Could Canwest go bankrupt?

But it’s Asper’s largest acquisition that’s causing him the biggest headache. It took place in January of last year, when Canwest gobbled up a big chunk of Alliance Atlantis to get its hands on popular specialty TV channels such as Food Network, HGTV and Showcase. Floyd says acquiring the channels was a smart move strategically, but they cost a whopping $2.3 billion, and Canwest had nowhere near that kind of cash. To pull it off, the company had to make a deal with the now-troubled U.S. investment bank Goldman Sachs. The agreement they struck is complex, but Chris Diceman, senior vice-president at Dominion Bond Rating Service, says the upshot is this: 2½ years from now, Canwest will have to merge all of its TV assets with the Alliance Atlantis business, which is now called CW Media. Both Canwest and Goldman will have a stake in this new entity, and how much Canwest ends up owning will depend on its earnings and debt levels. If earnings decline, Goldman will own more, and Canwest will own less. If earnings go low enough, and debt levels rise, Goldman could even force CW Media to buy out its stake at a minimum price. In the worst case scenario, that price could be more than Canwest could afford.

When the deal was first struck, Asper said he liked it because it put his fate in his own hands. But ironically, one of the main reasons for structuring the deal in such a complex fashion was because Asper felt his TV holdings were undervalued by the market at the time. Now they’re worth even less. “The problem is,” says Floyd, “that deal was struck in better times. Now we’re in a much worse economic environment, so deals like that can go sour.” Indeed, when you read the Dominion Bond Rating Service report it becomes clear that Canwest’s debt, which now sits at about $3.7 billion, is the real albatross around Asper’s neck. Dominion’s report predicts that the “ongoing deterioration of the advertising market” will be so severe that, as a group, Canwest’s main media holdings could stop making money for their parent, “which could put Canwest Media into a negative free cash flow position by the end of fiscal 2009.” It would be a disaster that could seriously compromise Canwest’s ability to pay its debt. Last year, Canwest was expected to raise close to $1.5 billion by selling off Network Ten in Australia. That would have gone a long way toward relieving the debt burden, but Asper never got an offer he considered to be adequate.

Canwest may soon need cash desperately, and as the economy worsens, it’s running out of options to get it. The company is trimming costs—it has cut down the physical size of its newspapers, reduced the National Post’s distribution in the West, and announced the elimination of 560 jobs just last month—but Dominion says that likely won’t be enough to keep cash flows from declining if revenues keep going down. Asper could start selling off assets, but if he were to sell off holdings such as Network Ten now, he’d have to do so at fire sale prices. He’s even rumoured to have considered another option, to buy up all of Canwest’s outstanding shares and take his company private, but again, that would require hard-to-get financing.

There is always the option of raising cash by borrowing more money (assuming Canwest could find a willing lender), but previous lenders have set strict limits on how much the company can borrow. Canwest Media recently managed to raise that limit by negotiating with creditors to step up its allowable total debt-to-EBITDA ratio from 5 to 6.75 by next August. However, Dominion worries that if the economy keeps getting worse, “the company’s covenant cushion could erode faster than its headroom increases throughout fiscal 2009.” Dominion has good reason to worry: right now, of all the major publishing and media companies in Canada and the U.S. that it compares Canwest to in its report, only Liberty Media, Clear Channel Communications and Tribune Company have higher levels of debt, as measured by the gross debt-to-EBITDA ratio, while Canadian rivals such as Torstar have levels around the industry average of three. Ominously, on the very day Dominion’s report came out, Tribune, which had the highest debt ratio at 10, declared bankruptcy.

Indeed, if Canwest can’t borrow more money, that could leave only the option of last resort: defaulting on the company’s debt—which would almost certainly lead to bankruptcy. Could it really happen? Edward Altman, professor of finance at the Stern School of Business at New York University and one of the world’s most respected corporate bankruptcy experts, says yes. Back in 1967, Altman invented an indicator that can predict corporate bankruptcy with a high degree of accuracy, called the Altman Z-Score. When applied to Canwest, he told Maclean’s that this strictly by-the-numbers analysis indicates that Canwest has about a 37 per cent probability of defaulting on its debt within five years.

That means Canwest has a better than 60 per cent chance of weathering the storm, but those odds aren’t high enough for some. In late November, shortly after the company announced a massive $1-billion writedown on goodwill and broadcast licenses, respected deep value investment manager Irwin Michael finally threw in the towel. His investment company, ABC Funds, specializes in buying up the stock of undervalued companies and waiting for them to bounce back, so he’s not scared off easily. But after first buying into Canwest at about $15 some years ago and then watching almost all of his investment evaporate, Michael has stopped waiting for the bounce. In a note to clients he explains that with 85 per cent of its revenue coming from advertising, Canwest is particularly vulnerable to the looming recession. He adds that he originally believed that “in the event of a serious downturn, Canwest could have sold Network Ten,” but now the Australian network has hit its own slump, and he doubts it could be sold. In the end, he writes, “We made the difficult decision and sold our position in Canwest. We will look to redeploy the capital into less economically sensitive positions with cleaner balance sheets, better cash flow and greater dividend income.”

Not everyone is giving up, however. Prem Watsa, president of Fairfax Financial Holdings and one of the most astute financial minds in Canada, seems to be sticking by Canwest. In fact, Watsa keeps scooping up more and more of the company’s stock at every opportunity. His company now owns 22 per cent of Canwest’s subordinate voting shares—and he may know something that other investors don’t. After all, Watsa not only accurately predicted today’s general financial ruin, he made more than a billion dollars off it through canny investments in credit default swaps. If he’s right about Canwest, and it pulls through to see sunnier days, he could be richly rewarded. If that happens, Asper will be proven right, and the naysayers will be kicking themselves in disgust. But it’s a pretty big “if.” For now, “they would be hard to recommend as a buy,” says one Toronto analyst. “There’s a lot of value in their properties, but there has to be some hope of a recovery.”