Financial Reporting and Credit Ratings

Transcription

1 Financial Reporting and Credit Ratings Greg Jonas Managing Director CARE Conference NAPA, CA April 20, 2007

2 Agenda Background about credit ratings Calculation, process, role of financial reporting Accounting issues and credit ratings 2

3 Background on Ratings 3

4 Background on Moody s ratings Ratings on $35 trillion of debt outstanding 170,000 corporate, government and structured finance securities 10,000 corporate relationships 100 sovereign nations Most ratings are freely available Proprietary research 2,600 subscriber institutions, 400,000 users 4

5 Scope of today s discussion Corporate Financial institutions We are Here Corporate investment grade Corporate high-yield Municipal Sovereign Structured finance 5

6 Uses of credit ratings Building Portfolios Pricing Credit Ratings Contracts Trading Regulatory Requirements 6

7 Benefits of ratings for companies Market access (gate keeping) Expands breadth of market Widens distribution Improves liquidity Improves pricing Helps management with independent, outside perspective on company Helps management monitor counterparty risk 7

8 Benefits of ratings for investors Due diligence efficiency Multiple independent perspectives Facilitates comparisons Tool in portfolio management Enhances secondary market liquidity Relatively stable over time Basis for performance benchmarks 8

9 What does a credit rating mean? Opinion on expected loss Expected loss = (Probability of Default) x (Severity of Loss) 9

10 Rating scale Investment Grade High Yield Aaa Aa(1-3) A(1 3) Baa(1-3) Ba(1-3) B(1-3) Caa(1-3) Ca C Minimal credit risk Watch list = under review Outlook = likely direction In default, little prospect of recovery 10

11 Historical Rating Distribution 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% US Non-Financial Corporates Aaa Aa A Baa Ba B Caa-C By Issuer Count

12 Average Loss and Default Rates Senior Unsecured Rating Aaa Aa A Baa Ba B Caa Ca C Default Probability % 0.052% 0.380% 1.32% 7.48% 19.94% 48.27% 100% 100% Expected Loss Rate % 0.026% 0.190% 0.66% 3.74% 9.97% 24.13% 50% 80% 1 4 year time horizon 12

13 Average Cumulative Expected Loss: Senior Unsecured Debt 30% 20% 10% Rating B Ba Baa A Aa Aaa % Years Out 13

14 Assume Moody s rates a company s senior unsecured debt A2, on review for possible downgrade - What does this mean? The company s debt is investment grade Based on historical averages, investors can expect to lose 0.19% from a portfolio of all debt obligations at this rating over a 4-year period Based on an average loss in default of 50%, the probability of the debt defaulting is 0.38% Because debt is on review, it will probably trade as a Baa1 rated debt (2 notch discount) 14

15 Relationship between long-term and CP ratings Long-Term CP Investment Grade Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Prime-1 Prime-2 Prime-3 High Yield Not prime 15

16 Types of high-yield ratings Company Instruments Corporate Family Rating (CFR) Risk of Loss Speculative Grade Liquidity (SGL) Loss Given Default (LGD) 16

17 Corporate Family Rating Expected loss = (Probability of Default) x (Severity of Loss) Assumes = Corporate family is a single entity with one class of debt 17

18 Types of high-yield ratings Company Instruments Corporate Family Rating (CFR) Risk of Loss Speculative Grade Liquidity (SGL) Loss Given Default (LGD) 18

19 Instrument ratings Corporate Family Rating Debt Classes Senior Secured B1 Subordinated 19

20 Defaulted Debt Recovery Rates % Bank Loans Senior Secured Senior Subordinated Preferred Unsecured Stock 20

21 Instrument ratings Corporate Family Rating Debt Classes Instrument Rating Senior Secured Ba2 B1 Subordinated B2 21

22 Loss Given Default Rating LGD Assessment Loss Range LGD1 0% - 10% LGD2 10% - 30% LGD3 30% - 50% LGD4 50% - 70% LGD5 70% - 90% LGD6 90% - 100% 22

23 Instrument ratings Corporate Family Rating Debt Classes Instrument Rating B1 Senior Secured Ba2 LGD3 Subordinated B2 LGD4 23

24 Assume Senior Secured Debt is Rated Ba2, LGD3 (40%) - What does this mean? The debt is speculative grade Based on historical averages, investors can expect to lose 3.7 percent from a portfolio of these debt securities over a 4-year period If the security defaults, investors can expect to lose about 40% of the principle and accrued interest The probably that the company will default on this security is about 10% 24

25 Types of high-yield ratings Company Instruments Corporate Family Rating (CFR) Risk of Loss Speculative Grade Liquidity (SGL) Loss Given Default (LGD) 25

26 SGL SGL 1 SGL 2 SGL 3 SGL 4 Operating cash flow + cash on hand Sufficient Sufficient except for extra capex Breakeven and limited cash Insufficient Committed facility Undrawn Needed only for extra capex Reliant and used, but not fully Needs external sources Covenants Compliant with headroom Compliant Barely compliant Likely violation Back door Present Present but impairment Unlikely Little Assets Unsecured Mostly unsecured Mostly secured Few alternatives 26

27 Rating quality What investors want from ratings Accurate (relative ranking of credit risk) Low ratings in advance of default Stable (few rating reversals) Don t incorporate market price information (selffulfilling, pro-cyclical) Independent, stabilizing force Separate point of view from each agency 27

28 Rating quality Key performance measures Investment grade defaults Accuracy measure (90% = average defaulter rating lower than 90% of all issuers) Stability measure # of issuers with rating changes divided by total number of rated issuers # of issuers with 3+notch changes divided by total number of rated issuers Rating reversals 28

29 Ways to assess credit risk Fundamental approach (e.g. Moody s credit ratings) Market implied ratings (e.g. bond or CDS prices) Mathematical models 29

30 Fundamental ratings Not quite as accurate but more stable 1-year accuracy 5-year accuracy Average rating Rating action rate Large action rate Moody s Bond- Implied MDP B2/B3 B3/Caa1 B

31 Calculation, Process, Role of Financial Reporting 31

32 Fundamental Analysis: Areas of Analysis Financial Reporting Issue Structure Company Structure Operating / Financial Position Management Quality Industry / Regulatory Trends Severity of Loss Probability of Default Sovereign / Macro Economic 32

33 Rating data flow Company Reports XYZ Company DATABASE Adjusted Financial Statement Data Rating Methodologies Adjustment Worksheets 33

34 Reasons to adjust reported amounts Apply accounting principles that we believe more faithfully capture underlying economics Identify and segregate effects of unusual or non-recurring items Improve comparability by aligning accounting principles Reflect estimate or assumptions that we believe are more prudent 34

35 Moody s Standard Adjustments All Accounting Regimes Defined benefit pension plans Operating leases Employee stock compensation Hybrid securities Securitizations Unusual / non-recurring items IFRS Only Capitalized development costs Income statement presentation of interest cost related to certain discounted liabilities U.S. GAAP Only LIFO Inventories 35

36 Purpose of U.S. GAAP adjustments Adjustment Pensions Leases Capitalized interest Stock compensation Hybrid securities Securitizations LIFO Unusual items Purpose Eliminate smoothing Capitalize operating leases Expense capitalized interest Expense and flag on CFS Apply Moody s framework Treat as securitized borrowings Adjust balance sheet to FIFO Highlight core earnings 36

37 Typical timeframe for data Historical Projected 5 years 3 years 37

38 more rating data flow Adjusted Financial Statement Data Analysis Other Company Specific Data Rating Committee Package and Recommendation Industry // Macro Economic Data 38

39 Industry methodologies Key metrics Benchmark and rate Weigh Indicative Rating Other qualitative factors Final rating 39

40 Key metrics Global Medical Devices Industry Size, Scale and Diversification Total Revenues (20%) Segment Diversification (7.27%) Concentration of customers (7.27%) Product and Portfolio Profitability R&D as a % of Sales (7.27%) EBIT Margin (7.27%) ROA (7.27%) Financial Strength CFO / Debt (7.27%) Free Cash Flow / Debt (7.27%) EBIT / Interest Expense (7.27%) Financial Policies Reliance on acquisitions, share buybacks and dividends (7.27%) Debt / Book Capitalization (7.27%) Debt / EBITDA (7.27%) Note Factor weight in parenthesis Financial metrics in Italics 40

41 Key metrics Most Commonly Used Moody s Industry Rating Methodologies * Metric Category Metric % of Methodologies Including Metric Size Revenue 58% Profitability EBIT (or EBITA) Margin 38% Return EBIT (or EBITA) / Avg. Assets 30% Free Cash Flow / Debt 55% Cash Flow Retained Cash Flow / Debt 30% Retained Cash Flow / Net Debt 28% Coverage EBIT / Interest Expense 45% Leverage Debt / EBITDA 50% Debt / Capital 40% * To date Moody s has published 40 industry rating methodologies. 41

42 Key metrics Global Medical Devices Industry An example Rating Grid 42

43 Industry methodologies Industry structure Financial policy Management quality Contingent liabilities Aggressive accounting Weak accounting control Governance risk Event risk Key metrics Benchmark and rate Weigh Indicative Rating Other qualitative factors Final rating 43

44 An Example Rating: Stryker Corporation Adjusted Financial Statement Data Analysis Other Company Specific Data Rating Committee Package and Recommendation Industry // Macro Economic Data 44

45 An Example Rating: Stryker Corporation Adjusted Financial Statement Data Industry Model Rating Grid Other Company Specific Data Financial projections Strategic plans Details of significant transactions Access to management / directors Industry / Macro Economic Data Other Qualitative Considerations Relatively high degree of exposure to the orthopedics market Potential litigation stemming from DOJ investigation Potential for acquisitions in consolidating market place 45

46 An Example Rating: Stryker Corporation Rating Committee Package and Recommendation 46

47 Accounting Issues and Credit Ratings 47

48 Moody s Specialist Groups Group Accounting Governance OBS/Structured Risk Management Focus Credit-relevant issues related to financial reporting Impact of governance issues on credit risk Credit impact of off-balance sheet structures Impact of complex financial instruments on credit risk 48

49 What do accounting specialists do? Area of Responsibility Time Allocation The Big Questions Are analytical adjustments useful? Help get ratings right 40% Publish on companies and topics 30% Train Moody s analysts 15% Evidence of aggressive accounting? Evidence of weak reporting control? Impact of financial reporting meltdown? Communicate with outsiders 15% 49

50 Getting ratings right Evidence of aggressive accounting Comment Letters Governance Concern Misleading Accounting Red Flag Metrics Analyst Concern 50

51 Getting ratings right Evidence of weak reporting control Evaluating the impact control weakness on ratings Category B 1 weakness + General uncertainty about company s reporting 2 + Rating that does not yet reflect uncertainty = 1 Pervasive weakness, e.g.: Not enough folks Insufficient skills Negative rating action 2 Examples: Delinquent filings Continuing restatements Aggressive accounting Investigations Weak remediation 51

52 404 problem #1: reports lag reporting problems Types of Financial Reporting Errors Preceding Material Weakness Disclosures None 5% Both 15% Restatements 38% Adjustments and Other 42% 52

53 404 problem #2: No one is talking about fraud Percentage of Companies with Material Weaknesses Citing Fraud Controls 5% Fraud-Control Disclosures No Fraud-Control Disclosures 95% 53

54 Getting ratings right - Impact of a meltdown Company Rating Before Problem Rating After Problem Adelphia High Speculative Grade Low Speculative Grade - Rating Withdrawn AIG Highest Investment Grade High Investment Grade Cendant High Investment Grade High Speculative Grade Computer Associates Low Investment Grade Speculaltive Grade Delphi High Speculative Grade Low Speculative Grade - Rating Withdrawn Dollar General Low Investment Grade High Speculative Grade Duke Energy High Investment Grade Speculaltive Grade Dynegy Low Investment Grade Low Speculative Grade Enron High Speculative Grade Low Speculative Grade - Rating Withdrawn Global Crossing Speculative Grade Low Speculative Grade - Rating Withdrawn HealthSouth Low Investment Grade Low Speculative Grade - Rating Withdrawn Lucent High Investment Grade Low Speculative Grade Qwest Low Investment Grade Low Speculative Grade - Rating Withdrawn RiteAid High Speculative Grade Low Speculative Grade Sunbeam Speculative Grade Low Speculative Grade - Rating Withdrawn Tyco High Investment Grade Speculaltive Grade United Rentals High Speculative Grade Speculaltive Grade Waste Management Low Investment Grade High Speculative Grade WorldCom Low Investment Grade Low Speculative Grade - Rating Withdrawn 54

55 Reporting meltdown factors to consider Covenant violations? Will bond holders accelerate? Is backup liquidity ready and bulletproof? What will banks do? Crisis of confidence with customers and vendors? Management distraction? Management s plan to mitigate damage? Rating impact when we don t have # s - basis to continue ratings? 55

56 Published materials 2006 examples Content Accounting? Credit Impact? Data? Adjustments Standard adjustments Multi-employer pensions Internally funded pension plans Volumetric production payments Backdating Pooling adjustments at oil and gas companies New Rules Expensing stock comp. Pensions - Phase 1 SAB 108 Uncertain tax positions Fair Value Option Fair value for servicing assets Leveraged leases Events 404 reporting - Year 2 Short-cut method Internal audit Pension reform 56

57 Financial Reporting and Credit Ratings Greg Jonas Managing Director CARE Conference NAPA, CA April 20, 2007