Despite Bankruptcy Code Risk Issues, I Just Bought Qurate Retail's Preferred Stock

Qurate Retail (NASDAQ:QRTEA) (QRTEB) (NASDAQ:QRTEP) made the list of retailers most likely to file for bankruptcy over the next 12 months, with a 9.99%-50% probability, which further depressed the price of QRTEA common stock and QRTEP 8.0% preferred stock this week. While I agree that there is a high probability of a filing for Ch.11, I made an extremely risky trade and bought some of the 8% preferred stock at prices below $20 per share. Besides covering the primary reason why I bought QRTEP, this article will cover some important issues related to specific sections of the U.S. Bankruptcy Code impacting Qurate, but this article is not intended to be a complete coverage of the company.

Risk of Bankruptcy Within Twelve Months

There was an article earlier this week on the website Retail Drive that listed 11 retailers at risk of filing for bankruptcy within the next 12 months based on metrics by Credit Risk Monitor, which used FRISK scores. The reality is that there were no real surprises on this list.

Why I Bought Preferred Stock

The primary reason why I bought the preferred stock was the yield compared to the probability of a bankruptcy filing over time. I consider it a rational, but extremely risky trade.

First, some items need to be clarified. The preferred shares do not have a par value of $100. Those asserting it is trading at some discount to par are incorrect. The actual par value per share is $0.01. The "liquidation price is $100". There is also confusion by some investors thinking that the dividend is based on a typical $25 par value, which is how many preferred stocks are issued. The 8.0% dividend, which is paid quarterly, is based on $100. These are not perpetual preferred shares. There is a mandatory redemption at $100, plus any unpaid dividends, on March 15, 2031, unless they have already been redeemed. This is a huge issue. Because of this redemption requirement, the preferred stock is reported in the liability area of the balance sheet instead of the customary shareholder area.

Unlike non-payment of interest on debt, non-payment of the preferred stock dividends does not force Qurate Retail into bankruptcy. The dividends accumulate if unpaid. If unpaid after a "30-day cure period, the dividend rate will increase by 1.50% per annum of the liquidation price until cured, plus an additional 0.25% commencing on the dividend payment date immediately following such nonpayment and for each subsequent dividend period thereafter until such nonpayment is cured, up to a maximum dividend rate of 11.00% per annum of the liquidation price". There are also some additional board of director items that could kick in.

Some investors use yield-to-maturity when assigning a yield to QRTEP because it has a redemption requirement. I take a somewhat different approach because the yield-to-maturity assumes that the $2.00 quarterly dividend is reinvested at the yield-to-maturity interest rate, which in this case is extremely unlikely. Using the latest QRTEP price of $19.58 and the $8.00 annual dividend, the current yield is 40.9%. Treating the redemption factor as effectively a zero-coupon bond implies an annual interest rate of almost 25% solely for the redemption feature. Those using yield-to-maturity would get an annual interest rate of almost 48%.

The expected next dividend decision day is in mid-November. There could be major stock price moves based on that decision by the board, which I may trade on.

Section 548 Potential Impact

There are a number of sections in the U.S. Bankruptcy Code that could have a significant impact on Qurate Retail and too often investors either ignore them or are unfamiliar with them.

First, I frequently read statements that they could sell Cornerstone Brands - CBI to raise cash to help paydown debt. Since they already sold Zulily earlier this year might seem logical. The reality is that the clock is ticking. There could be worries of section 548 issues by a potential buyer - actually often by a buyer's banker. If Qurate "received less than a reasonably equivalent value", filed for Ch.11 bankruptcy within two years of the close of the asset sale, and is eventually determined by the bankruptcy court to be insolvent or became insolvent because of the sale on the date of the asset sale, there is a risk that a creditor might file a motion to void that sale transaction during a Ch.11 process. (Note: don't be shocked by the title of section 548. It contains a number of different items under the same section title. I think this section should be divided into multiple separate sections.)

If they are planning on selling CBI or other assets, they need to act quickly, in my opinion, before they are at risk of being considered "insolvent". (Note: I am not asserting that they actually are insolvent. I am stating that they might be "considered" insolvent by some party in future litigation.) Remember it is up to the bankruptcy judge to make the final decision regarding insolvency. There is no absolute definition. Some judges make very quirky decisions, in my opinion. Some readers might remember when Judge Drain determined that the value of the 2lien noteholder's collateral was "$0.00" during the Sears Holdings bankruptcy process. Investors and some readers were shocked/appalled. There are many metrics to look at such as losses, stock prices, net short-term liquidity, and many other metrics to determine insolvency. Even if Qurate is not insolvent, if there is even the risk that there could be section 548 issues some bankers might be reluctant to finance a purchase.

Because of section 548, companies can't really have "fire sales" to raise needed cash to stay out of bankruptcy, which then sometimes results in them actually filing for bankruptcy. I have written a number of Seeking Alpha articles on this issue for some distressed companies that eventually filed for bankruptcy or are currently on the brink of filing for bankruptcy partially because of this issue.

Instead of buying a desired asset from a distressed company, a potential buyer might wait until they can buy that same asset during a Ch.11 process "free and clear" of any claims and sometimes cheaper. They would also not have to worry about section 548.

Potential Vendor Issues

Often the impact of certain sections of the U.S. Bankruptcy Code on merchandise vendors forces retailers into bankruptcy. These sections, however, don't have as much impact on other distressed companies, such as energy companies because they don't buy/sell merchandise.

Starting with the issue that surprises many investors and that is section 547 Preference Payment Rule and section 550. A company in bankruptcy can try to get payments returned from vendors who were paid within 90 days (one year for insiders) of a bankruptcy filing date. That is correct. Even if a vendor was paid and thought they were "lucky" that they did not get burned by the retailer filing for bankruptcy, could be required to return "property transferred" (which is cash paid). I am going to use part of the same demand letter (Sears docket 8959) sent to a vendor during the Sears Holdings bankruptcy process that I used in my Bed Bath & Beyond (formerly BBBYQ) article:

Plaintiffs seek to avoid and recover from Defendant, or from any other person or entity for whose benefit the transfers were made, all preferential transfers of property that occurred during the ninety (90) day period prior to the commencement of the bankruptcy case of the Debtors pursuant to sections 547 and 550 of chapter 11 of title 11 of the United States Code (the "Bankruptcy Code"). Subject to proof, Plaintiffs also seek to avoid and recover from Defendant or any other person or entity for whose benefit transfers were made pursuant to sections 548 and 550 of the Bankruptcy Code any transfers that may have been fraudulent conveyances.

Many vendors earlier this year did not want to deal with BBBY even if they were prepaid before shipment because they worried that they could get one of these repayment demand letters if BBBY eventually filed for bankruptcy. This is partially why their shelves were so empty. In their Ch.11 plan (BBBY docket 1712) BBBY mentioned they were considering using the Preference Payment Rule to recover some cash paid to vendors. At this point it is unclear if any repayment demand letters have been sent yet by the plan administrator.

Another major issue merchandise vendors worry about when dealing with distressed retailers is being considered just "general unsecured claims" under a Ch.11 bankruptcy plan, which often means little or no recovery because they are in a low priority class. To avoid this issue some vendors require significant deposits or C.O.D. when dealing with distressed vendors. (They still would have to worry about section 547 and 550 issues.) This often puts additional financial stress on the retailer because they have to use more cash to carry their inventories.

There are exceptions. Some vendors get classified as "critical vendors" and are paid during the Ch.11 bankruptcy process and do not have to wait until the plan becomes effective. This concept is actually based on case law and because there is a risk of litigation, the number of vendors considered critical vendors by the court is usually fairly limited. Another exception are those vendors whose merchandise was constructively received by the retailer within 20 days prior to the bankruptcy filing. These vendors have section

I assume readers can see the problem here. A vendor whose goods were received 21 days or more before the bankruptcy filing often get no or little recovery, but a vendor whose goods were received within the 20 day window often get full or close to full recovery. (There is also a different section for those who deal with the company during the bankruptcy process, but that is beyond the scope of this article.)

At some point in the future, I worry that Qurate Retail's vendors might become more reluctant to deal with them because of various sections of the bankruptcy code. Qurate has "deep pocket" people associated with the company, but so did Sears Holdings - Eddie Lampert - and so did Revlon - Ron Perelman. Because over the last six years so many retailers have gone bankrupt that often resulted in little or no recovery for vendors, I worry that vendors and the vendor's bankers might become stricter when dealing with Qurate Retail. This would put additional pressure on their cash position and increase the need to borrow more cash.

Conclusion

I am not now, and I never have been a fan of Qurate Retail, but the risk/reward for their 8% preferred stock seems like a rational trade below $20. I am not expecting to hold QRTEP for the long-term and I may just sell when the dividend decision is announced in mid-November -either way- paying dividend or not paying dividend.

The reality is the U.S. Bankruptcy Code can be very harsh especially for retailers. Certain sections make it more likely a distressed retailer, such as Qurate Retail, files for bankruptcy. At this point I am rating QRTEA common stock neutral/hold and putting the company on my watch list for a potential future downgrade. I rate QRTEP a buy below $20 per share.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.