Evaluating a Company’s Financial Strength: Part I

When I am considering the purchase of a company’s shares, a major factor in the decision is the company’s financial strength, which I will define as the measure of a company’s ability to service any obligation senior to common shareholders. These senior obligations include debt payments, preferred stock payments, the funding of any pension plan, and rental expense. Clearly, the ability of a company to service these obligations impacts shareholder return, after all, if a company defaults on its bonds, the value of its common shares fall to zero (or something very close to zero). Beyond avoiding bankruptcy, a high level of financial strength gives the additional benefit of a lower and much more stable cost of debt capital.

My starting point in assessing a company’s financial strength is the company’s long-term issuer credit rating, and I rule out any company with less than an investment grade rating. Limiting myself to investment grade companies substantially decreases my risk. To see why, consider the fact that in a study carried out using NYSE data from 1951 to 1998 over half of the companies in existence at the start of a ten year period were out of business by the end of the ten year period (“The level and persistence of growth Rates”, Chan, et al). Now compare this to investing in a portfolio of stocks at the lower end of investment grade (BAA3 credit rating), where over 90% of the companies would still be in existence after ten years.

Although a company’s credit rating is correlated to the probability of future default (see Moody’s default rate statistics from 1920 to the present), the credit rating agencies do sometimes miss potential problems, with plenty of recent examples in the banking and real estate industries. For this reason, I do my own credit analysis, and if necessary, reduce a company’s credit rating for the purposes of my analysis.

A common metric used to evaluate the ability of a company to service its debt is the interest coverage ratio, which is the ratio of earnings before interest and taxes to interest expense. However, I believe a better metric is the fixed charge coverage ratio, which adds both preferred stock interest payments and 1/3 of rental expense (this is the portion of any rent paid that is deemed representative of the interest component) to interest expense. Although a company’s fixed charge coverage ratio is a useful metric, a satisfactory fixed charge ratio is a necessary, rather than sufficient, condition for financial strength. Two companies with similar interest coverage ratios can be impacted very differently to an interest rate shock depending on their debt maturity schedules.

To see why, consider a simplified example of two companies with $5000M in debt, $250M in annual interest expense (let’s assume no preferred stock or rental expense), and earnings before interest and taxes of $1000M (which we will assume remains constant over the next ten years). So each company will have a fixed charge coverage ratio of 4:1 and a debt to earnings before interest and tax ratio of 5:1, and each company will earn $500M after tax (this assumes a 33% effective tax rate). There is however one major difference - company A has 10% of its debt maturing each year over the next ten years, whereas company B has all of its debt maturing next year. Let’s also assume both companies target a 50% dividend payout ratio.

Now consider an extreme scenario where interest rates double and then stay constant. Under these conditions, company A will see its interest expense rise by 10% during each year as it refinances debt at the higher rate. Although not ideal, things look much bleaker for company B, whose interest expense immediately doubles when it must refinance all of its debt at the higher rate.

Of course the interest expense of company A would end up doubling after ten years if it refinances all of the maturing debt at the new rate, but company A does have the option of either paying off the entire debt maturing in a given year using earnings or maintaining the dividend and paying off half of the debt using retained earnings - this would reduce the increase in interest expense to 5% annually. Company B on the other hand can at most pay down $500M of the $4500 in maturing debt (this assumes the company cuts its dividend), and its interest expense will rise by 90%, which means the following year only $368M is available to pay down debt, with the situation worsening in subsequent years. Although the example is extreme, it does clearly illustrate how a company’s debt maturing schedule impacts the sensitivity of a company’s financial position to an interest rate shock.

For a recent example of this sensitivity, consider two REITs, Kimco Realty (KIM) and Realty Income (O). At the end of 2008, both of these companies had fixed charge coverage ratios of 2.6. Kimco’s debt to funds from operations was 8.6, whereas the same ratio for Realty Income was 7.4. Although Kimco had slightly more debt with respect to funds from operations, at a first glance, their financial positions were pretty similar.

But when credit dried up in late 2008, the impact on each company was radically different. To see why, we need to look at each company’s debt maturity schedule. Whereas Kimco has a weighted (by the amount maturing in each year) average time to maturity of almost six years, Realty Income’s weighted average time to maturity was almost twelve years. Neither company wanted to access the credit markets at the interest rates that were on offer, but whereas Kimco was faced with rolling over $442M of debt in 2009, Realty Income only had to roll over $20M. So in 2009, Kimco ended up offering 105M shares of common stock for $7.10 a share (with 271M outstanding at the end of 2008, significantly diluting common shareholders. Realty Income on the other hand paid down its maturing debt using retained funds from operations. And where Kimco found it necessary to cut their dividend in 2009, Realty Income was able to slightly raise its dividend.

Going forward, Realty Income will be much less sensitive to the state of the credit markets, with no debt maturing until 2013 when $100M matures, and an average ratio of maturing debt to funds from operations of 0.62. Kimco on the other hand has significant amounts of debt maturing in each year through 2013 (and later), and has an average ratio of maturing debt to funds from operations of 1.23. The market seems to realize the difference in each company’s financial position - Kimco’s stock price has fallen from a value of $35 at the start of 2008 to a value of $9.27 today, as compared to Realty Income, whose stock price has fallen from a value of $23 at the start of 2008 to a value of $22 today.

Although this comparison between Realty Income is not perfect, with some confounding factors being Kimco’s higher quality tenants, offset by the high leverage employed in Kimco’s joint ventures, it does illustrate how a longer weighted average debt maturity benefited Realty Income during the recent credit crunch.

Getting back to the main topic of this article, I only purchase a company’s shares when, on average, retained earnings cover the company’s maturing debt in any give year. This gives some margin for declining earnings, in that the company can always cut their dividend to free up more cash to pay down debt. This purchase rule makes the companies in my portfolio relatively immune to the first order effects of an interest rate shock, although earnings can still be impacted by the effect of the shock on a company’s customers, with a recent example being the impact to 3M’s earnings due to the turmoil in the automotive industry.

My threshold for a company’s fixed charge coverage ratio depends on the company’s industry, with a higher ratio being demanded for industries with higher earnings volatility. To illustrate, a ratio of 4:1 would suffice for a company in the consumer staple industry, whereas a ratio of 8:1 or higher would be preferred for a heavy equipment manufacturing company.

You may have noticed I left out debt to equity as a financial strength metric. The reason is that as long as a company has a good fixed charge coverage ratio and a well-distributed debt maturity schedule that allows a company to pay down maturing debt out of retained earnings, debt to equity does not really have much bearing on financial strength. For an extreme example, when I purchased shares in UST, inc. back in early 2002, the company actually had negative equity. But the company had free cash flow of $520M after adjustment for litigation expense, compared to debt of $1.14B. Although there was a large payment of $600M due in 2012, on average, the company had maturing debt well covered by free cash flow. Here it was pretty clear that the lack of equity (according to GAAP) was not really an issue.

In a follow up article, I will write about several other metrics I use to quantify a company’s financial strength, including pension risk, sensitivity to input prices, and labor risk. For a more detailed discussion of analyzing a company’s financial strength, you can check out Chapter 5 in my book, which can be found on my website: web.me.com/briangaudet/ThePatientInvestor/Home.html

Disclosure: I do not own shares in Kimco, Realty Income, or UST, inc. I do own shares of 3M.

Comments

[granger:]

good stuff, enjoyed it, thanks for your efforts

Jun 24 02:08 PM

[maryanne:]

excellent analysis! Shows why O is the best!

Jun 25 04:22 PM