A Preferred Stock Investment in Forward Air and Cimpress / Expedia Precedents

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Overview

Forward Air (NASDAQ:FWRD), a North American leader of air freight and logistics services, has seen its shares decline by over 75% in the last year. While a large part of this is due to air freight demand returning to pre-pandemic levels, supply chain shocks stemming from rising geopolitical tensions and inflationary pressures curtailing consumer demand, the company’s struggles can largely be attributed their drawn-out acquisition of Omni Logistics. FWRD announced the $3.2bn acquisition in August 2023 and shares dropped by 40% the day after the announcement. Shareholders were undoubtedly disappointed; the transaction would have pushed the leverage ratio up to 18x EBITDA, and the company was looking to vertically integrate with another industry player larger than itself! Despite the company’s successive attempts to abandon the merger, the deal closed in January 2024 with a $2.1bn purchase price, a far cry from the $3.2bn promised in August.

As of March 15th, the company has a leverage ratio of 12.2x but management has outlined intentions to bring it down to 4.5x by the end of next year, which I think is ludicrous. The deal also gave Omni shareholders 35% of the combined company; the heavy stock component of the transaction has diluted existing shareholders significantly.

This company has an urgent need to deleverage significantly. Interest and principal repayments are expected to reach $180mm annually, and for a company that made ~$145mm of EBITDA last year and has ~$120mm of cash on hand, debt service will be a significant drain on liquidity.

Before the earnings release, FWRD amended its covenants, specifically its first lien leverage ratio, in its credit agreement from 4.5x to 5.5x, which I expect them to breach again, even with 8% revenue growth and 7% EBITDA margin expansion. Paired with the fact that the deal is expected to be dilutive this year, FWRD may need short-term liquidity soon as it looks to meet interest payments.

Cumulative Preferred Stock Investment Proposal

I believe this investment will be ideal for a company like Forward Air. Given that the credit agreement was already amended by lenders two months ago, I think it’s unlikely that lenders would be willing to amend again following a covenant breach without imposing new and serious restrictions. The company’s leverage ratio is already excessively high and contractual interest paypments would only increase the burden that the company is facing. Issuing new debt would surely come with new covenants that would not help.

If the company needs covenant relief, a preferred or common equity investment is ideal. While the entry valuation of common shares would be attractive for a new investor, common shareholders have already been diluted significantly a month ago and the market reaction would likely be dismal.

Therefore, I believe a preferred stock investment is ideal for the rescue financing. All of the company’s current outstanding debt is secured. Issuing second lien debt may be possible but it would be necessary to first determine whether there are enough unencumbered assets which, given the amount of existing secured debt, may be a notable limitation. Issuing unsecured debt does not make much sense in this context. The added safety of unsecured debt compared to preferred stock in this case would be misleading; newly issued unsecured debt and preferred stock would both sit at the bottom of the capital structure anyway. From an investor’s standpoint, why not get the extra return and potential convertibility option with convertible preferred stock?

Additionally, I believe preferred stock, as opposed to less expensive debt, will, in a way, actually reduce the risk that a lender will not be repaid. Rate cuts are expected to start in late 2024 and the company will issue debt to refinance the expensive preferred stock as soon as it can. In fact, the more expensive the debt, the more likely the company will be to refinance it. Now, an investor should add some call protection to get compensated for this but this works out to be a win-win for both parties.

Lastly, some may wonder — is this company not an attractive LBO target? Divesting the Omni asset and practically undoing FWRD’s work may be possible but I believe a traditional LBO doesn’t make sense either. Debt service costs are too high right now and an LBO does not put the company in a better liquidity position. General market pessimism surrounding the company may extend the holding period, as a multiple rerate may not occur for a while. There is also the added question of liquidiy and investor interest should a PE firm look to IPO the business.

There are some notable precedents for rescue financings that I think can be replicated with Forward Air: Cimpress and Expedia. Apollo’s Hybrid Value team invested in both companies at the beginning of the COVID pandemic and I’ve some similarities between the deals that I think can set a precedent for FWRD.

Cimpress

Apollo invested in both Cimpress and Expedia to provide covenant relief during the pandemic. Almost immediately, we can see some parallels with FWRD. Apollo has a history of investing successfully in cyclical businesses undergoing a downturn, from Caesars to Las Vegas Sands. Cimpress, a conglomerate focused on mass customization of products including everything from apparel to signs. The air freight industry, also somewhat cyclical, has also reached its trough and will begin to grow in the common years. As a result, FWRD is positioned to grow substantially in the coming months as industry tailwinds continue to drive growth.

Pre-COVID, Cimpress had a $500mm term loan due June 2023, a $1bn revolver ($500mm drawn) and $400mm of unsecured notes due 2026. The copmany has $231mm of EBITDA in Q1/2 2019 and ($41mm) in Q3 2019 (which was Jan — March 2020). Uncertainty around the company’s turnaround during COVID had made lenders hesitant to provide new money. Cimpress had already suspended its secured leverage and interest coverage ratios and following additional amendments earlier in the year, the company’s ability to incur new debt, conduct M&A activity and repurchase shares were all severely curtailed. So in order to pre-emptively avoid any covenant violation, the company issued $300mm of 5-year 2L notes to prepay part of the term loan which would make lenders more likely to bargain with the company. In a way, this entire transaction was just a very expensive amnedment fee for their senior secured facility. In return, they paid Apollo in many different ways. First, there was 103% prepayment penalty fee which the company decided to incur as they refinanced the expensive 12%-coupon debt one year later. In addition to the coupon, the OID of 98 and 7-year warrants with a $60-strike price sweetened the deal further. Regarding the warrants, the exercise price of $60 represented a 17% premium to the 10-day average price but given the volatility of the share price and the company’s turnaround, the warrants were in the money almost as soon as the deal closed.

Now, one key difference between my preferred stock proposal for FWRD versus Cimpress was that Apollo’s hybrid value fund (HVF) invested in the 2L, likely because, unliked FWRD, the company also had $600mm of unsecured notes that were partly issued just months before in February 2020.

However, I see many parallels in the two deals. Both companies are/were operating at the trough of a cyclical downturn when receiving funding, but are otherwise promising, cash-flow-generative businesses that had occasional liquidity issues. Both companies have/had too much secured debt with a covenant violation looming despite credit agreements that have/had been repeatedly amended. They have/had seen significant (40%+) declines in their share price and while an equity issuance could have been done at an attractive valuation for investors, existing shareholders would likely have been adamantly opposed to it given the heavy dilution.

For an investor, this story is promising. Investing in a junior tranche of debt or preferred stock is ideal to get compensated for the additional risk while simultaneously not having to worry about timing an exit — like an equity investor would — which would be difficult given share price volatility. Given the high cost of debt, issuers are also highly likely to refinance as soon as possible and with a high prepayment penalty in place, yield can suddenly become very attractive.

I have included a rough estimate of what Apollo’s returns on Cimpress could look like:

Expedia

Around the same time, HVF invested in Expedia, the online travel company that facilitates the booking of cars / hotels / flights / vacation packages etc. and collects commissions on each booking. As bookings crashed during COVID, the company was desperate to issue more debt to improve liquidity. Similar to Cimpress and Forward Air, Expedia was experiencing a cyclical downturn as well and had also rasied an additional $2bn of debt. The extra $1.2bn of 9.5% preferred stock provided by Silver Lake (SLP) and Apollo also provided covenant relief, allowing them to suspend a leverage ratio through 2021 and keep it at 5x EBITDA from 2022 onwards.

As a predictable, cash-flow generative business, SLP and HVF likely knew that Expedia would bounce back and the expensive preferred stock would be refinanced almost immediately in the low-rate environment at the time. As a result, they included a redemption premium of 105% for the first year and 103% for the second. Preferred dividends accrued daily and were stepped up from year 5 onwards to reach an eye-watering 15.5% in year 9. SLP and HVF were ultimately correct; the company issued $1.25bn of senior notes just months later in July 2020 to ultimately refinance the preferred stock in 2021.

Furthermore, in both cases (Cimpress and Expedia), HVF received warrants giving them ownership of ~3% of outstanding shares if exercised. As the market recovered and the share prices of both companies continued to rise, both sets of warrants were in the money before the end of the year.

I have included a rough estimate of what Apollo’s returns on Expedia could look like:

Ultimately, I see FWRD as an attractive preferred stock investment but not a practical equity or senior debt investment. With similarities to Cimpress and Expedia, I think that investors can structure the deal in an attractive manner (high dividend, prepayment penalty, some OID) so that FWRD will be incentivized to refinance as soon as possible; with rate cuts expected in the near future, I don’t think that this plan is too far-fetched as issuers would most certainly consider this solution. With modest operating assumptions, the injection of cash will also allow for significant upfront term loan paydown and ultimately moderate deleveraging, undoing the damage from the controversial Omni acquisition and the cyclical downturn.