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Cash & Working Capital

Calibrating Capital Structure as a Downturn Looms

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April 12, 2019

Balancing ratings, liquidity needs, and shareholder returns as the economy slows.

Accounting-MoneyThe challenge for treasury of getting capital structure right rises as companies engage in strategic M&A, adjust to changes in tax law and confront current or anticipated shifts in the global economy. And don’t forget about keeping rating agencies and shareholders happy and activists away. With all those factors in play, members of NeuGroup’s Treasurers’ Group of Thirty (T30) recently compared notes with the treasurer of a technology company who presented results from a capital structure checkup.

THE BIG PICTURE. This company’s treasury wants to err on the conservative side from both a capital and liquidity perspective in response to leadership’s concerns about a recession as the company delevers and normalizes its balance sheet following an acquisition. At the same time, it’s important to communicate this conservative capital structure carefully to avoid riling up shareholder activists (more on that below). This backdrop has both strategic and tactical implications.

FOCUS ON RATINGS. The session leader said that ratings, not leverage, determine access to capital, a key strategic consideration in the company’s capital structure. A low investment-grade rating provides the optimal balance of access to capital and its cost, as well as downside protection against a macro or firm-specific shock. He said his company’s BBB- rating and leverage of 2X debt-to-EBITDA, in line with peers, provide what it considers a near ideal cost of capital of about 9%.

BOND REFI CONGESTION IN 2021? The session leader said his company has more than $1 billion in bonds coming due in 2021, and that Standard & Poor’s had asked about its plans to refinance the debt. Worrying about refinancing now may seem premature, he said, but the rating agency is concerned about the volume of corporate debt coming due that year (See iTreasurer for Moody’s Investors Service’s view on refinancing challenges.)

FOCUS ON LIQUIDITY. “Liquidity shocks are what start the tumbleweed rolling for bankruptcies, and not necessarily leverage ratios,” the session leader said, underscoring that liquidity is another key element of the company’s capital strategy. He said its $2 billion to $2.5 billion in liquidity should enable the business to weather a recession, although treasury has recommended an additional $500 million to support growth and mitigate potential supply-chain-finance shocks. He noted that available liquidity is augmented with cash flow generation boosted by reduced working capital needs.

TACTICAL CONSIDERATIONS. The company relies on a significant portion of lower cost, floating-rate debt, including accounts-receivable factoring and supply chain financing. In addition, foreign-currency debt acts as a natural hedge to volatility in foreign operations and cash flow. Another tactic, communicating the company’s low leverage to investors, conveys capital-structure conservatism and low risk, but it can also prompt activists to knock at the door.

KEEPING INVESTORS AT BAY. Questioned whether shareholders complain about his company’s cash level and want more share repurchases, the session leader acknowledged such demands. But he said that announcing small buyback programs of $100 million or $200 million—that it commits internally to executing in 12 to 18 months—reduces investor noise. It buys big chunks when the share price falls below the company’s intrinsic value, while half the authorization is through automatic dollar-cost-average purchases.

SHARE REPURCHASE MESSAGES. The session leader’s company splits free cash flow evenly between M&A and share repurchases. He said the business doesn’t want to be locked into a dividend, and few shareholders have asked for one. Another member said investors in his technology company, despite its non-investment-grade rating, demand a dividend and are making noise about resuming stock buybacks, a move he opposes: “We’re highly acquisitive, so it sends a message that there are no more opportunities out there because we’re giving back cash.”

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