Could Canwest go bankrupt?

The stock has fallen by more than 90 per cent and major investors are bailing out, as fear mounts over a debt crunch

Could Canwest go bankrupt?

Next year will mark the 10th anniversary of Leonard Asper’s ascent to the top job at Canwest Global Communications, taking over the reins from his late father Izzy. But there might not be much of a celebration. It hasn’t been an easy ride. When the youngest Asper became president and CEO in 1999, Canwest was trading at close to $20 a share. As of early this week, it was treading water around 60 cents. What was once arguably Canada’s leading media company was kicked off the country’s main market index in September, and is now a struggling penny stock.

Asper himself seems more perplexed than anyone by his company’s rapid decline. After all, as he’s fond of pointing out, Canwest is not only making money, it’s making more money every year. Revenues have increased from $2.7 billion in fiscal 2006, to $2.9 billion in 2007, to $3.1 billion in 2008. Similarly, Canwest’s EBITDA (earnings before interest, taxes, depreciation and amortization)—a popular indicator of a company’s profitability—looks healthy. As of August, the end of Canwest’s latest fiscal year, its EBITDA hit a three-year high of $578 million—$91 million higher than the year before. Canwest’s various holdings, which include Global Television, Network Ten in Australia, various websites and 10 major daily newspapers (including the National Post), are as a whole still making money. And analysts say that from a strategic standpoint, the company’s decision to acquire Alliance Atlantis and its portfolio of top specialty TV channels last year made perfect sense.

And yet, the market is rebelling. One after another, major brokerages have slashed their projections for the company, and few are recommending clients buy the stock. At least one major institutional investor recently opted to cut his losses and bailed out completely. According to financial analysts and investors Maclean’s spoke to, Canwest’s stock price is now so low, it indicates that investors feel it could go bankrupt. The next three years may be the most crucial in the company’s history. If Canwest pulls through, it could once again surge back to health and recapture its former glory. If it doesn’t, Asper could find himself presiding over the collapse of his father’s empire.

Asper declined to be interviewed for this story, but he hasn’t gone completely silent. For the past several months he has been on a campaign to counter the perception that Canwest is a sinking ship. Back in July, before the worst of the market collapse hit, Canwest had already been reduced to a mere $2.50 a share from more than $7 at the start of the year. On a conference call with analysts that month, he practically begged them to look past the plunging stock and appreciate the true value of his company. “Let me start by saying that given our diversity and strength of our properties, I believe that Canwest stock is significantly undervalued,” he said. Later in the call he protested his company’s low valuation again, saying that his own reported earnings-per-share figures didn’t do Canwest justice. “I challenge the analysts and the media listening to not get caught in what are today’s accounting principles,” he said, “and to take the time and look at the underlying operating strength of our corporation line by line.”

The analysts participating in the call were evidently not impressed. As the summer and fall wore on, and the economy worsened, Canwest’s stock continued to swoon. According to Bloomberg, of the 11 analysts following the shares, five now rate it a “hold” and six rate it a “sell.” Moody’s has put Canwest’s credit rating under review, and just last week, Dominion Bond Rating Service reduced the issuer rating for Canwest Media from BB to B (high). That’s a serious tumble and it puts the company firmly in junk bond territory, meaning that Dominion now considers lending money to Canwest to be a “highly speculative” investment. According to Dominion’s rating scale, when a company receives a B-level grade, “there is a reasonably high level of uncertainty as to the ability of the entity to pay interest and principal on a continuing basis in the future, especially in periods of economic recession or industry adversity.” Which, of course, is exactly the sort of period Canada is entering now.

Despite Asper’s protests, analysts say Canwest is actually in dicey financial shape. One respected mutual fund manager with a large holding in the company’s stock (who spoke on the condition of anonymity) lists off the reasons why: “One, almost all media properties are selling at a depressed price,” he wrote in an email. “Two, media properties in general are facing huge challenges from Internet, cable, and new technology. Three, management have made several questionable acquisitions at high prices (looking with hindsight). Four, they compounded the problem with high leverage.” And finally: “Five, the Street does not think highly of current management.”

The first two reasons for Canwest’s plunge are no fault of its own. Readers and viewers are abandoning newspapers and conventional television for cable and Internet all over the world. In a conference call with analysts in mid-November, Asper himself went as far as saying, “The conventional television revenue model continues to be challenging, and I would dare say, broken.” Compound that with the current economic collapse, and you find that all media companies are getting hit hard. Corus Entertainment, for instance, which owns more than 50 radio stations and a slew of specialty channels, has seen its stock price slump from $25 a year ago to less than $13 today. Torstar Corp., which owns the Toronto Star, the Metroland community newspapers, Harlequin books, and a stake in CTVglobemedia, has seen its stock fall from $19 to $8 over the same period. Both represent declines of between 50 and 60 per cent. But over the same period, Canwest’s stock has dropped by a staggering 92 per cent. So the plunging market, it seems, is only part of the story.

The bigger problem falls under the heading of “questionable acquisitions at high prices,” and the piles of borrowed money required to close those deals. Since taking over, Asper has bought up a grab bag of properties. He has launched three radio stations in the U.K., acquired four radio stations in Turkey, and bought the New Republic magazine in the U.S. Then, just a few months ago, he turned around and sold the U.K. stations for an undisclosed price, less than three years after launching them. Such flip-flops have helped contribute to a perception that management doesn’t have a long-term plan. “What can I say?” says Robert Floyd, president of R.A. Floyd Capital Management in Mississauga, Ont. “They’re not the brightest bunch of boys when it comes to buying assets.”

But it’s Asper’s largest acquisition that’s causing him the biggest headache. It took place in January of last year, when Canwest gobbled up a big chunk of Alliance Atlantis to get its hands on popular specialty TV channels such as Food Network, HGTV and Showcase. Floyd says acquiring the channels was a smart move strategically, but they cost a whopping $2.3 billion, and Canwest had nowhere near that kind of cash. To pull it off, the company had to make a deal with the now-troubled U.S. investment bank Goldman Sachs. The agreement they struck is complex, but Chris Diceman, senior vice-president at Dominion Bond Rating Service, says the upshot is this: 2½ years from now, Canwest will have to merge all of its TV assets with the Alliance Atlantis business, which is now called CW Media. Both Canwest and Goldman will have a stake in this new entity, and how much Canwest ends up owning will depend on its earnings and debt levels. If earnings decline, Goldman will own more, and Canwest will own less. If earnings go low enough, and debt levels rise, Goldman could even force CW Media to buy out its stake at a minimum price. In the worst case scenario, that price could be more than Canwest could afford.

When the deal was first struck, Asper said he liked it because it put his fate in his own hands. But ironically, one of the main reasons for structuring the deal in such a complex fashion was because Asper felt his TV holdings were undervalued by the market at the time. Now they’re worth even less. “The problem is,” says Floyd, “that deal was struck in better times. Now we’re in a much worse economic environment, so deals like that can go sour.” Indeed, when you read the Dominion Bond Rating Service report it becomes clear that Canwest’s debt, which now sits at about $3.7 billion, is the real albatross around Asper’s neck. Dominion’s report predicts that the “ongoing deterioration of the advertising market” will be so severe that, as a group, Canwest’s main media holdings could stop making money for their parent, “which could put Canwest Media into a negative free cash flow position by the end of fiscal 2009.” It would be a disaster that could seriously compromise Canwest’s ability to pay its debt. Last year, Canwest was expected to raise close to $1.5 billion by selling off Network Ten in Australia. That would have gone a long way toward relieving the debt burden, but Asper never got an offer he considered to be adequate.

Canwest may soon need cash desperately, and as the economy worsens, it’s running out of options to get it. The company is trimming costs—it has cut down the physical size of its newspapers, reduced the National Post’s distribution in the West, and announced the elimination of 560 jobs just last month—but Dominion says that likely won’t be enough to keep cash flows from declining if revenues keep going down. Asper could start selling off assets, but if he were to sell off holdings such as Network Ten now, he’d have to do so at fire sale prices. He’s even rumoured to have considered another option, to buy up all of Canwest’s outstanding shares and take his company private, but again, that would require hard-to-get financing.

There is always the option of raising cash by borrowing more money (assuming Canwest could find a willing lender), but previous lenders have set strict limits on how much the company can borrow. Canwest Media recently managed to raise that limit by negotiating with creditors to step up its allowable total debt-to-EBITDA ratio from 5 to 6.75 by next August. However, Dominion worries that if the economy keeps getting worse, “the company’s covenant cushion could erode faster than its headroom increases throughout fiscal 2009.” Dominion has good reason to worry: right now, of all the major publishing and media companies in Canada and the U.S. that it compares Canwest to in its report, only Liberty Media, Clear Channel Communications and Tribune Company have higher levels of debt, as measured by the gross debt-to-EBITDA ratio, while Canadian rivals such as Torstar have levels around the industry average of three. Ominously, on the very day Dominion’s report came out, Tribune, which had the highest debt ratio at 10, declared bankruptcy.

Indeed, if Canwest can’t borrow more money, that could leave only the option of last resort: defaulting on the company’s debt—which would almost certainly lead to bankruptcy. Could it really happen? Edward Altman, professor of finance at the Stern School of Business at New York University and one of the world’s most respected corporate bankruptcy experts, says yes. Back in 1967, Altman invented an indicator that can predict corporate bankruptcy with a high degree of accuracy, called the Altman Z-Score. When applied to Canwest, he told Maclean’s that this strictly by-the-numbers analysis indicates that Canwest has about a 37 per cent probability of defaulting on its debt within five years.

That means Canwest has a better than 60 per cent chance of weathering the storm, but those odds aren’t high enough for some. In late November, shortly after the company announced a massive $1-billion writedown on goodwill and broadcast licenses, respected deep value investment manager Irwin Michael finally threw in the towel. His investment company, ABC Funds, specializes in buying up the stock of undervalued companies and waiting for them to bounce back, so he’s not scared off easily. But after first buying into Canwest at about $15 some years ago and then watching almost all of his investment evaporate, Michael has stopped waiting for the bounce. In a note to clients he explains that with 85 per cent of its revenue coming from advertising, Canwest is particularly vulnerable to the looming recession. He adds that he originally believed that “in the event of a serious downturn, Canwest could have sold Network Ten,” but now the Australian network has hit its own slump, and he doubts it could be sold. In the end, he writes, “We made the difficult decision and sold our position in Canwest. We will look to redeploy the capital into less economically sensitive positions with cleaner balance sheets, better cash flow and greater dividend income.”

Not everyone is giving up, however. Prem Watsa, president of Fairfax Financial Holdings and one of the most astute financial minds in Canada, seems to be sticking by Canwest. In fact, Watsa keeps scooping up more and more of the company’s stock at every opportunity. His company now owns 22 per cent of Canwest’s subordinate voting shares—and he may know something that other investors don’t. After all, Watsa not only accurately predicted today’s general financial ruin, he made more than a billion dollars off it through canny investments in credit default swaps. If he’s right about Canwest, and it pulls through to see sunnier days, he could be richly rewarded. If that happens, Asper will be proven right, and the naysayers will be kicking themselves in disgust. But it’s a pretty big “if.” For now, “they would be hard to recommend as a buy,” says one Toronto analyst. “There’s a lot of value in their properties, but there has to be some hope of a recovery.”

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