this capital raising may be very ugly

Earn-out burnout: Photon struggles with planned capital raising

James Chessell From: The Australian July 13, 2010 12:00AM

JEREMY Philips likes to say he was not wearing "rose-coloured glasses" when he agreed to be CEO of Photon Group about three months ago.
The former News Corporation executive, who started work at the embattled marketing services group in early June, said he did "a fair bit of diligence" and "spoke to a lot of people" before making his decision.

Like any new chief executive, Mr Philips expected a tough time clearing the decks, but as recently as two weeks ago predicted the business would recover.

In the past fortnight Mr Philips has been forced to renegotiate $176 million worth of earn-out payments to the owners of some of the 50 advertising, marketing, publicity and research firms that form part of Photon -- names such as BMF, Naked and Hotwire.

The payments are a huge liability in the context of Photon's previous earn-out guidance ($111m in August), its market capitalisation ($191m before trading in the stock was was halted in early June) and the company's forecast earnings ("normalised" net profit of $19m for 2009-10).

Photon cannot afford to pay the full amount.

Negotiations have become so dire that The Australian can reveal Mr Philips told owners at a meeting in Sydney last week they may have to accept cash payments equivalent to 35c in the dollar. The news went down like a lead balloon.

Photon founder and former executive chairman Tim Hughes built the business by offering many vendors upfront cash payments and agreeing to pay more if earnings exceeded certain targets, usually over a four-year period.

The irony of Photon's current predicament is that its most successful firms are a big part of the problem, as they are owed the biggest earn-outs.

"There isn't anyone who is owed an earn-out that has not consulted his lawyer in the past week," said the head of one large firm.

Owners are furious with the previous management but admit they are negotiating with a gun to their heads.

If they leave they get nothing. If they push too hard and Photon goes under they get nothing.

Nevertheless, there is a clear risk that Photon's financial woes could cause key talent to walk.

The earn-outs are just one of the serious problem facing Mr Philips.

Even if he can can convince the owners to accept reduced earn-outs, delayed payment and some portion in equity, he then needs to raise fresh capital to pay the owners as well as Photon's lenders.

It has been widely reported that Photon's advisers, Macquarie and UBS, have been sounding out likely investors about a rights issue of up to $200m priced at about 25c a share. It is believed the issue price would be closer to the 10c mark -- well below Photon's $1.02 a share price before trading was halted.

Photon would need to issue 2 billion new shares if it wanted to raise $200m.

It now seems a capital raising of closer to $100m is on the cards, although nothing has been settled.

Whatever the case, existing shareholders will be wiped out.

Photon, whose issue capital has already grown from 50 million shares to 190 million shares over its six years as as a listed company, will be drowning in paper.

But Mr Philips has little choice. Photon has drawn down $271m of its $280m in total debt facilities without reducing the earn-out payables on its balance sheet.

Mr Hughes spent heavily on acquisitions. The $36.7m purchase of Naked in February 2008 capped an eight-month shopping spree in which Photon paid $194.7m for 13 companies.

Photon's board also needs renewal. Its trio of non-executive directors, Susan McIntosh, Paul Gregory and Brian Bickmore, have served for at least five years each. It is obvious the board should have subjected the Hughes expansion plans to more scrutiny.

Earn-out liabilities were checked only twice yearly.

Mr Philips has made a point of not joining the board.

The symbolism is obvious. He won't be in any rush to join until search firm Russell Reynolds has found three new independent directors and Mr Bickmore is replaced as interim chairman.

A former senior executive at PBL and News Corporation, publisher of The Australian, Mr Philips is a well-regarded chief executive.

He has the support of ANZ and many of the firms that he is asking to take a haircut (although a few are understood to be holding out).

He believes the model can work if incentives are more aligned to group -- rather than individual -- performance.

He points out many Photon companies are extremely profitable on a standalone basis.

Two weeks ago Mr Philips said he did not regret taking the job even though Photon's finances turned out to be far worse than he expected.

Those close to him say that is still the case.


"It has always been clear that the light at the end of the tunnel has been very bright," he said.

That light may well turn out to be a train. Mr Philips and his bankers at ANZ Group still remain confident Photon can raise fresh capital and start anew.

But the process is proving far more painful than expected.