Susan Gordon featured in CFO magazine Rethinking Capital by Vincent Ryan CFO - November 20, 2008 It may be the worst contraction of credit since the Great Depression.  As the mortgage crisis has deepened, banks have been reluctant to lend money to anyone, including each other.  Debt investors have fled to the safest corners of the bond market.  And commercial paper has seized up, reducing a short-term financing option for working capital.  Any capital that is available is, unfortunately, much more expensive.   In this operating environment, CFOs must now wrestle with issues that required much less attention during the last few years:  cost of capital, optimum leverage, debt maturities, even sheer liquidity.  It’s time, in short, for finance chiefs to reassess their companies’ capital structures and manage them more tightly.   The choices won’t be easy.  Pay down debt or build up a rainy-day fund?  Increase leverage to scoop up competitors’ assets at bargain-basement prices or shrink it to preserve an investment-grade credit rating?  Cover the entire financing deficit from operations now or wait three months to see if rates drop?  Continue to rely on commercial paper or seek longer-duration capital with tight covenants?    In some ways it will be like turning back the clock.  “CFOs now have to think about capital in 1950s terms,” says Mark Sunshine, president of factoring company First Capital.  “Everything they’ve learned in the last 10 years about debt will have to be thrown out - that was an overheated market.”     TAPPING REVOLVERS   The credit crisis has already led to a flurry of draw-downs of revolving lines of credit.  Duke Energy, Bally Technologies, Goodyear Tire & Rubber, Caterpillar, and Winnebago Industries were among companies that drew down revolvers (or added new revolvers) in a span of two weeks in September.   “Having the actual cash on had cements a liquidity position, given the risk of nonperformance by bank group,” says Mark Oline, a managing director at Fitch Ratings.   Drawing on revolvers is risky though.  Companies subject themselves to significant interest-rate risk by using short-term debt, points out Susan Gordon, a managing director at Mackinac Partners, a restructuring advisory firm.  In addition, “renewals are very expensive, and banks, if they’re not calling in lines, are lending on 70 percent of receivables instead of 80 percent,” she says.  That means less credit.  Also, higher default rates on receivables means companies have to make up a deficiency in collateral with an upfront cash payment.    For companies that can secure new bank debt, the concessions are substantial.  Lenders are demanding a senior debt position and 100 percent warrant coverage.  “They want a taste of the action if equity improves,” says Karl D’Cunha, a managing director at Houlihan Smith & Co., a Chicago-based investment bank.      A DISCIPLINED APPROACH   Securing capital beyond bank debt is an option, but it requires long-term discipline.  Consider McCormick and Co., the $3 billion consumer food company introduced a plethora of new products in 2008 – salmon seasoning, low-sodium rice, chicken glaze, Slow Cookers Soups – and along the way stoked its appetite for commercial paper.  The strategy seems counterintuitive, given the state of that short-term funding market, but McCormick is sticking to it.  The company has a highly seasonal business; 40 percent of its earnings come in the fourth quarter, when holiday cooks restock their spice racks.  “We pay down most of our debt in the fourth quarter, but during other quarters we need access to liquidity,” says CFO Gordon Stetz.    Consistency in McCormick’s capital structure lets the company keep the doors open to the commercial-paper market.  The key is to maintain an investment grade rating (A2 by Moody’s) by adhering to targeted ratios:  debt to total capital of 45 to 50 percent and debt to total EBITDA of about 1.7.  “That has allowed us to access commercial paper as we need it,” says Stetz.    Occasionally, McCormick increases leverage, as it did last August when it acquired spicemaker Lawry’s from Unilever for $605 million.  Financing the deal first with commercial paper and then with long-term debt raised the company’s debt to total EBITDA and debt to total capital to 2.5 and 53 percent, respectively, Stetz says.  (McCormick did the same thing in 2006 when it acquired Thai-food company Epicurean International.)  Fitch Ratings and Standard & Poor’s downgraded the company’s debt a notch this time, but it remained investment grade.   Tempting as it is to squirrel away cash, McCormick is deleveraging again.  It suspended its stock-buyback program in the fourth quarter of 2007 (when the Lawry’s deal was announced) and is paying down debt.  Meanwhile, the Lawry’s acquisition helped boost McCormick’s sales 9 percent in the third quarter.  “What we’ve done has served as us well historically,” Stetz says.   Others agree that paying down liabilities has a place in financing strategies today.  “Why would you stock away cash unless you were worried about your bank failing?” asks First Capital’s Sunshine.  “It’s always good to reduce your liabilities.”     SWEET EQUITY   Building up the asset side doesn’t have to hurt either.  The rising cost of issuing corporate debt could make equity the answer to some situational financing problems, says Sunshine.  “For businesses that have legs, that have sound products people are willing to pay for, there’s always equity,” he says.    One such company, Waste Connections Inc., wanted to prepare itself recently for a potential pipeline of acquisitions, as market-share leaders in the waste-collection and disposal industry were merging and government mandated divestitures (resulting in assets coming onto the market) were on the horizon.  The company raised $394 million through a common-stock offering amid the September swoon in equities.   The cash gives the company flexibility and repositions Waste Connection’s balance sheet for growth, says CFO Worthing Jackman.  Meanwhile, the company stays one times leveraged.  “There was a certainty of acquisitions and uncertainty in the capital makes,” comments Jackman.  “We took the uncertainty off the table.”   William Welnhofer, a managing director at investment bank Robert W. Baird & Co., says equity financing is best used to complete an acquisition for which sufficient debt cannot be raised; to refinance debt that can be replaced only under onerous terms; or to finance capital expenditures if present leverage is high and covenants restrict incurrence of additional debt.  Preferred stock or convertible subordinated debt have been popular alternatives to common stock, he adds.    Terms are not light these days for convertibles, however.  Convertible subordinated debt for performing, non-investment-grade companies is being priced at a 10 percent coupon and a 15 percent conversion premium from a weighted average share price.  Terms also include “make-whole” provisions which require the issuer to pay the present value of the interest payments that the investor would have received until the bond’s maturity.  (That eliminates the incentive to hold on to the bond, ways Welnhofer.)   “The real question is whether a public company would be willing to suffer the dilution associated with selling equity – possibly at a discount,” Welnhofer warns.  “Few companies outside of regulated financial institutions in need of additional capital are likely to be interested in issuing new equity at these prices unless they have to.”   But while equity offerings may be dilutive in the near term, deploying the assets quickly can mitigate the dilutive effects, counters Jackman.     SLICING AND DICING   Thinking anew about freeing up capital also means exploring the sale of marginal assets, painful as it may sound.   When Tyco Electronics was spun off in 2007 and became a stand-alone public company, it performed an extensive review of its portfolio of businesses, using growth potential, market position, profitability, leverage with items in its portfolio, and return on invested capital as the measures, says Sheri Woodruff, a Tyco spokesperson.  Based on the reviews, the Bermuda-based company decided to divest a radio-frequency components and subsystems business and an automotive radar sensors unit.   The sales netted $470 million in cash in September – almost a quarter’s worth of the company’s total operating income.  The cash helped finance a $750 million increase in the company’s share repurchase program as well as a dividend boost.  Of course, not every company generates the free cash flow that Tyco Electronics does, which gives it the luxury to cut income-producing businesses.   If companies are considering asset sales, they should avoid the trap of basing portfolio decisions on performance instead of value, says Justin Pettit, a partner at Booz Allen Hamilton.  “Value is the present value of all future performances,” Pettit says.  “Sell assets that are worth more to someone else than they are to you.”   Indeed, jettisoning assets in a depressed market where demand is sketchy is not the shortest or more certain path to liquidity.  Strategic M&A for 2008 increased to $939 billion as of last September, up 16 percent from the same period a year earlier, according to Dealogic.  But, the sclerotic capital markets have corporate buyers nixing announced deals, either because they can’t raise the debt or the financial upside has evaporated.  “M&A advisers are not willing to take assignments,” says Mackinac’s Gordon.  There simply are no buyers – a lot of them aren’t even sure that bottom has hit yet.”   Since CFOs can’t know where the bottom is, the safest play is to build a capital structure that can withstand the bitter-cold shock of the credit markets.  For purposes of longer-term planning, decisions about optimum capital structures (Leverage up? Leverage down?) will diverge as CFOs confront a highly uncertain environment in which the standard playbook no longer applies.  Says Gordon:  “I don’t know if there is a good model right now for capital raising – everyone is in such a state of flux.”

Susan Gordon featured in CFO magazine

Rethinking Capital

by Vincent Ryan

It may be the worst contraction of credit since the Great Depression.  As the mortgage crisis has deepened, banks have been reluctant to lend money to anyone, including each other.  Debt investors have fled to the safest corners of the bond market.  And commercial paper has seized up, reducing a short-term financing option for working capital.  Any capital that is available is, unfortunately, much more expensive.

 

In this operating environment, CFOs must now wrestle with issues that required much less attention during the last few years:  cost of capital, optimum leverage, debt maturities, even sheer liquidity.  It’s time, in short, for finance chiefs to reassess their companies’ capital structures and manage them more tightly.

 

The choices won’t be easy.  Pay down debt or build up a rainy-day fund?  Increase leverage to scoop up competitors’ assets at bargain-basement prices or shrink it to preserve an investment-grade credit rating?  Cover the entire financing deficit from operations now or wait three months to see if rates drop?  Continue to rely on commercial paper or seek longer-duration capital with tight covenants? 

 

In some ways it will be like turning back the clock.  “CFOs now have to think about capital in 1950s terms,” says Mark Sunshine, president of factoring company First Capital.  “Everything they’ve learned in the last 10 years about debt will have to be thrown out - that was an overheated market.”

 

 

TAPPING REVOLVERS

 

The credit crisis has already led to a flurry of draw-downs of revolving lines of credit.  Duke Energy, Bally Technologies, Goodyear Tire & Rubber, Caterpillar, and Winnebago Industries were among companies that drew down revolvers (or added new revolvers) in a span of two weeks in September.

 

“Having the actual cash on had cements a liquidity position, given the risk of nonperformance by bank group,” says Mark Oline, a managing director at Fitch Ratings.

 

Drawing on revolvers is risky though.  Companies subject themselves to significant interest-rate risk by using short-term debt, points out Susan Gordon, a managing director at Mackinac Partners, a restructuring advisory firm.  In addition, “renewals are very expensive, and banks, if they’re not calling in lines, are lending on 70 percent of receivables instead of 80 percent,” she says.  That means less credit.  Also, higher default rates on receivables means companies have to make up a deficiency in collateral with an upfront cash payment. 

 

For companies that can secure new bank debt, the concessions are substantial.  Lenders are demanding a senior debt position and 100 percent warrant coverage.  “They want a taste of the action if equity improves,” says Karl D’Cunha, a managing director at Houlihan Smith & Co., a Chicago-based investment bank. 

 

 

A DISCIPLINED APPROACH

 

Securing capital beyond bank debt is an option, but it requires long-term discipline.  Consider McCormick and Co., the $3 billion consumer food company introduced a plethora of new products in 2008 – salmon seasoning, low-sodium rice, chicken glaze, Slow Cookers Soups – and along the way stoked its appetite for commercial paper.  The strategy seems counterintuitive, given the state of that short-term funding market, but McCormick is sticking to it.  The company has a highly seasonal business; 40 percent of its earnings come in the fourth quarter, when holiday cooks restock their spice racks.  “We pay down most of our debt in the fourth quarter, but during other quarters we need access to liquidity,” says CFO Gordon Stetz. 

 

Consistency in McCormick’s capital structure lets the company keep the doors open to the commercial-paper market.  The key is to maintain an investment grade rating (A2 by Moody’s) by adhering to targeted ratios:  debt to total capital of 45 to 50 percent and debt to total EBITDA of about 1.7.  “That has allowed us to access commercial paper as we need it,” says Stetz. 

 

Occasionally, McCormick increases leverage, as it did last August when it acquired spicemaker Lawry’s from Unilever for $605 million.  Financing the deal first with commercial paper and then with long-term debt raised the company’s debt to total EBITDA and debt to total capital to 2.5 and 53 percent, respectively, Stetz says.  (McCormick did the same thing in 2006 when it acquired Thai-food company Epicurean International.)  Fitch Ratings and Standard & Poor’s downgraded the company’s debt a notch this time, but it remained investment grade.

 

Tempting as it is to squirrel away cash, McCormick is deleveraging again.  It suspended its stock-buyback program in the fourth quarter of 2007 (when the Lawry’s deal was announced) and is paying down debt.  Meanwhile, the Lawry’s acquisition helped boost McCormick’s sales 9 percent in the third quarter.  “What we’ve done has served as us well historically,” Stetz says.

 

Others agree that paying down liabilities has a place in financing strategies today.  “Why would you stock away cash unless you were worried about your bank failing?” asks First Capital’s Sunshine.  “It’s always good to reduce your liabilities.”

 

 

SWEET EQUITY

 

Building up the asset side doesn’t have to hurt either.  The rising cost of issuing corporate debt could make equity the answer to some situational financing problems, says Sunshine.  “For businesses that have legs, that have sound products people are willing to pay for, there’s always equity,” he says. 

 

One such company, Waste Connections Inc., wanted to prepare itself recently for a potential pipeline of acquisitions, as market-share leaders in the waste-collection and disposal industry were merging and government mandated divestitures (resulting in assets coming onto the market) were on the horizon.  The company raised $394 million through a common-stock offering amid the September swoon in equities.

 

The cash gives the company flexibility and repositions Waste Connection’s balance sheet for growth, says CFO Worthing Jackman.  Meanwhile, the company stays one times leveraged.  “There was a certainty of acquisitions and uncertainty in the capital makes,” comments Jackman.  “We took the uncertainty off the table.”

 

William Welnhofer, a managing director at investment bank Robert W. Baird & Co., says equity financing is best used to complete an acquisition for which sufficient debt cannot be raised; to refinance debt that can be replaced only under onerous terms; or to finance capital expenditures if present leverage is high and covenants restrict incurrence of additional debt.  Preferred stock or convertible subordinated debt have been popular alternatives to common stock, he adds. 

 

Terms are not light these days for convertibles, however.  Convertible subordinated debt for performing, non-investment-grade companies is being priced at a 10 percent coupon and a 15 percent conversion premium from a weighted average share price.  Terms also include “make-whole” provisions which require the issuer to pay the present value of the interest payments that the investor would have received until the bond’s maturity.  (That eliminates the incentive to hold on to the bond, ways Welnhofer.)

 

“The real question is whether a public company would be willing to suffer the dilution associated with selling equity – possibly at a discount,” Welnhofer warns.  “Few companies outside of regulated financial institutions in need of additional capital are likely to be interested in issuing new equity at these prices unless they have to.”

 

But while equity offerings may be dilutive in the near term, deploying the assets quickly can mitigate the dilutive effects, counters Jackman.

 

 

SLICING AND DICING

 

Thinking anew about freeing up capital also means exploring the sale of marginal assets, painful as it may sound.

 

When Tyco Electronics was spun off in 2007 and became a stand-alone public company, it performed an extensive review of its portfolio of businesses, using growth potential, market position, profitability, leverage with items in its portfolio, and return on invested capital as the measures, says Sheri Woodruff, a Tyco spokesperson.  Based on the reviews, the Bermuda-based company decided to divest a radio-frequency components and subsystems business and an automotive radar sensors unit.

 

The sales netted $470 million in cash in September – almost a quarter’s worth of the company’s total operating income.  The cash helped finance a $750 million increase in the company’s share repurchase program as well as a dividend boost.  Of course, not every company generates the free cash flow that Tyco Electronics does, which gives it the luxury to cut income-producing businesses.

 

If companies are considering asset sales, they should avoid the trap of basing portfolio decisions on performance instead of value, says Justin Pettit, a partner at Booz Allen Hamilton.  “Value is the present value of all future performances,” Pettit says.  “Sell assets that are worth more to someone else than they are to you.”

 

Indeed, jettisoning assets in a depressed market where demand is sketchy is not the shortest or more certain path to liquidity.  Strategic M&A for 2008 increased to $939 billion as of last September, up 16 percent from the same period a year earlier, according to Dealogic.  But, the sclerotic capital markets have corporate buyers nixing announced deals, either because they can’t raise the debt or the financial upside has evaporated.  “M&A advisers are not willing to take assignments,” says Mackinac’s Gordon.  There simply are no buyers – a lot of them aren’t even sure that bottom has hit yet.”

 

Since CFOs can’t know where the bottom is, the safest play is to build a capital structure that can withstand the bitter-cold shock of the credit markets.  For purposes of longer-term planning, decisions about optimum capital structures (Leverage up? Leverage down?) will diverge as CFOs confront a highly uncertain environment in which the standard playbook no longer applies.  Says Gordon:  “I don’t know if there is a good model right now for capital raising – everyone is in such a state of flux.”