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Posts Tagged ‘Leverage’
Tuesday, December 28th, 2010 by Ron Carleton
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy - Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
2) Investing in People – While bank compensation levels haven’t necessarily returned to 2006-07 level (or most), we certainly see a lot of hiring at the analyst and associate levels, and more business and opportunities for more senior professionals.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
Tags: Cash Flow, Covenants, debt structure, Early Warning Signs, financial fraud, financial institutions, Financial Strategy, Leverage, Liquidity, Liquidity Position, Priority, Problem Credit, Risk Management
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Thursday, November 18th, 2010 by Ron Carleton
The Terrible Auto Market
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.
Tags: Bankruptcy, CAPS, Financial Strategy, Flexibility, Ford, General Motors, Leverage, Liquidity, Liquidity Position
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Monday, September 13th, 2010 by Tim Delaney
 Credit and equity often seem like different dimensions in the analytical universe, but they often intersect in compelling ways. Take General Motors (GM) and its plan to issue equity for example.
There’s a case to be made for GM’s having a lot of equity value. To make it, we also have to look at Ford.
For both companies, 2009 was a big improvement over 2008. But Ford did better, generating $11.0 billion in EBITDA, while GM had an EBITDA loss of $9.9 billion. And Ford has publicly traded common shares and an equity market value of about $42 billion, while GM has neither.
Let’s make two simplifying assumptions. One is that, in the absence of forecasts, we can use last year’s financials to value Ford and GM. The other is that over time GM’s performance will match Ford’s.
Ford’s enterprise value is the sum of its equity market value, minority interest, and debt net of cash: $84.9 billion. Its value multiple is its enterprise value divided by EBITDA: 7.7x. Its EBITDA margin is EBITDA divided by sales: 9.3%.
If we apply the same margin to GM’s 2009 revenues, we get an estimate of its longer-term earning power: $9.7 billion in EBITDA. If we apply the same multiple to GM, we get its enterprise value: $75.1 billion.
GM’s equity value is its enterprise value less minority interest and debt net of cash: $82.1 billion. GM’s equity value is higher than its enterprise value because GM’s cash reserves exceed its debt. But that includes only the debt GM carries on its balance sheet.
GM has $37.0 billion in unfunded benefit obligations that are not classified as debt. Credit analysts see them as equivalent to debt and include them in their leverage analysis.
If we bring them into our analysis of GM’s equity value, it falls to $45.1 billion. That makes a big dent in GM’s potential equity value.
In this case, the same factors that drive credit risk drive equity value. And a tool that’s long been in credit analysts’ kits proves useful over on the equity side of the financial space-time continuum.
Tags: General Motors, Leverage, Off-Balance-Sheet Debt, Pension Obligations
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Monday, June 14th, 2010 by Tim Delaney
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.
Tags: Flexibility, Hovnanian Enterprises, Leverage, Liquidity
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Wednesday, May 26th, 2010 by Ron Carleton
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.
Tags: CAPS, Competition, Covenants, debt structure, Financial Strategy, Leverage, Risk Management, Wal-Mart
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Tuesday, December 29th, 2009 by Ron Carleton
We hope everyone is having happy holidays. Last time, we defended Lehman Brothers from Andrew Ross Sorkin’s attack in Too Big to Fail. We’ve stolen some time from the seasonal festivities to take another look at the numbers, and we still feel there’s a strong case to be made for the way Lehman Brothers managed its finances right before its fall.
We compared Lehman to Morgan Stanley from November 2007 through August 2008, the three reporting periods leading up to Lehman’s collapse in September 2008. We looked at the progress each firm made improving three key measures of financial strength: leverage, exposure to mortgage-backed securities, and liquidity reserves.
We calculated leverage as the ratio of total assets to shareholders’ equity, exposure to mortgage-backed securities as the book value of residential and commercial mortgage-backed securities as a percent of shareholders’ equity, and liquidity reserves as total cash and unpledged liquid securities. To gauge the improvement in each measure, we calculated its value in August as a percent of its value in November.
In Sorkin’s account, Lehman Brothers went bankrupt because it had too little capital to absorb the potential losses from its real estate investments. But Lehman did much more to reduce leverage and cut exposure to mortgage-backed securities than Morgan Stanley, yet Morgan Stanley survived.
It’s true that Morgan Stanley did a better job of boosting liquidity than Lehman, but it needed to. Morgan Stanley did much more prime brokerage business with hedge funds than Lehman. It was the run-off in prime brokerage funds that brought Bear Stearns down, and it nearly ruined Morgan Stanley too. In the week after Lehman failed, Morgan Stanley went through nearly all $180 billion of its liquidity reserves and had to go to the Federal Reserve for rescue.
So what’s the risk management lesson in all this? Did Lehman Brothers deserve to die? Did it commit suicide, or was it killed? Could it have done anything to save itself? Too Big to Fail makes Lehman’s fate seem inevitable, and we agree.
Like any investment bank, Lehman relied on confidence-sensitive financing, and in September of 2008 the financial markets lost confidence in Lehman – and Morgan Stanley and Goldman Sachs. Nothing they could do about leverage, exposure to mortgage-backed securities, or liquidity reserves mattered.
It’s nothing new. As Walter Bagehot observed more than a century ago, “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”
Tags: financial institutions, Lehman Brothers, Leverage, Liquidity, Morgan Stanley, Risk Management
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Thursday, November 5th, 2009 by Ron Carleton
The heavy burden of hidden debt
BT Group, plc, is one of the world’s largest telecommunications companies. Since the telecom crash in 2001, it’s been struggling with operating, management, and reporting problems. You can add financial problems to the list as well.
Its leverage – or “gearing”, as the English put it – is high. Reported debt to capital (adjusted for actuarial losses in its pension plans) is 66%. That’s based on the numbers reported on the company’s balance sheet.
Look beyond the balance sheet, and leverage gets much worse. BT has retirement benefit obligations that exceed pension plan – or “scheme,” as the English say — assets by £2,870. If you consider that to be debt, leverage increases to 71%. Treat operating leases as a form of debt financing, and BT’s leverage climbs to 75% (capitalizing annual rental expense at 8x).
Off-balance-sheet debt equivalents
What explains the difference between BTs reported leverage and its adjusted leverage? Why treat pension and lease obligations as the equivalents of debt? How do you tell if an off-balance-sheet liability belongs in your leverage analysis?
We use these criteria. To be the equivalent of debt, an obligation has to:
• Be a financial obligation, not money owed to a supplier
• Have an imputed or actual interest rate
• Have a fixed payment schedule
• Allow the holder to demand payment in full on default
• Be a substitute form of capital
By these standards, unfunded pension obligations are debt because they are financial, are discounted at an interest rate, and often have a payment schedule that is enforced not just by pensioners but by government regulators as well. Operating leases are debt because they are another way of financing assets. If BT securitized its trade receivables, that would be another form of off-balance-sheet financing equivalent to debt.
U.S. and international reporting rules are precise about what debt is, but those rules don’t always capture the economic reality of how companies finance themselves. Sometimes reported leverage understates real leverage. That’s the case for BT.
Tags: BT Group, Financial Strategy, Leverage, Off-Balance-Sheet Debt, Operating Lease, Pension Obligations
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Tuesday, October 13th, 2009 by Ron Carleton
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.
Tags: Flexibility, Hovnanian Enterprises, Leverage
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