The content on this website is intended for investment professionals and institutional asset owners. Individual retail investors should consult with their financial advisers before using any of the content contained on this website. Breckinridge uses cookies to improve user experience. By using our website, you consent to our cookies in accordance with our cookie policy. By clicking “I Agree” and accessing this website, you represent and warrant that you are agreeing to the above statements. In addition, you have read, understood and agree to the terms and conditions of this website.

Corporate

Blog published on July 15, 2016

The Prize for Size in Investment Grade Companies

“Too Big to Fail” is one of the most recognizable phrases of the financial crisis. Following the crisis, banking regulators set out to identify large or prominent financial institutions whose failure could threaten the solvency of the entire financial system. These “systemically important” financial institutions now face stricter capital and liquidity requirements than do their smaller peers.

At major credit ratings agencies, attitudes toward company size seem to be just the opposite. For the most part, ratings methodologies look favorably on large size and dominant market share. The methodologies scrutinize various company attributes to determine creditworthiness, and size and competitive positioning together are more heavily weighted than financial leverage in the analysis. Therefore, large size can provide a significant boost to ratings. For example, the Moody’s Investors Service rating methodology for the Global Alcoholic Beverage sector has a weighting of 25 percent for “Franchise Strength and Profitability,” 34 percent for “Scale and Diversification” and 27 percent for “Leverage and Coverage.”[1]

The ratings agencies recognize that larger-size companies benefit from greater segment and geographic diversity, potentially reducing risk. Bigger companies can also have better opportunities for cost savings and revenue enhancements, potentially driving margin expansion. Finally, as more-valuable enterprises, larger firms typically have lower-cost access to capital.

However, since ratings agencies place so much weight on size and scale in determining ratings, large companies can potentially perform aggressive transactions without being downgraded – even when these transactions push leverage materially outside of the zone for the existing ratings. In recent years, some highly-levered AA or A rated companies have entered M&A transactions that historically would have prompted downgrades to BBB or even high yield. Instead, these companies have held their existing investment grade (IG) ratings because ratings agencies placed significant weight on the improved market share attained -- more than offsetting higher leverage or weaker interest coverage levels. 

In a recent example, beverage company Anheuser-Busch InBev (AB InBev) (A3/A) is in the process of combining with SABMiller plc, and the companies expect the transaction to close at the end of the year.[2] The merger will cause AB InBev’s pro forma adjusted net leverage to increase to approximately 5.5 times from 2.5 times. Despite leverage ratios that Moody’s considered to be speculative grade, the Agency said that it left AB InBev’s long-term rating within the ‘A’ category after reviewing the transaction, as ratings were buttressed by the company’s scale. With an estimated global market share of 30 percent, the transaction will create the world’s biggest brewer by a wide margin over its next-largest competitor (Dutch brewer Heineken N.V.).[3]

By contrast, in September 2008, Moody’s downgraded Anheuser-Busch Companies Inc (BUD) to Baa2 from A2 following its announced combination with InBev.  Moody’s said the combined company would have a “higher risk profile than BUD on a standalone basis given InBev's higher post acquisition leverage, more aggressive management approach, greater emerging markets exposure and execution/integration risks.”[4] In this 2008 example, net leverage rose from less than 2.0 times at Anheuser-Busch to just over 5.0 times for Anheuser-Busch InBev, and Moody’s responded with a multi-notch downgrade.

Similarly, Standard & Poor’s assigned a BBB- rating to the combined Kraft Heinz Company (Baa3/BBB-) after H.J. Heinz Company and Kraft Foods Group signed a merger agreement in 2015.[5] Post-acquisition leverage jumped two turns to almost five times leverage, well outside the bounds for most IG industrial companies. Nonetheless, the company maintained IG status, partly because the combined entity’s potential “increased scale and diversity” and “industry-leading operating margins”[6] supported its ratings.

In recent years, ratings agencies have given big companies a “longer leash” in terms of leverage. This is one reason that large companies have only gotten bigger in recent years, which is evident by increased concentration in several industries (see chart). An additional distortion is the large amount of “trapped” cash held overseas by large IG companies. This has enabled high U.S. borrowing with little in the way of credit rating implications, although computer technology firm Oracle Corp.’s outlook was recently revised to negative by Moody’s for the practice.[7]

We are seeing various levels of this consolidation trend across sectors. For example, oligopolies are evident in the Airline, Railroad, Carbonated Beverage and Banking sectors across the U.S. and Canada. In Telecom, wireless carriers Verizon Communications Inc, AT&T Inc, T-Mobile U.S. Inc and Sprint Corp. have combined market share of 76 percent.[8] While less common than oligopolies, duopolies are clear in Commercial Aerospace, Telecommunications, and payment technology firms. Duopolies are also evident across many countries in Europe, particularly in the Banking sector. Most of the companies in these duopolies have increased leverage over time, and have become exceedingly large from an earnings and market-capitalization perspective. Microsoft Corp. is one example of a company approaching monopoly status; market share is approximately 90 percent for Microsoft in computer operating systems. [9]

Despite ongoing consolidation, M&A volume declined in the first half of 2016 versus the same period a year ago.[10] While 2015 was a record year for M&A, hefty valuations combined with weak underlying earnings growth in some sectors have hindered new transactions. In addition, certain sectors have already become more consolidated, and less low-hanging fruit exists for more combinations. Additionally, large M&A has been dampened by equity market volatility, regulatory crackdowns on deals pushing the antitrust envelope and uproar over “tax inversion deals.”However, with little in the way of organic growth, many companies are opting for M&A given the low cost of borrowing and the benefits of size and scale. If rates stay low, M&A may not reach its 2015 record but will likely continue at a solid pace.

In many cases, size does make it easier for companies to de-lever by lowering the cost of capital. So size can help determine how much debt a company can support. However, the agencies’ shift toward placing a greater weight on quantitative metrics (such as size and scale) rather than on qualitative metrics could actually create a moral hazard in which larger companies perform aggressive transactions with no fear of a ratings downgrade.

Given that large companies may have high leverage not necessarily within the bounds of their ratings, it is more important than ever for investors to do their own research rather than simply relying on the ratings agencies alone to understand companies’ financial pictures. In addition, while size offers benefits to most companies, large M&A transactions require in-depth analysis to weigh the benefits versus the risks created.

 

[1] Moody’s Investors Service, as of May 26, 2016.

[2] Anheuser-Busch InBev, as of May 4, 2016.

[3] Moody’s Investors Service, as of May 26, 2016; S&P Global Ratings, as of October 8, 2015.

[4] Moody’s Investors Service, as of September 29, 2008.

[5] Standard & Poor’s, as of July 6, 2015.

[6] Standard & Poor’s, as of July 6, 2015.

[7] Moody’s Investors Service, as of June 29, 2016

[8]Bloomberg, as of December 31, 2014.

[9] Statista, taken from: http://www.statista.com/statistics/218089/global-market-share-of-windows-7/.

[10]Bloomberg, as of June 30, 2016.  

 

DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.