Tuesday, March 18, 2008

Hefty debt, sagging credit ratings

The continuing meltdown of newspaper stocks and bond ratings has provoked emails and calls from readers seeking a deeper understanding of the financial pressures facing publishers. This is the second of two posts (the first is here) answering the most common questions.

Q. The ratings on newspaper bonds keep falling. What are bonds, anyway? And why are ratings dropping?

Companies needing to borrow money to finance acquisitions, expansions and other normal business activities sell bonds, which are elaborate IOUs promising to pay lenders a certain rate of interest at prescribed intervals and to repay the loan in a defined period of time.

When a company issues bonds that will be bought and sold in the public market – as most are – they hire a private, for-profit rating agency to examine their finances and business prospects to independently assess the issuer’s ability to repay the obligation in accordance with the terms of the bond. In addition to rating a bond before it initially is sold, the agencies continue to monitor an issue through its lifetime and adjust the credit’s rating according to the company’s performance.

The major rating agencies are Standard and Poor’s, Moody’s Investor Services and Fitch Ratings. They rate the risk, and therefore the quality, of the bond on a scale that usually ranges from triple-A, for the most secure bond, to something starting with a “C” for the riskiest issues. Each agency uses a slightly different rating system but there’s a handy cheat sheet here.

A security rated at Ba or lower by Moody’s or BB or lower by S&P is considered to be a junk bond, which means that the likelihood of timely repayment is too uncertain to permit the security to be held as an investment in the portfolios of most pension funds, insurance companies and other institutional accounts. As you can see from the table below (which you can click to enlarge), the bonds of two out of three newspaper companies tracked by Moody’s are in junk territory.

Q. The bond rating of Journal Register Co. last week fell by two notches to B-minus from B-plus. What does that mean?

The downgrade of a credit rating signals that the independent agencies are worried a company will not have sufficient sales or profits to fulfill its future obligations to repay or reduce its debt. A rapid series of downgrades indicates a heightened concern that those obligations may not be met.

The bond ratings of most newspapers have dropped in the last three years , because a number of publishers unfortunately loaded up on substantial amounts of debt just as the industry was entering a dramatic and unprecedented decline.

Beyond JRC, the publishers whose credit ratings have fallen – in some cases multiple times – include Belo, GateHouse Media, McClatchy, Media General, MediaNews Group, Morris and Tribune. Others, like New York Times Co., have been put on a watch, meaning they are at risk of having their ratings dropped if their operating performance deteriorates.

Some publishers, like GateHouse, MediaNews and McClatchy, took on substantial debt to finance the acquisitions of additional newspapers. Other publishers, including Tribune Co., the Minneapolis Star Tribune and Philadelphia Newspapers, borrowed money to buy out other shareholders to become private businesses.

Q. Why does it matter if a credit rating drops?

A. The lower a credit rating goes, the more difficult and expensive it is for the company to borrow money. A company with a history of tumbling credit ratings will be forced to pay ever-higher interest rates. Here's why this matters:

The Tribune Co., which has been put on warning of a possible rating downgrade by S&P, would face an additional $20.5 million in interest payments it were forced as the result of a downgrade to pay 0.25% a year in additional interest on its $8.2 billion in debt. The additional $20.5 million in interest would be equal to a sixth of the newsroom budget of the Los Angeles Times.

If a company's credit ratings fell low enough, it could be shut out of the credit market altogether. This is of particular concern in a period when credit markets have constricted, as they have since mid-summer. And the Bear Stearns meltdown isn't going to improve the situation for any borrower.

Q. Is the newspaper industry that bad off or have the rating agencies just gotten stricter?

A. Both. While the newspaper industry undeniably is suffering from declines in readership, sales and profits, the recalibration of newspaper credit ratings is to some degree the result of heightened vigilance on the part of the rating agencies.

Having essentially failed to recognize the shaky financings responsible, in part, for the sub-prime mortgage mess, the agencies now have taken to aggressively re-rating issues in all industries so they aren’t accused of missing any future problems.

Q. What happens if a publisher can’t make its interest payment or fulfill other key bond provisions?

There is nothing wrong with borrowing money to finance business requirements, so long as a company has a plan to increase sales and profits to satisfy its debt. But there’s a big problem when a business can’t do so.

A company is said to be in default when it cannot repay its debt on a timely basis or when it fails to comply with other key terms of its loan. In the case of several of the publishers whose debt has been downgraded, one of the major requirements of their bonds is that they reduce over time the ratio of their debt to their operating profits.

While a company might have started out borrowing money at 7.5 times its operating profit, for example, it could be required a year later to have increased its profits (or repaid some debt) to the point that the debt was equal to only 7.25x profits. If the company is profitable but just not profitable enough to satisfy the prescribed ratio, it is in violation of the terms of the loan.

Depending on their severity and duration, breaches of a loan's provisions (typically called "covenants") can trigger a variety of consequences, ranging from higher interest rates to the forced sale of assets to, in the most extreme cases, the takeover of the company by its lenders.

The best way to assure compliance with convenants requiring specified levels of profitability is to increase sales without raising expenses. If sales don’t rise fast enough to meet the prescribed targets – or worse, fall – then the only alternative is for management to cut expenses. That’s why the highly leveraged publishers mentioned here have been reducing newsprint consumption, trimming headcount, outsourcing ad production and cutting every conceivable expense for the last few years.

While expense reductions can help a company comply with its debt covenants for a period of time, cost cutting is not a long-term strategy for success, because a newspaper can’t replicate annually the one-time benefit of eliminating its stock listings, closing a remote bureau or eliminating dental insurance.

Q. What would happen if a newspaper defaulted on its debt?

A default occurs when a borrower does not have the ability to repay a bond or to meet certain major covenants of the credit. Fortunately, lenders don’t want to be responsible for operating a struggling newspaper any more than banks want to own portfolios of abandoned, foreclosed homes.

So, the first effort in the event of a default would be to give the publisher some extra time to solve the problem – perhaps with the lender-mandated assistance of executives who specialize in cutting costs and otherwise restructuring troubled businesses. In that event, newspapers likely would undergo more vigorous cost cutting than anything seen to date.

If workout experts couldn’t find a way to improve the sales and profitability of a property, then it likely would be offered for sale (subject to the risks, challenges and investor skepticism discussed earlier here) in what for the foreseeable future would seem to be a less than hospitable market.

If a buyer couldn’t be found in a reasonable period of time, the business would be closed and its physical assets – from cubicles to vehicles – would be auctioned to the highest bidder.


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