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As Good as It Gets

New research for CFO Europe shows corporate balance sheets are in great shape, for now.
Jason Karaian, CFO Europe Magazine
June 22, 2006

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.


For now, though, CFOs are taking advantage of plentiful credit and emerging growth opportunities to leverage balance sheets more aggressively. As they should, says Mislav Matejka, a London-based analyst at JPMorgan. He estimates that the average ROCE in the euro zone was 11.7 percent last year, compared with an average WACC of 6.9 percent. The spread between the return on capital and the cost of capital, 4.8 percent, was thus more than double the long-term average of 1.9 percent. It's no wonder, then, that on an annualized basis, corporate bond issuance in the EMEA region will reach a record €320 billion this year, according to Fitch Ratings.

For its part, KPN issued €1.3 billion of new bonds in March, the event that prompted the company to communicate its plans to shift its financial profile. In doing so, KPN has had to take into account the proliferation of private equity players in Europe in recent years. As they move more aggressively to stalk companies across Europe, even large companies like KPN have become targets. And the key trait of private equity is leverage, which has been on the increase — last year, debt levels among European firms bought by private equity increased to 5.5 times Ebitda, on average, from 4.5 times in 2004, according to S&P. (Tellingly, KPN's March bonds included a change-of-control clause for the first time in the company's history.)

There is an "obvious arbitrage opportunity" between the gearing that private equity is able to achieve and the one that listed companies can reach without angering investors, notes Smits. This was taken into account when KPN's board devised the new capital structure, says the CFO. "You don't want that gap to be too big."

Barbarians Come Knocking
CFO Peter Gill of Rank, a £810m (€1.2 billion) London-based gaming and leisure group, is facing a similar scenario. "There was a sense [within the market] that we were probably under-geared," says Gill, recalling the leverage that private equity buyers were able to employ after taking stakes in Rank's U.K. rivals Gala and Coral.

Like KPN, Rank all but invited a rating downgrade earlier this year after announcing that its shareholders would receive, via a share buyback, nearly half of the £430m proceeds from a recent sale of its film distribution unit, and that its pension fund was going to get a £100m top-up. Rank also said it is now aiming for a net debt to Ebitda broadly in the range of 3.5 to 4.0 times, compared with a maximum of 3.0 times historically, and dividend cover of 2.0 times. In March, all three ratings agencies cut Rank's rating multiple notches, pushing it into junk status.

Gill notes that markets already priced Rank's debt as a "crossover credit," a term used to describe companies that sit in a gray area straddling investment grade and junk. Aside from triggering a redemption of a U.S. private placement, the downgrades had little effect on Rank's financing costs, a rise of no more than 50 basis points, says Gill. The finance chief was so pleased with the margins on offer that he recently signed a new £650m banking facility with his existing banks, £400m of which runs for five years instead of the company's usual three. "We have seen almost no drawbacks from being junk," says Gill. Still, he warns, "With plentiful credit and a benign interest rate environment, there is always the risk that companies lever up too much."

This is a timely reminder for CFOs, perhaps under siege from private equity predators, not to lose sight of the role that capital structure should play in supporting business strategy. It's been on Jèrôme Contamine's mind ever since Veolia Environnement, the €25 billion utility where he's CFO, was spun off from troubled conglomerate Vivendi in 2000.

Back then, saddled with some €20 billion of debt and a sprawling portfolio of businesses, Contamine devoted a lot of attention to asset sales and debt reduction.

He is now comfortable with the company's debt level of €14 billion, and says that he will allow a "margin for maneuver" of up to 3.5 times net debt to Ebitda, from 3.0 today. At the same time, he has been refashioning the company's financing profile. Because Veolia's revenue is derived mainly from long-term contracts (averaging around 15 years), the CFO and his team have lengthened the maturity of the debt, now at an average of seven years.

Contamine has also smoothed the firm's repayment schedule, buying back a €1.2 bond due in 2008 and issuing new bonds due in 2016 and 2020 with an aim to produce a "maximum repayment corridor" of around €1 billion a year, roughly equal to its annual free cash flow. With the company's financing matched to its current batch of contracts, each new project will require its own financing issue crafted to fit Contamine's targets, a useful way to instill discipline as the company pursues growth. "We are close to an optimal capital structure — we don't feel pressure to do anything radical," he notes.

Of course, what the CFO fails to mention is Veolia's role as the reported instigator of Italian counterpart Enel's mooted bid for French utility Suez earlier this year. Though it pulled out of the joint bid, the episode shows that Veolia is not immune to the merger mania sweeping across Europe. "If we go for an acquisition, the market will need to be convinced that it adds value," says Contamine. "For the time being, the market likes our organic growth story." It's hard to argue with the finance chief, given the first quarter's 16 percent rise in profits and revenues — largely from organic growth — which doubled the company's full-year targets. Veolia's share price has gained around 50 percent over the past year.


Still, something about the rationale behind a joint bid with Enel for Suez convinced Contamine and other executives at Veolia to abandon the mega-deal. Over the past three years, Veolia's EDF fell by 89 percent, according to MKMV. The debt required to finance the purchase of Suez, which had revenue of €41 billion and Ebitda of €6.5 billion in 2005, would surely undo much of that improvement in default risk.

Debt-fuelled dealmaking could soon be just one of a host of pressures that will put corporate balance sheets, so carefully nursed back to health in recent years, under new strain. When CFO Europe and Moody's KMV revisit the top of credit quality in two years, we'll find out more about how CFOs have struck the right balance between pursuing growth and defending credit quality under conditions very different from today's.

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


Explaining EDF
How Moody's KMV calculates credit risk.

Moody's KMV Expected Default Frequency (EDF) is a measure of the probability that a company will fail to make scheduled debt payments over a specified period — typically one year. EDF scores range from 0.02 percent (the safest credit) to 20 percent (imminent default). Conservative financial policies have pushed the EDFs of Europe's 100 largest debt issuers to historic lows, with 37 companies achieving a 0.02 percent EDF score this year, up from 16 two years ago. Here is a closer look at the key values that MKMV uses, via a proprietary model, to determine a company's EDF.

First, MKMV measures the level of a company's obligations. This is the company-specific level of the market value of its assets, below which it would fail to make scheduled debt payments. The estimate reflects the observation of thousands of defaulting companies since 1974, and of how each firm's "default point" acted in relation to the market value of its assets at the time.

Next, MKMV calculates the current market value of the company's assets. This measure reflects the market's view of the enterprise value of the company, as determined by its equity value, equity volatility, and liability structure. MKMV 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 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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