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Chapter 10 Getronics’ Debt Ratings Teaching Note Version: December 2013

Introduction This is a case about credit analysis. The main objective of this case is to let students apply debt rating prediction models to real-life data and in the process teach them the benefits and limitations of such models.

Questions for students 1. Determine a debt rating for each half year end during the years 2002 – 2007. Use the debt rating prediction model described in Chapter 10.

2. Benchmark your debt ratings against Getronics’ actual debt ratings (see the spreadsheet on the book companion website). What factors may explain the differences?

Case analysis Question 1 Using the model described in Table 10.8 to calculate debt ratings is a straightforward exercise. Exhibit TN-1 displays semiannual values for each of the five variables included in the model (see Table 10.8 and the accompanying text for a more detailed description of the model). Using these values and the model coefficients reported in Table 10.8, we calculate the debt rating scores displayed in the bottom half of the exhibit. Some simplifying assumptions are needed to make these calculations: in particular, we assume that Getronics only has operating assets (i.e., no investment assets, zero excess cash and zero NIPAT). This assumption seems reasonable given that most of Getronics’ other non-current assets consist of deferred tax assets.

The model appears to be relatively accurate. That is, with the exception of the first and last half year, the model is never off by more than one category. In the earliest half years, the model is a little more conservative than credit analysts; during the 2005 and 2006, the model is typically more optimistic than analysts. Both the model and credit analysts classify Getronics as below investment grade (and in some half years even close to bankruptcy).

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Question 2 Even though the debt rating prediction model is fairly accurate, as illustrated above, it does provide only a crude first estimation of the firm’s creditworthiness. Through analyzing the possible sources of differences between the model’s outcomes and analysts’ actual ratings, students can obtain some basic insights into the limitations of the model. This analysis would reveal, for example, the following limitations (Note that the list of information events may help students to better understand the changes in financial ratios): 1. Total assets is not always a good measure of firm size.

The model includes the natural logarithm of total assets as a measure of firm size. The coefficient on firm size is positive, indicating that larger firms typically have lower credit risk. The simplifying assumption underlying the use of total assets is that all assets contribute equally to the reduction in credit risk.

However, especially in the earlier years, Getronics’ assets consisted primarily of goodwill and current assets (accounts receivable). One could argue that the fact that Getronics “overpaid” for the acquisition of Wang is more likely to be one of the major causes of the company’s financial difficulties rather than a riskreducing factor.

If we exclude intangibles from the calculation of the firm size measure, the predicted scores decrease by, on average, 0.22 between 2002 and 2007, but the rating estimates do not change.

2. Negative values of interest coverage and profitability tend to be more transitory.

Two variables in the model relate to profitability. The underlying idea of including these variables is that current profitability is a good predictor of Getronics’ future cash flow generating ability. However, transitory components, such as impairment charges, have little predictive value. Especially when interest coverage and profitability are negative, such transitory items tend to be important components of earnings. Of course, if a firm recognizes an impairment charge it does so because its cash flow generating ability has decreased.

However, the euro effect of an impairment charge of €1 on future annual cash flows will not be €1, but more likely be in the order of €1×re.

To illustrate the effect of transitory charges on the model, consider the model’s prediction in 2002H2. Three months after the end of 2002H2 Getronics’ debt rating was B, whereas the model predicted a rating of CCC. One of the main drivers of this prediction was the company’s interest coverage rate of -12.9. If we exclude the impairment charge of €403 million from the calculation of Getronics’ 2002H2 interest coverage and profitability, the company’s debt rating score becomes 0.32 and the predicted rating changes from CCC to B.

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3. Not all debt components are similar.

An important determinant of creditworthiness is leverage. In the debt rating prediction model leverage is defined as the ratio of debt to capital. Not all components of debt, however, contribute equally to a Getronics’ creditworthiness. In particular, it would be reasonable to assign a lower weight to the company’s convertibles than to its other loans for at least two reasons.

First, the convertibles carry a lower interest burden than the other loans and have a non-zero probability of being converted into equity. Second, the convertibles are subordinated and therefore carry, at least from the perspective of ordinary debt holders, less risk.

Another tool that is helpful in understanding the benefits and limitations of the model is to calculate the variables displayed in Table 10.5 and assign debt ratings based on each variable separately. Exhibit TN-2 displays the results of this analysis.

Exhibit TN-2 shows that in some years the signals provided by the individual variables strongly diverge. This observation underlines one of the advantages of using a comprehensive model; that is, uncorrelated noise in the individual signals gets filtered out in the comprehensive model. In addition, the following observations are noteworthy: 



In some periods, the individual signals predict a rating of B or CCC, whereas both the comprehensive model predicts a rating of BB. The difference might be explained by the role of firm size. That is, the relatively large size of Getronics moderates the effect of negative performance on the company’s debt rating.

The variables Return on Business Assets and EBITDA to Total Debt produce sometimes strongly contradictory predictions. One cause of this is the influence of discontinued operations. In particular, the sale of HR Solutions in 2003H1 has generated a one-time profit that has boosted NOPAT to Capital. Although current net profits is typically a better predictor of future cash flows than current cash flows, these one-time events distort the informative value of net profits.

Consequently, the EBITDA based measure of performance has incremental information value.

Finally, Exhibit TN-3 combines the list of information events with a list of rating events, with the objective of illustrating the relationship between both types of events. This exhibit provides at least the following interesting insights. First, not surprisingly, many of the rating events occur shortly after earnings announcements, illustrating the relationship between financial statement disclosures and debt ratings. Second, some of the rating adjustments occur after a rating-relevant event but before the financial statement effects of such an event are public. This illustrates that analysts’ rating adjustments may anticipate changes in financial ratios. An example of such an adjustment is the downgrade from B to CC after the announcement that Getronics’ CEO and CFO stepped down on February 21, 2003. Analysts upgraded Getronics’ rating back 3

to B after the company had announced its (presumably reassuring) financial results on March 4, 2003. This timing advantage is also one of the reasons for why debt rating analysts outperform mechanistic debt rating models.

Conclusion This case shows that debt rating prediction models are simple, useful and relatively accurate. However, the case also illustrates that analysts can add value by (1) getting a more detailed understanding of the company’s financial ratios and making adjustments, (3) analyzing more information than a few financial ratios (including soft information such as CEO or CFO resignations) and (3) by providing information on creditworthiness on a more timely basis than periodically published financial statements do.

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Exhibit TN-1 Debt rating predictions 2002 – 2007

Debt rating prediction model (cf. Table 10.8) Natural logarithm of total assets Riskiness (3-year STD of ROA) Profitability

2007 H2

2007H1

2006 H2

2006 H1

2005 H2

2005 H1

2004 H2

2004 H1

2003 H2

2003 H1

2002 H2

2002 H1

0.500

0.583

0.663

0.797

0.874

0.821

0.494

0.526

0.669

0.629

0.777

1.110

0.087

0.120

0.098

0.032

0.132

0.126

0.333

0.288

0.426

0.256

0.282

0.306

-0.125

-0.177

-0.102

0.001

0.036

0.052

0.089

0.060

0.286

-0.162

-0.364

-0.512

Interest coverage

-2.078

-1.210

0.365

1.700

1.317

1.521

3.043

0.955

-1.069

-9.646

-12.929

-27.750

Leverage

0.577

0.766

0.643

0.628

0.499

0.558

0.554

0.569

0.697

0.661

0.885

0.711

Cash flow performance

-0.009

0.108

0.139

0.078

0.125

0.096

0.158

0.125

-0.027

-0.062

0.075

0.097

1.116

0.571

1.292

2.387

1.998

2.055

0.719

0.797

0.852

-0.554

-1.962

-3.200

B

B

B

BB

BB

BB

B

B

B

CCC

CCC

CCC

BBB+, negative

B-, watch positive

B-, negative

B-, negative

B, watch negative

B+, stable

B+, positive

B+, positive

B+, positive

B, stable

B-, watch dev

BB+, stable

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0

0

+1

+1

+1

0

0

0

-1

-1

-2

Score Implied rating Actual rating (3 months after period end date)

Deviation

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Exhibit TN-2 Four financial ratios 2002 – 2007

Financial ratios (cf. Table 10.5)

2007 H2

2007H1

2006 H2

2006 H1

2005 H2

2005 H1

2004 H2

2004 H1

2003 H2

2003 H1

2002 H2

2002 H1

Return on business assets

-12.5%

-17.7%

-10.2%

0.1%

3.6%

5.2%

8.9%

6.0%

28.6%

-16.2%

-36.4%

-51.2%

Implied rating

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

BBB

B or CCC

AAA

B or CCC

B or CCC

B or CCC

Pretax interest coverage

-2.08

-1.21

0.37

1.70

1.32

1.52

3.04

0.95

-1.07

-9.65

-12.93

-27.75

Implied rating

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

BB

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

EBITDA to total debt

-0.9%

10.8%

13.9%

7.8%

12.5%

9.6%

15.8%

12.5%

-2.7%

-6.2%

7.5%

9.7%

Implied rating

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

B or CCC

Debt to Capital

57.7%

76.6%

64.3%

62.8%

49.9%

55.8%

55.4%

56.9%

69.7%

66.1%

88.5%

71.1%

Implied rating

BBB

B or CCC

B or CCC

BB

AA

A

A

A

B or CCC

B or CCC

B or CCC

B or CCC

Actual rating (3 months after period end date) Predicted rating (see Exhibit TN-1)

BBB+, negative

B-, watch positive

B-, negative

B-, negative

B, watch negative

B+, stable

B+, positive

B+, positive

B+, positive

B, stable

B-, watch dev

BB+, stable

BB

B

BB

BB

BB

BB

BB

BB

BB

B

CCC

B

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Exhibit TN-3 Information and rating events Date

Rating, outlook May 5, 1999

December 8, 1999 February 9, 2000

BBB-, negative Getronics sells its ATM business, realizing a profit on the sale.

Annual results 1999 announcement. The acquisition of Wang Global boosts the company's results. The company announces ambitious growth plans.

March 3, 2000

March 13, 2000 March 16, 2000

BBB-, stable Getronics issues e450 in subordinated convertible debt (to replace maturing debt).

End of the dot-com bubble. Technology shares decline.

First half-year report.

Getronics announces that this year's earnings will be below expectations. Getronics' share price declines by 42 percent.

First half 2000 August 17, 2000 November 22, 2000 November 22, 2000 February 5, 2001 February 28, 2001 June 1, 2001 August 16, 2001 November 8, 2001 December 11, 2001 December 18, 2001 January 29, 2002 March 5, 2002

BBB-, negative Getronics signs e75 million contract with Shell.

Annual results 2000 announcement Getronics' CEO Cees van Luijk resigns and is succeeded by Peter van Voorst.

First half-year report BBB-, watch negative Getronics exchanges e295.3 million of subordinated convertible bonds for equity.

Getronics signs e90 million contract with Barclays.

BB+, stable Annual results 2001 announcement. Getronics decides to freeze wages of its employees after incurring a record loss.

Getronics announces that it plans to repurchase some of its outstanding convertible bonds Getronics' share price drops close to 40 percent after rumors that the company is close to applying for bankruptcy.

First half-year report

April 22, 2002 August 13, 2002

August 15, 2002 November 20, 2002 December 31, 2002 January 27, 2003 February 12, 2003

Announcement Getronics acquires US-based industry peer Wang Global; the company finances the acquisition through a mixture of new equity (e0.7 bln common and e0.3 bln preferred) and debt (e0.5bn loans and e0.3bn convertible bonds).

The amount of goodwill that Getronics recognized on the transaction is close to e2.4 bln.

BB+, negative Getronics repays all its amounts outstanding under the e500 million credit facility.

B, watch negative Getronics offers (mostly institutional) subordinated

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convertible bondholders equity in exchange for their bonds. Convertible bondholders deny the offer, resulting in a conflict between management and bondholders.

CEO Peter van Voorst and CFO Jan Docter step down. The new CEO of Getronics is Klaas Wagenaar.

February 21, 2003 February 27, 2003 March 4, 2003 March 13, 2003 March 21, 2003

CC, watch dev Annual results 2002 announcement B-, watch dev Getronics announces to reduce debt by selling assets rather than offering bondholders equity.

Getronics sells Getronics HR Solutions for e315 million in cash (and realizes a profit on the sale of e270 million).

Getronics immediately repays bondholders e325 million (in cash) and agrees for the repayment of the remaining e250 million in installments. The agreement resolves the company's conflict with its convertible bondholders.

April 22, 2003 June 10, 2003

June 12, 2003 June 20, 2003 July 1, 2003

B-, watch positive B, stable Getronics obtains a loan of e100 million, which will be used to replace a e200 million credit facility.

First half-year report Getronics issues e100 million in convertible debt (to replace maturing debt).

August 13, 2003 October 13, 2003 January 16, 2004 February 4, 2004

B, watch positive

February 9, 2004 March 2, 2004 April 19, 2004

B+, positive

Getronics sells 100 million new shares to institutional investors (proceeds: e233 million). The proceeds are used to repay e250 million in subordinated installment bonds on March 30, 2004.

Annual results 2003 announcement Getronics obtains a new credit facility of e175 million from a consortium of banks.

First half-year report Getronics announces the acquisition of industry peer PinkRoccade N.V for the amount of e350 million. The company will obtain a new credit facility of e125 million that, together with the credit facility obtained in April, will be used to finance the acquisition.

Annual results 2004 announcement Getronics issues new shares (proceeds: e388 million).

August 11, 2004 November 1, 2004

March 3, 2005 April 11, 2005 April 29, 2005 August 3, 2005 September 29, 2005 January 19, 2006 March 2, 2006

March 7, 2006 April 20, 2006 June 23, 2006

B+, stable First half-year report.

Getronics issues e150 million in unsecured convertible debt (to replace maturing bonds).

B+, watch negative Annual results 2005 announcement. Getronics also announces that its Italian subsidiary has committed fraud, hiding e15 million in expenses.

B, watch negative Getronics receives four bids for its Italian subsidiary.

Getronics sells its Italian subsidiary to Eutelia for an

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estimated amount of e135 million, realizing a loss of e50 million. The sale helps the company to meet its debt covenants again.

First half-year report. Disappointing results cause share prices to decline by close to 24 percent. Getronics announces restructuring plans.

August 1, 2006

September 5, 2006 November 15, 2006 December 14, 2006 February 27, 2007

July 30, 2007 July 31, 2007 November 8, 2007

B-, negative CFO Theo Janssen resigns unexpectedly. Soon two other Board Members follow.

Getronics issues e95 million in convertible bonds (to replace maturing bonds).

Annual results 2006 announcement. Getronics announces its annual results early. The company realized an unexpected loss of e145 million.

Royal KPN offers to acquire Getronics.

B-, watch positive BBB+, negative

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