Orthofix Credit Deal: A Litmus Test of the Times
BY JOHN MCCORMICK, OCTOBER 1, 2008
Even in these troubled markets, there is a price for everything. On Monday, in the midst of one of the greatest credit dislocations in history, Orthofix announced that it has amended its existing credit facility.
In an even more remarkable twist of fate, Orthofix closed the deal with Wachovia - the very day this goliath bank announced it was giving up the ghost and being acquired by Citigroup. Whew!
Now for some history and even histology (so to speak).
In September 2006, Orthofix entered into a term (that is, supported by cash flow) loan of $330 million and a revolver (that is, supported by receivables and inventory) loan of $45 million. The good news is that the company has paid down the whole $45 million revolver and about $40 million of the term loan. Roughly $292 million of the term loan facility was outstanding on June 30, 2008.
We participated in a well-organized investor day that the company held a few weeks ago where management forthrightly told investors the bad news that they they were likely to violate covenants (in essence, contractual limitations) on the outstanding term loan balance. The covenants, in a nutshell, require Orthofix to maintain debt levels to a maximum of 3.5 x EBITDA (an earnings-based cash flow metric) for 2H:08. According to equity analysts, Orthofix was heading toward something like 4.5 x EBITDA which is a perfectly reasonable level in prior years, but considered overleveraged today. Explanations abound, but we can generalize the problems to lack of growth and earnings in the company's troubled Blackstone spinal implant unit as compared to the relatively healthy, but low growth stimulation, bracing and trauma product lines.
Unlike mortgages, foreclosures rarely happen in the commercial world. When a company trips covenants in its creditor agreement, it usually has to go back to its bank and negotiate some kind of settlement with the existing bank. Normally the end result is a default waiver, amendment to the original agreement, forbearance agreement or the like, but fundamentally the bank gets to extract a pound of flesh if they so choose. In this case, Wachovia did just that. Fairly or unfairly, they are obtaining a much higher interest rate. Originally Orthofix was paying LIBOR (a benchmark floating rate) + 1.75% and the amendment (posted here with the Securities and Exchange Commission) calls for an increase to LIBOR + 4.5%. Ignoring the once-in-a-decade spike in LIBOR over the last two days (and the unusual minimum 3.0% LIBOR specified in the agreement), Orthofix's normalized interest cost went from about 5.25% to about 8.0%. Multiply that by $290 million and you get about $6.5 million of incremental annual interest cost. Again, that's assuming LIBOR normalizes.
The Blackstone acquisition just got a whole lot more expensive for Orthofix.
Not stopping at interest rates, Wachovia then added covenants demanding that Orthofix pay down their term loan quickly. In less than two years, Orthofix needs to bring their debt levels down to 2.5 x EBITDA to be in compliance. At their current level of cash flow - about $65 million of EBITDA - the debt level needs to be $162.5 million by July 1, 2010. But that's about two years of Orthofix EBITDA - and we haven't even factored in how EBITDA is needed to support capital expenditures, working capital needs and the required investment in instrument sets to support Blackstone's product launches in 2009 and the now higher annual interest cost on this debt. Anyone have $130 million to spare? Anyone smell an equity offering to de-leverage this business?
Fortunately, we work and live in an industry that shies away from leverage.
Where leverage applies, this recent transaction provides us with a litmus test of how the credit dislocations are effecting our industry in the short run. This tells us credit markets - even with a failing bank like Wachovia - are showing some signs of life, but at a considerable cost for companies not hitting their numbers.
