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  • CFO Europe Magazine

Credit Check

New research diagnoses the health of Europe's corporate balance sheets.

Read the rankings of Europe’s 100 largest debt issuers by Moody’s KMV.

Wolfgang Reithofer was exasperated. When presenting a stellar set of 2007 results, the CEO of Wienerberger, a €2.5 billion Austrian building materials group, lamented how the firm’s share price had “disconnected” from its financial performance.

Over the course of the year, Wienerberger’s operating earnings grew by 17% but its share price fell almost as much. As shares continued to slide in the first half of this year, despite the company’s guidance for market-beating 10% earnings growth, Reithofer and his colleagues took every opportunity to point out that share price performance “in no way reflected the strength of the company,” as the chief executive put it in his annual letter to shareholders.

New research shows that many companies could make a similar case. Moody’s KMV (MKMV), a credit research company owned by Moody’s Analytics, crunched the numbers of Europe’s largest 100 non-financial debt issuers for CFO Europe and found that the median company’s probability of default is no higher than it was three years ago. Given the economic gloom, slumping stockmarkets and soaring cost of credit, the findings may seem counterintuitive.

Going for Broke

MKMV, which operates independently from the ratings agency, uses a proprietary methodology to derive its measure of credit quality, expressed as a company’s Expected Default Frequency (EDF) score. These scores, which range from 0.01% to 35%, are calculated using market-based information such as share prices, balance sheets and the history of thousands of defaulting companies. (See “Explaining EDF” at the end of this article for the full methodology.)

“Believe it or not, business conditions relative to three years ago seem to be more stable,” notes Brian Dvorak, managing director for credit strategies at MKMV in San Francisco. “At least, that is what the market is saying about asset volatilities.”

Asset volatility, a key input to EDF scores, is nearly 10% less than three years ago for the median issuer in MKMV’s sample. By itself, a decline in volatility reduces a company’s EDF. But over the past three years, Dvorak notes, a rise in liabilities counterbalanced the fall in volatility. Compared with 2005, short- and long-term liabilities for the median issuer were, respectively, 45% and 22% greater. The net result is an EDF that’s largely unchanged for a typical large, non-financial debt issuer in Europe.

Graham Secker, an analyst at Morgan Stanley, agrees balance sheets for most non-financial firms in Europe are in “reasonable shape,” with aggregate gearing and leverage ratios in the region well below the heights reached going into the post dotcom downturn around 2000.

Nevertheless, few companies are finding it as easy to raise capital now as at any point in the recent past. MKMV tracks a measure it calls the “market Sharpe ratio,” gauging the excess return debt investors require per unit of risk. The spread demanded for a broad basket of corporate bonds in relation to their credit risk — as measured by EDF scores — peaked in March at the widest it has been since the early 1990s.

When Telekom Austria looked into issuing a new bond late last year, it boasted an EDF of only 0.02%. Still, CFO Hans Tschuden found the interest rates on offer unacceptable. Despite the creditworthiness of the €5 billion company, it was “not the best time” to issue a traditional bond, Tschuden says.

His team went away to think of other ways to raise fresh funds. In August the company issued four-year promissory notes, instruments seldom used by Austrian companies but popular in neighbouring Germany. Provided that finance teams look around to find the markets that offer suitable spreads, “raising money is not a problem,” notes Tschuden. He initially wanted to raise €100m, but demand from banks and insurance firms for the notes pushed the final issue to €300m — €200m in a floating-rate tranche that initially pays 6.2% and €100m in a fixed-rate tranche paying 6.08%.

Towards the end of the summer, despite reporting a lower than expected profit for the second quarter of this year, the telco’s shares were buoyed after it confirmed previous guidance for profit and revenue growth, and a stable dividend, for the full year. Jittery markets appreciated the confidence in what Tschuden describes as “realistic and achievable” guidance.

Confidence Game

Logica, a UK-based IT services group, did even better, boosting its guidance for 2008 revenue growth, and reaffirming margin and leverage targets, as it unveiled half-year results last month. Notably, this happened even after the company took on much more debt after a string of acquisitions and devoted half the proceeds of the sale of its telecoms-products division last year to a share buyback, shortly before the credit crunch took hold.

“It’s always easy to look back and say you should have done the share buyback at a different time,” says Seamus Keating, Logica’s CFO. “You do it when you do because you believe it’s the right thing to do. We’re confident in the cash flows of the business.” So are the markets. Over the past three years, Logica’s EDF has fallen by more than 60%.

But in the current environment, confidence can be especially fragile. In July the story Wienerberger was telling the markets shifted abruptly, as the group reported an 8% drop in Ebitda for the first six months of 2008, due to steep declines in mature markets such as Germany and the UK. Now the company expects operating profit to fall by as much as 15% this year, a far cry from the 10% growth predicted only a few months earlier.

Despite the “overflow of information” available to companies, “there was no way that we could have foreseen what is happening today,” says Willy Van Riet, Wienerberger’s CFO. And in an effort to arm the company for sudden downturns such as these, the finance chief notes that nearly €1 billion raised through a rights issue and hybrid bond last year means that it “hasn’t felt the crunch.” Indeed, going into this year, net debt to Ebitda stood at 1x, down from 2.5x at the end of 2006. Van Riet is adamant that the policy for a dividend in line with last year’s amount remains in place.

Wienerberger’s EDF at the end of July was more than double its level in June, and ten times higher than it was three years ago. At around 0.2%, the company’s current EDF implies a credit rating a full grade below its current status (BBB/Baa2), notes Dvorak of MKMV. And though it remains a relatively safe credit, the speed with which its business deteriorated, and the severity with which the markets punished the earnings shortfall, is startling.

Despite the current strength of the average corporate balance sheet, the anxiety captured in historically high credit spreads suggests that investors reckon more companies are heading for trouble. In the UK, David Owen of Dresdner Kleinwort notes that the aggregate ratio of cash and bank deposits to bank lending for non-financial companies fell to “recession levels” in the first half of this year. With companies drawing down deposits while continuing to borrow — deposits tend to build up at the same rate as borrowing in “normal” times — the analyst warns that “companies are running into increasing cash-flow difficulties.”

In July Spanish property group Martinsa-Fadesa defaulted on more than €5 billion of debt, “the first large-cap European leveraged-finance failure in this cycle,” according to Secker of Morgan Stanley. “We suspect there will be more,” he adds.

Jason Karaian is deputy editor at CFO Europe.

Explaining EDF

How Moody’s KMV Calculates Credit Risk

Moody’s KMV Expected Default Frequency (EDF) credit measure is the probability that a company will fail to make scheduled debt payments over a certain period of time, typically one year. EDF scores range from 0.01% (the safest credit) to 35% (the highest measured potential for default). Essentially, these scores represent default information contained in a company’s share price combined with its latest financial statements. A proprietary, market-based measure, EDF scores typically lead traditional ratings agency changes by around 11 months.

According to the EDF model, a company defaults when the market value of its assets falls below its outstanding liabilities due. Each company has its own “default point,” a specific market value below which it would probably fail to make debt payments. These estimates reflect the observation of thousands of defaulting companies over more than 30 years, specifically how each firm’s “default point” behaved in relation to the market value of its assets at the time.

The calculation of the value of a company’s assets reflects the market’s view of the enterprise value of the firm, as determined by its equity value, equity volatility and liability structure. Moody’s KMV treats the company’s equity value as a call option on its underlying assets, allowing it to determine a company’s market value from the market characteristics of its equity value and the book value of its liabilities.

The ratio of a company’s default point to the market value of its assets is its “market leverage.” The vulnerability of market value to large changes (“asset volatility”) is a measure of the business risk of the company — technically, the standard deviation of the annual percentage change in the market value of its assets. The higher the asset volatility, the less certain investors are about the market value of the company, and the more likely its value will fall below its default point.


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