Fundamentals of corporate credit analysis

In many respects, we consider ourselves teachers of credit analy-sis because—as any credit analyst at Standard & Poor’s will attest—everyspeech, every phone conversation, and every meeti

CREDIT ANALYSIS

OF CORPORATE CREDIT ANALYSIS

BLAISE GANGUIN

JOHN BILARDELLO

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who put up with our late, late nights and early, early mornings!

Cash Flow Forecasting and Modeling 108

PART II CREDIT RISK OF DEBT INSTRUMENTS 157

PART III MEASURING CREDIT RISK 271

Chapter 10

Putting It All Together: Credit Ranking 272

Chapter 11

Measuring Credit Risk: Pricing and Credit Risk Management 289

PART IV APPENDICES A TO G: CASES IN CREDIT ANALYSIS 309

Since the end of the dot.com and telecom bubbles, investors in both theequity and fixed income markets have been talking about the need to get

back to the basics The timely publishing of Fundamentals of Corporate Credit Analysis meets this need.

We are emerging from one of the most challenging credit cycles inrecent memory While the equity markets received most of the mediaattention for the “irrational exuberance” during the dot.com bubble, thedebt markets had their own debacle in the high-yield market The equitymarkets declined almost 40 percent from this peak in the spring of 2000.The high-yield bond market saw record defaults and dramatic declines insecondary prices From March 2000 to October 2002, the Merrill LynchHigh Yield Master Index declined 13 percent

The financial press, regulators, and the U.S congress focused onEnron, Worldcom, and Global Crossing In reality the overall losses in thebroader high-yield market were more widespread and severe

In the current environment when major investors are measured onhow they perform versus an index, when hedge funds thrive on volatili-

ty, and when new instruments have evolved that allow investors to hedgecredit risk, it is important that we not lose sight of the fundamentals.During the course of the past several years the bond markets haveexhibited a high degree of volatility and record default levels In order tocope with these trends and to enable portfolio managers to monitor thecredit quality of their portfolios, several new techniques and instrumentshave proliferated Among them are credit default swaps and the increaseduse of statistical models using market-based indicators While these toolscertainly have their place and role in credit analysis, they do not replacefundamental analysis—rather they supplement it Credit risk analysis is

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an art not a science It is impossible to quantify all the elements that onemust consider in credit analysis.

This comprehensive work by two senior executives in Standard &Poor’s Ratings unit provides a detailed and comprehensive review of thekey aspects of credit analysis

Edward Z EmmerExecutive Managing Director, Standard & Poor’s

Credit analysis is not rocket science, yet it can be a mystery to manypeople In many respects, we consider ourselves teachers of credit analy-sis because—as any credit analyst at Standard & Poor’s will attest—everyspeech, every phone conversation, and every meeting with corporateexecutives, investors, and financial intermediaries are opportunities to

explain how a specific credit rating decision was made That always

includes a discussion on how industry and economic trends and forecastsimpact business and financial performance

Yet the analytical process and decisions by credit ratings agenciesare often characterized as “the black box,” referring to a secretive method-ology But there are no secrets, just a comprehensive analysis that isn’teasily explained with “black and white” statements So, we thought it wasabout time for someone to write a book detailing this process!

As Ed Emmer stated, “Credit analysis is an art, not a science.” Whilethat means credit decisions are highly subjective in nature, it does not meanthere cannot be an organized methodology to help get to a decision That iswhat this book is all about We provide the methodology and the thoughtprocess all credit analysts should go through in making a credit decision

We were always taught that every credit decision is based on thethree to five most important issues affecting the ability of a company topay its financial obligations The trick of course is determining what arethose important issues because it is different for most companies In fact,this is exactly what credit analysts get queried about every day This bookintends to help analysts systematically analyze a company, identify themost important factors, and make a credit decision Importantly, to sup-plement the theoretical methodology, we also provide several real-lifecase situations that tie together the methods and the decisions

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Most books are written with the intent to answer all the questions.Instead, as authors of this book, we hope the reader can now ask evenmore questions The best analysts at Standard & Poor’s are the ones whoask the probing questions, who leave no stoned unturned

The reader of this book should generally be a student of financialanalysis, if not specifically credit analysis That student could be pursuing

an undergraduate business degree, a more advanced degree in finance,accounting, or economics, or even professional designations such as that

of Chartered Financial Analyst (CFA) One could also be a new employee

at an institutional investment organization, an investment bank, a mercial bank, and certainly at a rating agency Anyone who analyzes acorporation would benefit from reading this book

com-We cannot pretend to have seen it all, heard it all, or know it all So

a “how-to” book like this requires a lot of help and we have many people

to thank There are four people we specially want to thank because theyhave truly shaped corporate credit analysis and criteria for over 30 years First, we wish that Leo O’Neill could have seen this book But aspresident of Standard & Poor’s and the champion of credit ratings for 36years, Leo would not have needed to read our book, because he lived it!Leo was a great man who built and made Standard & Poor’s the greatorganization that it is Thanks Leo!

Ed Emmer has been the leader of corporate ratings at Standard &Poor’s since the mid-1970s He continues to inspire and challenge all ana-lysts at S&P to be the best He has instinctive credit skills with a knack foridentifying credits on the decline before anyone else We are certainlyproud to have Ed contribute the Foreword in this book Thanks Ed!Sol Samson and Scott Sprinzen have been—and continue to be—theprimary architects of Standard & Poor’s corporate ratings criteria sincethe early 1980s They have an incredible ability to sort through the mostcomplex issues and decipher the most appropriate analytical methodsand solutions We can honestly say that a large majority of Standard &Poor’s corporate criteria book—which we refer to often—was eitherwritten by or influenced by them Thank you Sol and Scott!

Standard & Poor’s is rich in talented credit analysts Many helped us

by contributing either a “Keys to Success” analysis or a case study Whilenot all contributions made it into the book due to length limitations, wewant to thank everyone These contributors are:

Jeanette Ward, Emmanuel Dubois-Pélerin, Paul Watters, Cindy Werneth,Tom Watters, Kyle Loughlin, Bob Schulz, Martin King, Linli Chee,Heather Goodchild, Michael Kaplan, Jill Unferth, Nicole Delz Lynch, Rich

Siderman, Bill Wetreich, Mary Lou Burde, Bruce Hyman, Bruce Schwartz,Andrew Watt, Craig Parmalee, and Phil Baggaley.

Many people also helped us by previewing chapters or providingstatistical and other information Thanks go to:

Professor Mark Williams from Boston University, Arnaud de Servigny,Olivier Renault, David Gillmor, Jamie Richardson, Dominic Crawley,James Penrose, Barbara Ridpath, Agnès de Pétigny, Pascal Bernous, EdLiebowitz, John Newcomb, Jack Harcourt, Bill Chew, Beth Ann Bovino,Paul Coughlin, David Wood, Takamasa Yamaoka, Patrice Cochelin, andPhil Mustacchio

Lastly, we have so many great colleagues that we rely on in our dailywork life We just want to thank the following people for being therewhen we needed them Thanks to:

Kathleen Corbet, Vickie Tillman, François Veverka, Ron Barone, NickRiccio, Tom Kelly, Chris Legge, Evelyn Nazario, Lars Bjorklund, MikeWilkins, Mark Mettrick, Eduardo Uribe, Laura Feinland Katz, Cliff Griep,Apea Koranteng, Anne-Charlotte Pedersen, Elena Folkerts Landau,Jerome Cretegny, Guy Deslondes, Trevor Pritchard, Christian Wenk, AlanLevin, Curt Moulton, Dorothy Hemingway, Neri Bukspan, Jane Eddy,Michael Petit, Michael Zelkind, and Ed Tyburczy

“Would you lend your money to this?”

This is the age-old question asked by loan providers, investors, andcredit analysts all over the world as a test of one’s commitment The rea-soning is that if someone is willing to invest their own money, then theymust have conducted a full due diligence analysis, vetting all assump-tions and verifying the facts Anyone who has the responsibility for lend-ing an institution’s money to another entity should have the same level ofanalytical commitment It is best to have a regimented and systematicapproach to the task, since the information is often varied and imprecise.This book is intended to help future and current loan providers, investors,and credit analysts to do their job efficiently and thoroughly

Let’s define what we mean by corporate credit analysis: It is an tigative framework that permits the systematic and comprehensive assess-ment of a firm’s capacity and willingness to pay its financial obligations in

inves-a timely minves-anner More recently, the focus of corporinves-ate credit inves-aninves-alysis hinves-asbeen expanded to include the assessment of recovery prospects for specif-

ic financial obligations, should the firm become insolvent

Most lending institutions are involved in credit analysis, whetherthey are banks, insurance companies, pension funds, or even mutualfunds (the last three are often referred to as institutional investors) Theseentities typically have entire departments dedicated to assessing the cred-

it standing of the firms they are exposed to

But credit analysis is not limited to banks and institutional investors.For example, when a firm ships equipment to or builds a plant for one ofits clients, it is exposed to nonpayment risk in exactly the same way as alending institution is Industrial firms also track their exposure to clientsthrough credit analysis, particularly when that exposure is material.Credit analysis helps to distinguish good borrowers from bad ones.But if analysts are comparing two firms that are neither totally good nor

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thoroughly bad, they need an analytical framework with more than justtwo categories Lending institutions and credit rating agencies have cre-ated scoring systems to rank credit risk along a continuum, with gradesgoing from nonpayment to an (almost) absence of risk Such a systemachieves several goals:

◆ By assigning marks, scores, or ratings on a predetermined scale,analysts can benchmark credit quality across firms from differ-ent countries and sectors

◆ A particular score provides an indication of the investment premium that would be required for a particular level of risk,assuming that in efficient markets, the higher the risk is, thehigher the reward will be

◆ For lending institutions with large portfolios of debt ments, a scoring system related to a robust analytical frameworkprovides an excellent tool for monitoring the evolution of creditrisk over time

instru-◆ Finally, these same institutions need to assess the recoveryprospects for distressed debt, particularly during recessions,when a portion of their portfolio is impaired

Good corporate credit analysis is a lot like building a brick house:There are many blocks and many levels, a strong foundation supports theblocks on top, and organized construction makes it easier to put it alltogether That is, good corporate credit analysis encompasses many dif-ferent factors in analyzing an entity, but if all the right questions are askedand all the factors are sufficiently covered, an analyst can effectively piecetogether the credit puzzle The reality is that it would be pure insanity tolend any money without a thorough analysis of the borrowing entity, itssurrounding environment, and its finances The building-block thoughtprocess approach helps credit analysts to systematically organize andthen analyze all the necessary and appropriate factors

Most credit practitioners have heard about or used one of the very

first such systematic approaches to credit analysis It is called the 5 Cs of credit, where the first C, Character, indicates that credit analysts must look

at the leadership of the firm, its reputation, and its strategy; the second C,

Capacity, focuses on the firm’s ability to make enough money to honor its obligations; the third C, Capital, reviews how well capitalized the firm is

or how much money the owner has invested in the venture; the fourth C,

Conditions, discusses the competitive environment of the firm and how

well the firm fits in; and the last C, Collateral, analyzes other potential

sources of repayment of the obligations, if these are supported by eral security

collat-Over time, analytical frameworks have evolved to capture twoessential types of credit risk:

◆ Default1risk, which is measured by assessing a firm’s capacity

and willingness to service its debt in a timely fashion

◆ Recovery prospects, which provides an assessment of how much a

creditor would recoup in the event that a company defaults, and

is measured by assessing the characteristics of each debt ment and structure, and collateral valuation

instru-When combined, default risk and recovery prospects provide a goodassessment of the risk of loss, which is important information for lendinginstitutions

The analytical framework we propose in this book is very much likethe building-block approach that we mentioned earlier, going from themore general to the more specific In broad categories, this includes ana-lyzing the risks related to the countries in which the operating entity doesbusiness, the sector(s) of activity in which that entity operates, the entity’scompetitive environment, its finances and strategy, its organizationalstructure, and its debt structure and actual debt instrument(s)

To assess these different risks, this book is organized in four parts:Part I, “Corporate Credit Risk,” presents the building blocks that help inanalyzing a firm’s capacity to pay principal and interest on its debt in atimely fashion At the end of this first part of the book, the reader should

be in a position to identify all the essential risks related to a particularfirm, and to measure them through benchmarking with peers andthrough a financial forecast

Chapter 1, “Sovereign and Country Risks,” discusses the risks

relat-ed to the country or countries in which the firm operates In particular, itshows the impact on business activity of the rules and regulations set bycountries; the support (or absence thereof) from the political, legal, andfinancial systems; the infrastructure and natural endowments; and thecountries’ macroeconomic policies

Chapter 2, “Industry Risks,” presents the ways in which sector acteristics influence the credit profile of firms in that sector, in particular,sales prospects; whether the sector is growing, mature, niche, or global;patterns of business cycles and seasonality; and industry hurdles and bar-

char-riers to entry, such as capital intensity, technology, and regulations Wefinish that chapter by asking whether a specific industry risk may limit acompany’s credit quality.

Chapter 3, “Company-Specific Business Risks,” a central chapter inthe book, offers an approach to assessing the degree of competitiveness of

a particular firm We discuss competitive position and competitor sis; market position, sales growth, and pricing; and regulations However,for the purpose of credit analysis, we also show that diversity of cash flowsources influences business consistency and stability, and how manage-ment strategy can affect the credit quality of a firm We recommend thatcredit analysts look beyond general characteristics of competitiveness foreach firm, and focus on sector-specific aspects (see Appendices A-Gwhich incorporate industry sector Keys to Success in each case study) Chapter 4, “The Management Factor,” introduces the impact thatmanagement behavior and decisions may have on a firm’s credit profile

analy-In particular, it discusses corporate governance and ways to assess it.Also, it shows how a firm’s financial policy should be assessed

Chapter 5, “Financial Risk Analysis,” discusses first the importance

of financial policies and how they allow credit analysts to understand therisk tolerance of a firm’s management In this chapter, we present creditmeasures relative to the balance sheet, profitability, cash flow adequacy,and financial flexibility, and show how to interpret them

Chapter 6, “Cash Flow Forecasting and Modeling,” concludes Part I

by introducing a practical approach to creating a financial model for casting cash flows and calculating credit ratios We present one case onCoca-Cola and one on Honda, to show the difference between stable andcyclical sectors

fore-Part II, “Credit Risks of Debt Instruments,” analyzes the impact ofdebt instruments and debt structures on recovery prospects, should a firmbecome insolvent At the end of Part II, the reader should be able to iden-tify all the essential features of debt instruments, recognize debt struc-tures, and measure the recovery prospects of each debt instrument issued

by a firm

Chapter 7, “Debt Instruments and Documentation,” gives a briefdescription of the major sources of funding available to a firm’s treasurerand provides a step-by-step approach to analyzing a loan agreement or abond indenture, the contracts governing the relationships between bor-rowers and creditors

Chapter 8, “Insolvency Regimes and Debt Structures,” analyzes theimpact of a firm’s financial distress on its creditors We discuss the differ-ent treatment of creditors across various insolvency regimes and theimpact of priority ranking in insolvency In particular, we present contrac-tual and structural subordination, and support through collateral We con-clude this chapter with an introduction to asset-based transactions, such asthose used for real estate, project, or transportation equipment financing,and a rapid description of leveraged buyout (LBO) transactions.

Chapter 9, “Estimating Recovery Prospects,” provides a practicalapproach to assessing recoveries on particular debt instruments We dis-cuss why businesses fail, how to assess discrete collateral, and how tovalue businesses by providing a case study of a fictional firm, MousetrapCorp Finally, we propose standard cash flow stresses to assess distress.Part III, “Measuring Credit Risk,” proposes a scoring system toassess a firm’s capacity and willingness to service its debt in a timely fash-ion, and to evaluate recovery prospects for debt instruments in the event

of a firm’s financial distress

Chapter 10, “Putting It All Together: Credit Ranking,” proposes ascoring system to assess both default risk and recovery prospects, withguidance relative to the weights between the different scores This chap-ter should permit students and practitioners of credit analysis to captureall the credit risks discussed in this book in an organized framework,resulting in scores reflecting a firm’s default probability and the recoveryexpectations for a particular debt instrument

Chapter 11, “Measuring Credit Risk: Pricing and Credit RiskManagement,” discusses the use of credit scoring as a benchmark for thepricing of debt instruments Also, the use of credit scoring and ratings ispresented in the context of Basel II Accords on bank capital allocation Weconclude this chapter by providing a brief description of credit ratingagencies and their studies of default risk and credit migration over time

We conclude by presenting ratings and certain credit models

Part IV, “Appendices A to G: Cases in Credit Analysis,” presentsseven real-life case studies prepared by senior credit analysts of Standard

& Poor’s These case studies reflect credit issues such as mergers, tions, governance, highly leveraged transactions, and sovereign issues.The intellectual debate has always been which is better: the top-down approach (i.e., to start by analyzing the country risks, then analyzethe industry, the company, and the specific debt instrument in that order)

acquisi-or the bottom-up approach (i.e., analyze first the debt instrument, then thecompany, industry, and country)? We believe that the argument is irrele-vant because good credit decisions are made by analyzing all factors thataffect a borrower’s ability to repay its financial obligations in full and ontime, and the factors that will affect the recovery, should the company beinsolvent It does not really matter where credit analysts start; what mat-ters is what was considered and analyzed to get to a decision

Investment managers and credit analysts sometimes may not have along time to make a credit decision, and it is impractical to expect thatevery last piece of information about an entity will be available beforemaking a credit decision So it is important for credit analysts to have thecapacity to zero in on the most critical specific factors that drive a compa-ny’s ability to pay its financial obligations When time permits, however,they should complete that preliminary assessment by a full-fledgedreview of the borrowing entity and of the debt instruments This bookhopefully shows the way to do that

NOTES

1 Several definitions of default exist Some place it at the first occurrence of nonpayment (after a contractual grace period has lapsed), some see it as occurring 90 days after nonpay- ment (assuming that it has not been remedied during that period), and yet another group place it after bankruptcy In this book, we use the first and most restrictive of these defini- tions of default.

CREDIT ANALYSIS

Corporate Credit Risk

Part I addresses all the factors that influence and determine the ing and financial performance of a corporation, and thus ultimately itscredit strength The development of corporate credit quality begins withthe macroeconomic and business environment surrounding a company Itthen is fully developed by the quality of the assets and the business, byhow management utilizes those assets, and eventually by the realization

operat-of the financial performance produced by those assets The chapters inPart I identify all the major analytical areas that an analyst should cover,and the last chapter provides a step-by-step cash flow modeling exercise

In Chapter 1, we discuss how a corporation’s business can be shaped

by the actions of a sovereign government Governments have a ranging impact We address the way the business rules established, such

wide-as tariffs, and even the government’s own fiscal situation affect corporateperformance In addition, the physical and human nature of a countryplays a great role in determining the types of businesses that arise in thatcountry and how successful they become

In Chapter 2, we focus on how every industry is different and howeach industry has credit risk built into it that could limit the credit quali-

ty of the companies in that industry We discuss the different types of salesgrowth patterns witnessed, such as high growth, mature, or cyclical.Some industries develop barriers to entry that sort out the viable com-petitors from the pretenders We identify the areas in which barriers candevelop and how to analyze them

In Chapter 3, we zero in on the risks inherent in a company’s ness Competitive analysis and competitor analysis is the key first step.Competition occurs in all aspects of business, but we stress recognition ofthe underlying factors that drive the competition and determine which

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organizations succeed and which fail We discuss the importance and thelimitations of market share analysis, and the various elements that lead toconsistency or volatility of operating performance, such as diversity, flex-ibility, size, and regulations.

In Chapter 4, the role of management is characterized as the pin between business risk and financial performance Its importance can-not be overstated We emphasize getting to know the management teamand understanding its risk tendencies, since that typically influencesfinancial and operating decisions Finally, we list many questions to pon-der regarding corporate governance

linch-In Chapter 5, we address the financial measures related to the ance sheet, profitability, cash generation, and liquidity Understanding theaccounting behind the numbers is key for any analyst, and we list numer-ous accounting topics to study While the trends and absolute levels areimportant, financial forecasting is paramount We identify the key ratiosand how to interpret them

bal-In Chapter 6, a financial model is created that projects cash flowsand generates other credit ratios It’s a practical step-by-step methodolo-

gy that credit analysts can replicate We present two sample models, onefor Coca-Cola and the other for Honda

Sovereign and Country

Risks

“The reality is that most emerging market corporate defaultsare caused by basic country risks.”

—Laura Feinland-Katz, Managing Director, Standard & Poor’s

Sovereign governments can wield vast powers that shape the financialand operating environments of all corporate entities under their reign.They establish the legal rights of the people, the regulatory framework,and the fundamental rules of engagement for businesses Of course, thatmeans that a sovereign government can create an environment in whichbusiness truly flourishes or an environment that stifles opportunities andsuccess Yet while the actions and decisions of a national government cer-tainly have a great impact on the business environment, the basic eco-nomic and business dynamics that develop within a country are influ-enced by more than just the government’s actions

In particular, each country has its own unique characteristics thatshape the businesses and corporations in that country This includes itsinfrastructure, including roads, ports, telecommunications, utilities,buildings, a labor force, an educational system, a legal system, financialmarkets, and natural resources, and the businesses that develop aroundthat infrastructure

The combination of these unique characteristics and the ment’s established business rules influence the country’s economic per-formance and thus the performance of individual companies Ultimately,the degree of corporate success or failure comes down to how well theavailable resources are used in conjunction with the governing businessregulations Most of the time, however, this is usually a case of the havesand the have-nots Well-developed countries generally support business

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success because they have abundant natural resources, a well-trained orwell-educated workforce, strong fiscal and/or monetary policy, a stablecurrency, a reasonable level of taxes and tariffs, a sophisticated domesticcapital market, a strong banking infrastructure, and established business-

es supported by an effective infrastructure

In contrast, “emerging” countries (or lesser-developed countries)stifle business success because neither the business community nor thesovereign government has been able to utilize the nation’s assets effec-tively In Africa, for instance, many countries have tremendous amounts

of natural resources that are valued highly by other countries, such as oil,gold, and diamonds One could assume that numerous successful busi-nesses would emerge from countries with such resources Sadly though,

in some of these countries, corrupt governments and a poor educationalsystem limit or even prevent business success As a direct consequence,corporations based in these countries are viewed as being of high risk

(Percent change from a year earlier)

This sovereign risk analysis is not just for entities in emerging tries In 2003, the World Bank released a survey entitled “Doing Business”that found that the least amount of business regulation fosters thestrongest economies The bank, working with academics, consultants, andlaw firms, measured the costs of five business development functions in

coun-130 nations The survey identified how regulations and legal systemsaffected an entity’s ability to register with the sovereign government, toobtain credit, to hire and terminate employees, to enforce contracts, and

to utilize the bankruptcy courts The World Bank determined that theleast regulated and most efficient economies were in countries with well-established common law traditions This includes the United States, theUnited Kingdom, Australia, Canada, and New Zealand In addition, othertop-performing economies were several social democracies (Denmark,Norway, and Sweden) that had recently streamlined their business regu-lations See Table 1-1 for comparative growth rates of different countries

Kingdom Japan Philippines Korea Arabia Brazil India Africa

Strong credit analysis, therefore, includes evaluating the extent towhich corporations are limited or supported by the government’s lawsand regulations Importantly, future business success can also be linked tothe physical aspects of a country, such as the natural resources, the infra-structure, and the labor pool This chapter breaks down the analysis intofive critical drivers about the country and its sovereign government thatinfluence the business environment These risk drivers are the sovereignpowers, the political and legal risks, the physical and human infrastruc-ture, the financial markets, and the macroeconomic environment.

SOVEREIGN GOVERNMENT POWERS:

THEY SET THE GROUND RULES

The financial condition of a sovereign government always affects the way

it governs and the laws it creates Yet not all sovereign governments are thesame There are democracies, dictatorships, and kingdoms, with differenthistories and with styles of governing that can be and usually are very dif-ferent As credit analysts or lenders of credit, though, we care about themain powers every government has under its control that affect the busi-ness performance of every company within that government’s domain.The main power is first and foremost the overarching right to createand change business regulations Next, of course, is the taxing and tariffauthority, and last is the ability to enact foreign currency exchange con-trols Regardless of the type of government or whether the government iscorrupt or upstanding, these are the issues a credit analyst cares about.Why? Simply because these are the key tools a government has that allow

it to access money and affect the business environment But sovereignsuse these tools for different reasons and at different times

Regulatory Framework

A national government can establish business rules that range from sive to vague, and it’s necessary to know the difference and the impact onbusiness Regulations can cover a very wide range of areas, includingexport/import restrictions, competition boundaries, service qualityguidelines, antitrust legislation, subsidies, and the percentage of local orforeign ownership Regulations can and do affect individual companies’business strategies Politics being what it is, analysts should investigatethe extent to which any company has influence over the political process,

inva-since that could affect the form and content of regulations Also, analystsshould track a government’s history of changing the rules For example, agovernment could force renegotiation of tax subsidies or royalty arrange-ments and could change the amount of taxes on imports, exports, or for-eign debt The characteristics of a supportive government differ depend-ing on whether one is analyzing a local or a foreign entity (i.e., the mag-nitude to which it supports the local entities) Still, a supportive environ-ment would include at least consistent business regulations.

Tariffs

Tariffs, or taxes paid by foreign companies trying to sell their goods in acountry, are another way in which a government can extract money fromcorporations But tariffs typically have another purpose—to influence theeconomics of a foreign entity’s goods and thereby reduce the demand forthose goods, to the obvious benefit of local suppliers

The most recent example was the tariffs the U.S government placed

on steel imports in the middle of 2002 The impact was to raise the price

of foreign steel sold into the United States, allowing the struggling U.S.steelmakers to also raise prices While this did benefit the U.S steel com-panies for about one year, it ultimately did not improve their financialperformance enough In addition, foreign steelmakers effectively ralliedtheir governments’ support, and those governments then threatened tar-iffs on U.S steel This drove the U.S government to withdraw the tariffs

at the end of 2003 The obvious point to credit analysts is that tariffs canand do affect the demand for goods and are a very important factor toconsider

Fiscal Policy—Taxation

Income taxes are the primary mechanism by which a sovereign ment can generate the revenue it needs to finance its activities Theincome taxes a company pays are, of course, a substantial portion of itsoverall costs: anywhere from 25 to 50 percent of income, depending on thecountry This is typically the cash outlay that corporations work the hard-est to reduce Likewise, it is an expenditure that credit analysts should try

govern-to understand and forecast very seriously

Unfortunately, analysts sometimes ignore income taxes because theyare usually characterized as a set percentage payment That would be a

mistake, since income taxes are far more complex than that The diligentanalyst should take the time to analyze the tax regime in a country andthe efforts a corporation could go to to reduce its income taxes.

Monetary Policy

In times of financial stress, governments will act to control the monetaryflow in the country to its benefit This is different from foreign currencyvaluation risk, i.e., the fluctuations in foreign exchange values Instead,foreign exchange controls, otherwise known as transfer and convertibili-

ty risks, are imposed by sovereign governments that are having difficultymaking payments on their own debts A sovereign government that hasnot met or may not be able to meet its foreign financial obligations is like-

ly to seek to retain its foreign currency reserves To do this, it can imposeseveral constraints on other government or private-sector borrowers,including:1

◆ Setting limits on the absolute availability of foreign exchange

◆ Maintaining dual or multiple exchange rates for different types

mar-♦ Implementing restrictions on the inflow and outflow of capital

♦ Refusing to clear a transfer of funds from one entity to another

♦ Revoking permission to repay debt obligations

♦ Mandating a moratorium on interest and principal payments, orrequired rescheduling or restructuring of debts

♦ Nationalizing the debt of an issuer and making it subject to the same repayment terms or debt restructuring as that of thesovereign

Foreign Currency Control

Foreign currency controls clearly are not good for any company becausethe company may not be able to access enough foreign currency to repayits foreign currency obligations, and it may not be able to access the cashflows of its foreign subsidiaries But it’s important to remember that theseare actions taken by a government under stress They are reactionaryactions to a deteriorated economic situation Before these events occur,credit lenders and analysts should be paying more attention to the othersovereign powers and the basic country dynamics because those charac-teristics generally occur before a government decides to control its cur-rency They help to predict negative credit trends in a deteriorating eco-nomic environment

The Republic of Argentina in 2001 and 2002 is the most comprehensiveexample in which a sovereign government imposed broad foreign exchangecontrols But it was the other country-specific issues (see the discussion ofRepsol/YPF in Appendix D) and not the restrictions on foreign currencythat caused most of the corporate defaults in Argentina at that time

Political and Legal Risks

By their very nature, the political and legal environment in a country or

in an entire region can be quite volatile and a dominating issue as far asbusiness success goes While a sovereign’s financial condition can andwill drive its decisions on money flows (taxing, currency controls, and soon), a country’s financial stress (or lack thereof) can affect how the popu-lation reacts or affects the business community or certain businesses

In this regard, credit analysts should be aware of the possibility forcivil unrest that could disrupt operations There are many countries aroundthe world in which public uprisings have led to work stoppages, declines

in revenue, and increases in costs, and even the physical destruction ofbusiness facilities In 2002, for example, Venezuelan oil workers engaged intwo prolonged work stoppages in a political insurrection against theadministration of President Hugo Chavez Venezuela’s national oil compa-

ny, Petroleos de Venezuela S.A., experienced a massive disruption in oilproduction, as there were no employees to offload crude oil, to fill storagetanks, or to operate the refineries Oil production declined more than 70percent, and no refined oil products were produced Since Venezuela, amember of OPEC, is one of the top 10 oil and oil products producers in theworld, this disruption caused a spike in oil prices that affected every region

of the world (Among the OPEC producers, Venezuela is the third largestoil producer, pumping almost 3 million barrels of oil daily.)

In a less global situation, the Colombian national government formany years has been in a constant battle against the illegal drug warlords,whose tactics against the government include frequent attacks on oilpipelines and their employees Disruptions in Colombian oil deliveriesare a regular event Obviously, in both of these circumstances, lenders ofcredit have to have their eyes wide open and reflect the substantial riskinherent in their investments

One way to get comfortable with lending in a country is to evaluateits legal system It is very important to know how dependable the rule oflaw actually is and whether there is an independent judicial system Thelevel of corruption at the government or business level is harder to deter-mine, but it would help to know that the judicial system is fighting it Atone extreme is the United States, which has a history of business case lawdating back to the late 1700s, and as a result provides a strong legal foun-dation for the formation of new businesses At the opposite extreme isIraq, which currently has no legal infrastructure to protect business and isonly now (in 2004) considering what appropriate laws need to be estab-lished to support commerce

In evaluating sovereign risks, it is important for credit analysts andlenders to understand the “legal” creditor rights In particular, is there abankruptcy code, and is it opaque or transparent? If there is a bankrupt-

cy code, does it support lenders or borrowers? Is there legal case history?The supportiveness of the local bankruptcy code tends to affect a coun-try’s credit culture That is, a creditor-friendly code could create an envi-ronment in which borrowers are not afraid to default on their debts,whereas a lender-friendly code (if strictly enforced) would prevent such

an environment (See Chapter 8 for an expanded discussion of friendly and creditor-unfriendly regimes.)

creditor-PHYSICAL AND HUMAN INFRASTRUCTURE

Natural Resources

Natural resources that both support domestic needs and may be valued byother countries for export usually determine the types of businesses thatdevelop and succeed in a country For example, minerals (oil, diamonds,gold, copper, iron, salt, and so on) beget the various mining and manufac-turing industries, forests beget the pulp and paper industries, and farm-

land begets the agriculture industries The quality, quantity, and economicextractability of these resources can also encourage entities from outsidethe country to invest in the development of those resources for the purpose

of exporting them to other countries Some countries, like the UnitedStates, are blessed with an abundance of natural resources But the ability

to use these resources for business and for profit is tied very closely to thebusiness regulations established by the government An overly protectivegovernment could inhibit business growth, and an aggressive, business-oriented government could strip the land of its resources too quickly TheU.S government is always struggling with the balance between encourag-ing new business development and maintaining the natural beauty andhealth of the land Credit analysts should understand how these rulesaffect a company’s ability to acquire the resources, extract the resources,and use or distribute (export) the resources

Physical Infrastructure

A physical infrastructure that supports the movement of people andgoods is critical because without it, only small amounts of business canoccur Roadways, railroads, airports, and harbors with seaports all facili-tate the delivery of raw materials and finished products to their appro-priate destination Infrastructure is vital to any industry involved withnatural resources, since these resources are either exported or moved to amanufacturing or processing facility

For example, the mining of any metals or precious stones would bevery slow or impossible without a railroad system When analyzing anentity that needs to move raw or finished products long distances, ana-lysts should investigate whether there are infrastructure challenges such

as potential port or highway bottlenecks, and the permission to use ing infrastructure for commercial business purposes

exist-Other challenges usually include the availability and sufficiency ofelectric power Many times corporate entities have to either build theirown electric power plants, roadways, and harbors, or significantly refur-bish the existing facilities Therefore, a key question is the cost of usingexisting infrastructure and the cost of constructing or maintaining infra-structure Again, business regulations can play a large role since they candictate the procedures for moving goods and the costs (such as throughtariffs) of doing so Typically, senior corporate executives work closelywith regulators and politicians in the negotiation of business regulationsand the construction of the needed infrastructure

Human Infrastructure

Businesses cannot capitalize on natural resources and physical ture without an adequate human infrastructure, i.e., a labor market andworkers that use the physical infrastructure The quality of the educa-tional system and of the training available, the skill level of the laborforce, and the sophistication of the business community are importantstructural features, as they will affect the complexity and acceleration ofbusiness growth This isn’t an issue in well-developed countries, such asthe United States, Japan, Canada, Australia, the United Kingdom, and therest of Western Europe It can be a problem in the lesser-developed coun-tries, but then again the cheaper labor costs found in Southeast Asia andLatin America are a real boon for many companies

infrastruc-Analysts should be wary of the development of complex businesses

in far-flung regions where the labor force and the business populationmay not be as well developed as in other parts of the world This couldrequire the importation of foreign expertise However, sovereign govern-ments have different views on the benefits of foreign employees Some seethe bringing in of employees as negative, as it takes jobs away fromnatives, while others see it as a quicker and better way to generate newbusinesses and therefore new tax revenues Nevertheless, the availability,quality, and cost of the workforce are key issues for all businesses

Labor

Labor issues are even more pronounced during stressful economic times,when many businesses are vulnerable to failure, and one of their firstactions is to reduce employee rolls and benefits Understanding the clout

of labor unions and/or the bargaining power wielded by employees iskey, as they can greatly influence business performance Understandingthe financial condition of the local government is important, too If it is infinancial distress, it may not pay its employees or it may just cut back onpublic services (utilities, trash disposal, and so on), probably resulting inlabor strife or insurrections that disrupt business activities

FINANCIAL MARKETS

A developed financial system will include a wide array of financial mediaries that effectively connect sellers with buyers, and then efficientlyprice the transactions These intermediaries include investment banks,

inter-insurance companies, mutual funds, private equity, hedge funds, andcommercial banks However, not all countries have all the needed com-ponents of a strong capital markets system Instead, many countries rely

on the large financial institutions from the United States and Europe toplay these various roles in the markets Credit analysts need to be aware

of the breadth of financial options available in a country

Banking System

A well-established domestic banking system is important for providingneeded capital to help finance the initial and ongoing development of abusiness or an asset Credit analysts need to be aware of the availability

of commercial lending because the accessibility of the global public andprivate capital markets is not always very good

In fact, companies in emerging markets (Latin America, SoutheastAsia, the greater China region, Eastern Europe, and Africa) are subject towavering international investor confidence and do not always have thecross-border European and U.S markets available to them Frequentlythese companies only have local lending available Credit analysts shouldknow how well these companies fare in their domestic lending markets

Is a company a top-tier borrower that has access to capital during a ereign financial crisis? Furthermore, does it receive better credit termsthan other entities during the good economic times? Limited access tocapital is typically a problem for emerging market companies Yet eventhe strongest private-sector (debt) issuers can have difficulties accessinglocal or international capital markets during periods of (sovereign) stress Credit analysts should know the depth of the local domestic bankingmarkets because in times of sovereign financial stress, the local banks willalso suffer from weakened liquidity So, to the extent that a borrowing enti-

sov-ty has a preferred standing with creditors and, importantly, has committedcredit lines, it would be better off than other companies A heavy reliance

on just capital lines poses risks, though, especially during times when thesovereign government is controlling its currency Thus, access to othersources of capital, such as trade credit (business-to-business lending) andforeign direct investment, could boost financial liquidity

Accounting System

The disclosure and transparency of accounting and financial reportinghas grown substantially in importance following the storied indiscretions

by Enron, Arthur Andersen, WorldCom, and Parmalat The presence of aregulatory enforcement body, such as the U.S Securities and ExchangeCommission, is critically important but, of course, does not prevent finan-cial or accounting shenanigans Still, analysts cannot ignore the account-ing and disclosure differences among companies and regions Conductingcomparisons (i.e., apples-to-apples) of credits in a similar accounting for-mat is necessary to make a diligent and fair analytical assessment.Once the structural makeup of a country’s physical aspects, its gov-ernment and legal system, and its financial markets have been appraised,credit analysts can proceed with the evaluation of the country’s volatility,trends, and overall economic performance to finalize an opinion on howwell supported a company or business in that country is This entails areview of the very many macroeconomic indicators

MACROECONOMIC FACTORS

The stability or volatility of an economy can be tied to the many sovereignand country factors mentioned in this chapter Analyzing that volatility orstability and what it means for corporate credits requires watching thetrends in consumer spending, manufacturing and service industries’growth and productivity, inflation, interest rates, and currency valuation.While this is an art that is usually left for economists to disagree over, ana-lyzing economic trends is a critically important aspect of credit analysis.The broad trends give a vivid “big picture” of the environment Creditanalysts, therefore, can determine how those broad trends are affectingthe performances of separate industry sectors and individual companieswithin those sectors

Consumer Spending

While it is difficult to pinpoint the most important economic indicator,some economists would argue that the ability of the consumer to spendmoney drives all other indicators While the authors of this book tend toagree with this premise, we will not and cannot defend the point, since weare credit analysts (i.e., novice economists) and not trained economists.Nevertheless, consumer-spending patterns are important to follow, as theyultimately influence the demand for products to be manufactured and sold.The supplies of products to be manufactured and sold are driven byother different factors, including the availability of raw materials, labor,

and manufacturing capacity There is substantial circularity when ing economic figures For instance, the level of employment and wagesclearly affects the ability of the general consumer to spend The rise andfall in consumer spending determines the need for manufacturing plantsand retail outlets, which in turn creates the need for more or less labor Thepoint is that whether an analyst is evaluating a manufacturing or a retailentity, a comprehensive review of all economic indicators is needed, sincethese indicators are interrelated (see Table 1-2) Economists know whether

analyz-Leading Indicators

Building permits, new private housing units

Manufacturers’ new orders, consumer goods and materials

Manufacturers’ new orders, non-defense capital goods

Vendor performance, slower deliveries diffusion index (ISM)

Average weekly manufacturing hours

Average weekly initial claims for unemployment insurance (inverted)

Consumer expectations index

Stock prices, S&P 500 Composite

Interest-rate spread, 10 year Treasury bonds less Federal Funds

Real money supply, M2

Coincident Indicators

Industrial production

Employees on nonagricultural payrolls

Personal income less transfer payments

Manufacturing and trade sales

Lagging Indicators

Average duration of unemployment (inverted)

CPI for services, rate of change

Commercial and industrial loans outstanding

Labor cost per unit of output, manufacturing

Ratio of consumer installment credit to personal income

Inventories to sales ratio, manufacturing and trade

Average prime rate charged by banks

TABLE 1-2: Economic Indicators

the indicators are leading, lagging, or coincident with the changes in grossdomestic product Analysts, of course, must be aware of this.

Inflation and Interest Rates

In countries with high inflation rates (see World Inflation Rates in Table 1-3),business regulations with pricing flexibility that permits the pass-through

of rising expenses becomes a critical factor to stability for many nies Many times, though, pricing flexibility can occur only in reasonablyhealthy economic times In periods of stress, consumers will buy whatthey need and spend what they can afford Also, sovereign governmentssometimes impose price controls, to the benefit of consumers but proba-bly at the expense of overall economic growth So, the elasticity of pricescan vary for different products and services

TABLE 1-3: World—CPI Inflation

(Percent change from a year earlier)