5.2 THE BOTTOM-UP APPROACH FOR INDUSTRIAL COMPANIES
5.2.2 Market risk (business risk)
Market risk and business risk will have the same meaning in the following paragraphs. Market risk is the uncertainty regarding future earnings of a company and is determined by the industry to a large extent. The quality of earnings is impacted by the variability of sales. The operating leverage, which is a measure of the amount of fixed costs in the operating cost structure of a company, can be another source of the earnings variability.
The higher the relative amount of fixed cost, the higher the operating lever- age and hence the operating risk. The operating leverage can be expressed in an equation as the percentage change in operating earnings relative to the percentage change in sales.
The market risk determines the parameters for the financial risk of a company; hence the analysis of the market risk highlights main factors,
which can have an effect on the credit quality of a company. A sensitivity analysis should make assumptions about the following factors, affecting the earnings situation of every company:
■ Business plan/strategy
■ Cost structure of the industry (operating efficiencies, R&D costs, labor costs)
■ Marketing and distribution network
■ Competition (domestic and global, position, product, price)
■ Cyclicality of an industry
■ Vulnerability to economic cycles (industry maturity, capacity utilization rates, supply and demand for major products and its production inputs–commodity prices)
■ Business environment
■ Growth potential
■ Market share (customer relationship, competitive pricing)
■ Industry structure/ industry trends/ life cycle of the industry (risk, financing need and profitability tend to decline over the life cycle of the industry)
■ Own position in life cycle/ product mix/ product quality in relation to peer group
■ Diversification of business units (revenue streams)
■ Geographic diversification
■ Political and regulatory environment (deregulation, liberalization, priva- tization, taxes, political stability, government guarantees and support etc.)
■ Exposure to litigation
■ Demographics
■ Technology transfer
■ Barriers of entry.
Coming back to the effect on credit spreads movements, it can be said that the spreads will tend to widen when one or more of the next points are true
for a corporate bond issuer:
■ A weak market position implies high investment costs in order to gain market share (costs resulting from the acquisition of new clients and external growth). The financial results will deteriorate in the short- and medium term. Generally, the cash requirements will be high when the market growth is high, independently of a low or high market share.
■ Weak numbers in top-line growth are a good indicator of problems on the operations side of a company’s business or a bad marketing strategy.
■ An environment with a high degree of price competition allows a differ- entiation against the competitors only by increasing the product quality.
The provision of value-added products results in a higher budget for R&D.
■ Regulatory restrictions lead to an increase of operational risk.
■ Products being in an early phase of their life cycle generally do not gen- erate positive cash flows.
■ Cyclical companies are always more impacted by economic downturns than defensive (noncyclical) companies.
■ Negative industry trends (e.g. high energy costs, change in consumer behavior, overcapacity and regulations) impact the credit quality of all companies within a sector.
The SWOT analysis offers a convenient way to capture the operating risks of a company. The current strategy of a company is compared with the changes taking place in the business environment. This approach tries to incorporate the strengths and weaknesses as well as the opportunities and threats of a company in a single model (Figure 5.12) and helps to identify the major driv- ers for success and the major reasons for failure at the same time.
Figure 5.12 SWOT analysis
Source: Kotler
Strength Weakness
Opportunity Threats
By forecasting future developments and changes in a company, analysts have to be able to recognize “weak signals” in the form of badly structured information as preliminary signs of discontinuities. This task is particularly difficult, because companies try to keep detailed information from the investors in their quarterly and annual reports and during one-on-ones they never give clear statements regarding operating margins in their busi- ness units, financial forecasts and liquidity positions. The focus of forecasts is on market development strategies, because sales growth is strategically very important particularly for external investors like creditors.
To evaluate the competitive position of a company we can use Michael E.
Porter’s Five Forces diagram as we have described already in Chapter 4.
The same external forces determine the competitive position of a company.
After defining an environment in which all companies from one industry have to operate, certain factors within an industry have to be analyzed in order to determine the success and failure of companies. These are:
■ Degree of specialization
■ Brand name
■ Distribution channels
■ Product quality
■ Technological advantage
■ Vertical integration
■ Cost position
■ Price policy.
Large diversified companies usually generate earnings and cash flows from various business units. Some businesses are strategically important and others can be considered as noncore businesses. According to the market attractiveness (measured by market growth rate) and the business strength (measured by relative market share) management has to decide about the allocation of their resources (Figure 5.13). For corporate bond investors the financial discipline of companies is a key investment consideration.
Businesses in maturing markets with low growth rates but a solid market position will generate positive cash flows. These cash resources should be invested into projects in attractive fast growing markets where it is likely that the company will be able to achieve the necessary market size. If a situation occurs when a business burns a lot of cash and struggles to improve its market position then the prospects of contributing to the overall performance of a company shrink. It then depends on the management team to decide about a divestiture of such loss-generating businesses.
Companies pursuing a bondholder friendly policy which are focused on balance sheet strength will reverse wrong strategic decisions early and take into account the small likelihood of selling a future top-performing business.
The company size has to be considered always when evaluating the credit quality of an issuer. The size of a company can be determined either by its total assets, market capitalization, sales or the number of employees. It can be argued that large companies usually have a better market position than small- and medium-sized companies because large companies are more diversified and have different income streams (prod- uct lines). These companies have a better access to the capital markets especially in a crisis scenario (slowing economy). The argument
“too-big-to-fail” is particularly right for European issuers. In Europe, politics play a big part in business decisions and it is not an uncommon practice that a government steps in and bails out a distressed company when too many jobs are at stake.
Figure 5.13 Multifactor Portfolio Matrix – each quadrant represents a business unit
Source:Kotler, pioneered by General Electric Invest to build
Protect position Build selectively
Build selectively
Protect and refocus
Manage for earnings Selectivity/manage
for earnings
Divest Limited expansion or harvest Business strength
Market attractiveness
Strong Medium Weak
LowMediumHigh
5.2.2.1 The management assessment
The wrong strategic decision made at the wrong time can result in a serious deterioration in the financial profile of a company. A loss of investors’ confi- dence in the management team can have a direct negative impact on the trading levels (spreads) of the bonds. A conservative management team is favorable for bondholders because too aggressive strategies usually favor only shareholders. A lot of companies have incentive systems in place in the form of employee stock option plans. Especially senior management is compensated on the basis of the company’s stock performance. This easily leads to business decisions, which result in a wealth transfer from bond- holders to shareholders. Bondholders do not necessarily participate in increasing equity prices if for example an aggressive growth strategy is largely debt-financed.
By evaluating the management team the following questions should be answered:
■ To what extent do bondholders pursue the same goals as the manage- ment team?
■ What is management’s financial philosophy?
■ Does management demonstrate enough commitment and what incen- tives systems are in place, for example, which employees qualify for a stock option plan?
■ How successful is management in achieving their goals?
■ How is the management performance monitored and how is compensa- tion structured?
■ Does management or the strategic investor have an exit strategy in place?
■ Is the management team experienced enough in leading a highly levered firm?
■ How flexible is the management and how fast can it adapt to a fast changing business environment?
■ Is the management willing and able to adjust its business strategy to its financial situation?
■ How is the decision process structured, for example, is there a strong management team in place or a strong equity sponsor, a strategic investor or are all important strategic decisions made by a single person?
■ Are efficient information systems in place and available to support the management decisions at any time?
■ Does the company implement an efficient cash management system and how are the company’s resources controlled?
■ Are there sufficient communication channels across all job levels in the company?
■ How is job satisfaction measured?
■ How effective is the public relations policy and how important are investor relations for the company, for example, is the management able to communicate the right business strategy?
■ Does management assign the appropriate importance to execution risk and event risk and can the proposed strategy be implemented?
Once again the importance of management’s integrity has to be pointed out because it is the management team which puts the business strategy in place and determines the risk profile of the company’s business and hence to a large extent its performance. Figure 5.14 highlights some of the dimen- sions that the management has to consider by formulating the business strategy. Hereby the company can develop its local markets but can also choose to expand into new markets and diversify its product portfolio at the same time. A lot of noninvestment grade and lower investment grade issuers are global market leaders in their respective niche segments and
Figure 5.14 Business strategy
Source: Igor Ansoff and Citigroup Market
Market Product
Present
Present NewNew
Market penetration Consolidation Status Quo Market penetration Consolidation Status quo
Market development Market development
Integration Integration
Low risk Low risk
Product development Product development
Diversification Diversification
Diversification Diversification
Medium risk Medium risk Present
Present
NewNew
Local ExpansionLocal expansion
International ExpansionInternational expansion Medium riskMedium risk High riskHigh risk
benefit from outsourcing trends of their large investment grade counter- parts. The business risk increases with increasing market expansion and increasing product differentiation and vice versa.
5.2.2.2 Equity performance
The analysis of corporate bonds has to incorporate the stock performance of the particular issuer even though the asymmetric risk profile does not allow to participate in the growth of a firm. Due to the limited upside for corpo- rate bonds and almost unlimited downside, when a credit actually begins to be distressed, market participants tend to worry about the value of the assets relative to the ability to pay off all debt. The relationship between a company’s equity and debt starts to become nonlinear when the stock price falls below a certain threshold. The equity price is a good proxy for the value of the assets of a company. The following definition establishes a rela- tionship between the equity price of a company and its leverage:
Leverage ratio⫽Total debt/(Total debt⫹Market capitalization) Market capitalization⫽(number of common shares⭈equity price) The deterioration of the ratio (Total debt/(Total debt⫹Market cap) ) above the range of 60–70 percent will result in massive spread widening and is hence a very good indicator of worsening credit quality of a com- pany. This ratio will especially deteriorate in times of falling equity markets (crisis scenario) and will bring additional pressure on the credit spreads.
At this point Ford serves as a good example (Figure 5.15). As long as Ford’s stock price traded above a certain level (here: around $14–$15) the correlation between the stock price and credit spreads was low. As soon as Ford’s stock price dropped below this range a threshold was passed where investors started worrying about the value of the firm and its ability to cover all indebtedness. Corporate bond investors began to demand a much higher risk premium because of the fear that their investment was not covered sufficiently by Ford’s asset base. For the period between July 2002 and November 2003 Ford’s stock traded in the range of $6–$13 and we find a very high correlation between Ford credit spreads and equity of ⫺85 percent.
During those periods equity-based techniques work quite well in meas- uring and monitoring potential credit risk. We have to consider as well that the sensitivity of debt to equity also increases with the leverage of a particu- lar company. The underlying business risk and asset volatility determine the level of sensitivity. Higher risk companies display a greater uncertainty about future earnings and cash flows hence have a higher volatility and will have a greater sensitivity to increasing leverage (here measured as total debt/(total debt⫹market cap)). The VIX Index is in certain periods a good measure for credit risk and works especially well for highly levered
companies. For Ford a high correlation of 90 percent was observed for the period October 1999 to February 2004 (Figure 5.16).
In February 2003, Ahold revealed accounting irregularities and both the equity market and bond market reacted very negatively to the news about fraud. Bonds began to trade on the expected recovery value but recovered since then as the equity value of the firm began to rise and it became appar- ent that the company would be able to survive in the long term (Figure 5.17).
WorldCom is another good example for the strong link between equity and corporate bonds when asset value drops below a certain threshold (Figure 5.18). In February 2002, WorldCom disclosed significant asset write-offs and accounting concerns persisted over the next couple of weeks.
Finally, liquidity concerns pushed the company’s equity and bond prices to distressed levels. WorldCom applied for Chapter 11 and the bonds traded down to around 15–20 cents on the dollar in July 2002.
5.2.2.3 Company selection
After completing all the steps in the analysis the results have to be put together in order to come up with an investment decision. Clearly many factors impact the credit quality of companies and perhaps most important are qualitative “soft factors” and their interpretation is very subjective. In Table 5.11 we summarize all important qualitative and quantitative factors and comment on what an investor should be focusing on. They consider fundamentals, technicals and valuation. The task is to bring all factors
Figure 5.15 Ford equity price and bond spreads between Oct. 1999 and Jan. 2004
Source: Union Investment
R2= 0.8294 0
100 200 300
400 500 600
7000 5 10 15 20 25 30 35
Ford equity price
Ford 7.375% 2009 OAS spreadinbp
Feb. 10, 2004
October 2002
Figure 5.16 Ford bond spreads and Ford implied equity volatility between Oct. 1999 and Feb. 2004
Source: Union Investment
0 100 200 300 400 500 600 700
10/21/9912/30/99 03/09/00
05/18/00 07/27/0010/0
5/00
12/14/0002/22/0105/03/01
07/12/0109/20/0111/29/0102/07/0204/1 8/02
06/27/0209/0 5/02
11/14/0201/2 3/03
04/0 3/03
06/12/0 3 08/21/0
3 10/30/0
3 01/0
8/04
Spreadinbp
0 10 20 30 40 50 60 70 80 90 100 110
Equity volatility
F 7.375% 09 spread Ford implied equity volatility
Figure 5.17 Ahold bonds and equity reacted sharply to the announcement of accounting fraud
Source: Union Investment
0 200 400 600 800 1000 1200 1400 1600
11/16/0112/10/0101/01/0201/2 3/02 02/14/0203/08/02
04/01/0204/2 3/02 05/15/02
06/06/0206/2 8/02 07/22/0208/13/02
09/04/0209/26/0210/1 8/02 11/11/0212/0
3/02 12/2 5/02 01/16/0
3 02/07/0
3 03/03/03
03/25/03 04/16/0
3 05/08/03
05/30/0 3 06/2 3/03 07/1 5/03 08/06/0
3 08/28/03
09/19/0 3 10/1 3/03 11/04/0
3 11/26/0
3 12/1 8/03 01/09/0402/02/04
Spreadinbp
0 5 10 15 20 25 30
Equity price
AHOLD 5.875% 08 spread AHOLD equity price
together and generate performance-enhancing investment decisions. For this purpose the various factors can be weighted according to their importance whereas the weights are set by the analyst. This means to pick a company with the highest outperformance potential out of a universe.
In the ideal case, investors will pick companies with the following funda- mental characteristics and an attractive valuation versus the peer group so that high outperformance potential is given:
■ Better and continuously improving average credit ratios than the peer group
■ Commitment of management to a defensive financial policy and high credibility of the management team
■ Positive outlook about future earnings
Figure 5.18 Relationship between Worldcom stock and bonds
Source: Union Investment
0 2 4 6 8 10 12 14 16 18 20
05.18.01 05.30.01
06.11.01 06.21.01
07.03.01 07.13.01
07.25.01 08.06.01
08.16.01 08.28.01
09.07.01 09.19.01
10.01.01 10.11.01
10.23.01 11.02.01
11.14.01 11.26.01
12.06.01 12.18.01
12.28.01 01.09.02
01.21.02 01.31.02
02.12.02 02.22.02
03.06.02 03.18.02
03.28.02 04.09.02
04.19.02 05.01.02
05.13.02 05.23.02
06.04.02 06.14.02
06.26.02
Equity price
0 20 40 60 80 100 120
Bondprice
WorldCom equity price WorldCom 6.75% 2008 Eurobond price
Table 5.11 Qualitative and quantitative factors applied in the company selection process
Factors Comment
Industry trends Focus on industry cycles, regulatory or environmental issues, capacity utilization rates, barriers of entry, competition
Market position Market leader or niche strategy, trend in market share and costs involved in maintaining market share
Business risk Technological innovations, high R&D costs, high sunk costs, high fixed costs
Event risk Litigation, change in capital structure
continued
Table 5.11 continued
Factors Comment
Financial/liquidity position Short-term liquidity, access to the capital market, maturity schedule
Cash flow generation Fluctuation of cash flows across the business cycle Leverage Leverage ratios in comparison to peers and within a rating
class, trend in ratios
Coverage Coverage ratios in comparison to peers and within a rating class, trend in ratios
Rating trend Ratings history, outlook, is the company currently under review?
Management strategy Disclosure of company strategy, experience of management team
CAPEX Plan Timing and size of CAPEX to support business
Earnings Fluctuation in earnings, does company permanently achieve stated earnings goals?
Operational performance Focus on revenue growth, gross margin, SG&A as a percentage of sales, EBITDA trend and cash flows from operations
Quality of assets Assets that serve as collateral, value of noncore assets that can be sold
Covenants To what extent do they protect a bondholder without limiting a company’s business plan, claim on assets and cash flows Equity performance Past equity performance relative to peers, firm value in
perspective to overall debt level Implied equity volatility Perceived riskiness of future earnings
Secondary market liquidity Particularly small issues have limited secondary market liquidity and therefore command an illiquidity risk premium Fund flows Determine demand for corporate bonds and hence the
demand for high beta or low beta bonds
New issue supply Net issuance will differ across sectors and companies, what volume can be absorbed without adverse effects?
Sentiment Historical evidence shows that market psychology dominates at the top and bottom of market cycles whereas fundamentals and valuation play a subordinated role.
Relative value Compare current trading level with past performance and with peer group, relative attractiveness versus other sectors and market, consider also spread volatility
Source:Union Investment
■ Generation of free operating cash flows
■ Operative outperformance versus peer group
■ A solid market position in its core business areas
■ A sound liquidity position and multiple sources of available financing
■ Favorable outlook for the business cycle
■ Spreads which offer a relative attractiveness versus peer group because all positive developments are not priced in the spreads yet.
5.2.2.4 Relative value
Analysts use many ways to demonstrate the relative attractiveness of a spe- cific bond. Some examples follow next:
■ Free Cash Flow: One of the risk metrics for corporate bond investors is cash generation. In a relative value framework companies can be grouped by the change in free cash flows and their respective spread lev- els. Companies with positive free cash flows and high spread levels have outperformance potential in the future.
The change in free cash flow can also be compared with leverage ratios like debt/EBITDA. Highly levered firms with corresponding higher yields but forecasted future increase in free cash flow have the potential to outper- form.
■ Sales: A good tool for evaluating companies is to put their sales figures in relation to CAPEX. Since CAPEX is an important determinant in balance sheet repair, we should look for companies with an expansion in sales and decreasing capital spending. Sales growth can also be put in relation to debt levels. The ideal company for bondholders will grow its sales and pay down debt at the same time.
■ Return on invested capital (ROIC): ROIC is a measure of how efficiently a company spends money. For this purpose annual averages of ROIC can be plotted in a matrix versus the ratio of CAPEX/sales. Companies with high CAPEX/sales ratios and low returns on invested capital are poised to underperform at times when fundamentals are the main drivers of the credit market.
Figures 5.19 and 5.20 are examples for selecting a specific bond from the telecom and auto sector. First we plug all bonds from one sector in a matrix with modified duration on the x-axis and spread on the y-axis. By this