Oilmageddon

Citigroup analysts are calling the effect of falling oil prices on global financial markets “oilmegaddon.” We think the term works well to describe looming cash flow, dividend, and credit problems at major oil companies too. After peaking at $60.07 in June of 2015, the price of West Texas Intermediate Crude fell to $42.65 a barrel at year end. The effect on oil company cash flows was drastic, as BP’s experience shows. Adjusted for a $4.8 billion gusher of cash from declining receivables and inventories in the fourth quarter, the BP’s cash flow from operating activities was down deeply in the second half of the year. That did not stop the company from pumping money to its shareholders. Combined dividends and share repurchases in 2015 were $8.0 billion, and they actually increased as the year went on. Add heavy capital spending on exploration and production, and the deficit in cash flow after capital spending and shareholder payments was $11.1 billion for the year. BP plugged the cash flow leak by cutting working capital, selling assets, and tapping cash reserves. But the credit concern is that those are not sustainable sources of funding. If, as seems likely, oil prices stay low, BP will have to trim dividends and share buybacks or boost borrowings. Raising leverage in the face of falling business fundamentals is risky. Shell did it in 2015, and was rewarded with a rating downgrade from Standard & Poor’s. BP is starting 2016 with higher leverage (35.1% debt to capital) than Shell (26.2%), so it has less room for maneuver to avoid a downgrade. Not that BP is worried about...

Tesco’s Not Even Close

Tesco just agreed to sell its South Korean operations for £4 billion, taking a loss of about £150 million on the sale. The deal will reduce borrowings by £4.2 billion over the next 18 months. That’s a step in the right direction, but it’s not enough. Tesco may also sell its operations in eastern European and in Thailand to cut debt even more. Analysts think they could be worth as much as £5.9 billion. But even that would not be enough. At the end of its latest fiscal year in February 2015, Tesco had £26.2 billion in adjusted debt, £4.2 billion in adjusted twelve-month EBITDAR, and shareholders’ equity of £7.1 billion. Adjusted debt to EBITDAR1 was 6.3x, and adjusted debt to capital was 79%. Proceeds from Korea would reduce those figures to 5.2x and 76%, while proceeds from Europe and Thailand would cut them to 3.8x and 70%.   As we said in an earlier post, because of the company’s high business risk we think it should be targeting debt to EBITDAR leverage of 3.0x and debt to capital of 40%. That means cutting debt by at least another £3.5 billion2 or raising EBITDAR to £5.3 billion and shareholder’s equity to £24.0 billion. We just don’t see an easy way for Tesco to get there. Cutting debt through asset sales is promising, but it has problems. If the company keeps taking losses when it sells assets, that will cut into shareholders’ equity, which already is at dangerously low levels. Asset sales take time. The Korea deal will span more than a year from deciding to sell to receiving payment and...

Breaking Tesco Out of the Box

Credit risk at Tesco Tesco disclosed details of its turnaround plan on January 8. The company was clear about its business problem — loss of share and profitability in the UK. And it was specific about the steps it is taking to tackle that problem — price cuts, store closings, and overhead cuts. Tesco was less clear about its financial problem — too much leverage. It promised to “protect and strengthen the balance sheet” through capital spending and dividend cuts, possible asset sales, and pension spin-offs.  But there was little sign of concern about the dangerous combination of risks we talked about in our last post, “Tesco’s in the Wrong Box,” nor was there a commitment to a better credit rating. Fully adjusted for off-balance-sheet debt equivalents like pension obligations and operating leases, Tesco’s leverage for its half-year ending in August 2014 was 5.0x debt to EBITDA and 50.8% debt to capital. That is too high. Given the company’s high business risk, we think it should be targeting debt to EBITDA leverage of 3.0x and debt to capital of 40%, putting it at the lower end of range of its peer group for those measures. Tesco can do that by improving earnings or reducing debt or both. We’re skeptical about a big or quick jump in earnings at Tesco. The challenge to its business model may be more than price and overhead cuts can overcome, there may be strong cultural resistance to change, and competitors are likely to respond with their own cuts. Cutting credit risk at Tesco That leaves paying down debt as Tesco’s most attractive option for reducing financial risk. At the...

Tesco’s in the Wrong Box

On January 8 Tesco announced more details of its plan to improve its competitive position in the UK, revive its profitability, and bolster its finances. It’s going to cut prices on popular brands, trim £250 million in operating costs, limit capital spending, stop the dividend, and sell assets. Some of the changes may already be working. The decline in UK sales is easing, with growth going from (5.4%) in the second quarter to (2.9%) in the third quarter to (0.3%) during the Christmas season. But January 8 brought more bad news as well. Moody’s downgraded Tesco’s credit rating to junk status (Ba1), and Standard & Poor’s did the same a few days later (BB+). Both agencies cited competition, profitability, and financial leverage as the reasons. Those are the risks we discussed in our January 5 blog post, “Testing Tesco.” But we think the rating agencies understate the risks. They don’t consider the difficulty of changing a company as large and as focused as Tesco. We see Tesco’s still unresolved financial reporting problems as symptoms of a damaged corporate culture that is likely to fight hard against change. The agencies don’t mention liquidity in their concerns about Tesco, but the declining trend in liquidity worries us at least as much as the increasing trend in leverage. The company’s liquidity position is at a four-year low, driven by growing current debt levels.   But our biggest worry isn’t any single risk or even the number of risks. It’s the compounding effects of Tesco’s risks, the way the company’s business and financial risks amplify one another. It’s common to think of credit risk in...

Private Equity Likes Strong Brand Names

Private Equity Funds often target companies with strong brand names in mature industries.  These companies often have strong, stable cash flows, which can be used to repay the acquisition debt.  Two transactions, both announced in February 2013, demonstrate this trend. Food behemoth H.J. Heinz Company agreed to be acquired by Brazilian PE firm 3G Capital and Warren Buffet’s Berkshire Hathaway at a total transaction value of $28.8 billion. As part of the transaction, both 3G and Berkshire invested approximately $4.1 billion to acquire common stock of the company.  Heinz is a leader in the mature condiments market with large and stable cash flow, and the potential for additional cost savings.  The transaction closed in June of 2013, and the new owners wasted no time in shaking up the HNZ management team by dismissing 11 executives and replacing them with new personnel. Dell Inc. announced a deal to sell the computer maker to founder Michael Dell and PE firm Silver Lake at a price of $13.65 per share, valuing the transaction at $24.4 billion.  The company also announced that the Board would commence a 45-day go-shop period to seek offers from other bidders. This action led to two competing offers, one from PE firm Blackstone, which offered $14.25 per share for the entire company, and one from Carl Icahn’s Icahn Enterprises, which offered $15.00 per share for a 58% stake. Blackstone eventually dropped out of the process after Dell reported declining sales, but Icahn continued to purse the transaction and offered several alternative structures to the Silver Lake deal. The Board of Directors was hesitant to pursue the Icahn deal...