Communications, Capital Management Critical as Downgrades Increase

Matt Gallino, North America Head of Ratings Advisory, and Marc Zenner, Global Head of Corporate Finance Advisory at J.P Morgan, provided two presentations on corporate rating agency best practices,  and  corporate investment and cash management trends.

Gallino began with a discussion of current trends among the major rating agencies, pointing out the downgrade-to-upgrade ratio is currently at its highest point since the great recession.  The downgrades are driven largely by the commodities sector, but also indicate rating agency negativity in the broader industrial sector.

Moody’s has been especially decisive in downgrading the oil and gas sector, with a significant number of three, four and five-notch downgrades in this area.  Moody’s has shown more negative sentiment with respect to the oil and gas and diversified industrials sectors than at any time since 2009, and  S&P seems to be following suit. Earlier in May, Moody’s oil and gas team indicated they believe a $60-per-barrel price will not become prevalent until 2019.

Going forward in 2016, J.P. Morgan has identified eight major trends:

• Liquidity assessments will dominate almost all rating discussions
• The need to refinance early to get ahead of maturities
• The “look forward” for M&A is becoming more constrained (by as much as 50 percent)
• Agencies are becoming less cognizant of companies’ flexibility in managing the rising risk of an industrial or economic recession
• With respect to financial policy, agencies are more skeptical of aggressive capital returns
• There will be greater implications of debt exchanges for lower-rated corporates
• There will be continued stress in commodities sectors

Gallino shared a “cheat sheet” of 10 best practices for dealing with rating agencies in this new environment:

1. No surprises - Provide a preview before major announcements (good or bad) and keep them engaged

2. Quarterly updates are helpful - Preview earnings and provide an opportunity to ask questions, or have a follow-up call after earnings

3. Meet annually in person  - One annual, formal meeting that reviews the company's strategy, performance to date and future direction
4. Provide three-year projections and drivers annually - Use an achievable management base case; agencies will stress-test

5. Get to know the lead analysts - It’s important that lead analysts know and trust their primary contact at the company

6. Know the criteria and peer ratings - Help management better position its story with the agencies

7. Manage expectations carefully - Like with investors, manage expectations about performance, leverage tolerance, growth, capital structure and financial policies

8. Use presentations - Rating agencies tend to respond best when they are provided with data that is well organized and explained

9. Tell the creditor story, not the equity story - How is the downside protected? What discipline and risk controls are integrated into growth plans?

10. Ask questions /debate with them - Discussions may not change an analyst's mind immediately, but could help sway their opinion over time.

Marc Zenner capped off the meeting with an analysis of corporate capital management trends, including  capital structure, liquidity, capital allocation and risk management.  After a brief review of the cost-of-capital curves since 2009, Zenner pointed out ratings matter with respect to returns in the energy sector (over $100 MM in market cap).

From June 2014 to the present, returns in the energy sector have declined across the board, but firms rated A- or above experienced a 29 percent decline and those with a BBB rating a 33 percent decline; while firms rated BB saw a 54 percent decline and firms B+ or lower experienced a drop of 73 percent in USD returns.

Zenner said while companies continue to expand cash balances (e.g., the non-financial S&P 100 increased total cash holdings 29 percent from 2011 to 2014), cash balances have shifted from predominately onshore (56 to 44 percent) to primarily offshore (47 to 53 percent) during this period, with offshore cash balances showing at 15 percent CAGR.  He emphasized highly rated firms with better access to capital markets had distinctly different cash balance frameworks than lower-rated firms; overall, the higher rated, the less need for liquidity.

Looking at the uses of operating cash flow, Zenner noted widespread criticism of the current trend of under-financing capex and R&D, and over-emphasizing cash distribution in the form of dividends and buybacks.  However, data appears not to support critics’ contention that the greater the investment in capex (including R&D), the higher the returns.

Zenner then charted the trend line in the cost of capital (WACC) for the S&P 500, showing that the 2015 WACC was near pre-financial crisis levels and historical trends.  He compared ROIC and excess returns by industry (ROIC - WACC), highlighting the significant and continuing decline of both indices in the energy industry (and less steep declines in the telecommunications industry) from 2006 to 2015.

Turning to trends in capital allocation, Zenner discussed M&A activity and shareholder distributions, noting dividend premiums since 2011 have remained strong despite the prospects for higher rates.  He concludes that shareholder return policies have outperformed through the cycle (S&P 500 total return from 2006-2016 was 96 percent, compared to total returns for “Dividend Aristocrats” at 167 percent and “Buyback Achievers” at 141 percent for the same period).

Zenner also pointed out the positive relationship between increases in cash flow and increases in buybacks, which gives the appearance that companies are engaging in higher levels of buybacks during periods of higher share prices. Nonetheless, a recent survey indicated 88 percent of institutional investors believe “a perspective on valuation is critical to the decision to repurchase shares”.

Zenner also looked at the growing negative impact of FX challenges on revenues, while noting the significant level of poor forecasting by economists in the last 18 months with respect to the U.S. dollar, crude oil prices and U.S. treasuries.  Forecasts for the 10-year Treasury have trended much higher than actuals, which have come in at the lower end of forecasts since 2011.

Zenner concluded his presentation with a brief review of factors worth considering in a zero-rate environment -- which is currently the case for 31 percent of government bond yields globally.  These included changes in: the cost of capital and hurdle rates, the risk profile of cash, the impact of searching for higher yields on risk, decelerating AR/accelerating AP and the expected return on pension assets – among others.