NYC Opera: The Final Curtain

It appears that the final curtain has fallen on the New York City Opera. Unable to raise the $7 million that it needs to pay its obligations, the company filed for bankruptcy last week and began to prepare to liquidate its possessions.

Does the loss of a single operatic arts company significantly impact the cultural environment of New York City? Perhaps not; after all, New York City continues to host the world renowned Metropolitan Opera in Lincoln Center.

In fact, billionaire Mayor Michael Bloomberg, whose nonprofit foundation supports cultural organizations around the world, declined to save the NYC Opera. When asked about the possibility of a donation, he simply noted that the company’s “business model doesn’t seem to be working.”

Once again, perhaps not … and yet few other New York City organizations have earned social reputations that are quite as illustrious as the NYC Opera’s. Founded during the Second World War and lauded as “The People’s Opera” by legendary Mayor Fiorello La Guardia, the company’s original mission was to deliver performances for all New Yorkers at highly affordable prices.

Based in the old City Center Theater, the company spent only $30,463 on operating costs during its first season. Ticket prices ranged from 85 cents to $2.20, amounts that were equivalent to four to nine times the price of a cup of coffee or a slice of pie. Imagine how many New Yorkers would still be attending the opera if tickets could be purchased for such prices!

The NYC Opera was also a trailblazer in the civil rights movement. Two years before Jackie Robinson arrived in Brooklyn to break baseball’s color barrier with the Dodgers, Todd Duncan became the first African American performer to integrate the stage of a major opera company in 1945’s production of Il Pagliacci.

So what went wrong? In 1966, the company joined the mighty Metropolitan Opera by moving to Lincoln Center, celebrating its arrival with Placido Domingo’s starring role in Don Rodrigo. Although the company subsequently enjoyed years of enhanced exposure and acclaim, its operating costs and ticket prices necessarily rose to Lincoln Center levels. The company also struggled to differentiate itself from The Met, its far wealthier co-tenant.

Thus began a downward financial spiral that culminated in last week’s bankruptcy announcement. Although it is always sad to lose a major performing arts company, it may be even sadder to observe the gradual (and, likely, irreversible) abandonment of Mayor La Guardia’s original vision of operatic performances for The People.

Introducing … The New General Motors!

Have you heard the news? A new General Motors emerged from bankruptcy this past week.

What’s so new about it? Well, let’s start with its new name. Historically, the firm had been named General Motors Corp, but now it’s named General Motors Co. That seems like a tiny modification, doesn’t it?

Financial and legal bankruptcy professionals, though, understand that this change of name actually reflects a major change in corporate structure.  In fact, the bankruptcy proceedings were altogether quite remarkable in how quickly and thoroughly they enabled the firm to shed many of its fiscal obligations.

Government Behind The Wheel

Business analysts were surprised by several aspects of the process. One surprise, of course, was that the firm declared bankruptcy at all. And another surprise was that it agreed to eliminate so many brands. Rick Wagoner, long time GM chief executive, repeatedly insisted that GM would derive no benefit from shedding brands and could not possibly survive a bankruptcy filing.

But that was before the federal government stepped in and brusquely dismissed Rick Wagoner. The bankruptcy proceedings were completed in merely six weeks, and more than half of its brands – including Hummer, Pontiac, Saab, and Saturn – were targeted for sale and/or elimination.

Analysts were also surprised at the speed, determination, and forcefulness of the government’s actions. After all, analysts often criticize government bureaucrats for being slow-moving dinosaurs, and yet these so-called dinosaurs moved at lightning speed to implement the very decisions that analysts had recommended for years.

It’s NewCo Time!

Even more surprising was the strategy that was implemented to permit GM to escape its obligations to its shareholders, bondholders, and employees. This approach is known as a NewCo asset transfer; it’s a common technique that helps firms shed troublesome assets and liabilities.

The strategy is, in theory, quite simple.  We begin with an OldCo (here, General Motors Corp.), a firm that possesses certain valuable assets but that is also burdened with very significant liabilities. We then create a new corporate shell, an entity known as NewCo (here, General Motors Co.). Finally, we transfer all of the valuable assets from OldCo to NewCo, leaving the liabilities (and perhaps a few relatively insignificant assets) with OldCo.

Voila! NewCo, shed of its burdensome liabilities, suddenly becomes an unstoppable competitive juggernaut. And what happens to OldCo? Well, its shareholders, bondholders, and employees realize that there is little left within OldCo to pay their debts, and thus they agree to settle for pennies on the dollar.

So who ends up owning NewCo? It depends on the circumstances. The new General Motors Co., for instance, is majority owned by the United States government and minority owned by the automobile unions. Other NewCo firms may be owned by private investors, employees, bondholders, i.e. any one who may wish to possess a stake in the new entity.

Defeasances, Any One?

Sound familiar? This strategy has actually been employed in various forms over the years. Debt defeasances, for instance, first became popular in the 1980s; they involve the shifting of liabilities to NewCo entities and the concurrent transfers of sufficient assets at the times of the transactions to repay creditors over time. Though in these situations (unlike the situation involving General Motors) a significant amount of assets is indeed transferred to repay the debts, the risk that fluctuating valuations may create future imbalances between NewCo’s assets and liabilities are borne by the creditors and not by OldCo.

Of course, there is another distinct difference between debt defeasance transactions and the General Motors transaction. Namely, in debt defeasance transactions, the old debt is transferred into the new firm and the bulk of the original firm’s assets remain in the original firm. GM, on the other hand, left its old debt in the original firm and transferred its valuable assets into the new firm.  That’s because the old firm, upon entering bankruptcy court, was doomed for liquidation.

Financial service professionals may also recognize this strategy in Treasury Secretary Hank Paulson’s original proposal to use federal bailout funds to purchase illiquid (i.e. worthless, at least in the short term) investment securities from banking institutions that were sliding into bankruptcy. He proposed the creation of a federally owned Bad Bank that would restore financial institutions to health by removing toxic assets from their balance sheets.

Government: The 800 Pound Gorilla!

Interestingly, some critics seem to be more concerned about the prospect of the government managing an automobile business than about the specter of government helping a private corporate entity evade its obligations through legalistic restructurings. Truth be told, though, many governments in established capitalist economies have managed private companies for many years.

Airbus, for instance, is a sterling success story of a number of Western European nations that joined forces to create a business goliath that has seized half of the aircraft manufacturing market away from Boeing and other competitors. And in the United States, the FDIC has often exercised its authority to determine that commercial banks are insolvent, to dismiss their executives, to seize control of their operations, and to manage all day-to-day activities until sales or liquidations can be arranged.

In other words, the General Motors transaction may be a surprising one, but it is not at all a new phenomenon.  Rather, it is simply a new “spin” on a long history of balance sheet restructuring and government intervention.

Citigroup vs. Twitter: Cash Flow vs. Earnings!

To the delight and astonishment of the entire financial world, the stock market soared 10% during an incredible four day rally last week. The press attributed this sudden burst of optimism to Citigroup’s unexpected announcement that they actually managed to earn a profit during the first two months of 2009. But market analysts remain worried about the possibility of a Citigroup bankruptcy in the near future.

Profitable, but still going bankrupt? How is that possible?

If that sounds strange to you, consider the fiscal status of a very different firm, one that has never turned a profit in its existence, and yet one that is swimming in cash. Evan Williams, the co-founder of Twitter, has publicly acknowledged that his micro-blogging service is slow to turn on its revenue-generating engines. But just last month, a large investor assured the financial markets that “We have a ton of cash. We have far more cash than we need, so I’m not in any hurry.”

Huh? Citigroup is profitable, and yet is going bankrupt. And Twitter is unprofitable, and yet is swimming in cash. What does it mean to be profitable, anyway?

The fundamental answer to this question can be found at the very heart of our centuries old accounting model. And true insight regarding such matters can often be gleaned by engaging in some simple back-of-the-envelope arithmetic.

Profitable Yet Bankrupt: A Sample Illustration

Let’s assume that a seemingly healthy retailer begins the year with the following strong balance sheet ($s in millions):

Now let’s assume that it sells $10 million (retail value) of inventory each month and purchases $7 million (cost value) of inventory to replace it. Its customers all buy on credit and take three months to pay their invoices; thus, there are no receivable write-offs whatsoever. Inventory generally sits in stock for two months until it is purchased by customers; thus, there are no inventory write-offs either.

To maintain its policy of fiscal conservatism, the firm pays down 50% of its vendor payables and 75% of its bank loan during the year. And to maintain the value of its rapidly depreciating (at a rate of $5 million annually) building, it spends $20 million at year-end on a series of renovations that prepare the store for future growth. Furthermore, the bank that carries its loan has offered a simple interest arrangement; it charges an annual interest fee of 10% on any balance that is owed at year-end. Finally, the firm pays $1 million per month in rent to lease its facilities.

Based on this information, the preliminary year-end balance sheet is:

And the preliminary income statement is:

Good news! The retailer is highly profitable. It earns $18 million on sales of $120 million, a highly impressive net margin of 15%. Thus, its equity value soars from $40 million to $58 million during the year, a spectacular 45% gain.

So what’s the problem? Well, the problem isn’t a matter of profitability; it’s a matter of cash flow. Here is how the cash flow worksheet translates into the statement of cash flows; this statement is required to produce the cash balance that plugs into the following year end balance sheet:

And thus the full picture emerges. Yes, the retailer begins the year with $50 million in cash and ends the year with a healthy profit. But it also ends the year with a bank balance that is overdrawn by $1 million, spelling a catastrophic bankruptcy.

How Can This Be Possible?

How can this be possible, you ask? True insight lies in the cash flow worksheet, the output of an accounting model that has not changed since the medieval monk Luca Pacioli first presented it to the world in 1494.

Sure, the firm begins the year with $50 million in cash. It then earns $18 million, which is actually $23 in cash earnings because the $18 million value is depressed by a non-cash expense of $5 million. Depreciation doesn’t trigger any cash disbursements, y’know!

On an operational basis, though, it allows receivables and inventory to creep up by $10 million and $4 million, respectively. Whenever customers take longer to pay their bills, and whenever inventory piles up on shelves, cash flow suffers the consequences. And furthermore, the firm decides to pay down its vendor payable balance by $10 million; its vendor may have appreciated this decision, but cash flow suffers the consequences yet again. So the retailer may earn cash income of $23 million, but it fritters away $24 million, producing an overall operating cash flow loss of $1 million.

Is that a big deal? You might think not, considering that the retailer begins the year with $50 million in the bank. Why doesn’t it end the year with $49 million?

Look again at the statement of cash flows. The retailer may only be losing $1 million on operations, but it also spends $20 million on renovations and $30 million on loan repayments.  Thus, its entire beginning cash balance of $50 million is spent on its investing and financing needs, and its $1 million in operating cash losses ends up throwing the firm into bankruptcy.

Drip, drip, drip …

Why would a firm decide to pay down debt and invest in renovations when it is in the process of going bankrupt? Such incongruities often occur as an unavoidable result of poor timing. Bank repayment schedules and other financing decisions must often be finalized months or even years in advance; major capital improvement projects also demand significant advance planning activities to address zoning, construction, and other issues. Thus, our illustrative retailing firm might well have made their debt and renovation spending commitments long before an unexpected economic slump drove up their receivables and inventory balances.

The “bottom line,” though, is that earnings and cash flow are two entirely different concepts. An organization can earn significant profits and still go bankrupt. Conversely, it can incur significant losses and still have “a ton of cash.” And in the case of our illustrative example, it can make ostensibly reasonable commitments to invest in its future growth, and then watch with horror as the drip, drip, drip of working capital melting away drives their firm into bankruptcy.

The solution to this problem lies in the practical application of enterprise risk management, a process that we described in our January 12, 2009 posting regarding Citigroup. We all know, though, that a firm cannot last forever in an unprofitable condition; Evan Williams of Twitter might thus be wise to review our previous posting!