13 January 2008

AAA Non-Financials Down to Five

In the last week, Standard & Poor's dropped the credit rating of United Parcel Service (UPS) to a notch below AAA. There are now only five U.S. non-financial firms sporting the highest ranking. According to BusinessWeek, these are:
  • Johnson & Johnson (JNJ)
  • Automatic Data Processing (ADP)
  • General Electric (GE)
  • Exxon Mobil (XOM)
  • Pfizer (PFE)
The days when companies vied for the highest ratings and the longest records for increased dividends seemed to have receded into history. (Quaint traces of the competition can still be found, more so with dividends than credit ratings.) Firms are willing to operate with greater financial leverage as evidenced by higher Debt-to-Equity ratios. They will even take on additional debt to repurchase shares in the company, which increases the ratio from top and bottom, but might increase earnings per share. Home Depot intends to do just that, as part of a recapitalization plan; however, their borrowings might be less than originally planned because credit is more difficult to obtain these days.

This is, by no means, a new phenomenon. In the book Quality of Earnings, which we recently completed, Thornton Oglove cites a relevant example involving a stock repurchase from the 1980's involving Avon.

At GCFR, we include two debt-related metrics in our Cash Management gauge: the aforementioned ratio of Long-Term Debt to Equity and total Debt to Cash Flow from Operations. We like to see some leverage -- corporate investments in productive capital equipment or R&D is a justifiable use of debt -- but it has to be affordable. When debt levels get to high, it becomes that much harder for the company to get additional cash needed to take advantage of new opportunities or to get through a bad spell.

We suspect the current problems in credit markets might actually lead to increased emphasis on corporate credit-worthiness. Might the list of AAA-rated firms actually go up instead of down one day? We don't know when this last happened.

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