Where Credit Is Due

A new study of the largest issuers of corporate debt shows that recent gains in creditworthiness are more fragile than you think.

On the other hand, Caterpillar Inc. also has a big financing arm, which helps sustain its heavy-equipment manufacturing business, yet it is one of the few such companies whose improvements in creditworthiness placed it among the top 10 for both the one-year and three-year periods. Caterpillar’s performance reflected a much larger increase in the market value of its assets. In fact, the company’s leverage has been reduced, thanks to a huge increase in its stock price—reflecting strong global demand for its products. Here, a certain amount of luck is involved: Caterpillar benefits from the need to build or replace public infrastructure in many parts of the world.

What of Growth?

That, however, only underscores the fact that companies with heavy debt burdens in slow-growing markets find themselves in a quandary: how to reduce debt without cutting the spending necessary to produce new products and services necessary to sustain their business.

Nextel also was lucky, insofar as it had a lot of low-hanging fruit to pick. Shortly before Saleh came aboard, Nextel began reeling into headquarters such highly decentralized operations as marketing and outsourcing others, such as customer service. The cost savings, combined with efforts to maximize capital efficiencies and reduce debt, improved Nextel’s operating margin from 30 percent to 42 percent—and with it its ratio of debt to operating income before interest, taxes, depreciation, and amortization (OIBITDA), which fell from nine times in 1999 to just under three times today.

But deleveraging wasn’t easy, says Saleh. The company’s bank covenants were about to become more restrictive, and require Nextel’s debt-to-OIBITDA ratio to fall to 5 starting in 2002. While Saleh insists Nextel was never close to missing that target, investors worried about the prospect nonetheless—indeed, vulture investors were eyeing the company’s bonds, he admits. But when investors were finally convinced that the company would become free-cash-flow positive in the not-too-distant future, Nextel was able to exchange many of its bonds trading at 50 cents on the dollar for equity. As cash flow from operations improved enough to let Nextel begin using cash to retire expensive debt, the public markets became more receptive, and the company was able to substitute cheaper short-term debt for expensive long-term financing.

Yet Nextel still has a long way to go, says Saleh, who would prefer to put more of the $3 billion or so in cash that it has on its balance sheet to work on new initiatives. “If we were investment grade,” he wistfully observes, “we wouldn’t need to keep so much cash on the balance sheet earning 1 percent in interest.”

In other words, debt remains a drag on the company’s ability to grow. And if that’s true for Nextel, it’s even more true for many others. Which shows what a difference a bear market makes when it comes to managing capital structure.

Ronald Fink is a deputy editor at CFO.

The Best and the Worst
One-year change in expected default frequency
Biggest % decrease Current
EDF
% Change Change, Basis Points
1. Nextel Communications 1.82% -88% -1,273
2. BCE 0.17 -87 -115
3. Tyco International 0.97 -79 -374
4. Caterpillar 0.08 -79 -29
5. Xerox 2.66 -75 -788
6. General Mills 0.02 -72 -47
7. Verizon Communications 0.18 -72 -47
8. Williams 6.33 -68 -1,367
9. Wal-Mart Stores 0.02 -68 -4
10. Entergy 0.16 -66 -31
Biggest % increase Current
EDF
% Change Change, Basis Points
1. Duke Energy
Canda
1.77% 270% 130
2. Delta Air Lines 7.11 221 489
3. TXU 1.46 200 97
4. El Paso 11.62 195 768
5. FirstEnergy 0.75 180 48
6. Progress Energy 0.37 173 23
7. Duke Energy 1.77 108 92
8. Sears, Roebuck 0.84 65 33
9. AMR 10.22 55 361
10. Altria Group 0.15 52 5
Source: Moody’s KMV

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