MYOB Sub Notes: Explosive for returns, or your capital

‘Debt’s back baby. People are buying this crap,’ was a quote, attributed to a banker, your author heard recently. It wasn't related to this offer, but if you're buying into the high yield securities market, it's worth bearing in mind.

MYOB Sub Notes isn’t a rapacious offering; it’s fair but risky. Bain Capital, owner of MYOB, is paying handsomely to claw back some of its capital, offering a margin of 6.7% over the 90-day bank bill rate. To understand why it’s issuing expensive debt, see Healthscope Notes? No thanks.

The returns are high but this is ‘seat of your pants’ stuff compared to term deposits, bonds and blue chip shares. If you don’t have the appetite for junk securities, stop reading now.

If you are considering this offer, understand these three facts:

1. This is not a hybrid. There’s no conversion to listed shares to get your money back. This is traditional subordinated debt, which must be repaid from operating cashflow.
    
2. It’s ‘all or nothing’. MYOB has a great business selling accounting software but it’s not a tollroad or airport. It’s also highly leveraged—debt to equity is over 100%—leaving it open to left field events like inroads from competitors (for instance, new ASX listing Xero), discounting, litigation, law changes or a data security scare.
   
   Any such major event would leave MYOB struggling to pay its senior debt, let alone the Sub Notes. In most cases you’ll get a margin of 6.7% and your principal repaid. In the remainder, you’ll get little, or nothing.
    
3. Flawed offer structure. The offer had an initial target size of $125m, raised to $150m at the bookbuild, with the capacity to increase it further. A further increase could see more than two-thirds of MYOB's operating cash flow going to pay interest. The debt-to-equity ratio would be well above 100%. Most lenders want to know the amount they’re lending. The only way for lenders to know in this case is to wait and buy on listing.

Bain and MYOB were clever to leave the option of increasing the deal size after the fact, without having to increase the margin. Retail investors holding back and causing the offer to be downsized, and therefore of lower risk, would be even smarter.

Unfortunately, there’ll be plenty of brokers spruiking the attractive margin but only a very few pointing out that retail investors are doing themselves harm by making the float a success.

The offer

The terms of MYOB Sub Notes are set out in section 2 of the prospectus. The key ones are:

• Notes will be issued with $100 face value and listed on the ASX (code MYBG)
   
• Five year term (maturity date December 2017)
   
• Margin (over floating 90-day bank bill rate) of 6.7%, payable quarterly
   
• Interest payments are compulsory unless a ‘suspension condition’ occurs (for instance, default on the senior debt or insufficient ‘cashflow cover’ – refer section 2.2.8)
   
• Skipped interest payments accrue with 2% additional penalty margin
   
• Subordinated to the senior debt facilities—senior debt needs to be repaid before the Sub Notes (despite the stated Dec 2017 maturity)
   
• 10% guaranteed minimum interest for the first year (which doesn’t have much practical effect unless the 90-day bank bill rate falls dramatically)
   
• Holders are granted a 2.5% discount on applying for shares in any IPO (not much value without a commitment to float)
   
• Can be redeemed early at MYOB’s option (with a slight penalty payable in the first three years – see section 2.3.2) or the occurrence of certain events (a change in law, for example)
   
• Holders are subject to a ‘stand still’ on enforcement (refer section 2.4.7), meaning the Sub Notes take a back seat to the senior lenders when it comes to recovering unpaid amounts.

It’s a simple proposition. If MYOB’s earnings continue to grow, the Sub Notes will be highly profitable. If something bad happens, they’ll blow up. Payments will be skipped, maturity will be deferred and the $0.5b worth of senior lenders will hold all the cards. That’s the deal.

The business

MYOB is a provider of business management, accounting, payroll and tax software in Australia and New Zealand. It’s a great business. Customers need the product and changing providers can be a nightmare. Page 64 of the prospectus explains how the company has managed to increase revenue in recent years by increasing prices, without losing customers. Not many businesses can do that.

Table 1 shows the pro-forma income statement (from section 4.2 of the prospectus). Expenses don’t change much year to year and the bulk of earnings (EBITDA) ends up as operating cashflow ($86m for the year to 30 Sep 12, due to $12m of capital expenditure and working capital requirements).

So, $86m in cash flow to pay $40m of senior debt interest and $12.5m (or more) on the sub notes: That doesn’t sound so scary does it?

Potential landmines

There’s a big catch, not obvious from the pro-forma income statement. Page 78 of the prospectus tells us that, not only does the company have interest payments to make, there is also some large principal repayments on the senior debt, payable from December 2012 onwards (see Table 2).

The first couple are covered by the $38m of cash currently on hand. But, starting 1 July 2013, there’s an extra $35m-$50m that needs to be repaid each year. The annual interest bill will go down a little but the simple story is that MYOB needs further revenue growth to meet its scheduled debt repayments. If it can’t get it, Sub Note payments will get suspended.

This is where the flexible issue size of the Sub Notes becomes a dilemma. Another $5m, say, of Sub Note interest will make it that much harder for MYOB to pay its bills.

The other landmines Sub Note investors need to be aware of are the various ‘coverage ratio’ tests in the senior debt facility. Failure to meet this entails a default on the senior debt and suspension of interest payments on the Sub Notes.

There’s a lot of talk of ‘cashflow cover’ in the prospectus. Your focus should be on the ‘senior leverage ratio’ (p76 of the prospectus). This ratio, an undertaking to the senior lenders, decreases over time. Right now it’s 5.6, meaning senior debt can be 5.6 times earnings (with a few minor adjustments which take the number just over $100m). By Dec 2015 it falls to 2.5.

By then, MYOB will have made scheduled debt repayments of about $130m, leaving over $300m of senior debt outstanding. ‘But’, you say, ‘it only makes $100m a year and 300 divided by 100 equals three. It will breach the senior leverage ratio!’

That’s right. Without an increase in earnings, or an unscheduled reduction in senior debt, this ratio will be breached, the senior debt will default and payments on the Sub Notes will be suspended.

That’s why the Sub Notes are paying a 6.7% margin.

Boom boom

Either your returns will go up or your capital will be vaporised. That’s the essence of this offer. Unless you’re running a diversified junk bond portfolio, this isn’t a suitable investment.

Addendum (added 10 December 2012):

Since publication of the original article several points have been brought to our attention which, whilst they don't change our overall view, expand or clarify some of the points made above:

1. The 'total net leverage ratio' (refer pages 38 and 63 of the prospectus) acts as a defacto 'cap' on the amount of Sub Notes which are able to be issued. Currently, only $155m of Sub Notes can be issued before MYOB would be in breach of the 'total net leverage ratio' covenant.

2. The partial repayment of senior debt (from Sub Notes proceeds) results in a 0.25% reduction in the interest payable to the senior lenders. This reduces the effective cost of issuing the Sub Notes.

3. We pointed out that MYOB needs to grow earnings to avoid breaching the 'senior leverage ratio'. This creates a financial incentive to make sure the business is properly capitalised. We note also that MYOB, in its original media announcement, said that Bain 'may reinvest those proceeds in future product development or for acquisitions'. So, whilst the prospectus states that the excess Sub Notes proceeds will be used to repay capital to Bain, there is a chance capital may be left in the business or reinvested (although Bain is under no obligation to do so).