Capital Markets

Favorite Finance Flavor: Plain Vanilla

Only investment-grade companies may have it so simple, however; speculative-grade issuers may need to rely on more-complex finance arrangements.
Marie LeoneDecember 9, 2005

CFOs of investment-grade companies don’t need to chase complicated financial engineering deals or exotic financial instruments to raise capital, nor do they want to. “If I can’t explain a security to the board without a team of lawyers and accountants, I don’t use it,” asserted Brian Jennings, chief financial officer of oil and gas exploration company Devon Energy Corp. at an industry conference Thursday.

For the most part, raising capital is not a primary issue in the shrinking universe of investment-grade companies. They have cash on the balance sheet, and by definition they also have a healthy debt-to-equity ratio that keeps the cost of capital in check. Nevertheless, complex arrangements are thriving. “It’s become almost a sport [for investment banks and private equity funds] to create something that sticks to the letter of the law rather than the spirit,” Jennings told the audience at a corporate credit seminar sponsored by Standard and Poor’s.

These deals are pervasive, he reckoned, because margins on such products are lucrative for the bankers and other dealmakers that sell them. Furthermore, the number of speculative-grade companies is increasing, and it is these companies that traditionally have trouble accessing traditional, low-cost financing and welcome the more complex structures.

Indeed, S&P managing director John Bilardello told the crowd that speculative-grade companies represent 66 percent of all the issuers his agency rates, compared with 32 percent in 1980. What’s more, only 12 percent of issuers currently hold an A, AA, or AAA rating; in 1980, fully 50 percent held one of those high ratings.

Speculative-grade companies are attracted to the large pools of capital made available by hedge funds and private-equity players, said Cendant Corp. president and CFO Ronald Nelson, but hedge-fund lending can be problematic. He observed that often, a hedge fund will arrange a leveraged recapitalization deal with a non-investment grade company, secure its own financial return, then exit the deal — leaving the company holding a debt-laden bag. “It requires real management fortitude” to focus on long-term business goals when management is being pressured by lenders who focus on short-term returns, said Nelson.

Although CFOs of investment-grade companies don’t feel the kind of pressure that hedge-fund managers dish out, they often get it from Wall Street analysts and shareholders who demand better earnings, quarter after quarter. Thursday’s panelists, however, didn’t seemed to feel the heat.

“We don’t focus all that much on quarters,” said Kenneth Martin, CFO of Wyeth, who noted that the nature of any pharmaceutical company is to develop and manage a pipeline of products that will come to market 10 to 12 years in the future. Martin neatly summed up his strategy by adding that “we get paid to generate a profit in the near term in a way that is consistent with the long-term health of the company.”

The other CFO panelists agreed. Home Depot Inc.’s Carol Tomé said her management team may do away with earnings guidance completely and stay true to the retailer’s rolling three-year strategic plan. Devon Energy’s Jennings commented that short-term earnings guidance is useful because it provides assurance to the market that management understands the business and the changing dynamics. But “quarterly results are not important to us,” he added, considering that the investment cycle for oil and gas exploration is 8 to 10 years.

Looking ahead, the CFO panel thought deploying capital correctly and meeting operational challenges were their biggest hurdles in 2006. Wyeth’s Martin said he expects to spend a “tremendous amount of cash” looking for new products and managing the turnover in the company’s product portfolio. Devon faces a similar challenge — spending a lot of money at great risk to find new oil reserves — said Jennings, whose first job was as a petroleum engineer. In the long run, he added, “the U.S. will have to go on an energy diet.”

Nelson expressed worries about Cendant’s individually sectors. In October, the company announced that it would split into four separately traded businesses — travel, hotel, real estate, and car rental.) For instance, Cendant’s car-rental business buys 400,000 vehicles a year with puts back to the carmakers, but falling credit ratings for Ford and General Motors require Nelson’s team to reevaluate how certain deals are structured.

For Tomé, the big financial decision for the year ahead is to “correctly apply” the $10 billion in revenues generated by the company’s cash-cow retail outlets. The choice is classic: Reinvest in growth, including Home Depot’s service-contracting and construction-service businesses, or return cash to shareholders though dividends or buybacks.