With the success of the GM IPO, we may be tempted to forget the terrible decade the U.S. auto industry has just completed. Car sales steadily declined from 2000 through 2007, then collapsed in 2008 and 2009 to a level not seen since 1951. Truck sales, which saw dramatic growth in the 1990s and finally eclipsed car sales in 1999, saw some growth in the early 2000s, but also dramatically retreated in the 2007-09 recession.
The “big 3” U.S. auto makers also suffered market share declines in this period, from a combined 65% of the U.S. market in 2000, to 53% in 2006, to 44% in 2009. It should be no surprise that GM and Chrysler filed for bankruptcy in 2009. The real question is: Why didn’t Ford go bankrupt?
Why Didn’t Ford Go Bankrupt?
By 2006, it was clear to the big 3 auto makers that there was a problem. Ford’s sales and net income had been flat for many years. Ford, like the other auto makers, began a major restructuring to reduce capacity, cut costs, and accelerate product development. The key to Ford’s success, however, was in aligning its business and financial strategies.
How did the Ford finance team respond to declining sales and the company’s new operational restructuring? By borrowing over $12 billion, increasing the company’s auto sector debt (excluding the financial services business) by 66% from $17.9 billion to $30.0 billion. Ford borrowed this money at the peak of the credit bubble, right before the recession hit and vehicle sales dropped by over 1/3. Why isn’t Ford bankrupt?
Why the New Debt?
Ford’s financial strategy was to maintain adequate liquidity to complete the operational restructuring, consistent with the auto industry’s high degree of cyclicality. So why borrow over $12 billion? The bulk of the new debt, almost $9 billion, went to increase the company’s cash hoard, with the remainder funding losses, capital expenditures, and other operating needs. During 2006, the company’s auto sector cash and marketable securities increased from $25 billion to almost $34 billion. Add to that over $12 billion available under the company’s revolving credit facilities (which were also renewed in 2006), and the company’s total liquidity going into the recession was over $46 billion.
Debt Maturities Matter Too
In addition to building cash and revolver availability, Ford had a conservative strategy on debt maturities. At December 31, 2006, 95% of Ford’s auto sector debt was long term (i.e. maturing beyond 1 year). In fact, over 88% matured beyond 5 years. While long-term debt typically costs the issuer more than short-term debt, Ford accepted this additional cost in order to reduce the risk that it would have to come to the financial markets to rollover debt during a downturn.
Lessons Learned
Ford, GM and Chrysler all faced significant operational challenges in the mid-2000s. All began major operational restructurings to cut capacity and costs and simplify their manufacturing and distribution networks; we are seeing signs of the operational turnaround at all three companies.
Ford was able to avoid bankruptcy in 2009 because of its operational restructuring, but also because of a successful financial strategy. It opportunistically borrowed money under favorable terms, built a large cash position, and kept very long maturities on the bulk of its debt. This financial strategy gave the operating side of the business the breathing room to complete its restructuring and survive the recession.
For the 7th time in 10 years, Wal-Mart is #1 on the Fortune 500 list (in the other 3 years, it was #2). The company is the largest private employer in the U.S. and accounts for 8% of total retail sales in the US. As big box retailers (including Wal-Mart, Target, The Home Depot and others) have gained market share over their smaller competitors, consumer products companies feel the need to sell to these large retailers in order to grow sales. For some companies, however, selling to the big box retailers has a darker side – what we call “Wal-Mart Risk.”
Customer Concentration Risk
The risk is customer concentration – that a significant portion of a company’s sales are to one company. The dangers of customer concentration include:
1) Credit risk – the risk that the customer will go bankrupt and the company will be unable to collect its receivable.
2) Switching risk – the risk that the company will build capacity to satisfy a large customer, and then the customer switches to another supplier, leaving the company with significant excess capacity (and perhaps unsold inventory).
3) Buyer power – the risk that the customer uses its position as a large buyer to drive down the price it pays the company for goods.
In order to address customer concentration risk, revolving credit agreements that include a borrowing base often exclude accounts receivable from customers above certain concentration limits (say 10% of total receivables). This provision significantly limits revolver availability for some borrowers and does not protect lenders from the main risks of customer concentration – switching risk and buyer power.
How is Wal-Mart Risk different?
How should we look at customer concentration risk differently when the large customer is Wal-Mart or one of the other big box retailers?
1) Credit risk is significantly reduced. It is unlikely that Wal-Mart will go bankrupt and not pay its suppliers.
2) Wal-Mart takes advantage of its buyer power more than most. The downside of selling to big box retailers is that they will demand lower prices, leaving their suppliers with lower margins. In addition, Wal-Mart is well known for setting other strict terms for its suppliers in terms of product quality, inventory levels, distribution and returns.
Can we “structure around” Wal-Mart risk?
So how should lenders address the ever-increasing Wal-Mart risk among their borrowers?
1) Waive concentration limits for receivables from high quality vendors, like Wal-Mart, but consider lower advance rates to account for the higher dilution likely from aggressive return and warranty claims.
2) Consider the impact of the loss of a large customer on the borrower. Does the company have a contingency plan? Will it be able to bring down costs and capacity to match lower sales?
3) Lower leverage! Companies with significant customer concentration have higher business risk than companies with a diverse customer base and should thus have a more conservative financial strategy – that means less debt.
Have you seen companies and/or their lenders address this risk? Tell us how – we welcome your comments.
In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond. For one company, Jarden Corporation, we showed that the bond’s cost is 50 basis points higher than the loan’s cost. Since both debt instruments were issued by the same borrower, shouldn’t they cost the same?
Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two. This applies if you are looking at it from the perspective of the issuer or the investor. For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).
Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. “high yield”) bonds is typically higher than the yield on non-investment grade (i.e. “leveraged”) loans. This is because high yield bonds are more risky to own than leveraged loans, for these reasons:
Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured. Thus, in a bankruptcy, the loans should get repaid before the bonds.
Maturity and Amortization: Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years. In addition, bonds typically have “bullet” maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time. This longer maturity and lack of amortization make bonds more risky to own than loans.
Covenants: Loans have more (and more restrictive) covenants than bonds. Thus, as a company’s operating performance begins to deteriorate, the loan will default long before the bond. This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.
Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.
Issuer: Risk vs. Cost
As with Jarden, for non-investment grade issuers, bonds typically have a higher all-in-cost than loans. This is because bonds are less risky for issuers and provide issuers additional flexibility.
Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it. If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk. Companies can reduce their refinancing risk by issuing debt with longer maturities. The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
Flexibility: Bonds place few restrictions on a borrower’s operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.
Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.
Loan-Bond Relative Value
When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis. In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.
If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.
If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.
Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam. On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012. Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities. Over the next 7 months, it completed two transactions.
August 2009: “Amend and Extend”
In August 2009, the company extended the maturity of $600 million of Term B loans (”TLBs”) from January 2012 to January 2015 through the creation of a “Term B4″ tranche. This new tranche was priced at LIBOR + 3.25%. The remaining $724 million of term loans remain due through 2012.
Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.
January 2010: Senior Subordinated Notes
In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020. The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.
So which is cheaper? With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond’s effective cost is 7.625%. So the loan is a cheaper source of capital than the bond? Not so fast! The loan is floating rate – if LIBOR goes up, the company’s interest cost will go up with it. The bond is fixed rate – no matter what happens to interest rates, the coupon on the bond will not change. So we cannot just compare the current loan cost of 3.5% to the bond’s cost of 7.625% – that would be comparing apples to oranges.
Combining a Loan and a Swap In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate. This is done using an interest rate swap. Let’s swap the loan to a fixed rate, as follows:
Step 1: The company borrows at LIBOR + 325 basis points.
Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.
The current quote for such an interest rate swap is about T+10:
The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract.
These transactions can be expressed as follows:
We can now calculate the effective fixed rate cost of the loan-swap combination:
Payment to loan holders: LIBOR+325 basis points
Received from the swap bank: LIBOR
Payment to swap bank: Treasury +10 basis points
The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders. The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335. The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.
Why is the bond more expensive? And why would the company issue the bond if it is more expensive than the loan? Watch the blog for answers to these questions.
There are lots of measures of liquidity. The classics are the current ratio and the quick ratio, but they’ve fallen out of favor because they don’t include cash flow, a critical component of liquidity. Cash burn is too recent to be classic, even though it’s been around for a while. But it’s limited to on-balance-sheet sources of liquidity.
The liquidity position is the latest addition to the liquidity analysis toolkit. It has limitations, but we like it because it includes internal and external sources of funds. Here’s a short slide show about it.
According to Bloomberg.com, American Airlines is asking its lenders for a covenant waiver. A conference call was held on June 22 and responses are due by June 25. Why the rush? The covenant would be waived for the quarter ending June 30, so the company wants the amendment done before the end of the quarter.
As we have discussed in earlier entries, many companies are amending their credit agreements to reflect lower than expected operating performance driven by the recession. Airlines have been especially hard hit by the downturn, so the pressure on American’s covenants is no surprise. The interesting element of this amendment is the lending group – institutional investors.
Term Loan B
A Term Loan B (”TLB”) is a term loan structured for sale to institutional investors, such as collateralized debt obligations (CDOs) and prime rate mutual funds. Traditional term loans, called Term Loan A’s, are typically originated by and sold to banks. Here are the main differences between the two:
Negotiating Amendments with Institutional Investors
Amendments to corporate loan agreements happen all the time. When the lenders are banks (as is typical for revolvers and TLAs), the relationship between borrower and lender often goes back many years and may include other business, such as cash management or bond underwriting. As a result, banks are often willing to work with borrowers towards a long-term solution (i.e. banks are more willing to grant waivers). TLA banks are often referred to as “relationship lenders.”
Institutional investors are “transaction lenders” – their relationship with the borrower often goes no further than the individual loan. As a result, they are often less inclined than banks to grant waivers or agree to amendments.
American Airlines “Pays Up” for its Amendment
American’s proposal to its TLB lenders is to waive the fixed charge covenant this quarter and cut it through the loan’s maturity in 18 months. In exchange, the spread on the loan would go from 200bp over LIBOR to 400bp, and there would be a new LIBOR floor of 2.5%. This would immediately increase the interest rate on the $435 million loan by about 3.9%, increasing interest expense by over $16 million per year. In addition, the lenders would get a 75 basis point amendment fee, costing American over $3 million. These terms are not unusual in today’s market for “B” rated companies like American.
With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:
Acceleration (i.e. “call the loan”) – declare the principal of the loan to be immediately due and payable. This typically would result in the bankruptcy of the borrower since they do not have the cash on hand to repay the loan.
Foreclose on collateral – As with acceleration, this would result in the bankruptcy of the borrower.
Stop funding unused revolver commitments. Banks will typically continue to allow some revolver borrowings because cutting off the revolver would often result in a bankruptcy.
After a covenant default, banks typically do not exercise their rights – they do not call the loan or foreclose on collateral, and they often allow the borrower to continue to borrower under the revolver. Banks know that these actions would result in bankruptcy, and it is in everyone’s interest to avoid bankruptcy.
So what really happens?
Most covenant defaults result in an amendment (or waiver) to the loan agreement. The financial covenants that were breached are loosened in order to get the borrower out of default. Ideally, the company and banks should see the covenant breach coming and work out an amendment before the default happens.
A good example of this is the recent amendment done by Actuant Corporation (ticker ATU), a diversified industrial company headquartered in Wisconsin. The company was forecasting deteriorating financial performance which could have breached covenants. Before the defaults happened, the company negotiated an amendment which increased its leverage covenant from 3.5x to 4.5x (with future step-downs) and reduced its fixed charge covenant covenant from 1.75x to 1.65x.
What do banks get in exchange?
In exchange for giving a borrower more room under its covenants, banks typically get one or more of the following:
Increased pricing and/or a one-time fee – to compensate them for the increased risk,
Additional collateral – to improve their loss in the event of a bankruptcy,
Reduced exposure – if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
Additional covenants – to ensure that cash is used to repay debt (e.g. dividend and/or capex limitations) and to better monitor the company’s performance.
In the Actuant example, the banks received:
An amendment fee and increased pricing (spread went from L+250 to L+375; commitment fee went from 40 to 50bp),
Faster term loan amortization (from $1.5 million per quarter to $10 million), and
Competition affects credit strength, and never more than in tough times. Favorable conditions can mask competitive weaknesses. Consider General Motors at the peak of the SUV craze. Unfavorable conditions can amplify weaknesses. Consider General Motors today.
This video is about Southwest Airlines and American Airlines and the recent problems in the airline industry. It explores the subject of sustainable competitive advantage. How does a company get it? How likely is it to last? The video is about four minutes long.
Loans to non-investment grade and middle-market companies are typically secured by the borrower’s receivables, inventory, and fixed assets. Pledging this collateral, however, does not reduce the borrower’s likelihood of default. Security should reduce the loan’s loss given default, but not necessarily in the way you expect. Here’s how.
How Are Loans Repaid?
Banks that make secured loans do not expect to foreclose on the collateral to repay the loans. Loans are typically repaid from cash flow from operations or by refinancing with new debt. Foreclosing on collateral is a last resort. Some lenders, such as those that provide asset based loans, equipment finance, or mortgages, are expert in disposing of foreclosed assets, but most banks are ill-prepared to seize assets and sell them.
So Why Take Collateral?
Most secured lenders to bankrupt large corporate and middle-market companies never take possession of their collateral. Instead, the companies are reorganized or sold using the bankruptcy system (e.g. Chapter 11 or Chapter 7 in the U.S.). Proceeds from the bankruptcy, either cash or new securities, are then distributed to creditors. Secured creditors have a higher priority when these proceeds are distributed, giving them lower losses than unsecured creditors.
Does Collateral Mean the Loan Will Be Repaid?
Unfortunately not. Even if the value of the collateral exceeds the amount of the loan when it is made, it is likely that the value of the pledged assets will be substantially lower when the borrower is in financial distress. After all, an asset is only worth what someone will pay for it, and, as we’ve seen, many assets decline in value in a recession.
What’s the Lesson?
As a lender, by all means take collateral when you can get it – just don’t rely on the collateral as your primary (or even secondary) source of repayment. Instead, analyze the company’s ability to generate cash flow to repay its debt. Remember, taking collateral doesn’t mean the company or its assets will retain their values. Unless you are an asset based lender, the biggest benefit you get from collateral is that it moves you to the front of the line in a bankruptcy.
Wendy’s/Arby’s Group, Inc. (ticker WEN) was formed in September 2008 through the merger of the Wendy’s and Arby’s fast food chains. In March 2009, WEN announced it had redone its main loan agreement to reflect the merger. Nothing unusual there. The surprise is that Wendy’s/Arby’s Group, Inc. is not a party to the loan agreement. Here’s why.
Holdco – Opco Structure
Wendy’s/Arby’s Group, Inc. is a holding company (”holdco“) – it has over 60 direct and indirect subsidiaries that actually own, franchise, or operate the restaurants (the operating companies, or “opcos“).
The opcos have real assets (buildings, inventory, receivables, contracts, etc.) and hopefully generate cash flow from their operations.
The holdco’s assets are stock in the opcos, and the holdco’s primary source of cash is dividends from the opcos.
A Quick Lesson on Bankruptcy
Under the absolute priority rule, a bankrupt company must repay its creditors (i.e. lenders, suppliers, employees, etc.) in full before it can distribute any cash to its owners. So, if WEN and its subsidiaries ever went bankrupt, who would be repaid first: lenders to the holdco (i.e. Wendy’s/Arby’s Group, Inc.) or lenders to the opcos (i.e. the 60 subsidiaries)? Answer: the opcos, since they have the assets and cash flow and must repay their creditors before paying dividends to the holdco.
Structural Subordination
The idea that opco creditors are paid before holdco creditors is referred to as structural subordination. Because of structural subordination:
Lenders to high risk companies (such as WEN) often prefer to lend to operating subsidiaries rather than to a parent company.
Loans to holdcos often include a subsidiary debt limitation and upstream guarantees in order to limit the impact of structural subordination.
The rating agencies typically rate the debt of a holdco lower than the debt of its operating subsidiaries. For example, Standard and Poor’s rates Wendy’s/Arby’s Group, Inc. “B-” but assigned the slightly higher “B” to the loans of its subsidiaries.
What do Whirlpool, Fiat, Sony, and Heinekin have in common? All took major restructuring charges recently, driving down profits that already were under pressure from the global economic slowdown. As the recession lasts longer and spreads farther, we’ll see many more companies taking big restructuring charges.
What are restructuring charges and how do they affect the company’s operating results and financial condition? This video gives a quick answer.
How do restructuring charges affect credit risk analysis? At the technical level, they complicate things by prompting us to make adjustments to important profitability, coverage, and leverage measures. At the fundamental level, they signal problems with unsustainable operating costs or overstated asset values or both.
For many companies, financing an acquisition is a two-step process. The long-term strategy might call for raising cash using syndicated term loans and revolvers, bonds, equity, and asset sales. However, many companies use bridge loans to initially fund acquisitions, then repay those loans with other financings and/or assets sales. In fact, according to Reuters, the largest syndicated loan in the U.S. in 2008 was the $14.5 billion one-year bridge loan backing Verizon Wireless’ acquisition of Alltel Corp.
What is a Bridge Loan?
A bridge loan is a term loan where the expected source of repayment is a specific event, typically a debt or equity financing and/or asset sale. These loans typically have a bullet maturity (i.e. no amortization) of 1 year or less. As an incentive to borrowers to refinance bridge loans quickly, they typically include interest rate increases and “duration fees” tied to how long the loan is outstanding. For example, the Altria bridge loan (described below) calls for the interest rate to increase by 0.25% and for an additional 0.75% fee if the loan is not repaid within 90 days (with additional step-ups and fees each 90 days thereafter). Bridge loans are typically underwritten by a small group of banks rather than being widely distributed in the syndicated loan market. These underwriting banks typically also manage the “takeout financing” (e.g. the bonds issued to repay the bridge loan).
Altria Uses a Bridge Loan
On September 8, 2008, Altria Group, Inc., the parent company for cigarette maker Philip Morris USA and other companies, announced an agreement to purchase UST Inc., a leading manufacturer of smokeless tobacco. The transaction, scheduled to close within 4 months, called for Altria to pay UST shareholders $10.4 billion cash and to assume $1.3 billion of UST debt. The company’s plan was to finance the purchase with $11 billion of long-term, public bonds. However, at the time they announced the acquisition, they also announced a $7 billion dollar commitment (split between J.P. Morgan and Goldman Sachs) for a 364 day bridge loan which, when added to the company’s existing unused credit facilities, could fund the entire purchase.
Here’s the timeline:
September 8 – Altria announces agreement to buy UST and $7 billion loan commitment.
November 4 – Altria issues $6 billion in 5, 10 and 30 year bonds.
December 18 – Altria issues $775 million in 18 month bonds.
December 19 – Altria closes (but does not draw down) on $5 billion 364 day bridge loan (reduced from the original $7 billion commitment). The bank group expands from JPM and Goldman to include 6 other banks.
January 6 – Altria closes on the purchase of UST and draws down $4.3 billion from the bridge loan.
February 3 – Altria issues $4.225 billion in 5, 10 and 30 year bonds (bringing the total bond issuance to the planned $11 billion) and repays the bridge loan. The 8 banks that underwrote the bridge loan are all joint book-running managers on these bonds.
Wendy’s and Arby’s fast food chains. In March 2009, WEN announced it had redone its main loan agreement to reflect the merger. Nothing unusual there. The surprise is that Wendy’s/Arby’s Group, Inc. is not a party to the loan agreement. Here’s why.