Pyxus International’s Second Lien Debt

Note: this was written prior to Pyxus’s bankruptcy in 2020. For an updated analysis of what went wrong, check out Bankrupt: Pyxus International Inc. Stock.

Pyxus International, fka Alliance One International, coordinates the purchase, processing, and storage of leaf tobacco from farmers all over the world and then bundles it all together and sells it wholesale to the major tobacco product manufacturers. They’re headquartered in Morrisville, North Carolina and employ about 3,300 people. They recently changed their name to reflect the new, expanded focus of their company that includes e-liquids, CBD oil, and medical marijuana, in addition to their legacy tobacco leaf processing business.

Their claim to fame, or competitive moat if you want to use those fancy MBA terms, includes the following:

  1. Logistics acumen required to take a seasonally harvested product that has a limited shelf life until processed;
  2. Technical capability (agronomy) and partnerships with farmers to help them improve farming practices, which leads to better yields and quality; and
  3. Technical capability (traceability) that allows them to accurately track the source of their product and its inputs.

They had a rough year in their FY17 as the global tobacco harvest was greatly affected by weather. Besides the normal impact to revenues and gross margins from bad weather, the Company took the opportunity to take an impairment charge on some of their assets in Africa and the Company’s former US cut rag facility. Compounding their problem is that the Company is heavily indebted between the ABL facility that is used to fund the working capital requirements of seasonal harvests on top of two tranches of term debt. The bad year in FY17 caused the Company’s already expensive term debt to sell off, pushing up its yield to maturity. Happily, this created an opportunity for both the Company and any investor willing to become new creditors.

Tobacco Demand is Wilting

Ever since the late 90s when the big tobacco manufacturers agreed to pay billions in fines in what is still the largest single civil litigation settlement in US history, even after the TBTF banks made a strong effort to take the crown after the Great Financial Crisis, investments in the tobacco industry have been tainted. It wasn’t so much the size of the fine as the tipping point it indicated. Consumer preferences had changed enough due to health education over the past decades that only 25 percent of adults smoked versus more than 40 percent thirty years prior.

Trends in Current Cigarette Smoking Among High School Students and Adults, United States, 1965–2014
Source: CDC

As a result, investors started shunning companies involved in the tobacco business. What investors failed to understand 20 years ago was the tobacco companies’ ability to steadily increase prices charged to consumers. Up until just recently, tobacco majors handily outperformed the broader S&P 500.

Marijuana’s Growing Demand

As demand for tobacco waned, other intoxicating substances replaced it. Marijuana has seen a strong resurgence as the “Don’t do drugs” stigma has slowly worn away.

Line graph shows percentage of past month marijuana use among persons aged ≥18 years in the United States during 2002–2014 by highest level of education completed. Education levels completed are less than high school, high school graduate, some college, and college graduate. Percentage increase over time is statistically significant for all education levels.
Source: CDC

Legal marijuana markets are just in their infancy but already there is serious venture capital money positioning itself to take advantage of the opportunity. More than 145 mergers and acquisitions in the marijuana industry have been announced in the first half of 2018. Venture capitalists aren’t the only ones: strategic buyers such as Coca-Cola are looking to expand into new market segments.

What makes the most sense: tobacco companies acquiring cannabis companies.

In December 2017 Pyxus acquired a minority interest in Criticality (CBD oil from industrial hemp) plus majority interests in Goldleaf Pharma Inc. (Ontario-based medical cannabis) and Canada’s Island Garden Inc. (Prince Edward Island medical cannabis). These businesses involve the cultivation and/or processing of agricultural products similar in certain ways to leaf tobacco, and accordingly share commonality with Pyxus’s agronomy, traceability, and agricultural processing expertise. They are also subject to huge commercial and regulatory hurdles, much like tobacco.

These recent cannabis acquisitions aren’t expected to have a large near-term effect on Pyxus’s financials; however, it represents a potentially valuable kicker that isn’t immediately obvious from just looking at their balance sheet.

Pyxus’s Capital Structure: where to play

Pyxus is an interesting situation because you have technical expertise in a company involved with the declining tobacco industry combined with relatively cheap access to a couple cannabis investments. The value of the cannabis businesses are currently being obscured by the rough patch that Pyxus went through caused by the twin effects of high leverage and harvest problems.

Their FY18 that ended 3/31/18 was a better year for them than their FY17. Sales, margins, and operating income bounced back due to a more normal harvest season. Their first quarter of FY19, which ended 6/30/18, continued those trends although the first quarter is a seasonally slow period for them.

A straight up equity purchase could be interesting because of the higher leverage and the marijuana kicker. However, there’s no guarantee that the marijuana businesses will develop quickly enough to offset the slow decline in global tobacco consumption. And when that is combined with a debt load that eats up all the existing cash flow it’s harder for the Company to make the investments in the marijuana businesses that will help them flourish.

Since the debt load is currently eating up all the cash flow it makes the most sense for an investor to buy the debt so that he can be the one that gobbles up the payouts.

Pyxus’s Senior Secured Second Lien Notes

If owning the equity of Pyxus is an interesting play then owning the most junior debt, which also has the added benefit of paying the highest interest, is probably the best place to put money to work. The senior secured second lien notes were issued on August 1, 2013 in an aggregate principal amount of $735MM with a 9.785% coupon, payable semi-annually. These notes mature July 15, 2021. They are behind the Company’s ABL facility, which had outstandings of $580MM as of 6/30/18, and the first lien senior secured notes that had $259MM. As of the 6/30/18 financials the senior secured second lien notes had $652MM outstanding after the Company repurchased ~$11MM of the notes at a discount in the open market, followed by another $7MM purchase in July, also at a discount.

The chart below shows the fixed charge coverage for Pyxus for the past three years and the most recent TTM period using adjusted EBITDA. This is a common metric used by credit analysts to help determine the creditworthiness of a borrower. A ratio below 1.0x means the Company isn’t generating enough cash to service its fixed charges, namely its capex, cash taxes, scheduled principal payments, and cash interest expense. That shortfall has to come from somewhere. Companies can either dip into existing cash balances, use their revolving line of credit, stretch payables to suppliers, sell off divisions, raise more long-term debt, or issue equity to fund the shortfall.

Actual FYE16 FYE17 FYE18 TTM19
Operating Income $201,787 $84,568 $110,603 $115,857
Restructuring/Impairment $5,888 $1,375 $382 $1,923
Dep. & Amortization $28,361 $34,476 $33,598 $34,488
Non-Cash Compensation $2,874 $1,712 $1,189 $1,139
Adjusted EBITDA $238,910 $122,131 $145,772 $153,407
Capex $17,194 $13,683 $22,783 $24,769
Cash Taxes $20,369 $18,088 $18,691 $27,213
Cash Flow for Debt Service $201,347 $90,360 $104,298 $101,425
Net Cash Interest Expense $97,591 $98,976 $115,985 $113,951
CPLTD $2,894 $356 $46 $164
Debt Service $100,485 $99,332 $116,031 $114,115
Fixed Charge Coverage  2.00 0.91 0.90 0.89

If a company exhausts all of those options they’ll file for bankruptcy. A company like Pyxus would file for Chapter 11, which would allow them to reorganize their capital structure under the protection of a bankruptcy court. If this were to happen to Pyxus then odds are the ABL revolver would continue generally as-is given their collateral position and the ongoing need for working capital financing, the senior secured first lien term debt holders would remain as-is since the Company is generating enough annual cash flow to create real enterprise value, the second lien senior secured term debt holders would get either partially or fully converted to equity, and the existing equity holders probably get wiped out.

If we assume that the existing equity holders get wiped out and the senior secured second lien holders get fully converted to equity, then the resulting fixed charge coverage ratio as shown in the chart below on a proforma basis using historical adjusted EBITDA after a Chapter 11 bankruptcy would be back above 1.0x, total cash flow leverage would be below 4.5x, and the second lien holders would now own the company at a reasonable enterprise value.

Proforma-ish FYE16 FYE17 FYE18 TTM19
Operating Income $201,787 $84,568 $110,603 $115,857
Restructuring/Impairment $5,888 $1,375 $382 $1,923
Dep. & Amortization $28,361 $34,476 $33,598 $34,488
Non-Cash Compensation $2,874 $1,712 $1,189 $1,139
Adjusted EBITDA $238,910 $122,131 $145,772 $153,407
Capex $17,194 $13,683 $22,783 $24,769
Cash Taxes $20,369 $18,088 $18,691 $27,213
Cash Flow for Debt Service $201,347 $90,360 $104,298 $101,425
Net Cash Interest Expense $28,533 $32,312 $51,749 $50,610
CPLTD $2,894 $356 $46 $164
Debt Service $31,427 $32,668 $51,795 $50,774
Fixed Charge Coverage  6.41 2.77 2.01 2.00

Given the modest turnaround underway at the Company, combined with the number of ways out through a bankruptcy process, the senior secured second lien notes represent a more reliable return on capital and return of capital.

Will buying the senior secured second lien notes provide the highest risk-adjusted return? I don’t know.

But based on the debt service requirements over the next three years against the likely trajectories of the tobacco leaf industry and the marijuana industry, it appears to me to be the more optimal play.

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