Rational Exuberance?

Gentler treatment by credit-rating agencies suggests that M&A activity has grown saner.
S.L. MintzMay 1, 1999

Want evidence that there’s method to U.S. dealmania? Consider the fact that credit rating agencies have responded with relative aplomb to last year’s frenzied merger-and-acquisition activity.

Despite the record number and dollar value of nonfinancial mergers and acquisitions tracked by Securities Data Corp. last year, only 34 nonfinancial companies suffered M&A-related downgrades by Standard & Poor’s, the only rating service that identifies rating changes stemming from M&A activity. Half of these down-grades cost issuers only one notch– say, from A to A-.

In contrast, says Rick Escherich, managing director of the M&A group at J.P. Morgan & Co., a similar list from 1988-89 would show much more leveraging of balance sheets and many more and larger downgrades.

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“The gut reaction of many in the market would probably be to associate M&A activity with a higher level of risk,” he says. To be sure, some recent dealmakers have taken it on the chin from S&P. For Pioneer Natural Resources Co., a one-notch decline to BB+ meant losing investment-grade status. Caesars World tumbled four notches to B+ from BBB-, while food retailer Star Markets and hotel operator ITT Corp. each slipped three notches.

Yet 20 upgrades by S&P in the latter half of 1998 affected almost twice as much debt as downgrades. Short of suggesting that event risk has vanished, the virtual absence of severe downgrades in the wake of last year’s M&As does not square with expectations. “It’s a puzzle,” says Stephen A. Ross, finance and economics professor at the Massachusetts Institute of Technology. “We used to care a lot about event risk, but not now.”

So what’s going on? Some observers contend the rating agencies are largely captives of the prevailing credit climate. “Ratings tend to stay high during periods of easy and easing money,” says Dean LeBaron, former chairman of Batterymarch Financial Management Inc., an investment management firm in Boston. “And I doubt if they really forecast much more than harder rain when drizzle has started.”

Credit agencies rebuff the suggestion that they’ve grown more lenient toward deals with hefty price tags. “I don’t think we’re jaded and saying everybody’s doing it,” says credit analyst Cindy Werneth of S&P.

Aside from strengths and weaknesses of particular companies, three broad trends account for the rating agencies’ new level of comfort: consolidation-driven merger strategies, stock-based transactions, and more-nuanced rating criteria.

“These are mainly tactical acquisitions, not LBOs where companies leverage up to the hilt with a plan to dig their way out,” says senior vice president Bruce Clark of Moody’s Investors Service. Clark contends that despite inherent uncertainties, the nature of the deals pose a less-serious risk to timely payment of interest and principal.

Far from betting the company, deals these days feature cost cutting and improved distribution, says Susan Ryan Goodman of Fitch IBCA Inc. When Donohue Inc. in Quebec paid $450 million for the newsprint division of Champion International, for example, Goodman quickly tallied, among other factors, the cost savings Donohue would enjoy by not shipping paper from Quebec to Texas.

“People are not doing dumb deals,” Goodman observes. “For the most part, they dig in and do a lot of homework.”

Payment of stock in lieu of boosting leverage also mitigates risk, at least to bondholders. By exchanging richly priced shares for richly priced assets, companies avoid burdensome debt loads that cash deals impose.

Even when a company doesn’t borrow to pay cash, its debt ratio rises. And while firms are paying hefty premiums through stock deals, that shouldn’t trouble bondholders, so long as the boost to cash flow is commensurate, says Robert C. Merton, a Nobel prize winner in economics. “The premium paid by one group of shareholders to another should not by itself be a cause for a ratings change for the debt,” he insists.

Greater Stretch

Finally, ratings nowadays incorporate an intrinsic measure of event risk. “In the current environment, we have companies with stated acquisition strategies that leave flexibility in the ratings,” says Lisa Tesoriero, an S&P director. In this respect, current ratings incorporate some element of the event-risk ratings that S&P suspended in November 1992, after a little more than three years.

Even firms making heavy use of debt to do deals have won S&P’s wary approval. Consider Armstrong World Industries, which completed two debt-financed deals. Those deals increased the interior-surfaces firm’s sales by half, added wood-flooring products, and extended its competitive reach into Europe. They also increased debt nearly fourfold, to $1.9 billion.

Granted, S&P downgraded Armstrong’s credit rating by a notch and lowered the ratings outlook from stable to negative. But that left Armstrong with a still very robust A-. Moody’s took a somewhat more skeptical stance, lowering the credit rating two notches, to Baa1.

But even Armstrong found the actions relatively mild. “The downgrades were not as big as the debt ratios alone might imply,” says vice president and treasurer E. Follin Smith. She cites two key factors that ultimately bolstered the company’s ranking: a strong, logical argument for the deal, and rating-agency confidence in financial policies aimed at restoring Armstrong’s credit ratios to a mid-A level.

S&P’s Werneth corroborates Smith’s explanation. S&P believes the two acquisitions will make a stronger company in the future, while reducing its vulnerability to domestic demand for its products. Further, an A rating was very strong to begin with, and Armstrong’s leverage was low by industry standards. New ratings increased Armstrong’s cost of debt in line with expectations, says Smith. The yield on commercial paper rose by about 10 basis points, and the yield on term debt by about 25 basis points.

Of course, some CFOs of companies that experienced downgrades contend that the rating agencies still fail to appreciate the virtues of their deals. After Watts Industries announced a plan last December to spin off its industrial oil-and-gas-valves interests to shareholders, for example, S&P bumped its rating to BBB+ from A-. Watts also remains on credit watch, with negative implications. The actions annoyed Watts CFO Ken McAvoy. Was it fair? “Absolutely not,” he charges. In part, S&P reacted to a proposed spin-off that would reduce the company’s sales to $500 million from $800 million. “They first gave us an A- rating when we were a $500 million company,” says McAvoy. Moreover, he doesn’t see why the rating services acted even before the spin-off won regulatory approval, which is still pending. In his eyes, raters downgraded Watts “proactively and prematurely.”

Smaller Gripes

All $500 million companies are not equal, responds S&P analyst Dan DiSenso. In this case, the spin-off will reduce revenues almost by half and shrink financial flexibility to an extent that is still hard to determine. Absent new acquisitions, growth prospects are slim for the remaining water-valves business. Moreover, shortly before announcing the spin-off, Watts completed its largest acquisition, an oil-and-gas- valves business that it now plans to jettison. In the process, leverage rose higher than historical levels. “It was not going to fit the profile of the A category,” says DiSenso, who notes that tight family control and no visible regulatory obstacles make this deal highly probable, if not certain.

This reply might not satisfy McAvoy today, but the odds are he’d have had more to complain about 10 years ago.

S.L. Mintz is CFO’s New York bureau chief.