The fateful day was the 6th of October 2015. That was when Denis O’Brien started to lose full control of Digicel, his trophy asset.

O’Brien had spent the previous six months working on an initial public offering (IPO). The idea was to sell 39 per cent of Digicel (which is 92 per cent owned by O’Brien) on the public market, and use the proceeds to pay down Digicel’s debt.

The IPO was set to raise about $1.7 billion, which would have valued O’Brien’s remaining stake at about $3 billion. Of the proceeds, $1.3 billion was earmarked for cutting debt. But with less than 48 hours to go, O’Brien pulled the plug. He decided he wasn’t happy with the price on offer. He kept his 39 per cent — and Digicel kept the $1.3 billion of debt.

At the time, the plan was to go back to the market and IPO in another year or two, when conditions were more favourable. With 13 million customers and a near-monopoly in 32 Caribbean and Pacific markets, O’Brien must have felt Digicel was strong enough to wait it out. 

But October 2015 turned out to be as good as it got for Digicel. Since then, the company has struggled to keep control of its debt. It now owes $6.7 billion, which is 7.5 times Ebitda. Digicel has passed a critical point where Fitch, a ratings agency, says “a default of some kind appears probable”. And a $1.3 billion wall of bonds is coming due in the next 18 months. 

If that comes to pass then, unless O’Brien comes up with a big chunk of cash, it’s likely he’ll have to hand over control of the business. For the sake of an extra couple of (hundred) million in the IPO, he may lose it all. 

How did Digicel get so indebted? Why have the debt markets turned on the company? How did it come to this?

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Setting aside its debt troubles for a moment, Digicel is an amazing success story. In 2001, Denis O’Brien spotted that Caribbean telcos like Cable & Wireless were flabby and their products were overpriced. He realised he could undercut them. 18 years later the company he founded has operations in 31 markets, holding the number one position in 25 of them. 

The beauty of the Caribbean from Digicel’s perspective is the peace and quiet. There’s very little competition in most Caribbean markets — only John Malone’s Liberty Latin America. Both companies enjoy Ebitda margins of 40-45 per cent.

Digicel’s margins have always been great. It has a problem though: top line revenue is falling. It has been hit hard in recent years by the decline of old-fashioned phone calls. 

Voice calls have been the cash cow for Digicel, as for most telcos. But in the last few years, there’s been a shift. People are calling less, and when they do call they’re often using over-the-top (OTT) services like WhatsApp, Facebook or Skype. OTT companies get to capture all the value, leaving the likes of Digicel to provide the incredibly-expensive infrastructure. Denis O’Brien railed against this in a recent YouTube video, in which he demanded the OTT providers step up and pay a share of the telcos’ capital expenditure.  

Digicel has been hit harder by the decline in voice than most telcos. That’s because it’s less diversified, meaning it makes a smaller proportion of its revenue from data, services and broadband. Sul Ahmad of Fitch, a rating agency told The Currency:

“If mobile voice was the biggest driver of your revenue and that is falling by 5, 10 or 15 per cent per year, and it used to be 70-80 per cent of your revenues, that’s really going to weigh on your company’s overall performance. The company has gotten walloped by the decline in mobile voice.”

Voice is one problem. Foreign exchange is another. Digicel makes its money in various Caribbean and Pacific currencies. But its debt is denominated in dollars. So when the dollar strengthens relative to Caribbean currencies, its debts grow. Take Haiti, which is one of Digicel’s three biggest markets. In 2015, 100 Haitian gourde bought $2.10; today it buys $1.02. The dollar has strengthened against the gourde – admittedly an extreme example – along with most Caribbean currencies.

So the decline in voice, and the Caribbean currencies, dragged down Digicel cash flows by a couple of percentage points each year. But telecoms being a capital-hungry industry, Digicel needed to keep investing in infrastructure. And in fairness to O’Brien and Digicel, the company is fully invested — it’s invested $5 billion over the years. But capital expenditure continues to take up 13-15 per cent of revenues. And of course, in addition to capital expenditure, there are the interest payments.

The following chart shows how the slowdown in voice has fed through to the bottom line. Forex and the drop in voice revenue hit operating cash flow; interest payments and capex stayed high; when they were deducted from operating cash flow, free cash flow to equity (sometimes known as levered free cash flow) turned negative. Free cash flow to equity is, ultimately, the number that matters. It says how much cash the company makes for its owners once all spending is taken into account. 

The chart tells the story. Interest payments of $410-$465 million per year have left Digicel highly exposed to a drop in revenue. In order to cover interest bills, the company is spending down its cash. In its most recent results last week, we learned it has burned $70 million since September. It has just $110 million left. According to Reorg, a consultancy, 

“investors said they are sceptical that Digicel can remain above its minimum cash level — a threshold that management has outlined as the minimum amount of cash it needs to remain operational… the broader question, they said, is whether the company can raise financing since it is running out of cash”.

The other story of the chart is that, debt apart, Digicel is a healthy company. Take away the debt and it would be richly profitable. 

So why did Digicel take on so much debt in the first place? Well, usually it makes sense for telcos to take on a lot of debt. Their cash flows tend to be fairly stable. And telcos need a lot of capital expenditure. So they borrow in order to grow. For example Digicel’s big rival in the Caribbean, Liberty Latin America, has $6 billion of debt, which is 4.2 times its Ebitda. That’s normal for the industry.

Digicel, however, is different. Its debt levels are a step above its peers, or Liberty Global’s. It owes $6.7 billion, which is 7.5 times Ebitda. And by borrowing in dollars it exposed itself to foreign exchange risk, which ought to have caused it to be extra-careful with its debt. 

The difference between Digicel and the likes of Liberty Global comes down to Denis O’Brien. Digicel’s debt is unusually high because, according to Moody’s, it has “a history of debt-funded shareholder payouts”. It has paid him $1.9 billion in total.

First,  the company borrowed money to pay O’Brien dividends. Then he declined to sell a portion of his equity to pay down the debt. Now, according to Bank of America Merrill Lynch, “cash dividends to owner Denis O’Brien, [have] left the company over-levered. Key concerns include the company’s limited liquidity position and its ability to refinance maturities as they come due.” And judging by the bond markets, his equity is worthless.

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The smart strategy in this situation is to play for time. The hope would be, if it delays long enough, Digicel will eventually grow its cashflows enough that it will be able to afford its interest payments. Then it’ll be able to refinance more easily.

The other benefit of playing for time is that Digicel’s debts get more and more distressed. For example, some Digicel bonds currently trade for 15¢ on the dollar. That makes it easier for O’Brien to restructure them, or potentially buy them out.

This year, Digicel used what sources close to the company call a carrot and stick approach to buy itself more time. It had some junior debt (ie debt which is low down the ranking of creditors) due to mature this year. So it demanded the junior creditors extend their debts’ maturities on the threat of raising more senior, secured debt ahead of them, which would push their claim out of the value in the event of a debt restructuring. This manoeuvre is called “priming”. And to sweeten the deal, the company offered them security if they took up his offer. 98 per cent of those creditors eventually agreed to it.

You can see how it worked in the chart below, which shows Digicel’s complex corporate structure. The gist of it is that the pink boxes with rounded corners are the Digicel companies; the square boxes on the left are the debts. The operating assets are the rounded shapes at the bottom.

The layers of companies — DGL2, DGL1, DL— are intermediate holding companies, which hold different layers of debt. The holdcos were introduced in the last year. The bright pink box is DIFL. That’s the wholly-owned subsidiary which owns the operating assets in the Caribbean. As a creditor, that’s the company you want owing you money, because in the event of default you’re close to the assets.  

Why the complicated corporate structure? Well, it takes away the negotiating leverage of the lowest ranked creditors in the event of a restructuring. Sul Ahmad of Fitch says of it, 

“Its about retaining control over the Caribbean assets that generate the bulk of the groups cash flows… They did that to add different levels of subordination to bondholders. Particularly at the DGL2 and DGL3 levels. We had always assumed after that restructuring that they were divvying up the bondholder buckets a little more finely so they could then in turn restructure those lower ranked, more junior debt buckets in the future.” 

But extending maturities only gets you so far. There eventually comes a day of reckoning, and for Digicel it looks as though that day may be the 15th of April 2021. That’s when $1.3 billion comes due.  

Normally a company in this situation would refinance (ie, issue another long dated bond, and use the proceeds to pay back the $1.3 billion). But that’s not likely be an option for Digicel, with what Moody’s calls its “high refinancing risk”. Those 2021 bonds are trading at 73¢ on the dollar, for a yield to maturity of 34 per cent. That tells you the market suspects they’re not going to be paid in full.

Going back to the corporate structure map, the 2021 $1.3 billion notes are owed by Digicel Ltd, (DL), which is the second-ranked company in the structure. In the event of a default of the 2021 bonds, some of the bonds ranked behind it would be sucked into default too. Sul Ahmad says, 

“There’s a risk of cross defaults on the Digicel Limited April 2021s triggering other defaults, as well as the fact that any one of these other bonds is going to be hard enough to pay off or refinance on its own. That could trigger cascading defaults up the corporate structure.”

At that point, it’s a question of ranking — which creditors have the top-ranked claim to the underlying assets. For example the bottom-ranked debt — the 9.125 per cent PIK notes, owed by DGL2 — trade at 15¢ on the dollar. That’s a yield of 97 per cent. The market is pretty certain they’re not getting paid. 

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Where does all this leave O’Brien?

He has been able to deal with his creditors to this point. But now the market, and the ratings agencies, are saying Digicel is likely to default. If there is a default, barring an intervention in the courts, he could lose the company. 

The hoped-for growth in cash flows hasn’t materialised. Now the company has basically two options left. 

The first option, the long shot, is to try restructure the debt — ie, to renegotiate it. It would be, Sul Ahmad says, “the largest restructuring of debt in the history of the Caribbean.” 

He has some levers to pull here. For example, he could try swapping the low-ranked, unsecured debt for higher-ranked secured debt, with a lower face value. He’d be leveraging the fact that unsecured bonds are trading at a deep discount to reduce the face value of the outstanding debt. Swapping deeply discounted 2024 debt would give him the best bang for his buck here — though the 2021 $1.3 billion note, which trades at 73¢, is the most urgent need. According to Bank of America Merrill Lynch, there’s room for around $1 billion of bonds to be exchanged “uptier” in this fashion. 

But financial engineering is only likely to get him so far. The debt is so big that unless he comes up with some cash — or the Caribbean courts help him out — chances are the bondholders will get the company. Sul Ahmad of Fitch:

“When we put them on CCC, what we’re saying is that there’s definitely a strong likelihood of default at those levels. Because operating performance could improve between now and then – but not likely enough for the company to be able to refinance those debts at those levels.”

O’Brien would be left with maybe one per cent of the equity — what’s known as a “tip” in the debt restructuring business.

His other option, if he really wants to keep the company, is to come up with the cash. How much would be needed? Well the DGL2 notes, which are ranked at the bottom of Digicel’s debts, are deeply out of the money (ie, they trade for much less than their face value). He could buy them back. He’d need to tender at a premium over the debt’s current price. But for, say, $450 million or so he could buy the DGL2 notes off the market and shrink the debt pile by $1.9 billion, to $4.8 billion. Annual interest payments would drop by $167 million – for reference, it paid $441 million in interest last year. That should do it.

With the debt load back under control, Digicel could probably refinance that troublesome $1.3 billion 2021 note. Who knows, maybe there’d be another chance to raise money with an IPO down the line.

No doubt it would stick in O’Brien’s craw to end up back where he started, several hundred million dollars worse off. But what’s done is done. And at least he’d get to keep the company he built.