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| General Motors announced it will borrow under its $15 billion in bank revolving-credit arrangements |
What impact will an economic and business downturn have on the ability of companies to manage debt on the balance sheet, both short- and long-term?
Few companies, if any, projected what we are experiencing today. Most companies go through exercises to project worst-case scenarios and recessionary environments. Most companies expect businesses and the economy to ease into a downturn. Few companies expect a downturn to appear from nowhere and have immediate impact on revenues, earnings and cash flows.
For COVID-19, regulators and lawmakers stepped immediately. In the U.S., the new CARES Act is supposed to present short-term relief by providing funding to companies in designated industries and companies of a certain size (if they request it).
For the most part, companies are on their own to manage the months to come.
As the previous financial crisis (2008-09) receded into history, a growing global economy helped companies improve revenues and earnings until 2019. Part of this growth is attributed to central-bank-sponsored low interest rates from the late 2010s until today. Low interest rates, during those years, encouraged big companies to finance investments and capital expenditures via long-term debt. Low interest rates also encouraged companies to reengineer their balance sheets by using some of the new debt to fund rewards (dividends and share buybacks) to shareholders.
By late 2019 before the current crisis, large companies all over (and the investors, analysts and rating agencies who observe their financial performance) had become tolerant of excess amounts of term debt. Stable, predictable earnings could manage these highly leveraged balance sheets. Excess balance-sheet cash could get companies through occasional, but sufferable downturns.
Some companies had begun to reduce debt in 2019 after an upturn in interest rates in late 2018. Yet corporate balance sheets continued to be highly leveraged by most standards when the calendar turned to 2020.
High leverage is measured often by Debt/Equity and Debt/Ebitda metrics. Analysts may use other metrics: Debt/Total Capital, Debt/Operating-Cash-Flow, Net-Debt/Ebitda, Total Liabilities/Equity, Debt-Service-Coverage Ratio, etc. It is also measured by companies' trends in long-term debt outstanding. Many companies more than doubled long-term debt in the past decade.
Tesla, for example, has $12 billion in debt (Debt/Equity=5). Companies like Merck, Coca-Cola and PepsiCo report debt obligations each above $20 billion. Companies in vulnerable industries like J.C. Penney and Goodyear must manage debt of about $4-5 billion, as they proceed through precarious times. Debt at Netflix, now at $15 billion, increased $13 billion in just five years.
The New York Times reports aggregate U.S. corporate debt totals about $6 trillion. Not all is due in 2020, but companies must at least generate cash to pay interest and current portions this year. (About $178 billion is due this year. In "good" years, much of that can be refinanced.)
Lenders include banks, syndicated arrangements among banks, bond investors, and the growing number of non-bank lenders (hedge funds, ETFs, insurance companies, and CLOs).
Companies in some industries are more vulnerable than others. They are not hard to find, and they have already been prominently identified: transportation (airlines included), hospitality and travel, energy, etc. Revenues are declining swiftly. Healthy earnings will become losses within the next quarter or so.
All companies seek to meet obligations (principal and interest) from operating cash flows. Investment-grade companies often manage principal obligations by refinancing them when due, because they can. When operating cash flows decline or disappear and become deficits, companies must retrieve Plan B, tapping other sources like cash stockpiled on the balance sheets, proceeds from selling off non-strategic businesses and other assets. Some will hope their lenders can agree to a restructuring of debt (by extending tenor, reducing rates, or altering amortization schedules).
(When it endured a down period a few years ago, the mining company Freeport McMoRan managed to reduce long-term debt by selling assets and investments, generating about $2-3 billion in cash.)
In the U.S. in anticipation of a prolonged downturn, the Federal Government's CARES Act attempts to help small and large businesses and will provide funding, investments and guarantees to companies in identified segments and industries. Such support will come with restrictions (including caps on compensation to executives and prohibitions on dividend and buyback payments), restrictions that airlines, hotels and other affected industries can bear until business improves.
In the months to come, where are corporate borrowers vulnerable? How could they have prepared for unforeseen, worst-case scenarios? What companies will thrive? What companies will risk default, bankruptcy or non-existence?
Debt analysts and ratings agencies have already begun to track deterioration. Moody's predicts default rates for non-investment-grade issues will top 10% by the end of 2020 (vs. 13% in 2009). Even before the current crisis, S&P had already begun to downgrade a larger-than-usual number of corporate names.
As expected, investors have observed "credit spreads" on traded corporate bonds increased sharply the past month. Higher credit spreads imply investors expect a higher probability of default (and higher expectations that investors should be rewarded for the risks they are taking on).
Earnings and Cash Flows
Few companies will be insulated. (Yes, some are reported to be thriving and are experiencing immediate upturns in performance--Zoom, Walmart, et.al.) A drastic decline in the U.S. and global economy will have impact on revenues. Companies with high-fixed-cost structures, low operating margins, and without the ability to reduce variable costs quickly will begin to report earnings (and deficit cash flows).
Companies with diverse business lines and industry sectors may survive better. Companies operating in "consumer discretionary" segments will see immediate decline in performance.
Companies with substantial amounts of cash on the balance sheet will be able to endure and continue to operate until the new year, as they meet expenses and other obligations.
Many large companies benefitted from tax reductions in 2017-18, which boosted earnings and helped to contribute to stockpiles of cash on many balance sheets. Tesla above, despite erratic performance over the years, has $6.2 billion in cash; Twitter has $6.3 billion in cash and a modest amount of debt ($2.5 billion). PepsiCo reports over $10 billion in cash. Some of the cash companies report is earmarked or pledged (for capital projects or specific creditors). Some of the cash exists in overseas subsidiaries or in regulated industries.
Synopsys, a Silicon Valley-based technology company that has long avoided debt, has over $700 million in cash with less than $120 million in debt. It has long-term contracts with clients to ensure revenues will not sink suddenly.
Netflix has over $5 billion in balance-sheet cash, much of that likely already earmarked for new content development. (Monthly subscription payments arrive at Netflix routinely, generating new cash. Much of that, however, must be used to manage its existing $15 billion debt.)
Other companies are cash-strapped. Lackluster performance has not contributed sufficient cash flows to keep cash on hand. J.C.Penney has a string of operating losses the past eight years. That's not a surprise, given its retail-industry business models. It struggles with less than $500 million cash (and $4 billion in debt) and few signs its $12 billion annual revenues will turn upward again.
Liquidity and Working Capital Management
An examination of cash on hand for corporates leads to an assessment of overall liquidity. Companies plan for long-term growth, but they also plan for next week, next month and next quarter to meet current obligations. An assessment of liquidity requires an examination of the company's working-capital needs and operating cycle, or what others call "cash-conversion cycle" or "asset-conversion cycle."
Liquidity includes cash; it also includes access to cash from committed bank funding. And it must account for other assets and funding sources that can convert to cash quickly. Financial institutions are governed by regulation to ensure they are always sufficiently liquid. Corporate borrowers rely on discipline and shrewd financial management to ensure they are liquid and operations are performing smoothly. (They may also be held in check by the banks that provide ongoing funding and may require borrowers to meet liquidity benchmarks.)
Beyond the cash on the balance sheet, most companies will have bank credit lines they use to gain liquidity or to meet current obligations. Many will have already arranged committed revolving-credit facilities from banks (including bank syndications). The largest companies rely on cheaper commercial-paper funding, but will still have "back-up" revolving-credit lines from banks.
(History suggests if a ratings-agency downgrades commercial paper, short-term investors will disappear quickly. Companies prepare for this scenario by routinely arranging back-up facilities for a certain percentage of CP outstandings.)
In the early days of this crisis, CFOs and corporate treasurers quickly drew down on "revolvers"
(a) to ensure they had cash reserves if and when other cash flows and funding sources disappear and
(b) to ensure they can borrow today when they may not be able to do in quarters to come (especially if a breach in "financial covenants" prohibits them from borrowing or if a bank is unable to fund commitments reliably).
(In extreme stress, some banks may look for both covenant breaches and legal loopholes to avoid providing funds to a rapidly deteriorating borrower.)
An airline today might still be eligible to draw down on a bank line this week, but could be ineligible when it reports first-quarter earnings in a few weeks. Banks could expect to see some large companies, which never bothered to use their credit lines and arranged them only as "dry powder," borrow in billions this month, if they haven't done so already.
By the end of March, General Motors had planned to draw down on its $15 billion revolver. Macy's, struggling for years with its increasingly antiquated retail model, drew down its $1.5 billion line. McDonald's announced it will borrow $1 billion under arrangements.
(It is not unusual for the largest companies to have revolving facilities totaling $5-10 billion with arrangements in the U.S. and in other countries/currencies and with availability often at the parent company, which uses the funds at its discretion within the company's global structure.)
Companies must also watch for unusual delinquencies and defaults on accounts receivable, an asset item many presume is a cash-equivalent. For example, a company with receivables normally collected within 45-60 days might observe longer periods to collect the cash (60-90 days). Higher-than-normal delinquents and defaults reduce liquidity.
With declining amounts of business activity, inventory may not turn over as quickly or may take longer periods before sale (and eventual conversion to cash). A company in a vulnerable industry, for example, might have observed inventory being sold within 45-60 days now requiring over 90 days to be turned over.
Delinquent receivables and longer "days on hand" for inventory (longer periods before sale) also require longer periods of working-capital funding. Inventory that resides on the balance sheet too long require longer periods of short-term funding (and higher interest expenses).
Companies must also detect problems or challenges on the supply side: Have suppliers become concerned about their customers and begun to alter terms for payment (putting pressure on companies to meet accounts payables more quickly)? Are suppliers themselves experiencing problems in delivering raw materials or inventory? Are they, too, hampered by liquidity issues or inability to maintain funding to support their own balance sheets?
Companies that manage efficiently operations, working capital, working capital funding, and the cash-conversion cycle and understand the risks of each step in the operating process are the ones best-equipped to manage costs and cash flows through difficult periods.
Unfortunately some banks will choose to walk away, having concluded the risks of continuing to provide short-term funding for companies in decline are too much to bear. Companies often will have planned for such contingencies and often will have lined up enough banks, such that if one or more disappear, there will still be a core of supporting banks.
Fixed Assets, Planned Investments
Companies often start a year with lists of planned investments and projects, which result in planned capital expenditures. From year to year, companies must invest in plant, property, and equipment to maintain or restore the fixed assets that anchor business operations. Fixed assets deteriorate (and depreciate in value). They will also have determined the projected revenues and returns from those expenditure/investments and the manner in which they will fund them.
Companies make capital expenditures and investments for various reasons, besides maintenance and restoration.
They also invest in
(a) operating efficiencies and technology that result in improved business processes and lower operating costs and
(b) business growth and expansion that lead to growth in revenues, earnings, and eventually "enterprise value" (or the market value of the business).
In an economic decline or emergency scenario, they will focus on current operations and efficiencies. Plans for long-term expansion and growth might be tabled for now, and certain projects may be postponed, new investments deferred.
Capital expenditures, therefore, won't disappear; they must be rationalized and purposeful.
Funding Sources: Long-Term-Debt
The same investments and capital expenditures described above require funding. Companies will have already adopted a funding strategy for 2020 for these purposes:
(a) Operating cash flows,
(b) debt,
(c) equity, or
(d) combinations of debt and equity.
In a stress environment, operating cash flows may dwindle or cash will be reserved for funding short-term operations if the business generates losses.
Too much uncertainty will limit access to equity markets--public and private. Debt markets may be available, if transactions are structured to reduce risks for banks and investors. This might entail higher credit spreads, more collateral pledged, and tougher financial covenants.
In the U.S., as mentioned above, anticipating the needs of corporates, the Federal Government (via the CARES Act and other legislation that could follow) has stepped up with plans and ideas. From day to day, the Federal Reserve explores how best to fund businesses (big and small) directly or indirectly.
Because companies have begun to use revolving credits at higher levels than normal, bank loans will have increased in the first quarter, 2020. But they will increase up to a certain point. Regulatory oversight and specific rules will increase bank capital required to support increased loan portfolios. Bank risk managers will also set bank-wide limits on total credit exposure--by industry, by country, by currency. (Accounting requirements related to increased loan-loss-reserves ("CECL") come into effect in 2020 and may discourage banks from increasing long portfolios, too.)
Some banks have already urged clients to consider other debt markets, notably public debt markets.
Companies with declining cash flows are at risk. The same companies with sturdy balance sheets, longer tenors on debt obligations, and minimal amounts of scheduled payments (refinancing risks), sheets within the next five years can buy time.
How long, nonetheless, will public debt markets remain accessible to large corporates? At what point will investors avoid corporate issuers, even if issuers promise higher yields to compensate for growing risks? One of the first signs of trouble in the mid-2000s was when in mid-late 2007 some corporate issuers had difficulty rolling over commercial paper (short-term debt) and difficulty proceeding with plans to sell bonds to the public (long-term debt).
Debt markets can shut down, at least temporarily. Will companies, therefore, rush to issue new debt this spring while they can? Will issuers need to provide enticements--higher yields, warrants, convertibility, better pricing and terms once the environment improves?
Debt markets can be divided in many ways:
(a) short-term vs. long-term,
(b) public vs. private,
(c) investment-grade vs. non-investment grade,
(d) U.S. issues vs. Non-U.S. issues,
(e) amortizations vs. balloon payments,
(f) secured vs. unsecured, and
(g) senior vs. subordinated
Issuers will consider whether a new debt offering (a) refinances old debt or (b) increases total debt outstanding on the balance sheet.
Companies, advised by CFOs and investment banks, will decide when to issue, how much, and on what terms. In the current environment, they will need to structure issues to get lenders and investors comfortable with pricing and risk mitigation. In the best of times in negotiating terms, corporate borrowers (particularly investment-grade issuers) have advantages in negotiations and gain lower pricing, lower fees, and the best of terms ("covenant lite" transactions, e.g.).
In deteriorating scenarios, lenders and investors will have an edge and will look for protection and ways to reduce risks: better collateral, stronger liens, longer lists of financial covenants, higher pricing, senior ranking and positions, intercreditor agreements, etc. Credit spreads have increased substantially in recent weeks--especially in non-investment-grade markets. BBB-rated issues are approaching 500-bp spreads; B-rated issues approaching 1,000-bp spreads.
In the months to come, debt markets may not shut down entirely as much as banks and investors will influence terms in ways they have lost advantages in recent years.
Financial covenants, which benchmark expected performance, may increase in number, permitting revolving-credit banks a legal excuse to rescind funding commitments if borrowers slide rapidly toward insolvency. The wave of "covenant lite" deals should ebb.
Capital Structure
Will companies suffer for having reengineered capital structures in the late 2010s, where they reduced equity (via share buybacks) and took on larger debt burdens--to take advantage of low interest rates and because they (and the marketplace) were confident they could generate stable cash flows indefinitely? Reengineered balance sheets also helped boost stock values, as earnings per share and returns on capital increased.
In 2020, well-capitalized balance sheets will relieve companies of pressure to generate steady streams of cash flow to pay principal and interest on large amounts of debt. A company can always choose not to reduce or not pay out dividends. It can always cancel share buyback programs. A failure to pay principal and interest on debt and the collective unwillingness of debt-holders to restructure obligations could lead to insolvency or bankruptcy.
The balance sheets of the 2010s were crafted based on optimistic, continuing streams of operating cash flow--and low interest rates. Not all companies piled on debt, paid high dividends, and bought back stock. Some operated consistently on a hunch the worst case was always one quarter away.
For companies with substantial debt, are there ways they can repair unstable balance sheets and brace themselves for stress?
Issuing new equity is a solution, but an impractical one--whether in private or public markets today. There still may exist a private-equity fund willing to buy a large stake in a company whose market values are unfairly or excessively under-valued, a company that will thrive when signs point to an economic upturn.
Companies will consider working with commercial and investment banks to extend debt maturities and provide banks and investors comfort with collateral and opportunities to gain rewards on an upside (convertibility, warrants).
In the months to come, expect companies and their banks (including commercial and investment banks) to be in constant dialogue. (Some boutique investment banks (Lazard, e.g.) have experienced restructuring units.) Many banks and their risk management squads have vast amounts of experience in crises. Banks know, too, that corporate managers remember and later reward the banks that shepherded them through tough periods.
Rating Agencies
Rating agencies (S&P, Moody's and Fitch) have begun to issue negative outlooks. They had begun to increase downgrades earlier in the year. Downgrades were outpacing upgrades.
After the debacle of the crisis in 2008-09 and regulators' perception of the their contributions to that crisis, ratings agencies are poised to be better prepared this time. Regulatory activities are supervised by the SEC in the U.S. For a few years after the last crisis, regulators and financial-services industry mulled over the role, responsibilities and compensation methodology of rating agencies.
In this crisis, rating agencies won't adjust and revise ratings (name by name) irrationally or inexplicably. Or too rapidly. Wise, attuned investors know credit spreads (and yields) increase far more swiftly than ratings agencies elect to downgrade.
An A-rated borrower's credit spreads on bond issues will change the same day the market digests more bad news about the company. The rating-agency downgrade requires a more deliberate, objective process, but a process that likely will occur more rapidly and carefully than years ago.
Vulnerable Industries
Banks and debt and equity investors quickly began to identify the industry pockets of risks around the globe. Equity investors respond, of course, from day to day. Bond and derivatives traders respond similarly with higher yields and credit spreads in bond issues and credit-default-swaps pricing. Traders also respond by declining to step up to make markets in certain products. Liquidity evaporates, signaling concern and uncertainty.
In the assessment of corporate industries, survivors and "thrivers" are on one list. (In March, companies like Zoom and Clorox appeared to be candidates to survive in the months to come.) Vulnerables and Red Flags are on another list.
Corporate industries most vulnerable (on many lists by bank analysts, equity analysts, and ratings agencies) include "consumer discretionary" industries (hotel, restaurant, airlines, in-person entertainment, and travel). Other vulnerable industries include oil-and-gas, automotive, auto supply, banks and insurance.
Industries less vulnerable include utilities, household products, software, healthcare technology, food and staples, wireless telecommunications, and biotechnology. The good news is this list is not too short.
Vulnerable industries will include companies that may experience red flags and problems described above. Well-capitalized, efficiently operated, and cash-rich companies in these industries will have the best chances of enduring tougher periods.
Collateralized Loan Obligations (CLOs)
One market segment worth casting an eye on is CLOs, which issue tranches of rated debt securities, the proceeds for which are used to purchase bank loans. This special securitization structure has permitted non-bank financial institutions to participate in loan markets, giving them opportunities to buy secured corporate debt and buy it in baskets.
They buy tranches of debt backed by a pool of bank loans. A typical feature is the basket includes almost entirely collateralized BB-rated loans, which pay higher interest rates. Nonetheless, in 2020, this a vulnerable segment with high probabilities of default in stable environments and even higher in stress scenarios. There is always the likelihood that BB-rated companies slip toward CCC ratings or "jump to default."
CLOs are structured by asset managers working with ratings agencies. The current scenario will likely put their structuring models to test. The structures benefit from loans being senior in ranking and being collateralized. CLO senior-tranche debt can be rated AAA, because of excess collateral assigned to that exposure and because of an adequate amount of "residual" or equity capital beneath it. The models, which have been updated to incorporate lessons learned from 2008-09, include stress tests that should have incorporated a 2020 scenario. The model determines the amount of "residual equity" cushion and is based on worst-case scenarios.
If the CLO market perceives BB-rated loans will deteriorate and default at higher levels than projected, then watch for CLO debt to decline in value, CLO debt to become more illiquid and harder to sell, and AAA-rated CLO securities to be downgraded.
Tracy Williams
See also:
CFN: The Burden of Corporate Debt, 2015
CFN: Netflix and Its Mounting Debt Burden, 2018
CFN: Banking 101: Corporate Borrowers, 2020
CFN: Updating Financial Models, 2015
CFN: Apple With All That Cash, 2013
CFN: What About Corporate Banking? 2010
CFN: Big Company Woes: GE, Sears and Tesla, 2018
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