Capital Crumple Zones

Is it time to think about using your capital structure as a buffer against abnormal events?

Dennis Arriola, finance chief of SunPower, a maker of solar-power components and systems, is the “person who is paranoid at all times,” and ensures the company “has sufficient liquidity balanced by the cost of that liquidity.”

After projecting capital needs, Arriola performs “what-if” analyses, including a scenario in which liquidity in the bank markets dries up. “We recognize that any projections the company puts together are wrong,” he stresses. “The question is, how wrong can we afford to be? I try to look at the bookend of risks we can work with and how to manage around those extremes.”

SunPower did some deleveraging in 2010, paying off $143 million in convertible debentures and $34 million in bank loans. It also deconsolidated $233 million in debt from a joint venture in Malaysia. The company’s debt- to-EBITDA (earnings before interest, taxes, depreciation, and amortization) has dropped significantly, and its long-term total-debt-to-capital is within its targeted 25%-to-35% range.

While Arriola doesn’t spend much time on events that are statistical outliers, he does consider their potential consequences in certain contexts. On capital projects such as SunPower’s expansion in the Philippines and Malaysia or its building of solar-power plants, Arriola posits questions like, “What happens if we don’t get the permits we need and we’re extended? How much can I fund from my balance sheet?”

How Much Leverage?

Many companies maintain debt ratios consistent with a target financial rating. By running less-leveraged they have greater flexibility, in essence creating what might be called a “crumple zone” for large negative events. That can come in handy when the company runs the risk of, say, missing an interest payment, but it can be economically costly as well. “What’s the right earnings-per-share hit in order to support a long-term, save-the-company strategy?” asks Chirico. “What’s the right reduction in return on equity?” The answer will be different for every company.

Companies that don’t want to take such hits from using less debt can pursue longer maturities, less bank debt, or roomier covenants (for a price). Considering leverage in light of other finance risks is another way to get comfortable with higher amounts of debt.

Terremark Worldwide, a cloud computing and hosting provider, has a healthy debt-to-EBITDA ratio of 7.0. The $320 million company tapped the bond markets twice in 2010, but CFO Jose Segrera says he’s very careful about leveraging up the B-minus-rated company. He doesn’t pursue incremental capital without knowing where the cash flow to support the additional indebtedness will come from. But because revenue is growing almost 20% a year and cash flows are annuitylike, “our visibility and comfort with the cash stream is very high,” he says, even in prospective downside scenarios. “We’re not working to sell more every quarter.” Segrera also incorporates the creditworthiness of Terremark’s customers into his risk monitoring.

In a shock-free world, debt may be a wise strategy, but McKinsey’s Koller says that most companies — especially large ones — should have investment-grade balance sheets because the tax advantages of debt are small.


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