Jacphanie Cheung , Associate, Corporate & Infrastructure Ratings, Standard & PoorÆs
Institutional investors have beaten a path to the high-yield market in ever-larger numbers over the past few years, but they'll need to keep a close eye on credit risks. Standard & Poor's default studies show that when things go wrong, this type of asset class can fall into a distressed situation much more quickly than investment-grade credits.
Standard & Poor's applies similar analytical methods to all credit classes, but minutely scrutinizes several areas of particular concern for high-yield, or "speculative-grade", credits, such as cash flow, liquidity and liability risk management, and structural issues. It also applies stress scenarios to expose potential funding gaps and dissects complicated corporate structures for cash flow leakages. This article explains the key tools that Standard & Poor's uses to analyze and keep close surveillance on companies in this popular, but risky, credit category.
Cash Flow -- A Useful Guide To Debt Protection
Analyzing cash flow is critical for speculative-grade-rated companies, as these companies tend to have volatile financial positions and need to use cash rather than earnings to meet interest and principal payments. Despite the strong relationship between cash flow and earnings over the long term, cash flow is a better measure of debt protection over the near term, as it is subject to fewer accounting manipulations and can highlight potential cash leakages.
Standard & Poor's frequently uses funds from operations as a general measure of a company's cash flow from operations. For start-up, high-growth, or trading companies, however, free operating cash flow may better reflect cash flow positions, given these companies' need for high working capital and capital expenditure. Start-ups include Mandra Forestry Finance Ltd. (B/Stable/--), a forest plantation company operating in China, while high-growth companies include Thailand's G Steel Public Co. Ltd. (B+/Stable/--) and Indonesia's PT Gajah Tunggal Tbk. (B/Stable/--), which plan large capacity expansion over the next few years. Despite generating positive funds from operations, companies like these consistently generate negative free operating cash flows because investment is needed to support growth, resulting in increased external financing. Specific cash flow ratios to be considered include:
ò The ratio of free operating cash flow to interest
ò The ratio of free operating cash flow to total debt
ò The debt payback period (ratio of total debt to discretionary cash flow)
Watch out for distortions
Cash flow analysis has its limitations, however. Cash flows can sometimes be lumpy, requiring a close examination of their components and nature. Some cash flow items may need to be reclassified when calculating financial ratios. For example, repayment of shareholders' loans from subsidiaries or associates may be a common recurring cash inflow item for some companies. While similar in nature to dividend payments, such items may not necessarily be classified as operating cash flow. Cash flow ratios including these repayments can be significantly different from those without. Cash flows also do not take into account qualitative aspects, such as a company's financial flexibility.
Stress Scenarios -- Spotting The Likelihood Of Funding Gaps
To assess downside protection levels, Standard & Poor's reviews financial projections from companies, scrutinizes the reasonableness of assumptions, and applies various sensitivity scenarios to determine the likelihood of funding gaps that may lead to defaults. For instance, a price-sensitivity scenario may be appropriate for companies that face volatile business cycles or with limited pricing power in the market.
Such tests could include historical medium-term average prices. However, historical price cycles may not reflect price trends over the next business cycle resulting from fundamental changes in industry conditions. For instance, historically high prices resulting from tariff or regulatory protection may not be sustainable.
As product prices of steel companies, for example, have stayed above international market prices, the price premium would be removed in stress testing. For high-tech companies, such as Taiwan's Ritek Corp. (B+/Stable/--), a stress test is likely to involve changing average selling prices and capital expenditure. This reflects the short product cycle for this industry and the high capital needed for research and development.
For a commodity producer, such as PT International Nickel Indonesia (BB-/Stable/--), historical medium-term and low prices/rates, as well as a cost breakeven analysis, will probably be applied, as the lowest cost producers are more likely to survive the next downturn in a business cycle. If companies face significant start-up risks, such as Macau casino operator Galaxy Casino S.A. (B+/Stable/--), a stress scenario could include delays to the company's implementation plan, construction setbacks, and cost overruns.
A similar stress scenario is applied to companies rapidly expanding their capacity, such as Singapore's Continental Chemical Holdings Ltd. (B+/Stable/--), which plans to build a large production facility in China. Other typical stress scenarios may involve interest rate changes, foreign-exchange fluctuations, a slowdown in sales, and cost increases.
