Amazon (AMZN) recently came to market with a $2.5 billion corporate debt issue, which wound up being rated at AA- by Standard & Poor's and Baa1 by Moody's Investors Service.
For the average retail equity investor/stock trader, this debt issue meant nothing, but as soon as I saw the wide divergence in the credit ratings, it caught my attention since this wide of a quality spread in terms of a corporate bond credit rating is analogous to a scratch golfer turning in a 105 on their score card, on a par-3 golf course. (The immediate question for an informed observer is, "what's wrong here?")
Most credit rating "divergences" are AA-/Aa or perhaps even Aa/A with the Aa (at the low end i.e. Aa3) and maybe an A+, but to have a true AA-/Baa1 spread is an unusual extreme for the rating agencies, and is probably indicative of the post Worldcom and post 2008 mortgage meltdown change in credit rating methodologies.
As a former credit/fixed-income analyst in the 1990's, and as someone who followed the rating agencies closely when working with portfolio managers on issues with credit risk, I got to understand how the rating agencies arrived at their respective credit ratings in the 1980's and 1990's. Although it needs to be covered in a longer article, corporate rating methodology (in my opinion) began to change dramatically in the early 2000's after the Worldcom default, since Worldcom was rated investment-grade (BBB/Baa) far too long before the default.
There is nothing more disastrous for a rating agency than to have an investment-grade credit default, and Worldcom touched off a sea of changes in the rating agencies, which were only then exacerbated by what happened in the Mortgage Crisis of 2008.
The point is that it seems like from my perch that rating agencies, after a remarkably tumultuous 12 years, have now become:
1.) More forward looking in their ratings analysis;
2.) A firm's culture and corporate governance now matter greatly;
3.) The rating agencies - after virtually ignoring how the capital markets debt traded in the 1980's and 1990's - now seem to give quite a bit of credence to the information capital markets relate (i.e. corporate credit spreads), and seem to have attached particular importance to the Credit Default Swap (CDS) market on issues which are rated.
In reviewing the two Amazon credit analysis reports from Moody's (Baa1) and Standard & Poor's (S&P), there were many similarities, as there usually is between the rating agencies.
S&P noted Amazon's "strong" business risk profile, their leadership position in e-commerce, and minimal financial risk profile. S&P also noted Amazon's "strong" management team and corporate governance principles.
Moody's discussed Amazon's "very good liquidity" and "strong balance sheet."
|Variable / metric||S&P||Moody's|
|Senior unsecured rating||AA-||Baa1|
|Financial profile||Minimal||very good liquidity|
* Source: rating agency reports
* EBIT - Earnings Before Interest, Taxes
* EBITDA - Earnings Before Interest, Taxes, Depreciation and Amortization
Although there were a lot more quantitative metrics that could be discussed, to differentiate themselves, the various agencies tweak the ratios, and it can become involved to work through the different formulas. Suffice to say that the "softer" criteria like business risk, financial profile and governance issues, both agencies seemed to be in close agreement.
The biggest issue I saw and likely why Moody's assigned such a lower rating to the deal than S&P was the low EBIT margin, which S&P noted, but which S&P expects to return to the norm, while Moody's seems to be adopting a "show me first" stance with the rating.
Moody's even goes on to say specifically, "However as EBIT margin improves, we anticipate an improvement in its credit metrics." S&P noted that the "adjusted EBITDA margin remains pressured."
The bottom line here is that while S&P seems to have incorporated a "forward-looking" aspect to the rating and expects operating margins to return to normal, Moody's seems to be of the stance that "well, we'd like to see the improvement first."
As a former credit analyst who wandered over to the dark side (i.e. equity investing) in mid-1995, we incorporated balance sheet and cash flow analysis into our bottoms-up equity analysis, instead of focusing on just the income statement.
Here is our own analysis of AMZN's cash-flow:
|Quarter end||Op mgn||4q trail CFO||4q trail FCF|
|q3 '12||1.7%||$3.4 bl||$1.0|
|q3 '09||4.6%||$2.9 bl||$2.5 bl|
Op mgn - operating margin
4q trailing CFO - 4-quarter trailing cash from operations
4q trailing FCF - 4-quarter trailing free-cash-flow
As of 9/30/12, Amazon had no long-term debt outstanding, so this $2.5 billion shelf is its first debt issue, and given the above analysis is easily covered by free-cash-flow, not to mention the $5 billion in cash on the balance sheet as of the end of September.
Although equity analysts are familiar with AMZN's SG&A (sales, general and administrative expenses) surge as well as the capex expansion, this pressure has been a drag on earnings for some time, but it hasn't yet impacted the stock price, since AMZN continues to remain a market share and revenue momentum story.
It was interesting to note in the rating agency reports that both expected AMZN's "capex" to fall in 2013, (more free-cash would then be generated) and both would NOT like to see AMZN increase its share repurchases (and you would have to wonder why management would do that with the stock selling at 120(x) earnings).
The current spread on the AMZN debt is roughly 60 - 65 basis points (bps) on the 5-year paper, and +95 bps on the 10-year paper, so the market is telling us that it is likely that S&P has this "more right" than Moody's on AMZN's credit at this point in time.
This debt issue could also be Amazon's signal that the margin-crushing SG&A and capex is nearing an end.
With 1% of global retail sales, we remain long AMZN's stock, as we think this company is in the very early innings of a 9-inning ball-game, albeit in small quantities in client accounts until the stock sees a decent correction. The equity valuation is extreme thanks to the crushing of margins by longer-term investment.
(This article was longer than we thought, but for someone who has done both fixed-income and equity analysis, I thought it would be an interesting perspective on credit analysis for readers. Believe it or not, understanding how credit rating methodologies have changed over the last 12 years would be a very long article.)
Disclosure: I am long AMZN.