Moody's is overstating the credit risk of The Goodyear Tire & Rubber Company (NYSE:GT) with its Ba2 rating. However, Valens' fundamental analysis highlights a much safer credit profile for GT. The company's stable cash flows easily cover all their operating obligations. Moreover, their sizable cash build should allow them to service all obligations including debt maturities in years when their cash flows fall short. Valens therefore rates GT four notches higher at an IG4+ credit rating, or a Baa1 equivalent using Moody's ratings scale. (To register for free access to our corporate credit ratings, please click here.)
Moreover, cash bond markets are materially overstating GT's credit risk, with a cash bond YTW of 5.227% relative to an Intrinsic YTW of 3.077%.
Cash Flow Profile
Valens Credit produces a Credit Cash Flow Prime™ chart for The Goodyear Tire & Rubber Company, as it does for every company it evaluates. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Credit's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
GT's cash flows would consistently exceed their operating obligations, indicating that the firm is operationally sustainable. Moreover, the firm's material cash on hand levels and sizable expected cash build should allow the firm to service all obligations including debt maturities through FY 2022. Additionally, the firm's robust recovery rate would likely allow access to credit markets and facilitate debt refinancing if necessary.
Like most people, senior executives and board members do what they are paid to do. This is why GT's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Valens' Incentives Dictate Behavior™ analysis focuses on GT's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
GT's management compensation framework shows positive signals for debt holders. Their short-term compensation is focused on EBIT, operating free cash flow, and operating drivers, which includes new product vitality, manufacturing productivity, and working capital excellence. Three of those metrics, operating cash flow, manufacturing productivity, and working capital excellence, focus on improving Asset' Turns over time. Additionally, EBIT compensation should drive management to improve margins while also growing the business.
Meanwhile, long-term compensation is based on net income growth and total cash flow net of debt. The net income compensation metric should focus management on expanding margins and fostering revenue growth, while the total cash flow net of debt metric should focus them on reducing leverage while improving asset turnover and margins. Overall, this compensation framework is focused on improving ROA' and reducing debt, two factors that will benefit debt holders over time.
Valens provides analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of GT, the analysis of their Q4 2015 earnings call highlighted mostly highly questionable markers from management. They appeared confident when saying that their working capital is expected to be a use of about $50mn, and when saying their capex outlook is $1bn-$1.1bn. On the other hand, management appears concerned about the sustainability of operating income growth in North America and Asia Pacific. They also appear concerned about the sustainability of raw material price tailwinds, and may lack confidence in their ability to position themselves to benefit from market growth in China. (More about Valens' innovative research tools is available here.)
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. GT's credit risk is being overstated by Moody's, and materially overstated by cash bond markets. Given GT's stable cash flows relative to operating obligations, healthy liquidity profile, and robust recovery rate, ratings are expected to improve and cash bond market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.