As Good as It Gets

View the ranking of Europe's largest 100 debt issuers.

If you had to choose one company that embodied the ups and downs of the business cycle over the past 10 years, KPN might be it. From euphoria in the late 1990s to the plunge in share prices in 2000 and 2001, frenzied cost-cutting in subsequent years and, recently, a return to growth and dealmaking, the €12 billion Dutch telecoms company has seen it all.

Last month, KPN proudly unveiled impressive first quarter results, including a 40 percent rise in profits, thanks in large part to the takeover of rival Telfort in late 2005. Over the past three years, the steady improvement in its balance sheet has meant that KPN has cut its probability of default by 98 percent, making it one of the top performers over this period, according to a new study of the 100 largest European debt issuers prepared for CFO Europe by Moody's KMV (MKMV), a credit research company. Indeed, the study, which is commissioned every two years, shows that balance sheets have rarely been in better shape. The median issuer has cut its probability of default by more than 80 percent. Only two issuers in our sample, financial holding companies Finatis of France and IFI of Italy, experienced an increase in default risk over the period. (See "Reality Check," June 2004, for the previous study.)

This trend, however, may now be set to go into reverse. At KPN, for example, CFO Marcel Smits is reassessing the company's capital structure. With debt down from €23 billion in 2001 to around €8 billion today, and with nearly €3 billion of cash on hand, "invariably, people ask whether there are circumstances under which we would be comfortable relaxing our financial framework," Smits says. "The answer is 'yes.'" That's why, he explains, it was becoming increasingly urgent for KPN to map out its new balance sheet vision for the financial community.

So, in February, KPN announced that it will pursue a more aggressive financial profile, targeting net debt to Ebitda of between 2.0 and 2.5 times, compared with 1.9 at the end of 2005. Payouts will include dividends this year and next of at least €950m (the amount paid for 2005), and €1 billion of share buybacks this year in addition to the €2.8 billion of shares that it has repurchased since 2004. The announcement triggered immediate credit rating downgrades (to BBB+ by S&P, Baa2 by Moody's), leaving the company a few notches above "junk" status. But according to the finance chief, the downgrades were fully anticipated and will result in "no significant penalty" as far as financing costs are concerned.

Like KPN, companies across the region have shored up their balance sheets via cost-cutting programs, asset sales, and conservative investment policies. Now, with economic growth picking up and borrowing costs low for the time being, companies are poised to "make a break from the parsimony" of recent years and begin investing in M&A and other growth plans, noted a S&P report issued last month.

Detecting Default
MKMV's research uses a proprietary methodology to calculate the likelihood of a company defaulting, expressed as its Expected Default Frequency (EDF), which ranges from 0.02 percent to 20 percent. In addition to stock market data and balance sheet information, MKMV's default risk model takes into account the history of thousands of company defaults going back to the early 1970s. Moreover, MKMV's model captures the fact that as companies move assets and liabilities off balance sheets, it reduces the value of what remains.

The companies in our sample, to varying degrees, have benefited from favorable trends in two key inputs used for MKMV's EDF scores. First, there's asset volatility, a measure of the range of values that investors assign to a company, and thus a proxy for overall business risk. This fell 21 percent over three years for the median company. Second, a combination of rising share prices and modest debt growth has widened the gap between companies' asset values and their "default points," the company-specific level that a firm's asset value must fall to before MKMV's historical database suggests that a default is on the horizon. These two inputs are captured by a measure that in MKMV parlance is known as "market leverage," which for the median company has declined by 18 percent over the past three years. (See "Explaining EDF" at the end of this article for more on the methodology.)

"While there may be a popular perception that we live in a riskier world, the data suggests that the markets have not been looking at it that way," notes Brian Dvorak, managing director of MKMV. Indeed, the spread on the broad-based MSCI corporate credit index has narrowed sharply from a peak of 120 basis points in 2002 to around 30 today, with about 20 basis points-worth of improvement in the past year. This is despite a median rise of 15 percent in short-term debt over the past 12 months recorded by MKMV.

But what lies ahead? The sharp sell-off in stock markets around the world in mid-May was a reminder of how quickly investor sentiment can change. What's more, at the end of April, S&P said that there were twice as many companies in its rating universe with a negative outlook, suggesting an impending downgrade, than those with a positive outlook. The ratings agency predicts a rise in defaults in 2007, widening the spreads on non-investment grade credits by around 100 basis points on top of benchmark interest rates that central bankers have already begun to hike in the euro zone and elsewhere.

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