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.

Unless you’re willing to bet that stock prices bear little or no relation to corporate financial strength, you’re wise to take the recent improvement in the capital markets with a large grain of salt. In fact, a new study shows that major issuers of corporate debt have not shored up their balance sheets as much as is widely believed.

To be sure, other signs suggest that corporate creditworthiness has improved dramatically in the past year or so. The gap between yields on investment-grade corporate bonds and those on Treasury securities has narrowed since the beginning of 2003 from 181 basis points to 111, according to Lehman Brothers. Spreads on derivatives known as credit-default swaps have also shrunk, recently hitting a 17-month low, according to one model. And while more than three times as many nonfinancial U.S. companies have seen their credit ratings downgraded as upgraded by Standard & Poor’s this year, the rating firms rating agencies are purposely slow to revise their opinions.

Wall Street, in short, is clearly more sanguine about companies’ ability to pay their debts—which is welcome news to finance executives who have seen a fall in their companies’ stock prices call into question the virtues of financial leverage. “During good times, leverage really helps the equity holders,” observes Paul Saleh, CFO of Nextel Communications Inc., the Reston, Virginia-based wireless-service provider. “But during down times, leverage becomes a limiting factor in the ability of the stock price to advance.”

Yet investors might not be so optimistic if they took a closer look at credit trends. The reason corporate creditworthiness has improved is not that companies have made great strides in paying down or refinancing their debt. That conclusion is based on a study for CFO magazine of the 100 largest North American issuers of debt by credit research firm Moody’s KMV (MKMV), a subsidiary of Moody’s Corp.

Instead, the improvement in credit quality reflects higher stock prices and lower asset volatility, the study indicates. How so? Simply put, corporate leverage is determined by trends in the value of both equity and debt. If stock prices rise, as they have since the equity market hit bottom in October 2002, such ratios as debt to equity and debt to total capital will naturally fall.

In fact, while the median market value of the top 100 issuers’ assets rose 16 percent during the past six months, and their volatility fell by about 11 percent, the amount of the issuers’ short-term liabilities fell only 5 percent during that period, while their long-term liabilities rose by 7 percent. Clearly, companies’ likelihood of default has not been reduced much by efforts to lighten their debt burden.

That fact becomes even clearer when trends are examined over three years for the top 95 issuers. (Data for 5 of the top 100 issuers did not extend back to the beginning of the three-year study period.) Without the tailwind of rising stock prices helping to boost asset values and reduce their volatility, the median issuer’s chances of defaulting within a year are up almost 30 percent during the past three years, says MKMV. The median issuer’s asset values rose less than 1 percent during that period, while its short-term liabilities rose slightly and its long-term obligations soared by almost half.

The upshot: if stock prices don’t maintain their recent momentum—a distinct possibility in light of persistently weak economic conditions—many if not most debt-laden companies could soon be back where they started not long after the market bubble burst, with investors seriously worried about their balance sheets.

Analyzing Default Risk

The MKMV study uses a proprietary methodology to analyze a company’s likelihood of defaulting, which it expresses as its trademarked Moody’s KMV Expected Default Frequency (EDF). The firm counts some 80 of the world’s 100 largest banks as its clients, and almost all of them use the methodology to make decisions on loans and to manage risk, says MKMV president Doug Woodham. (See “Explaining EDF,” at the end of this article, for a detailed explanation of MKMV’s methodology.)

Because trends in supply and trading volumes can influence spreads on bonds and credit derivatives, and because ratings change so slowly, MKMV’s methodology is a more accurate measure of short-term changes in credit quality, claims Woodham. It has “higher accuracy in terms of predicting default,” he says, and therefore serves banks well as “an early warning system.” (One reason for that may be that the methodology takes into account any off-balance-sheet debt, as efforts to move assets and liabilities off the balance sheet reduce the value of what remains.)

What’s more, says Woodham, a number of banks are using the methodology to help determine whether they’re earning enough on corporate credit, and using that to figure out how much more fee income they may need from providing other services to a company to make the relationship worthwhile. The methodology is also being used by an increasing number of institutional investors, he adds. Given that, MKMV’s most recent findings suggest that the cost of capital supplied by banks and the public debt markets for many large issuers of debt may be higher than credit ratings alone may lead their finance executives to expect.

The study does confirm the impression that corporate credit quality is improving—though, again, the main reason is rising stock prices, not falling debt. MKMV found that the likelihood that companies will default on their debt obligations within a year or so has fallen dramatically during the past 12 months, and especially the past 6 (see “Trend Spotting” at the end of this article).

Lightening the Load

Issuing public debt, however, is only one of the circumstances that make private companies subject to Sarbox. Those attempting to merge with public companies, of course, must prepare to comply. And, increasingly, lenders and investment bankers are using the act’s provisions as a due-diligence gold standard.

Of course, the study also shows wide variations in the data among individual companies (see “Explaining EDF” at the end of this article). And that reflects different approaches to balance- sheet management, as interviews with top finance executives at some of these firms illustrate.

Companies like Nextel, Verizon Communications Inc., and Xerox Corp., for instance, have done much to reduce their short- or long-term liabilities, or both. To one degree or another, they’ve cut spending and shed noncore assets, using the cash to pay down debt, exchange it for equity, or both. Where possible, they’ve also refinanced debt—terming out short-term obligations, or substituting cheaper short-term debt for long-term—to improve their interest coverage. But that’s easier said than done, which helps explain why other companies still labor under heavier obligations than they might want.

Consider Nextel. Like other telecom companies, it faced a sharp loss of investor confidence after the Internet bubble burst. And that’s evident in its EDF Credit Measure, which has more than doubled during the past three years, from 0.81 percent to 1.82 percent, despite a 6 percent decrease in asset volatility, according to the MKMV study. What’s driven the rise in EDF? A soaring increase in market leverage, a measure based on both the market value of a company’s assets and on what MKMV calls its “default point,” the point below which a company’s asset value must fall before MKMV’s historical database suggests it’s likely to default on its debt. In fact, while Nextel’s stock price fell to as little as $2 a share (against $20 today), its liabilities were growing, and as a consequence MKMV says Nextel’s default point peaked in 2001.

Since then, however, the company has taken a sharp turn in its capital structure, paying down some $5 billion in debt. Meanwhile, Nextel’s market cap has grown from $7.5 billion to $19.5 billion. All this has reduced its default point some 16 percent during the past year and contributed to its overall decline in market leverage of 49 percent. As a result, Nextel’s EDF has shown the most dramatic decrease of all 100 issuers during the past year, falling some 88 percent from more than 14 percent at the end of the second year of the study. “We spent a lot of time figuring it out,” says Saleh, who left his position as CFO of Walt Disney International to become CFO of Nextel in September 2001.

Verizon, in contrast, has had an easier time. The MKMV study finds that the telco’s EDF fell by 26 percent during the past three years, from 0.25 percent to 0.18 percent. But like Nextel’s, most of Verizon’s improvement has come during the past year, when this measure of default probability plummeted by 72 percent from a three-year peak of 0.80 percent in 2002. Also like Nextel, Verizon has been busy paying down debt. Net debt (total liabilities minus cash and cash equivalents) has been reduced by some $15 billion, from $63.4 billion at the end of 2001 to $48.1 billion at the end of second-quarter 2003. Most of that reduction reflects debt repayment from cash generated by reduced capital expenditures; sales of nonstrategic assets, including stakes in international subsidiaries; and productivity gains and other operational efficiencies.

While Verizon CFO Doreen Toben, who was appointed to the position in April 2002, says that the company “never had a liquidity issue” and has had “no access-to-capital problems at all,” she says pressure from the rating agencies in the wake of the meltdowns of Enron and WorldCom made it impossible for Verizon to avoid efforts to improve its balance sheet. The pressure has since eased, but Toben says the agencies “are still very nervous”—and not just about the telecom industry.

Similarly, Xerox’s EDF has fallen some 8 percent during the past three years, from 2.9 percent to 2.7 percent, but not before soaring to more than 15 percent at one point. The 75 percent decline in its EDF during the past 12 months largely reflects a $3.6 billion recapitalization last June. The recap included offerings of common stock, convertible preferred stock, and 7 and 10-year senior unsecured notes, as well as a new $1 billion credit facility. Xerox used the proceeds from the offering and the credit facility, as well as a portion of its current cash balance, to terminate $3.1 billion in outstanding obligations under its existing bank facility.

Survivors

For some companies, overhauling the balance sheet has been a matter of survival. Look, for instance, at The Williams Cos., whose 68 percent reduction in EDF last year also landed it in the top 10 among those showing the biggest one-year gains. The Tulsa gas-pipeline and-production company faced a severe liquidity crunch following the loss of its energy-trading business some two years ago, and that, coupled with a credit-rating downgrade from BBB- to B-, required a $900 million “rescue loan” last year from Berkshire Hathaway and Lehman Brothers. No wonder Williams’s EDF reached 20 percent in August 2002, placing it among the 12 companies most likely to default, according to MKMV.

But thanks to $3 billion in sales of noncore assets this year, Williams increased its cash position to $3.2 billion at the end of the second quarter of 2003 from $1.7 billion at the end of 2002, and reduced its debt by almost $1 billion. Its default point, to be sure, rose 5 percent during the past 12 months, but the increase was much smaller than during the two previous years (the rise in its default point for the entire period was 61 percent).

Meanwhile, Williams’s market leverage and asset volatility have decreased in the past year. As a result, notes company spokesperson Kelly Swan, “the capital markets reopened to us this spring,” allowing Williams to redeem enough preferred stock to save $17 million a year in aftertax financing costs and help move the company toward its goal of investment-grade credit ratios by the end of 2005.

Other companies have seen their EDFs remain stubbornly high despite dramatic efforts at capital restructuring. Take Sears, Roebuck & Co. Although it decided earlier this year to sell off its credit-card portfolio and return to its roots as a retailer, Sears’s EDF rose some 65 percent during the 12 months that ended last August 31, from 0.51 percent to 0.84 percent. That put the company in the same league in terms of percentage change (but not basis-points change) as troubled energy concerns like Duke Energy, El Paso Corp., and FirstEnergy. On the other hand, Sears’s three-year numbers look better. And, of course, its EDF remains much lower than that of many struggling energy companies or, for that matter, Delta Air Lines, which saw its EDF soar more than 220 percent in the past year, to about 7 percent.

Tarred and Tethered

Delta is mired in an industry deeply out of investors’ favor, and indeed, all four airlines among the top debt issuers fall in the bottom 20 of MKMV’s EDF ranking. Telecom and energy are also overrepresented at the bottom; the latter industry includes Duke Energy Canada, which had the highest percentage increase in EDF during the past year, and El Paso, which had the highest basis-point increase (see “The Best and the Worst,” at the end of this article).

A company inside a poor-performing industry may find itself trapped, even if it shows an improvement in creditworthiness. One such company is TXU Energy, which saw its EDF more than double during the past three years, while its asset value declined 21 percent. While TXU has reversed that trend in the past six months, its overall EDF remains much higher than it was three years ago. TXU was in large part a victim of the terrible environment for energy companies, with its asset volatility rising some 31 percent during the period.

Short of exiting one industry for another, in fact, there isn’t much a company can do about asset volatility, as MKMV’s measure primarily reflects investor perceptions of an industry. In TXU’s case, a rise in asset volatility plus a decline in the market value of its assets more than offset an improvement in its default point, raising near-term liquidity concerns in late 2002. In response, the company has raised some $1.25 billion in debt securities, cut its dividend, terminated expansion into nonregulated markets, and cut costs. That has enabled the company to build cash and pay down some $2.3 billion in bank debt this year.

“We recognized that we had a challenge on our hands,” notes CFO Dan Farell. He concedes that TXU’s efforts to shore up its balance sheet won’t be complete for another year or so.

Of course, capital restructuring is never easy, if only because the old saw about credit being available only when you don’t need it happens to be true. As Williams found, it wasn’t until a few brave souls stepped forward with new financing that the company was able to get more from others, including the public.

In some cases, the challenge amounts to turning around a battleship in rough seas. That’s the case at General Electric Co., whose huge amounts of commercial-paper issuance were the subject of intense concern among some large bondholders in the wake of Enron’s meltdown in early 2002. But GE had already begun terming out large chunks of commercial paper, trading the shorter-term liabilities for long-term—a move that a spokesperson describes as a concerted effort to adopt “a more balanced debt portfolio.”

At this point, the results of the effort are mixed. While lengthening the maturity of the liabilities postpones the amount of principal due nearer term, GE’s EDF has risen by more than 1,300 percent (a 38 basis-points change) during the past three years, ranking it 84th among the top debt issuers in overall improvement during that period. And that result came despite a small decline in asset volatility. The culprit was a huge spike in market leverage, and the cause of that was GE’s default point, reflecting for the most part the company’s liability structure. This measure rose almost 49 percent during the period, while the market value of its assets fell by 17 percent.

Granted, those numbers have improved during the past six months, with GE’s default point rising only 5 percent during the period and its asset value improving by a robust 12 percent, thanks to a rebound in its stock price. But for the full year, GE still trails most companies in terms of improved creditworthiness. Its 17 percent decline in EDF during the period ranked it 66th among the top 100 debt issuers.

With some 40 percent of its profits coming from financial services, GE is inherently dependent on leverage—and equity investors realize that. The auto companies find themselves in a similar position, with huge financial subsidiaries no less critical to their strategy.

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
Trend Spotting
Median changes for top 100 debt issuers as of August 31, 2003.
Current Period Versus 6 months ago 1 year ago 3 years ago*
EDF Change
(Basis Points)
-22.58 -11.26 8.59
EDF Change (%) -37.43% -22.97% 29.47%
Asset Volatility
Change (%)
-10.68% -14.60% -18.07%
Market Leverage
Change (%)
-9.03% -6.82% 25.88%
Market Asset
Value Change (%)
16.13% 2.92% 0.81%
Default Point
Change (%)
7.36% 8.23% 45.05%
Short-Term
Liabilities Change (%)
-5.08% -6.53% 0.25%
Long-Term
Liabilities Change (%)
7.07% 12.34% 46.41%
*Five issuers did not have data for the three-year study period.
Source: Moody’s KMV

Explaining EDF
How Moody’s KMV calculates credit risk.

Moody’s KMV expected default frequency is a measure of the probability that a company will default, or fail to make scheduled principal or interest payments, over a specified period of time—typically one year. According to MKMV’s model, a company defaults when the market value of its assets falls below its liabilities payable (the default point). Here is a closer look at the three key values that determine a company’s EDF.

  1. Current market value of the company (the market value of its assets). This measure reflects the market’s view of the enterprise value of the company, as determined by its equity value, equity volatility, and liability structure. Because the market value of assets is not directly observable, MKMV computes this value using a proprietary model, which treats the company’s equity value as a call option on its underlying assets. This approach enables MKMV to determine a company’s market value from the market characteristics of its equity value and the book value of its liabilities.
  2. The level of the company’s obligations (default point). This is the level of the market value of a company’s assets, below which the company would fail to make scheduled debt payments. The default point is company-specific and is a function of the company’s liability structure. It is estimated based on empirical research by MKMV and reflects the observation of thousands of defaulting companies since 1974, and how each company’s default point acted in relation to the market value of its assets at the time.
  3. The vulnerability of the market value to large changes (asset volatility). This is a measure of the business risk of the company—technically, the standard deviation of the annual percentage change in the market value of the company’s assets. The higher the asset volatility, the less certain investors are about the market value of the company, and the more likely the company’s value will fall below its default point.

See America’s top debt issuers ranked by Moody KMV’s Expected Default Frequency

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