We’ve been running a poll on the Comments on Credit blog for the past few months asking 2 questions:
It is no surprise that bankers like the debt service coverage and fixed charge coverage ratios best – they are good measures of a company’s ability to pay its financial obligations as they come due (without relying on external financing). We think they are the best ratios to measure a company’s liquidity (much better than the current and quick ratios, but that is a topic for another post).
If debt service coverage and fixed charge are the best measures of coverage (and liquidity), the real question is why we don’t use them more often in covenants? The most used coverage covenant (in our survey and in our experience) is EBITDA coverage.
Accuracy vs. Simplicity
Whenever we look at ratios, for analytical purposes or for covenants, there are always the conflicting goals of accuracy and simplicity. We could write a ratio that looks at a company’s internally generated cash flow (say, free cash flow) relative to all of its future, normalized financial and operating cash outflows, but by the time we write the definition into a credit agreement it would be too long and cumbersome. As it is, we’ve see fixed charge coverage definitions that exceed one full page of (very small) text. And even then, there may be disagreements between borrower and lender about how it should be calculated.
So, in order to make the numbers easy to calculate and avoid disputes in the future, we sometimes go with simpler covenants, even if they are not the best measures of a company’s risk. Thus, EBITDA coverage is used more often than debt service coverage.
When the Deepwater Horizon blew up in April of 2010 and the Macondo well started spilling thousands of barrels of oil a day into the Gulf of Mexico, BP’s management had to deal with massive human, environmental, operational, and financial challenges. The controversy over how well BP handled the disaster will take years to resolve. But BP’s response to the financial aspects of the crisis is beginning to come into focus.
This post is about how BP met the financial challenges that flowed from the Macondo well spill. Although the company may not be a model for safety management or environmental stewardship, BP is a surprisingly good model for liquidity management under stress.
Operating Results Suffer
The financial impact on BP was sudden and severe. Although BP’s revenue was scarcely affected, there was a massive operating loss in the second quarter of 2010; and the company barely broke even in the third quarter.
Spill Costs Soar Then Plummet
Costs for the spill were $32.1 billion in the second quarter, but then fell to $7.7 billion in the third and to only $1.0 billion in the fourth. The expense in the second quarter was a special charge to create a reserve for oil spill costs. Adjusted for spill costs, BP’s operating margins fell only slightly — from 12.9% in the first quarter to 11.8% in the fourth.
Spill Expenses Exceed Spill Spending
The cash outlays for the spill followed a different pattern from the expenses. BP accrued $40.9 billion in spill expenses in 2010 but made only $17.7 billion in cash payments related to the spill.
Rising Liquidity Position
Still, coming up with $17.7 billion in a hurry was a problem for BP, as it would be for any company caught in a costly, fast-growing crisis. Yet BP was able to improve its liquidity in the face of those extraordinary demands on its cash by adding $7.6 billion in new revolving credit commitments and $20.0 billion to its cash reserves.
Sources and Uses of Cash
With so much money pouring into the Gulf oil spill, how was BP able to add so much to its cash reserves? The company cut uses – mainly shareholder payouts (dividends and share repurchases), which fell from $2.5 billion in the first quarter to under $100 million in each of the last three. It also boosted sources – mainly $16.4 billion in asset sales and $10.8 billion in borrowings in the last two quarters. That drove cash flow to $10.2 billion for the year, in spite of outlays for the spill.
How to Handle a Liquidity Crisis
What made BP’s response so effective? Is what BP did a good model for evaluating companies facing liquidity problems? We think so. Companies struggling with liquidity problems need to:
React quickly
BP recognized the severity of the problem right away. In financial terms, that meant taking a big charge in the same period as the Deepwater Horizon disaster.
Reduce discretionary spending
BP stopped share repurchases and cut most of the dividend in the second quarter. It had less flexibility with capital spending, which remained at pre-spill levels or more throughout the year.
Increase cash from operations
In the second quarter, BP was able to generate only slightly less cash flow from operations than in the first, thanks to a $13.5 billion inflow from working capital. Big gains in working capital efficiency are difficult to sustain, and BP’s cash flows from operations went negative in the following two quarters.
Exploit other internal sources
What BP couldn’t get from operations it generated from asset sales. The company sold gas and oil fields, pipelines, and retail operations to strategic buyers.
Tap external sources
BP turned to the financial markets for funding. It raised $4.6 billion in bank loans backed by crude oil sales from fields in Angola and Azerbaijan. It raised another $6.2 billion from bond issues in Europe and the United States.
It’s not over for BP: costs and cash outlays are likely to rise. But the worst of the crisis is behind them. Today, Tokyo Electric Power Company is struggling with an even greater problem. The challenges they are facing are likely to dwarf BP’s. It will be interesting to see how well they cope with them, and, financially at least, whether they are as effective as BP.
The Wall Street Journal reported yesterday that Borders Group Inc. was halting payments to some suppliers, and that one publisher had stopped shipping books to Borders. The end is near. As we discussed in an earlier post, if trade creditors lose faith in a company, bankruptcy is almost unavoidable. The term we use is “confidence sensitive cash flows,” which includes, in addition to trade credit, short term borrowings like commercial paper (think Lehman Brothers) and counterparty credit (think Bear Stearns). Once one supplier stops shipping, they all will stop.
Today, the Wall Street Journal reported that two senior executives had resigned (the General Counsel and the Chief Information Officer). This is another classic early warning sign. Let the countdown begin …
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.
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…
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.
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.”
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.
There’s a new book about the collapse of Bear Stearns. It’s House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, and it is getting good reviews. The New York Times calls it “…high drama that is gripping…”
The story may not seem so relevant or interesting today. After all, Bear’s demise was a year ago; Lehman’s was only last September. Bear’s vital organs were saved by transplant into the body of J.P. Morgan; Lehman was allowed to expire in the emergency room.
But we think the book will answer questions about Bear that are as urgent and compelling today as they were when the company failed. What brought the Bear down? Was it just arrogance, or did negligence, ignorance, or bad luck play a role? Was it ruthless attacks by short sellers or mainly extreme market conditions?
Mistakes in Liquidity Management
Whatever else contributed, mistakes in liquidity management were important in the company’s downfall. Thanks to the failure of two of its own hedge funds, Bear was painfully aware of problems in the financial markets. It took steps to improve liquidity, increasing cash and unpledged securities from $27.7 billion in November 2007 to $35.2 billion in February 2008.
It was too little, too late. By Bear’s own reckoning, those sources of liquidity in February had to cover at least $21.7 billion in potential uses, including maturing unsecured debt, funding commitments, and standby letters of credit. That left only $13.5 billion to cover client withdrawals and secured funding shortfalls.
At the time, Bear owed $91.6 billion to clients and had secured short-term debt of $98.3 billion. It would take only a small percentage decline in either of those amounts to exhaust the company’s liquidity reserves, and it did. In the three days starting March 10, Bear went through $12.1 billion in cash alone and was forced to turn to J.P. Morgan and the Federal Reserve for a rescue.
Bear failed to anticipate its liquidity needs. We’ll have to read Mr. Cohan’s book to learn if it was through bad management, because of unprecedented illiquidity in the financial markets, or on account of those nasty short sellers. We can’t wait to find out.
Over the past 15 year, many businesses have adopted sophisticated inventory tracking systems and just-in-time inventory policies. As a result, they have gotten much more efficient in their use of inventory, as shown in this chart:
Source: Wachovia Economics
This long downward trend in the inventory-to-sales ratio has recently and dramatically reversed. What happened?
As we noted in an earlier post, companies are often slow to respond to lower sales, waiting to cut production and/or reduce purchases. As managements “catch up” to the current sales reality (or as sales improve), we would expect the inventory-to-sales ratio to return to normal, lower, levels (with the associated benefits for corporate cash flow).
The 2007 year-end selling season was not good for the home furnishings retailer “Linens ‘n Things.” Quarterly sales were up 0.6%, but only because the company opened four new stores. Ignoring the new stores, same store sales were down 1.0% for the quarter and 3.4% for the full year 2007. Even worse, margins were hurt by the “highly promotional environment” and increased marketing spending: quarterly gross margin declined from 36.7% to 33.8% and operating margin (adjusted for non-recurring items) turned negative.
Cash is King: What About Liquidity?
The news was not all bad. For the quarter, adjusted EBITDA was $15.3 million and cash from operating activities was $137.9 million (the large difference between EBITDA and cash flow was the result of the normal year-end sell-through of inventory). Standard liquidity measures looked good at year-end: the current ratio was 1.9x (about the same as the prior year-end) and it had excess availability under its asset-based revolving credit facility of over $300 million.
So what went wrong?
The sales decline accelerated in the first quarter of 2008 and the company responded with an aggressive cost cutting plan. In an effort to conserve cash, the company also began to aggressively manage working capital: it slowed purchases to reduce inventory levels and it began to slow pay some of its vendors. This strategy backfired. By late March, many vendors stopped shipping to Linens ‘n Things, citing slow pay and even no pay on outstanding invoices. By mid-April, the company had begun paying cash before delivery to certain key vendors in order to obtain goods.
This cash drain was unsustainable. In the four months from year-end 2007 until its bankruptcy filing on May 2, 2008, the company’s use of credit (i.e. revolver borrowings and letters of credit) increased by over $170 million, a burn rate of over $42 million per month.
Lessons Learned
This situation highlights the importance in credit analysis of of looking at a company’s confidence sensitive cash flows. This refers to funding (or other cash flow) which depends on a third party’s willingness to accept the company’s (typically unsecured) credit risk. Examples of confidence sensitive cash flows include short-term borrowings (such as commercial paper), counterparty risk, and (as in the case of Linens ‘n Things) trade credit.
How did General Motor’s run through so much liquidity so fast? Static measures like cash and liquidity don’t really give us the full answer. We need a more dynamic view of what’s driving GM’s liquidity; something that focuses on uses and sources instead.
Here’s a table that shows where GM has been using and sourcing its liquidity for the nine months ending in September of this year.
Cash income has been the biggest use of liquidity, caused by the steep drop in vehicle sales that began earlier this year. Working capital has been a use largely because of decreasing accounts payable – a sign that suppliers are cutting back on the credit they give GM. Capital spending is another major use, as the company invests in new models. Credit market conditions forced GM to pay down much of its short-term debt, draining away even more liquidity.
GM met those demands for liquidity through liquidating assets, mainly by selling marketable securities and letting its portfolio of vehicle leases run off. The next biggest source was borrowing under its committed bank lines. But the most important source of liquidity by far was drawing on cash reserves.
GM found the sources it needed to survive, but only by consuming crucial liquidity reserves. That’s not sustainable. As of September 30, 2008, the company had only $7.2 billion in operating lease assets, $300 million in marketable securities, $16.0 billion in cash and equivalents, and $100 million in unused bank lines – at best enough last another nine months.
So it seems GM has been telling the truth. It really does need help to survive the next year. The challenge for them will be to put their liquidity on a sustainable basis, along with the rest of their financing.
As we move further into recession, we often see a pattern in corporate free cash flow (defined here as cash from operating activities minus capital expenditures and dividends). A company’s ability to manage cash flow as sales decline is a key determinant of credit quality and an important way to judge management effectiveness.
Here is a typical pattern:
Phase 1: Denial. Sales begin to decline, but management is unclear if it is temporary or the sign of a longer term trend. Optimistic management teams (and those without real-time sales data) do not cut production or purchasing, so inventory balloons in the face of declining sales. Receivable days may also increase as customers struggle with their own cash flow problems. These increases in working capital push free cash flow negative, even as operating income and net income remain positive.
Phase 2: Manage Working Capital. A good management team (with good financial reporting systems) will quickly recognize the cash flow drain and act to bring down working capital. Actions may include cutting production and/or purchases to reduce inventory, aggressively collecting receivables, and perhaps slowing payment on accounts payable. These actions can quickly generate significant amounts of cash, but can also hurt relationships with customers and suppliers.
This chart shows the quarterly financial performance of a capital goods manufacturer in the 2001 recession (shaded). As expected, sales and operating income began to decline as the recession began. However, there was an immediate large drop in free cash flow (caused by a large increase in working capital) followed by an equally large increase in free cash flow (as management slowed production and worked down inventory).
Phase 3: Cut Costs. As management recognizes the true nature of the sales decline, they will begin to cut costs in an attempt to maintain margins. This often means layoffs and pressure on suppliers. This should result in improvements to operating profit and cash flow a few months or quarters into the recession, depending on how quickly management recognizes the problems and moves to cut costs. Today, many companies are in this phase.
Phase 4: Long-Term Restructuring. In some industries, the recession may signal a fundamental shift in demand dynamics – sales may take years to return to pre-recession levels (or may never get there). Companies in these industries must make changes beyond working capital management and short-term layoffs. This long-term restructuring typically involves permanent reductions in capacity, including cuts in capital expenditures and asset sales. On the financial side, the dividend may be reduced or eliminated. These moves are especially painful for management (and often shareholders) who have been focussed on growth. However, if management does not recognize and respond to these trends, the long-term viability of the company is threatened.
The chart above for the capital goods manufacturer shows positive free cash flow (and an improving free cash flow trend) even as operating profit remained negative. The improvement in free cash flow resulted from aggressive cost cuts, asset sales, working capital management, cuts in capital expenditures, and a significant cut in the dividend rate. While painful, these actions by management ensured that the company survived the recession.
The Wall Street Journal 
