Could These Trade Creditors Have Avoided a $54 Million Surprise?
Earlier this month, after years of declining sales and recurring losses, regional electronics retailer hhgregg filed for bankruptcy.
And the top 20 unsecured creditors of Gregg Appliances -- one of hhgregg's wholly-owned subsidiaries --may be on the hook for as much as $54 million, or an average of $2.7 million each.
While it remains to be seen how these claims will be dealt with post-petition, it looks like these trade creditors may only recover a fraction of the amount owed.
Learn to spot growing retail credit risk: Read the hhgregg bankruptcy case study
Was this retail bankruptcy really a surprise?
With retail bankruptcy soaring in 2017, there are important lessons for trade creditors in the wake of this Chapter 11 filing. And it should be noted that hhgregg’s creditors may have considered the risks, and opted to extend credit anyway.
After all, there are many reasons to offer a credit line to a troubled customer, and ways to protect your company in the process, should the struggling business be unable to work out their financial difficulties. Some bankruptcy claims are recoverable post-petition, and some of hhgregg’s creditors may have taken steps to mitigate these risks.
But there’s another, more troubling scenario.
Before extending credit to this financially distressed retailer, some vendors may have underestimated the true risks, and failed to change terms or take other proactive steps prior to bankruptcy.
The financial red flags were there
There was ample warning, for those monitoring hhgregg's financial distress.
Here are some of the red flags we spotted, leading up to their bankruptcy filing:
- Net losses in each of the past five quarters
- Negative free cash flow and a non-existent interest coverage ratio
- Drastic decreases in stockholder equity and working capital
- A reduced credit facility, NYSE listing requirement violations, and off-balance sheet arrangements that encumbered inventory in the case of liquidation
- Consistent bottom quartile performance compared to 32 retail sector peers, for liquidity and leverage ratios
- A FRISK® score of ‘1’, the most reliable bellwether of financial distress for public companies.
Learn the entire pattern of risk for bankrupt retailer hhgregg: Read the complete bankruptcy case study.
Why the DBT Index was misleading
It’s important to note that hhgregg maintained a positive payment history with vendors, even while financially distressed. With a DBT Index of 7 at the time of filing, creditors may have been unpleasantly surprised.
We’ve discussed the reasons for this phenomenon -- where relying on a traditional, payment-based metric underestimates public company risk -- in One Way Credit Portfolios Get Blindsided: The Wrong Credit Risk Metric.
The pattern of payment behavior that masks financial distress in public companies is called the ‘cloaking effect’. It occurs because most public companies continue to make timely payments right up until filing for bankruptcy. This contrasts to private companies, where late payments are a reliable signal of financial distress.
That’s why high-performing credit teams use different predictive metrics to assess public company financial health, instead of relying on payment-based risk models.
4 ways to detect At-Risk retailers
So, we return to our original question: Could hhgregg’s creditors have detected growing risks beforehand? There were four reliable ways to do so:
- The first warning: A FRISK® score of 5 or less is a warning sign you can’t afford to ignore. When the financially troubled retailer first entered the red zone of increased bankruptcy risk, that was an early sign that trouble was brewing.
- Signs that financial distress is getting worse: As hhgregg’s FRISK® financial risk score dropped further, from a ‘3’ to a ‘2’ to a ‘1’ in the year before bankruptcy, alarms should have been sounding. It’s a sure sign of increasing financial distress.
- Avoiding ‘head fakes’: Creditors could also have avoided being misled by a healthy DBT Index. For hhgregg, this traditional risk metric was at odds with all the other warning signs, which is often the case.
- More bad news: ‘News alerts’ would have turned up timely news of deepening distress, in time to mitigate risk. That’s why it’s essential to monitor financially distressed counterparties closely.
So for those who wished to avoid it, there was ample time to see this bankruptcy coming.
Spot big risks in your trade credit portfolio
There are two simple lessons to this bankruptcy case study.
First, when a financially troubled company starts to send up the red flags of financial distress, it’s essential to spot the early warning signs. And, as retail bankruptcies increase, trade creditors must be even more vigilant.
Concerned about the risks for a retailer or other counterparty? Our proprietary risk score is part of a suite of credit risk tools that upgrades your risk management capabilities. We helped our clients predict more than 98% of public company bankruptcies in the past two years, and at least 96% in the past ten.
Take the next step: Please get in touch.
To see the entire pattern of events for financially distressed retailer hhgregg:
Read the full hhgregg bankruptcy case study
CreditRiskMonitor is a financial news and analysis service designed to help professionals stay ahead of public company risk quickly, accurately and cost-effectively. More than 35% of the Fortune 1000, plus thousands more worldwide, rely on our commercial credit reporting and predictive risk analytics for assessing the financial stability of more than 56,000 global public companies.
At the core of CreditRiskMonitor’s service is its 96%-accurate FRISK® score, which is formulated to predict public company bankruptcy risk. One of four key components calculated in the FRISK® score is crowdsourced subscriber activity. This unique system tracks subscribers' patterns of research activity, capturing and aggregating the real-time concerns of what are essentially the key gatekeepers of corporate credit. Other features of CreditRiskMonitor’s service include timely news alerts, the Altman Z”-Score, agency ratings, financial ratios and trends. CreditRiskMonitor’s network of trade contributors provides more than $140 billion in trade data on their counterparties every month, giving them visibility into their biggest dollar risks.