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.
The last time we looked, Hovnanian Enterprises was trying for lower financial leverage. We saw signs of progress along those lines, but we were concerned about the company’s financial flexibility. Let’s see if they made any progress in the last six months.
Using cash reserves, the company brought debt down from $2.5 billion in 2008 to $1.8 billion in 2009. But debt was stuck at $1.7 billion in the second quarter of 2010. Cash flow wasn’t strong enough to let Hovnanian pay down more debt, and the company was reluctant use any of its $459 million in cash reserves.
Hovnanian also made big changes in its debt maturity structure between 2008 and 2009, as the chart shows. It cut $1.1 billion of the debt maturing between 2012 and 2015 by targeting prepayments on debt maturing in those years and by refinancing $785 million of old debt with new, senior secured notes due in 2016.
But the company was able to prepay only $100 million of its 2012-2015 maturities in the first half of 2010 — again because of weak cash flow and the need for large cash reserves. Ironically, one reason Hovnanian needed so much cash is that it had no revolving credit to help with liquidity needs. The company was forced to cancel its $300 million revolver to do the $785 million debt issue in 2009.
The lesson is that financial risk can be hard to manage. It involves complex trade-offs among leverage, flexibility, and liquidity. Hovnanian was able to reduce leverage and improve flexibility in 2009, but only by compromising liquidity. And it still has a $1.1 billion mountain of debt to climb in 2016.
The problems of the last leveraged buyout bubble are still with us. From 2004 through 2007, the U.S. experienced an unprecedented level of LBO activity. That all ended with the collapse of the debt markets in the summer of 2007 (and the disappearance of the debt markets after the Lehman bankruptcy).
LBOs are funded primarily with debt – somewhere between 60% and 80% of the capital structure. These are the debt products used:
Institutional Term Loans (also know as “Term Loan B” or “TLB”) – often the single biggest tranche of debt, these loans are sold to institutional investors, such as collateralized debt obligations (CDOs) and prime rate funds. They have very little principal amortization and a final maturity of 6-7 years.
Pro-rata Loans (comprised of a revolving credit facility and a Term Loan A) – these loans are sold to banks and typically make up a smaller part of the capital structure than the TLB. Standard terms for a Term Loan A include significant principal amortization and a final maturity of 5 years.
High Yield Bonds – are sold to institutional investors. They have a bullet maturity (i.e. no principal amortization) and a final maturity longer than the Institutional Term Loans, typically 7-10 years.
The Debt is Coming Due!
Starting in 2012, we will see significant amounts of LBO debt coming due. Knowing the typical maturities of the debt products and counting forward from the boom years of 2006 and 2007, first we’ll see large amounts of pro-rata loans come due, then institutional term loans, then high yield bonds, as this chart shows:
What is the solution?
Highly leveraged companies have been working on this problem for some time. Given their earlier maturities, much attention has been focussed on refinancing the loans. Companies have issued new loans (with longer maturities) and high yield bonds in order to repay existing loans and extend their debt maturity profiles. There have also been many “amend and extend” agreements whereby existing lenders extend the maturity of their loans (in exchange for fees, increased interest spreads and other consideration).
Looking out into 2012 and beyond, the question is whether or not there will be capacity in the loan and bond markets to refinance all of the maturing debt. The jury is still out on this question.
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.
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.
Getting Better and Worse The worst seems to be over for the housing industry in the United States. It may even be on the mend. In the competition for building sites, companies with less financial risk will have an advantage. Hovnanian Enterprises, the sixth largest homebuilder in the country, has been doing some interesting financial deals to improve its competitive position
Hovnanian had the highest leverage among its closest competitors. At the end of 2008, the company’s debt-to-capital ratio was 88.7%, while its rivals averaged 66.2%. With competitors buying foreclosed land from banks at historic-low prices, Hovnanian is forced to spend money on debt service instead.
Worse, Hovnanian had even less financial flexibility than the competition. Looking at maturities of debt over the next five years, Hovnanian had 28.3% of its debt coming due, while its competitors had only 23.0%. Worse still, the company’s debt was much more concentrated in a single year, as the chart below shows.
Maximum 1-year debt maturities as a percent of total debt are the highest value for debt maturities over the next five years as a percent of current period total debt.
Having so much of its debt maturities crowded into a single year is a problem for Hovnanian. It has a lot more refinancing risk than the companies it competes with. If its credit quality gets weaker or the capital markets take another dive when all that debt matures, Hovnanian will be in serious trouble.
Less Progress than Meets the Eye
To its credit, Hovnanian saw the problem and did something about it. Through exchanges offers, open market repurchases, and cash tender offers in the first three quarters of 2009, Hovnanian repaid $780 million of its debt. About $271 million of that was debt maturing in the next five years.
Unfortunately, Hovnanian’s efforts reduced leverage but reduced flexibility as well. Maximum 1-year debt maturities actually increased to 37.7% of total debt. The company had more success retiring its longer-maturity debt than the debt coming due in the next five years.
Financial leverage is a risk in its own right, but embedded in leverage is another risk: financial flexibility. And financial risks are closely connected to competitive risk. Good financial strategy manages all of those dimensions of risk effectively. Hovnanian seems still to be struggling to do that.
