Companies Look To Reduce Debt, Improve Ratings

By ANTHONY PALAZZO
Staff Reporter

Having gorged on debt during good times, companies in Los Angeles and elsewhere now find themselves on a crash diet, trying to slim down bloated balance sheets to a level that reduced business expectations can support.

There's still some ways to go, according to a Business Journal analysis of corporate debt ratios, based on data compiled by Bloomberg News.

Of the 200 locally based companies in the sampling, 32 had a ratio of total-debt-to-Ebitda of five or greater. Ebitda, or earnings before interest, taxes, depreciation and amortization, is a common measure of the cash flow generated by a business' operations. Debt analysts typically become watchful of a company's debt load when the ratio reaches four.

"They borrowed during peak earnings and thought they were reasonably leveraged," said Doug Martin, vice president at Chanin Capital Partners, a Los Angeles restructuring shop. "You have a lot of companies that maybe haven't turned unprofitable, but they've had their Ebitda margins cut by 40 to 50 percent, and what was supportable before is now highly leveraged."

Standard & Poor's reports a median total debt-to-Ebitda ratio of 2.5 for long-term debt it rated BBB (low investment grade) from 1999 to 2001, and a 3.8 ratio on BB rated (speculative) debt. Companies receiving a highly speculative rating available from S & P;, CCC, had a mean total debt to Ebitda ratio of 5.7.

At Hilton Hotels Corp., L.A. County's fifth largest corporate borrower, lowering debt is a top priority. It carried a debt/Ebitda ratio of 5.75, based second-quarter results (the ratio fell to 5.2 as of Sept. 30).

"We have about $4.4 billion of debt, and with the net cash flow that we generate this year and next, our primary focus is further debt reduction," said Marc Grossman, a spokesman for Beverly Hills-based Hilton.

It's critically important for Hilton to get its debt ratios down. After Sept. 11, Hilton and virtually every other hotel company had their debt downgraded by the major ratings agencies, Standard & Poor's and Moody's, as business fell sharply. Lower ratings mean higher costs to the borrower, because the perceived risk is higher.

Last month, Moody's improved its outlook on Hilton debt to stable from negative, but it's still rated below investment grade, or "junk." S & P; maintains Hilton at its lowest rating that is considered to be investment grade, BBB-.

"We want to be solely investment grade rated at both of the agencies," Grossman said. He said the split rating hasn't had a significant impact on Hilton's borrowing costs to date.

Hilton is among scores of companies that have been trying to pay down debt all year, as predictions of an economic recovery get pushed further into the future.

Ford Motor Co., General Electric Co. and others have seen spreads, the difference between rates at which the companies can borrow money versus the U.S. Government's borrowing rates, widen on their corporate debt.

"There has been an incredible focus on (companies) improving their balance sheets and strengthening the credit profiles," said Albert Turner, director of corporate finance at Fitch Inc. in Chicago, another debt ratings agency.

In August, Turner cut Fitch's ratings on Walt Disney Co., L.A.'s second most profligate borrower, with $15.2 billion in debt.

With a ratio of 4.3, Disney remains within investment-grade ratings, but a weaker earnings and cash flow stream, coupled with additional debt taken on for acquisitions, prompted the downgrade, Turner said.

Disney is "very focused" on cleaning up its balance sheet, Turner said.

Assessing levels

The amount of debt a company can reasonably carry varies, depending on the reliability of its revenue streams, its cash levels and other factors. Real estate companies, for example, carry high debt loads to leverage their investment in properties that they rent out, sometimes on leases that run 20 years or more. A number of real estate investment trusts made the Business Journal list.

The Business Journal excluded financial companies, including L.A.'s biggest borrower, Countrywide Credit Industries Inc., with $30.8 billion in total debt, according to Bloomberg. Banks and lending companies borrow huge amounts and lend them out, making money on the difference in rates. They are analyzed differently than other companies.

Also excluded were companies with less than $10 million in total debt. The screen was run last week, during earnings season. As a result, the figures may not reflect balance sheet changes that may have been reported subsequent to the screen being run.

Hilton, which reported third quarter results last week, is a case in point.

According to data compiled by Bloomberg, Hilton had total debt of $4.8 billion as of Sept. 30, down from $5.3 billion on June 30. Using those figures, Hilton's debt-to-Ebitda ratio fell to 5.2 from 5.8 during the same period.

When calculating its figures internally, Hilton excludes debt on its balance sheet that's being paid off by Park Place Entertainment Corp., a gaming company spun off from Hilton in 1998. Hilton figures its current debt-to-Ebitda ratio is closer to 4.4, and is trying to get this number down to 3.75 by the end of 2003, Grossman said.

Even during the boom years, banks would only lend up to three or four times a company's Ebitda, said Martin. With business off, companies now find themselves more highly leveraged, and they struggle to find creative ways to replace or extend credit lines.

"We'll continue to face these issues for the next 12 to 18 months, until credit really loosens up a bit," Martin said.

Alpha Technologies Group, a Los Angeles-based maker of thermal management products and aluminum extrusions, recently sold and leased back its Pelham, N.H., facility and used the proceeds to pay down its bank debt by $5 million, as required by the company's credit agreement.

The deal lowered Alpha's quarterly payments under the credit line to $750,000 from $1.2 million, with a balloon payment due later. It also allowed Alpha to extend a working capital credit line and reset its loan covenants to lower financial expectations.

"We had to align ourselves to what the market is doing, and in order to do that, and the banks agreed, to reduce payments for 2003," said Chief Financial Officer James Polakiewicz.

Cost of relief

While such transactions can keep a company's lenders at bay, they often come at a cost to shareholders. In Alpha's case, the company took a $2.3 million charge on the transaction, and it will pay out $325,000 more per year in rent than it previously paid in interest and non-cash depreciation expenses.

In addition, the property's buyers (which included a company director) extracted from Alpha warrants to buy 250,000 shares at $1.42 each a burden that will slow any rise in the stock price once business does improve.

Besides selling off assets, some companies are turning to issuance of preferred stock or convertible debt to replace bank debt.

Korn/Ferry International took this route earlier this year, issuing $40 million of convertible debt and $10 million of preferred equities in a private placement.

The issuance replaced bank debt that the lender wasn't going to renew. "Often when companies are on the verge of being potentially distressed, all kinds of covenants and restrictions" are demanded by the new lender, said Christopher Gutek, an equity analyst with Morgan Stanley. In Korn/Ferry's case, the terms were fairly favorable, he said.

Nevertheless, Gutek cut his rating on Korn/Ferry to underperform in October, based on valuation.

Since peaking in late 2000, Korn/Ferry's revenue run rate has fallen by about half, Gutek said. The company has drastically cut costs to remain viable.

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