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July 1, 2009

COPING WITH THE CREDIT CRUNCH: CREDIT WHERE CREDIT IS DUE

The credit market has improved, say investment bankers and analysts, but the cost of credit will remain higher than it was.

 

SCOTT A. ANDERSON, senior economist and vice president, Wells Fargo & Co., Minneapolis, Minnesota

ELI LUSTGARTEN, president, ESL Consultants, St. Louis, Missouri, and senior vice president and senior analyst with Longbow Research, Cleveland, Ohio

RICHARD McLAUGHLIN, steel and metal industry specialist leader, Deloitte Consulting, Cleveland, Ohio

VINCENT PAPPALARDO, managing director, Dresner Partners, Chicago, Illinois

MARK PARR, managing director and equity research analyst, KeyBanc Capital Markets, Cleveland, Ohio

JOHN SAFRANCE, senior analyst, Fraser Mackenzie, Toronto, Ontario

JAMES SWEENEY, director of global strategy research, Credit Suisse Group, New York City

ROBERT WUJTOWICZ, managing director, InterOcean Financial Group, Chicago

How would you describe the current state of the credit markets, particularly as it relates to the metals industry? Can you offer any numbers to put the current conditions into perspective?

McLaughlin: There are two things happening right now which are damaging—one is the shrinkage in overall credit availability, and another is the deterioration of credit quality in certain industry sectors, such as the automotive industry. The automotive industry is very important [to the metals industry], and it’s in a state of disarray. In addition, housing and construction in general are big end users of metals. The deterioration of those markets due to credit tightness has slowed many metals markets dramatically.

Parr: It was the removal of credit from most creditusing segments of the economy that really threw the world into a recession last summer. We’ve seen a number of significant actions that have resulted in major steps toward the reorganization of the credit markets. This would include direct capital injections into the financial sector and the TALF [Term Asset- Backed Securities Loan Facility] funding program. Interbank lending rates and the LIBOR spread have returned to the levels seen before the credit mess really began.

You have seen capital markets willing to supply increased equity raising or new equity-raising [tactics]. The industry has access to both debt and equity in this environment, which is unusual. Normally you see the equity window shut down. It’s a tremendous acknowledgment of the improvement the industry has achieved in the past decade.

Sweeney: We are seeing significant issuance of new debt securities and corporate bonds, but these are debt securities issued directly to market, which are different from bank loans. If you are a big company and can access capital markets, you can raise debt right now.

However, outlook for bank-loan growth is more troubled. A lot of [banks] have troubled loans on their books and are not willing to take chances on loans.

Pappalardo: There have been a significant number of metals-related companies—particularly those that may have had write-offs in November and again in January or February—that are getting pressure from their lenders to get junior capital, which may take the form of subordinated or mezzanine debt or preferred common equity, has a lower priority in a liquidation or wind-down, and doesn’t stand to get paid anything until the senior secured lenders are repaid in full. The banks are seeing many covenants get threatened and are worried about fixed-charge coverage ratios as well as the impact of the drop in inventory values on their collateral base.

Wujtowicz: The regulators, of course, are looking over the banks’ shoulders with added scrutiny. Naturally then, the banks are having to put the squeeze on service centers and, in effect, telling them, “You have to put down more equity or be forced to liquidate your company.”

Lustgarten: One of the series that we monitor is a Federal Reserve series on commercial and industrial loans, [which] measures the tightening and easing of lending across markets. During this cycle, [the United States] got to be one-third tighter on lending than ever in history. Now there has been an improvement in willingness for banks to lend. … It’s not to say that things are over, but the fear is dissipating.

Anderson: The credit facilities that the Feds have set up—I count 11 of them now—are working their monetary magic, so to speak. The federal funds rate is down to zero and has been there for about six months now and is starting to get some traction. We’re starting to see liquidity spreads moving down, and they are back to where they were prior to the Lehman Brothers collapse last fall.

What has been the impact of the credit crunch in terms of mergers and acquisitions? Has there been a lower transaction volume? How have companies reacted?

McLaughlin: [A recent Deloitte study] refers to deal volumes within the metals industry from March 2005 through March of 2009. In 2007 there were $73 billion worth of transactions worldwide. In 2008, that number fell to $31 billion. In the first three months of 2009, transactions had not even totaled $1 billion. So mergers and acquisitions have virtually stopped, with the exception of China.

Canada is intertwined with the U.S. and is suffering from the same dynamics that we are. No mergers and acquisitions of note have taken place there. The automotive industry plays a significant role in the economy of Ontario. The difficulties that U.S. automakers are having are affecting Canada more than the U.S.

Pappalardo: Transaction volume has definitely slowed. That is no surprise. Most buyers that are in decent financial shape are just trying to preserve cash and are not actively looking at growth via acquisition. The year-end financial statements have made their way through the banking system, and they’re going through their annual review cycle. [These] guys are realizing the cash their borrowers made over the past few years is dwindling. For the most part, forced liquidations are just beginning.

Anderson: The credit crisis could accelerate M&A activity as we come out of this downturn as companies feel the need to combine, cut costs and improve efficiencies.

Safrance: My guess is 2010 will heat up [M&A activity] as some of the companies that were particularly beat up in this go-around can’t get off of the mat.

Sweeney: In terms of leverage, the buyout market was really booming [a few years ago], and that was symptomatic of the credit climate. Some of the debt used in that leverage loan market has really suffered in the crisis. You are not going to get as many leveraged buyouts as before because debt is now more difficult to raise.

Has there been a shift in emphasis on financing sources—say, from public sources of financing to private sources, such as banks or private investors? What has been the effect in terms of the duration of borrowings— that is, short-term versus long-term?

Anderson: When the bond markets froze up or got more expensive, we saw movement toward the banks to fund at least some short things such as payrolls and that sort of thing.

McLaughlin: The public markets seem to be the best option available for metals companies. U.S. Steel recently completed successful offerings—both equity and debt—and ArcelorMittal issued a substantial amount of debt. Corporate offerings are fairly attractive in this market—there’s no question that traditional loans are shortening in maturity and our clients are all facing liquidity concerns.

Sweeney: Borrowing from the government is not something [a company] wants to do, it’s something that it is forced to do. It’s a response to market panic and credit crisis—financial institutions that have borrowed from public sources will want to pay that back. A healthy economy should come from private savers. We are seeing more private lenders make loans.

Pappalardo: Many metals companies will have a bank for a traditional revolving credit facility, but that credit is getting uncomfortably large based on what the projections for the year are. The bank, for example, may have lent to them based on three times total debt to EBITDA [earnings before interest, taxes, depreciation and amortization] a year ago, but now the bank is looking at a significantly reduced EBITDA level and a total debt to EBITDA ratio in excess of five. This makes lenders uncomfortable, and they’re saying, “Wow, we’re getting to the point where our senior loan is at or very close to the value of the entire enterprise, and what we need to happen is to have some junior capital come in below us so that we’ve got an appropriate capital cushion,” even though it’s shortsighted to assess value and leverage based on depressed EBITDA levels, and people expect a recovery at some point.

Are some of these companies in danger of being forced to liquidate if they can’t raise junior capital?

Pappalardo: What I’m more concerned about is that there’s going to be a bit of a supply-demand imbalance with the large number of metals companies looking for junior capital to strengthen their balance sheets. For the sub-debt and mezzanine players active in this sector, there’s going to be a huge number of potential investment opportunities available, and they will have to choose which deals they can devote time to. Unfortunately there’s going to be a few people for whom those deals won’t get done because those mezzanine players are just too busy.

In light of the current market, is it dangerous for companies to continue extending credit to their customers? If not, when does it become dangerous?

Sweeney: The most acute crisis phase has passed, and in that phase, extending credit to customers did have increased risks. A lot of company models—including metals companies—are built on extending vendor financing to customers. I’m confident that these markets will be getting gradually better. LIBOR spiked last year and now it’s well below 1%, which is a good sign. It’s indicative that credit is moving more, banks are lending at greater terms. The confidence in government programs has been helpful in alleviating concerns. It’s not a completely healed credit market at this point, but it’s improving.

Are there any general signals outside the industry for metals companies that will indicate freer credit availability is near?

Parr: Credit communities tend to be more backward- looking than forward-looking. The front end of a recovery is financed internally. The signals that you would look for include improving capacity utilization, commodity pricing trends, ISM [Institute for Supply Management] numbers, and durable- and capital-goods orders.

McLaughlin: What the government is trying to do is to offer the banking system an opportunity to dispose of illiquid securities, especially collateralized, mortgage-backed securities. They are still out there as potential write-offs. [As long as they are out there], those keep the credit markets skittish and banks maintain ownership with an ongoing concern about their value.

Will the current credit tightening have any long-lasting effects on the metals industry as a whole?

Anderson: We’re not going back to the leverage that companies were able to enjoy during the boom years. We are in an era of “new normal,” and we’re going to see a much more balanced approach to lending. Underwriting standards probably got too liberal, and we’re moving back to a more sensible underwriting environment with much stricter regulatory oversight. Cost of credit will probably remain somewhat higher than what we’ve seen in the past, and that will be factored into a lot of decisions that metals companies have to make.

Safrance: What I have seen, at least in North America, is an unprecedented willingness to cut production. This is primarily due to consolidation over the past decade. North American mills are operating at approximately 40% of capacity, which is unheard of.

Pappalardo: It’s going to lead to more consolidation. The companies that make it through this— which is all you really want to do—are going to understand just how bad it can be, and they will understand getting scale—which will better help insulate their business from market risks and help their availability of credit— is what’s going to be important in the long run.

McLaughlin: In the future, the U.S. automotive industry might be structurally smaller. With gas up to $4 a gallon, smaller cars are more attractive [for consumers]. That cost would reduce the amount of automotive output, which reduces demand for metals.

What are the characteristics of metals companies that have suffered the most from the current credit crunch? Which are better poised to actually benefit from tightening credit?

Safrance: No rocket science here, as it can be applied to just about any industry. Those that have suffered most have carried enormous levels of highcost inventory or have highly levered balance sheets or high fixed costs.

McLaughlin: I can’t think of anyone benefiting from the tightening of the markets. Steel divides production into flat and long products. The steel in a car body tends to use flat products while companies that produce long products produce supply materials that are used to build roads and bridges. With the [American Recovery and Reinvestment Act] stimulus package tending to be focused on infrastructure, those companies will do better. For example, AK Steel and U.S. Steel principally produce flat products while a company like Gerdau Ameristeel produces long products.

Anderson: Smaller companies are always the first to get discriminated against in terms of credit. We at Wells Fargo do a survey of our smaller and mid-sized business customers, and they’re all reporting lower sales and revenue and other financial problems, but access to credit remains very scarce for them as well.

Pappalardo: Service centers operate at the lowest margins of the value chain, and half of what they do is availability of inventory and stock for people. So they got hit with the biggest downturn in steel prices because they keep the biggest inventory level relative to their margins.