?
Capex for the nine months ended July 31, 2019, was down a bit year over year. Can you review the work you are doing at the Roanoke plant to optimize its operation in light OCC's company-wide capex?
Can you provide a detailed review of the "unintended throughput constraints and inefficiencies that we experienced in our Roanoke facility"? How long do you expect the "costs, constraints and inefficiencies which negatively impacted the first nine months of fiscal year 2019" to continue? What sort of improved gross margin and higher revenue capacity do you expect when completed?
What is OCC's backlog/forward log?
I have made repeated attempts, via email, telephone, NYC IR, and even Seeking Alpha and twitter, to engage OCC's management in a dialogue. Crickets. As is management's right. Management habitually answers on quarterly conference calls nearly all my emailed questions. Thank you!
I am providing this disclosure since it might affect, positively or negatively, how some readers might evaluate this report.
This report reviews a long-term investment thesis that OCC stock is anticipated to, perhaps erroneously, be higher in the future. There are any number of reasons the investment thesis could be wrong. And certainly, this article will be at least partially wrong.
Investing is a probabilistic endeavor. Let's engage in a scenario-playing exercise: a year from now, OCC stock is trading at $2.00 (not my base case); what happened? The circumstances might be similar to one of the following descriptions. A year from now, Ted Weschler is selling his stock to exit his OCC position. A year from now, OCC continues to experience larges operating losses and investor concern is growing with respect to the viability of the company. A year from now, Pinnacle has not exited its revolver, OCC is not cooperating with Pinnacle, and it is OCC is living under new harsh covenants imposed by Pinnacle's Special Assets department. An investor who specializes in distressed investing extended a loan to OCC with harsh covenants; OCC is violating the covenants, while the investor tries to drive the stock price down so it can buy stock cheap. A year from now, tax loss selling is depressing OCC's share price (which could happen this year as well).
As an analyst covering a publicly traded company, I am not able to contact Pinnacle Bank to ascertain their willingness to entertain various alternatives that might be proposed by outside parties beyond Pinnacle and OCC.
Just as OCC stock skyrocketed in September 2018 following the filing of Ted Weschler's 13g, and then fell 50%, the same sickening fall could happen again from some level. 50%! This report covers a long-term investment (potentially flawed) thesis. OCC's short-term stock movements will likely be volatile, and risky! The stock's market capitalization is tiny! Understand the risks of losing money!
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.