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Customer concentration risks in spotlight after American Tire bankruptcy

American Tire Distributors Inc. saw a rapid change in fortune after its two largest customers formed their own retail distribution venture, sending its bonds plummeting 60% almost overnight. But while the issuer's subsequent filing for bankruptcy in October was a dramatic twist, it is not alone among companies at risk from harboring large customer concentrations.

Several loan issuers are struggling to maintain their capital structures in the face of critical contract losses, while others continue to operate with significant potential risks due to their heavy reliance on just one or a handful of customers.

Most recently, generic pharmaceuticals concern Lannett Co. Inc. enlisted Kirkland & Ellis and Lazard to evaluate options regarding its capital structure. This follows the company's unsuccessful attempt to renew its distribution agreement with Jerome Stevens Pharmaceuticals Inc, a contract that represented at least 36% of the company's revenue and 40% of its EBITDA on an annual basis, according to S&P Global Ratings.

Lannett's $622 million B term loan, a constituent of the S&P/LSTA Leveraged Loan 100 Index, fell sharply in the aftermath of the announcement, with quotes as much as 20 points lower from a context of 98/99 prior to the news, sources said.

"Increasingly, we are seeing borrowers and businesses that either should not be leveraged at current levels or be given the amount of runway or flexibility that their governing credit documents are affording," Frank Ossino, senior managing director and senior portfolio manager at Newfleet Asset Management said, arguing that marrying marginal borrowers and business profiles with high leverage and loose credit terms is testament to the aggressiveness of the current vintage of loans and typically a sign of the later stages of a credit cycle.

"Anyone risk — be it customer, distribution, geographic concentration, an inability to realize operating synergies or the makeup of a capital structure — can create challenges for investors, making classic bottoms-up fundamental analysis that much more important today."

Risk cannot be quantified

It's a challenge that Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, recently detailed in a report, in which he noted that such issuers share a characteristic that has long challenged credit analysts and traders who translate their conclusions into issue-specific risk premiums: operating risks that cannot be quantified by measuring past volatility in operating earnings.

"That approach is useful for companies in well-established businesses that face no major disruption by technological or other environmental changes," said Fridson, arguing that analysis of income statements from past cycles is of no help for investors trying to put a number on business concentration risk, a peril that was lurking at American Tire Distributors, when its bonds traded above par.

American Tire Distributors lost key contracts collectively said to be worth about 33% of annual sales in the space of two months. The company faced disintermediation and market risk in the tire distribution business that became apparent in April when two of the largest tire manufacturers in the U.S., Goodyear Tire & Rubber and Bridgestone, announced plans to form TireHub, a joint retail venture to distribute their tires.

Rating agencies note that the capital structure for Tweddle Group Inc., another Loan Index member, is under major strain following the loss of a major contract with Fiat Chrysler Automobiles. Tweddle produces car owner manuals and equipment.

"Because the lost client contract represented roughly 40% of Tweddle's 2017 revenue, we believe the company will be hard-pressed to manage its debt service and amortization needs after 2018," S&P Global Ratings analyst David Snowden wrote in a recent report, adding that the contract loss will cause a total sales decline of 15% to 20% in 2018 and about 25% in 2019.

Steeply declining cash flow generation as a result of the loss could culminate in insufficient headroom for Tweddle to service its fixed charges by the end of 2019, S&P Global Ratings said. Furthermore, the issuer is expected to violate its senior secured credit facility's net leverage covenant in the first half of 2019.

Consequently, Tweddle's $225 million B term loan has shed 60% of its face value since allocating at 98 in 2016. Proceeds of the loan were aimed at refinancing debt and funding a shareholder distribution.

Borrower-friendly market

Privately held Tweddle is now reportedly in talks with term loan lenders on a restructuring deal that would "equitize" the loans.

Strong market conditions have given issuers the upper hand. Despite a handful of notable mega-loans, such as the financing to back the $14.25 billion Refinitiv leveraged buyout in September — the second-largest post-crisis LBO — the supply shortage at the time was as severe as it has been all year, enabling a surge of borrower-friendly price-flexes in the primary market and rising prices in the secondary.

Restaurant Technologies Inc., for example, reportedly met with a significant demand for its recent LBO offering, tightening pricing on both the first- and second-lien tranches backing its September buyout by a new sponsor, West Street Infrastructure Partners III. The company, which did not respond to a request for comment, is said to rely on McDonald's Corp. for nearly 40% of its cooking oil solutions sales, according to Debtwire.

Alhough the customer concentration is significant, concerns have been somewhat assuaged by Restaurant Technologies' roughly 20-year relationship with McDonald's as the chain's only approved bulk cooking oil provider, as well the fact that the company sells and contracts with individual franchisees, Moody’s analyst Brian Silver noted in a September report.

LCD is an offering of S&P Global Market Intelligence. S&P Global Market Intelligence and S&P Global Ratings are owned by S&P Global Inc.