Southland Corporation:

From Profitability to Financial

Distress to Profitability

Case Summary: This case follows Southland Corp. from its prosperous times in the 1980s to its
leveraged buyout in 1987 and its subsequent financial distress and bankruptcy in 1990. Southland
went through typical stages in the bankruptcy process. It first tried to negotiate a settlement with its
creditors in the spring of 1990. When that failed, it presented a prepackaged reorganization plan to
the bankruptcy court. The plan was approved again by shareholders and by the court. The
reorganization substantially reduced the interest burden that was hampering Southland. As of mid-
1993, the company appears to be climbing back to profitability under its new Japanese owners.

Twenty-four years of record-breaking high revenues and earnings. Eleven consecutive

years of dividend increases. Steady and continual growth. It is a description of Southland Corp.
through 1985. It sounds like anything but a bankrupt firm. Yet this is a description of soon to-be
bankrupt Southland Corp., the owner of more than 8,000 7-Eleven and other stores, as well as Citgo
Petroleum Corp., Chief Auto Paris, dairies, and food processing and distribution operations.
Southland reorganized through a Chapter 11 bankruptcy filing in 1991 after years of negative
earnings from 1987 onward. The firm's financial troubles were a combination of too much debt at
high interest rates and reduced cash flows.
Southland tried to stay afloat through an equity infusion from Ito-Yokado, Ltd., the Japanese
owner of profitable 7-Eleven Japan, Ltd., and through negotiation with its creditors. When informal
talks failed, Southland entered formal Chapter 11 proceedings.

A HOSTILE TAKEOVER AVERTED

In hindsight, Southland's troubles began early in 1987 when rumors of a takeover bid blew
across Wall Street, The stock rose steadily from the $40s to the high $50s amid rumors that the
company had a breakup value of $70 a share. The company was managed by the Thompson
brothers, sons of company founder Joe Thompson, but insiders owned only about 15% of the
outstanding common stock. By June, rumors of a planned recapitalization, involving large amounts
of debt, joined the takeover rumors, and the stock price climbed to $69.1 On July 5, Southland
announced a "going private" transaction. In the $5 billion leveraged buyout (LBO), the Thompson
family's holding company paid $77 a share for two-thirds of southland's stock. The remaining one-
third of the shareholders would receive some cash and 1007o of the stock in the new Southland'
The Thompson family and insiders now owned about half of Southland. Southland announced that
it would sell some of its convenience stores and all of its non-convenience store businesses to raise
money to buy out shareholders and pay down close to $3 billion in high yield junk bonds acquired
in the LBO

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COMPETITION HEATSUP AND THE BUSINESS SUFFERS

The first bad news event—and one beyond Southland's control—was the October 1987
stock market crash. This had a serious impact on Southland's ability to raise junk bond debt, which
became almost prohibitively expensive at l5%-18% coupon rates after the crash. Southland needed
the proceeds of the high-yield debt to pay back the short-term bridge loans it received to buy out
the majority of its shareholders.
Southland earnings reports following the LBO were monotonous in their bad news refrain.
Although operating profits were positive, shareholders faced substantial losses after interest
payments were subtracted. Overall revenues declined as large portions of the company were
divested. The firm instituted stringent cost cutting measures, including reducing internal spending
on raw products and eliminating expansion through acquisition. Competition in the convenience
store business heated up as major oil companies built thousands of convenience stores next to their
gasoline pumps. Southland's operating margins declined steadily. (See Exhibit I balance sheets and
income statements for a progression of Southland’s financial distress.) Southland blamed its
troubles on increased competition as well as a generally weak retail sales environment, weaker
domestic economic condition, and inflation. The firm sold off more and more assets, including its
interest in Citgo, over 1,000 7-Eleven stores, and all of its non-convenience store businesses.

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 Exhibit 1
Southland Corporation
Income Statement
(in thousands)
1992 1991 1990 1989 1988 1987 (s) 1987 (p) 1986 1985 1984 1983

Revenue 7,426,000 8,010,000 8,348,000 8,275,000 7,950,000 3,211,000 4,865,000 8,578,000 12,719,000 12,035,000 8,772,000

Expenses 7,197,350 7,530,710 8,017,500 7,732,750 7,397,890 3,162,308 4,584,920 8,086,715 12,197,960 11,575,400 8,367,725

Depreciation 180,000 200,000 207,000 230,000 247,000 92,000 114,000 186,000 187,000 165,000 145,000
Net operating
income 48,650 279,290 123,500 312,250 305,110 (43,308) 166,080 305,285 334,040 294,600 259,275

Interest 123,650 189,290 459,500 572,250 560,270 163,515 45,080 59,285 51,040 122,600 73,275
Other non-cash
charges 45,000 156,000 93,000 1,003,000 70,840 14,177 - - - -

Taxes 11,000 800 (128,000) (12,000) (110,000) (71,000) 31,000 46,000 70,000 12,000 54,000

Net income (131,000) (74,000) (301,000) (1,251,000) (216,000) (150,000) 90,000 200,000 213,000 160,000 132,000
Earnings per
share (0.32) (0.22) (15.14) (6.48) (1.22) (0.75) 1.42 3.96 4.41 3.41 3.26
Number of
share 409,375 336,364 19,891 193,056 177,049 200,000 63,380 50,505 48,299 46,921 40,491

Stock price 3.06 1.93 - - - - 76.25

(7/31)

67.13
(12/15)

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 Exhibit 2
Southland Corporation
Balance Sheet
(in thousands)
1992 1991 1990 1989 1988 1987 (s) 1987 (p) 1986 1985 1984 1983
Current
assets 351,000 640,000 635,903 769,575 739,350 298,623 452,445 746,811 646,828 1,393,384 1,584,886
Plant,
property,
and
equipment 1,356,000 1,592,000 1,715,501 1,555,700 1,494,600 603,668 914,620 2,272,624 1,722,496 1,815,974 1,589,924

Other assets 338,000 380,000 447,638 331,000 318,000 128,440 194,600 351,653 864,194 130,414 134,645

Total assets 2,045,000 2,612,000 2,799,042 2,656,275 2,551,950 1,030,731 1,561,665 3,371,088 3,233,518 3,339,772 3,309,455

Current
liabilities 765,000 770,000 4,298,119 827,500 795,000 312,100 486,500 952,541 1,038,409 1,137,263 1,002,031
Long-term
debt 2,408,000 2,874,000 142,315 3,815,000 3,735,133 1,090,100 300,533 639,496 575,586 856,646 1,125,643
Other
liabilities 191,000 179,000 182,536 281,350 270,300 109,174 165,410 161,220 122,700 150,176 106,819
Total
liabilities 3,364,000 3,823,000 4,622,970 4,923,850 4,800,433 1,511,374 952,443 1,753,257 1,736,695 2,144,085 2,234,493

Preferred
stock - - - - - - 125,000 125,000 125,000 - -

Common
equity (1,319,000) (1,211,000) (1,823,928) (2,267,575) (2,248,483) (480,643) 484,222 1,492,831 1,371,823 1,195,687 1,074,962

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SOUTHLAND TRIES TO LIGHTEN ITS LOAD

By early 1990, the Thompsons all but gave up. The company warned that it might not be
able to meet scheduled interest payments in the future. Its precarious position was recognized in
the market in the form of deeply discounted bond prices and bond ratings lowered to CCC. (The
bonds eventually received D ratings.) Company auditors said they doubted that southland had the
ability to continue as a going business. The Japanese company lto-Yokado, Ltd., a majority owner of
7-Eleven Japan Ltd., agreed to buy 75% of Southland's shares for a desperately needed infusion of
new capital.3 As part of the purchase agreement, Southland needed to negotiate with its
bondholders to lighten its debt load. Bondholders were offered zero coupon securities and common
stock in exchange for their high coupon bonds. Bondholders would own 10% of the proposed
restructured Southland, as would the Thompson family.

Bondholders criticized the offer as "too little, too late," indicating that the plan favored
equity holders at their expense. One analyst said that liquidation would net more than twice the
present value of the bonds. Another said, “They’re asking bondholders to take a huge haircut and
equity holders would still have value. It’s absurd.” Southland advanced the counterargument that in
the fierce competitive environment that developed after the LBO, Southland’s assets declined in
value. The bondholders owned a mortgage on those assets, but since the underlying value had
declined, so did the value of bonds. Even with the proposed restructuring of debt, the company did
not expect to become profitable until the end of 1993. Southland contended that the large amount
of debt restricted its capital spending and left it vulnerable to competition.

SOUTHLAND THREATENS BANKRUPTCY

By early April, Southland threatened to file bankruptcy if it could not reach an agreement
with its creditors. Its creditors, on the other hand, thought bankruptcy might not be a bad thing.
One analyst was quoted as saying that the bondholders might be better off in bankruptcy: “The
bondholders are already unhappy and this is really the only way out.” The firm officially defaulted
by missing $70million in interest payments. Southland improved its offer to bondholders, more
than doubling the previous equity stake of bondholders and preferred shareholders to 25% and
giving bondholders new intermediate-term debt securities bearing 12%-14% interest. The existing
shareholders, including the Thompson family, would have an equity stake of 5%, and Ito-Yokado
would increase its capital infusion to $430 million in exchange for 70% of the equity. The
restructuring plan would include a one-for-ten reverse stock split.

PREPACKAGED PLAN

In July, Southland, its bondholder committee, and Ito-Yokado announced that they agreed to
the restructuring plan. In what may have been a move to cover all the bases, at the same time
Southland asked bondholders to embrace its proposed exchange terms, which needed to be
accepted by 95% of bondholders and two-thirds of preferred shareholders. It also filed a
prepackaged reorganization plan. The prepackaged plan was largely the same as the exchange offer.
This plan needed only a two-thirds majority for acceptance. If the prepackaged plan was

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subsequently accepted by bankruptcy court, the it would be binding on all securityholders.
Southland estimates that a prepackaged reorganization plan would be approved within six months.
Whereas a traditional Chapter 11 proceeding might take several years to complete.

Southland did indeed fail to get the supermajority it needed, and in October 1990, it
officially filed for protection under Chapter 11. The company simultaneously filed the prepackaged
bankruptcy plan with the court, because it did receive the required two-thirds acceptance by
creditors. The prepackaged plan was the first ever filed by a major retailer. A syndicate of lenders
offered $400 million in debtor in possession (DIP) financing for use as working capital. Southland
planned to continue business as usual during the bankruptcy proceedings, which began December
14, 1990.

A PLAN IS APPROVED

Bankruptcy judge Harold Abramson dismissed Southland’s prepackaged plan and required
a new vote on the plan, despite the previously gained two-thirds majority. Creditors objected to the
Thompson family retaining a 5% equity stake in the company, and they were allowed to circulate
details of their objections to securityholders. Judge Abramson was quoted as saying, “We’re now in
bankruptcy and I want to follow the bankruptcy code.” A month later the count was in, and
securityholders overwhelmingly accepted the reorganization plan, which was in turn confirmed by
the bankruptcy court. This cleared the way for Southland’s relatively quick emergence from
Chapter 11 and for a purchase of its stock by Ito-Yokado. Southland’s chief financial officer (CFO),
Clark Matthews, said:

“Southland will now be able to go forward as a much stronger company, with significantly less debt,
reduced debt service obligations, and most importantly, a sizeable cash infusion from new majority
owners who share both our enthusiasm for and knowledge of the convenience store business.
Implementation of this plan will help ensure Southland’s financial stability and greatly enhance our
long-term ability to compete effectively in today’s very challenging convenience retailing
environment.”

Southland’s governance and management changed substantially. The post-confirmation

board consisted of three members designated by existing shareholders, ten selected by Ito-Yokado
and 7-Eleven Japan, two chosen by the bondholder’s committee, and two independent directors.
Masatoshi Ito, president of Ito-Yokado and chairman of 7-Eleven Japan’s board, was chairman of
Southland’s new board. Brothers John and Jere Thompson, former Southland chairman and
president respectively, were co-vice-chairmen of the board, and founder Joe Thompson was a board
member. Clark Matthews, Southland’s CFO who shepherded the company through negotiation and
bankruptcy proceedings, was the new president and CEO of Southland.

The market responded favorably. Southland’s bond received a B rating. Though still at junk
bond levels, the bonds were considerably better than the imminent default implications of a D
rating. In spite of the restructuring, Southland remained a highly levered company, with long-term
debt of $2.9 billion on total assets of $2.6 billion. Its financial position continue to improve, and its
September 1992 commercial paper issue was rated A1+ by business moved into “everyday fair

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pricing” and away from discounting and price promotions, which resulted in higher gross operating
margins. The company returned to its policy of improving sales by providing more and varied
products and through a $200 million remodeling of older stores. By the end of 1992 the company
still experienced a net loss of $131.4 million, but this was less than previous losses. Revenues were
$7.5 billion, compared with $12.8 billion at the firm’s peak in 1985. The reduction in revenues
reflects the sale of large portions of Southland’s assets. Southland expected a profit in 1993.

QUESTIONS

1. A firm becomes financially distressed when its liabilities exceed its assets, or when its cash
flow is negative. Usually market value numbers are used to determine the point of financial
distress. Use book value to determine when Southland’s liabilities exceed its assets and
when its cash flows became negative. (Note that you need to look at noncash items in the
income statement, as well as add depreciation back to net income.)
2. What does ratio analysis show about Southland? In particular, look at Southland’s current
ration, times interest earned, return on equity, return on assets and cash flow from
operations. It is useful to plot these ratios over time and look for trends. The current ratio is
(current assets)/(current liabilities). Times interest earned is a measure of how well a
company can meet its interest payment and is defined as (net profit before taxes +
interest)/interest. Return on assets is (revenues – expenses – depreciation)/total assets.
Return on equity is (net income)/(shareholder’s equity). Cash flow from operations is
(revenues – expenses).
3. Was there a deviation from absolute priority in Southland’s final reorganization plan? What
might have been the reasons for this deviation? Did bondholders transfer some their wealth
to shareholders?
4. How did Southland benefit from its prepackaged bankruptcy plan?
5. Were the any agency problems associated with Thompson family control of Southland?
What about after Southland’s bankruptcy change in corporate governance and
management? Why did Southland’s bond rating improve after Ito-Yokado’s purchase?
6. Southland insiders, primarily the Thompson family, saw their equity position go from 15%
of old Southland to 50% of the Southland LBO to 2.5% of new Southland. What changes in
value does his represent?
7. What implications does the Southland situation have for determining a company’s optimal
capital structure?