When Charlie Munger passed away last month, just a few weeks shy of his 100th birthday, he and his legendary investing partner Warren Buffett, had amassed well-deserved reputations as value investors. Together, the two had understood the opportunities presented by poorly managed companies in distress and knew how to turn them around to realize their true value. The list of distressed companies they helped rescue is extensive and includes such well-known names as Bank of America, Goldman Sachs, General Electric, Johns Manville, USG, and many others.
The current environment is one that offers tremendous opportunities for an investor like Munger because there are just so many companies heading into distress or already in Chapter 11. We have examined many of these in this space recently, including FTX, Grayscale Trust, National CineMedia, regional banks, and WeWork, to name just a few.
One of the more interesting distress stories right now is that of Yellow Corporation. This company was one of the nation’s top trucking firms, grossing over $5.2 billion in revenues last year. Nevertheless, it is now in the midst of a bankruptcy liquidation. At a recent court-overseen auction, it sold $1.9 billion worth of real estate, which was a higher figure than many had expected. That total includes $870 million that a competitor, XPO Inc (XPO.N), paid for 28 of Yellow’s terminals.
At the time of its bankruptcy filing, Yellow also owned 12,000 tractors and 35,000 trailers which are also being sold. One competitor, auto hauling trucking company Jack Cooper, offered to save what was left of the liquidating trucking giant and even said it would hire back most of its union employees. However, Yellow rebuffed that offer since it was speculative and hinged on getting $700 million in new subsidies from the U.S. government.
During bankruptcy, Yellow has seen its stock rally but that represents more of a last gasp than a revival. Yellow pointed the finger for its demise at the International Brotherhood of Teamsters. However, the real culprit was the company’s underfunded pension plans, which amount to over $5 billion in liabilities.
What makes Yellow Corporation such an interesting case is that it shows how secular change, underfunded pension plans and poor management of those pensions can rapidly drive a company into bankruptcy. It reminds us that, when interest rates were so low many pension plans became underfunded because the discount rate for future liabilities dropped so much, combined with poor performance in the market on the asset side of the pension plans’ balance sheets.
Yellow was like many other old economy companies with big legacy liabilities that face distress. But in this case, it also faced secular change. E-commerce giants Amazon and Walmart have been tough on trucking company vendors, squeezing their profit margins which were already burdened by rising fuel and maintenance costs. On top of that, Yellow faced massive labor inflation in the form of higher wages and work concessions.
This is really a casebook study of what can happen to a business like Yellow Corporation, when its balance sheet gets out of whack. Its liabilities included not just commercial debt, but also leverage in the form of underfunded legacy liabilities including pension plans or other employee-related liabilities.
What is probably most surprising with Yellow Corporation though is just how fast the business completely shut down. This may become emblematic of what we can expect with other distressed businesses now that interest rates have climbed so much. The cost of servicing that debt is much, much higher, putting overleveraged firms at a serious competitive disadvantage.
In addition to underfunded legacy liabilities, tort litigation claims are also causing numerous bankruptcies. We see this with litigation claims related to talcum powder (J&J), earplugs (3M), weed killer (Bayer), and multiple opioid-producing companies. The most prominent opioid case is that of Purdue Pharma, which the US Supreme Court recently agreed to hear. That case is especially important because it addresses a key legal question of whether third party releases can be forced upon people who don’t agree to them.
In this case, Sackler family members were the main operators of Purdue Pharma for many years. Over time, they received ~$11 billion in cash from the business as it printed more and more money by selling addictive opioids and other drugs. The family moved large amounts of this money into overseas trusts and accounts which were not attachable by US prosecutors. However, the Sacklers ultimately agreed to a settlement where they would return $6 billion of that cash in exchange for releases from future liability.
At the time of the settlement, plaintiffs, including individual victims, Native American tribes, municipalities and states, agreed to the deal because they figured there was no chance of getting the money back from the Sacklers’ creditor-proof offshore trusts.
And so, virtually all of the plaintiffs agreed to release the Sacklers, even though the family members themselves weren’t in bankruptcy – instead, their company was. That is the question for the Supreme Court today, whether this long-standing principle in bankruptcy law of granting third party is fair to victims. It is interesting that the Supreme Court has taken it on because it could affect how future bankruptcies are structured.
Distressed investors will also have a lot of other things to keep an eye on in 2024 as activity in this space picks up. Investors can’t ignore the possibility of recession since leading indicators, like the inverted yield curve, are still flashing red. There has been a lot of back and forth about whether the Fed might start lowering interest rates in 2024 but that seems really premature and likely wishful thinking.
The good news is that the US economy is still buzzing along. The rate of inflation has dropped, although it remains above the Fed’s target. People are travelling and spending money as we all saw during Thanksgiving and the stock market has been rallying.
Looking forward, the prospect for equity markets seems even more uncertain than usual at this time of year. The Magnificent Seven, which were the primary drivers of the S&P 500’s performance this year, had a great 2023, but may not deliver similar gains in the next 12 months. Some of those companies are now priced to perfection.
Still, investors who have a special niche edge and who do the work should find opportunities for making money in 2024. May your Holidays be Happy, your Christmas Merry and your New Year prosperous.