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Rethinking Capital

To weather the credit crisis and a recession, CFOs will have to unlearn much of what they thought they knew about capital structures.
Vincent Ryan, CFO Magazine
November 1, 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, that 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 drawdowns 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.

Credit raters approved, because they are wary of assuming that companies will be able to tap undrawn amounts. "Having the actual cash on hand cements a liquidity position, given the risk of nonperformance by bank groups," 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 mean some 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 us well historically," Stetz says.

Others agree that paying down liabilities has a place in financing strategies today. "Why would you sock 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 Connections'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 markets," 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, says 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 effect, 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 performance," 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 most 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 even willing to take assignments," says Mackinac's Gordon. "There simply are no buyers — a lot of them aren't sure the 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 to 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."

Vincent Ryan is a senior editor of CFO.


Virgin Territory
An M&A deal that also made the balance sheet healthier

Pressures on companies' capital structures can play a huge role in how M&A deals are configured. Just ask Virgin Mobile USA. The prepaid wireless operator had plenty of balls to keep in the air last June as it was forging a deal to buy Helio, a mobile virtual-network operator partly owned by Earthlink and SK Telecom.

"We anticipated a large payment of debt due in 2010," says CFO John Feehan, who is leaving the company this month. "While we knew that we could manage our business to prevent tripping a covenant, external perceptions were uncertain in this rocky environment, and the covenants were pretty restrictive. Investors had raised concerns about our ability to get credit in the future."


Fortunately for Virgin Mobile USA, it was able to tweak its capital structure and purchase Helio at the same time — largely by giving up equity to reduce debt. The numbers are head-spinning, but in the end the acquirer ended up with almost 20 percent less in senior secured debt and $90 million in additional revolving credit availability, before using some of the revolver to pay Helio's outstanding debt of $15 million. (SK Telecom and Virgin Group, an investor in Virgin Mobile USA, provided the company with a new $60 million line of credit.) While the price of the combined company's senior debt increased 100 basis points (to LIBOR plus 550), Virgin also gained the option to add $15 million of borrowing capacity, and the banks reduced its leverage-ratio covenant by 25 basis points.

Of course, Virgin Mobile USA had to make concessions — substantial ones, some would argue. SK Telecom and Virgin Group each got $50 million in equity in the combined company in the form of mandatory convertible preferred stock. That was on top of the $39 million in shares that Virgin Mobile exchanged for Helio. (SK Telecom now has two board seats.)

But Feehan says the economics of the deal are excellent. Helio's 170,000-strong customer base and infrastructure for offering postpaid wireless services are expected to produce an immediate cash-flow benefit — about $1.7 million per quarter, Feehan says, more than offsetting the $150,000 increase in revolver interest-rate charges.

"Before, we might have had to decide not to grow, which would have been bad," he says. "Now we are positioned to make the right decision as opportunities arise — we have the cash flow and the covenant headroom." — V.R.




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