Standard & Poor's Summarizes Request For Comment Process For New Corporate Methodology

Transcription

1 Standard & Poor's Summarizes Request For Comment Process For New Corporate Methodology Corporate Ratings: Mark Puccia, Global Criteria Officer, New York (1) ; Table Of Contents Corporate Criteria: Business And Financial Risk Profile Matrix Corporate Criteria: Country Risk Diversity Corporate Criteria: Competitive Position Corporate Criteria: Competitive Position Group Profile Corporate Criteria: Competitive Position (Medial Volatility Table) Corporate Criteria: Competitive Position (Volatility Of Profitability) Corporate Criteria: Time Horizon And Ratio Calculation Corporate Criteria: Cash Flow/Leverage Analysis Corporate Criteria: Capital Structure Corporate Criteria: Financial Policy Corporate Criteria: Comparable Ratings Analysis Corporate Criteria: Diversification/Portfolio Effect (Components Of Correlation) Ratios And Adjustments: Surplus Cash NOVEMBER 19,

2 Table Of Contents (cont.) Ratios and Adjustments: Operating Lease Adjustment Industry Risk: Transparency Group Rating Methodology Key Credit Factors For The Regulated Utility Industry Country Risk Criteria NOVEMBER 19,

3 Standard & Poor's Summarizes Request For Comment Process For New Corporate Methodology Standard & Poor's Ratings Services would like to thank the market participants who provided feedback on our proposed methodology for rating nonfinancial corporate issuers. The relevant request for comment (RfC) components that prompted this feedback are: Request for Comment: Corporate Criteria, published June 26, 2013 Request for Comment: Corporate Criteria: Ratios and Adjustments, published June 26, 2013 Industry Risk for Corporate and Public Finance Enterprises, published June 26, 2013 Methodology and Assumptions of Country Risk For Non-Sovereign Ratings, published July 31, 2013 Group Rating Methodology: Corporate Entities, published Aug. 12, 2013 Key Credit Factors For The Global Regulated Utility Industry, published June 26, 2013 Key Credit Factors For The Real Estate Industry, published June 26, 2013 Key Credit Factors For The Railroad/Package Express Industry, published Aug. 5, 2013 Key Credit Factors For The Transportation Infrastructure Industry, published Aug 9, 2013 In addition, we published two supplementary articles associated with the RfCs: Standard & Poor's Publishes Preliminary Country Risk Assessments For 93 Countries, published Sept. 9, 2013 Standard & Poor s Assigns Preliminary Industry Risk Assessments To 38 Nonfinancial Corporate Industries, published June 28, 2013 After careful consideration of the feedback, we have finalized and published the following criteria: Corporate Methodology, published Nov. 19, 2013 Corporate Methodology: Ratios And Adjustments, published Nov. 19, 2013 Methodology: Industry Risk, published Nov. 19, 2013 Country Risk Assessment Methodology And Assumptions, published Nov. 19, 2013 Group Rating Methodology, published Nov. 19, 2013 Key Credit Factors For The Regulated Utility Industry, published Nov. 19, 2013 Key Credit Factors For The Transportation Infrastructure Industry, published Nov. 19, 2013 Key Credit Factors For The Railroad And Package Express Industry, published Nov. 19, 2013 Key Credit Factors For The Real Estate Industry, published Nov. 19, 2013 This article provides an overview of the changes made between the requests for comments and the final criteria as well as the rationale behind those changes. Corporate Criteria: Business And Financial Risk Profile Matrix We added the following potential outcomes to the matrix in determining an issuer's anchor: Strong business risk profile/intermediate financial risk profile: 'BBB+' NOVEMBER 19,

4 Satisfactory business risk profile/significant financial risk profile: 'BBB-' Vulnerable business risk profile/intermediate financial risk profile: 'B+' Previously there was only one potential outcome for each of the above combinations without using comparative ratings analysis. These additional outcomes reflect common outcomes for these combinations of business risk profile and financial risk profile. In addition, the additional outcomes allow for smoother ratings transitions. Furthermore, there had been only one combination of business risk profile and financial risk profile that would result in a 'BBB+' anchor rating when a number of companies currently rated 'BBB+' have other weightings of business and financial risk factors to arrive at that outcome. Corporate Criteria: Country Risk Diversity We simplified the conditions necessary to receive credit for country risk diversity. There are now four conditions required to receive a one-category improvement on the preliminary weighted-average country risk score: Head office in country with a risk score better than the preliminary assessment; No exposure higher than 20% (either in revenues, EBITDA, or another relevant metric) to country with a score equal to or lower than the preliminary country risk score assessment; Funding primarily done at holding (head office) level or if any local funding can very rapidly be substituted at holding level; and Industry score is '4' or better. We also stipulated that a company with greater than 75% exposure to one country cannot receive any better score than the score of that country. We concluded that the initial description for country risk diversity was complex and difficult to apply practically. At the same time, we still believed we needed a country risk diversity mitigant. A corporate exposed to a single country with a risk of '4' entails more risk than a company exposed to 10 countries each with a risk of '4'. Corporate Criteria: Competitive Position We changed the increments in Table 14. Previously they were: < < < < NOVEMBER 19,

5 < <5.00 The new increments are: > > > > > Under the old increments if a company had all its qualitative competitive position scores assessed as "adequate", it would get a preliminary commercial paper score of '4' ("fair"). This is counterintuitive, and the new increments resolve this issue. Corporate Criteria: Competitive Position Group Profile We added an additional competitive position group profile, "product focus/scale driven". We wanted to add a competitive position group profile that had "scale/scope/diversity" as the key business risk driver and "competitive advantage" as the second most important business risk driver. Corporate Criteria: Competitive Position (Medial Volatility Table) #1 We now include the Medial Volatility table in the general criteria document. Initially this table was included only in the utilities and transportation Key Credit Factors. Issuers with a corporate industry and country risk assessment (CICRA) of 1-2 can use the Medial Volatility table under certain circumstances. Certain inter-industry comparisons would be difficult to explain without the option to use the Medial Volatility table. For example, it would make little sense to use the more lenient Low Volatility table for a diversified midstream energy company (CICRA of 2) compared with integrated utilities that largely use the Medial Volatility table. NOVEMBER 19,

6 #2 We tightened the proposed ratio ranges for cash flow from operations to debt in the intermediate, significant, aggressive, and highly leveraged financial risk profile categories. The ratio thresholds for cash flow from operations to debt in the intermediate, significant, aggressive, and highly leveraged categories had been more demanding in the Low Volatility table than in the Medial Volatility table. Corporate Criteria: Competitive Position (Volatility Of Profitability) #1 We further clarified the criteria supporting upward and downward adjustments to the standard error of regression-derived volatility assessment. The potential downward adjustment to this volatility assessment was extended to two grades from one under certain circumstances. Further, we added guidance surrounding exceptions for not using standard error of regression-derived volatility. These exceptions were companies that have materially changed their business lines and companies that have undertaken abnormally high levels of M&A over the last seven years. We wanted to add more flexibility for volatility of profit adjustments especially in cases where historical volatility data is distorted. #2 We changed paragraph 83 of the RfC to read, "In certain circumstances, the SER derived from historical information may understate--or overstate--expected future volatility, and we may adjust the assessment downward or upward. The scope of possible adjustment depends on certain conditions being met". This is now paragraph 86 of the final criteria. Previously it read, "In certain circumstances, the SER derived from historical information may understate--or overstate--expected future volatility, and we may adjust the assessment downward or upward. The scope of possible adjustments is limited: it depends on the direction of the adjustment and requires certain conditions being met." We do not feel that the scope of adjustments is limited given that certain companies have demonstrated low volatility throughout their history. Corporate Criteria: Time Horizon And Ratio Calculation We added as paragraph 117 in the final criteria "This weighting changes, however, to place even greater emphasis on the current and forecast years when: The issuer meets the characteristics described in paragraph 113, and either shorter- or longer-term forecasts are applicable. The weights applied will generally be quite forward weighted, particularly if a company is undergoing a NOVEMBER 19,

7 transformational event and there is moderate or better cash flow certainty. The issuer is forecast to generate negative cash flow available for debt repayment, which we believe could lead to deteriorating credit metrics. Forecast negative cash flows could be generated from operating activities as well as capital expenditures, share buybacks, dividends, or acquisitions, as we forecast these uses of cash based on the company's track record, market conditions, or financial policy. The weights applied will generally be 30%, 40%, and 30% for the current and two subsequent years, respectively. The issuer is in an industry that is prospectively volatile or that has a high degree of cash flow uncertainty. Industries that are prospectively volatile are industries whose competitive risk and growth assessments are either high risk (5) or very high risk (6) or whose overall industry risk assessments are either high risk (5) or very high risk (6). The weights applied will generally be 50% for the current year and 50% for the first subsequent forecast year." We made this change to improve the transparency of our criteria. Corporate Criteria: Cash Flow/Leverage Analysis We changed the first sentence of paragraph 249. In the RfC, it read, "For corporate issuers rated in the investment-grade universe, discretionary cash flow (DCF) to debt can be an important barometer of future cash flow adequacy as it more fully reflects a company's financial policy, including decisions regarding dividend payouts." This change is in paragraph 249 of the final criteria. It now reads, "For corporate issuers primarily rated in the investment-grade universe, DCF to debt can be an important barometer of future cash flow adequacy as it more fully reflects a company's financial policy, including decisions regarding dividend payouts." DCF to debt can be a meaningful payback ratio for some companies outside the investment-grade universe. Corporate Criteria: Capital Structure #1 We developed the Currency Risk of Debt section to include circumstances in which currency risk is mitigated. We will not penalize an issuer for currency mismatches under the following scenarios: The country where a company generates its cash flows has its currency pegged to the currency in which the company has borrowed, or vice versa (or the currency of cash flows has a strong track record and government policy of stability with the currency of borrowings). Moreover, we expect such a scenario to continue for the foreseeable future. A company has the proven ability, through regulation or contract, to pass through changes in debt servicing costs to its customers. A company has a natural hedge, such as where it may sell its product in a foreign currency and has matched its debt in that same currency. NOVEMBER 19,

8 In the above circumstances, the one-notch deduction for currency risk of debt is too harsh. #2 We changed the first sentence of paragraph 128 of the RfC to read, "Capital structure is a modifier category, which adjusts the anchor for a company after any modification due to Diversification Portfolio Effect." This change is in paragraph 137 of the final criteria. Previously, it read, "Capital structure is a proposed modifier category, which adjusts the initial anchor (combination of business risk profile assessment and financial risk profile assessment) for a company". We made this change to improve transparency in our ratings methodology. #3 The first sentence of paragraph 132 of the RfC now reads, "The fourth subfactor, investments, as defined in paragraph 153, quantifies the impact of a company's investments." This change is in paragraph 141 of the final criteria. Previously we had not defined "investments". We made this change to improve clarity in our ratings methodology. Corporate Criteria: Financial Policy #1 There is no longer a restriction that prohibits the financial policy modifier from moving an anchor higher than 'BB+'. There is fundamentally no reason to exclude this case if we believe long-term financial policy is a strong support factor. In particular, it would be problematic for a 'BBB-' rated company with temporarily weaker credit measures but that we expect to take proactive and strong action to restore its balance sheet over the next 18 months. #2 The assessment of financial policy has been revised to account for ownership by a financial sponsor. Given the intrinsic characteristics of a financial sponsor's strategies, we will assign the financial risk profile score to a sponsor-controlled firm based on expected leverage. Analytic focus should be on projected leverage, not current leverage and projected leverage. #3 For firms that are not sponsor controlled, we separate assessments of a company's financial policy framework and financial discipline to determine any adjustment. NOVEMBER 19,

9 Effectively, we don't distinguish between management and a controlling shareholder that is not a financial sponsor. #4 Financial discipline will be based on three instead of four subfactors. Effectively, the assessment remains the same since the remaining subfactors still seek to gauge the likelihood of event risk and management's leverage tolerance. We merely wanted to simplify the analysis. Corporate Criteria: Comparable Ratings Analysis #1 We clarified the ultimate purpose of Comparable Ratings Analysis. We now describe it as an area to "fine-tune" ratings outcomes, even after the use of other modifiers. We removed all references to "peers". We added guidance surrounding additional factors that could lead to the use of relative ranking. Again, this was a case where the underlying intent of the criteria remains the same; we simply made a change to clarify that intent. We removed the reference to "peers" to avoid confusion with analysis of business risk profile. #2 Comparable Rating Analysis now explicitly highlights that contingent liabilities can be a risk factor that underpins the use of this analysis. There had been no direct mention of contingent liabilities in the RfC and particularly no placeholder for such contingent liabilities that cannot be reasonably assumed in our forecast. Corporate Criteria: Diversification/Portfolio Effect (Components Of Correlation) We changed the first sentence in paragraph 124 of the RfC to: "We determine the assessment for this factor based on the number of business lines in separate industries (as defined in Table 27)". Previously, it read: "We determine the assessment for this factor based on the number of divisions in separate industries and the degree of correlation between these divisions as described in table 19". The new sentence is in paragraph 133 of the final criteria. We wanted to simplify the analysis of diversification. NOVEMBER 19,

10 Ratios And Adjustments: Surplus Cash #1 We removed Step 1 in our proposed surplus cash adjustment, the adjustment for working capital needs. We now plan to develop any intra-year working capital adjustments in our liquidity analysis. #2 In Step 2 of our surplus cash adjustment, we added examples of when the haircut or discount to cash will be less than 25%. We made this change to help the market better understand our surplus cash adjustment process. #3 We replaced Step 3 in our proposed surplus cash adjustment, an adjustment of forecast negative cash flow, with a condition in the Cash Flow/Leverage Criteria that requires we adopt a three-year ratio time series for companies with forecast negative pre-financing cash flow. The time series will comprise the current year with a weighting of 30%, the year 1 forecast with a weighting of 40%, and the year 2 forecast with a weighting of 30%. We felt this was a better way to reflect ongoing cash usage on operating losses, share buybacks, and acquisitions. Ratios and Adjustments: Operating Lease Adjustment We will use a 7% discount rate in operating lease adjustments for all issuers instead of using differing rates for investment grade and non-investment grade issuers. There is a level of circularity involved in basing the discount rate used for lease adjustment on whether an issuer is investment grade or non-investment grade. Such a differentiation assumes we know if the company is investment grade prior to rating the company. The 7% discount rate for all issuers is a simpler solution. Industry Risk: Transparency We changed the line in paragraph 8, "Risk of secular change and substitution of products, services and technologies from other industries" to read "Risk of secular change and substitution of products, services and technologies." These competitive threats could emerge from an issuer's own industry as well. NOVEMBER 19,

11 Group Rating Methodology #1 We removed paragraphs 24 through 26 of the RfC on Group Rating Methodology, the section detailing the impact on family-owned entities. We did not believe that the Group Rating Methodology would apply to the significant majority of family-owned entities. #2 We expanded the description of how we intend to treat captive finance entities. This change was made to clarify our overall Group Rating Methodology. #3 We enumerated specific situations in which a rating on a group member can be higher than the sovereign rating on that entity's country of domicile. We wanted to supplement the general criteria on rating issuers above the sovereign as it applies specifically to corporate group entities. #4 We added a section outlining situations in which a rating on a group member can be higher than the transfer and convertibility assessment on that entity's country of domicile. We added this section to anticipate all potential scenarios surrounding a group member domiciled in a low-rated sovereign. Key Credit Factors For The Regulated Utility Industry #1 We explicitly defined "peers" and "average". We made this change to clarify our Key Credit Factors. #2 We gave more color on the weightings attributed to regulatory advantages and broadened the description or relevant regulatory mechanisms. NOVEMBER 19,

12 We made this change to clarify our Key Credit Factors. Country Risk Criteria #1 We modified the title of the criteria, and the scope section, to clarify that the focus of the criteria is to explain how we will arrive at our country risk assessments, which in turn will apply as indicated in related sector-specific criteria, such as Corporate Methodology. #2 We clarified the use of peer comparisons in arriving at the overall country risk assessment. #3 We updated the Calibration section of the criteria to more clearly explain why we chose the specific four sub-factors used in the criteria, and to explain why we generally apply equal weighting for those sub-factors. These changes do not materially change our approach to country risk assessments, but should enhance the transparency of our approach. NOVEMBER 19,

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