EXHIRIT RW-2
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Corporate Ratings
Criteria
2008
For the most complete and up-to-date ratings criteria, please visit
Standard & Poor's Web site at www.corporatecriteria.standardandpoors.com.
EXHIBIT RVH-2
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To Our Clients
tandard & Poor's Ratings Services' criteria pubIications represent OUT
endeavor ta convey the thought processes and methodoIogies empIoyed
determining Standard & Poor's ratings. They describe both the quantitative and qualitative aspects of the analysis. We M i e v e our rating product
has the most vaIue if users appreciate aU that has gone into producing the
S
in
Iettcr symbols.
Bear in mind, however; that a rating is, in the end, an opinion, T h e rating
assignment is as much an art as it is a science.
Solomon B. Samson
Chief Rating offcer, Corporate Ratings
Stambd & Poor's u Corpomta Ratlngs Criteria 2008
3
MNlBlT RW-2
Paga36of139
Ana lytica I Contacts
Solomon B. Samson
NewYotk (1) 212-438-1653
Neri Eukspan
NewYork (11 212-438-1792
Ernmanuel Dubok-Pelerfn
Paris (33) 1-4420-6673
Published by Standanl ?
h fis oa Division nf The McGmwliill Cornprim. Inc.b;ecu!ive offices: 1221 A m u a of tho Americas,
Mew Yo& NY lIwna Editorial afficrs: %Warn Sueel. NmvYarlz BY 1W41.Subsuihr services: (1)212-438-72EO. Copynflht 0
2DZ3 bf i h a McGraWlillCompanios. Inc Reproduciionin wholn 01 in pad pohibited lacept bpermission. RI rights rcsemd.
Information has been obtained by Standard & Poor?- from snum Mi& to be reliabla. H m r . bemuso of tho possibility of
human 01 rneEhsnical error h o u r SOUICE. Standard & Fwfs w olhers. Standard & Fwfs &s not guarantes tha accuracy.
adequacy. or wmp%teness nf arry inionation and is ~t respwibb for any m a or ornissiw or tho rmtt obtained from h
us8 of such information.
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databaso in ha U.S. and access Is limited to a u M z e d persons. I[you rmuld prefer not l o hava your informationusd as
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p l w a call us at (I] 21?-43&7280 or write us a t ~ s l a & r d a n d p w n . a r n , For mom infofination about Thha McGmHitl
Cornpilnim m
ty Policy please visit www.mcqnwhilI.rndprivrrcy.h~ml
AMMc swh @dml
9and;Ud & W s hhqs swices I'lbting Senim-)am tho result of scpamro aclivitia dEigwl Io
pmmnfie inaepenamCe and ot@tivifl of m t i q opinions. The adt ratings and obtimmntaWk i n am Sorely
stalcmcnts af opinion and no; statements of fact u mxrmmcndatii to puduso. htl.or sell any seurrititra mako any other
hestrait decirions. M q b , arrywcr of h infmtim wntairted herein shwld mt rc& (#Iany m d t d q w other opinion
mntaiFed k i n in nuking irmtimt W o n Ratinp mbsdMI infmtionreceivedty Ratings Senrim Other M s i i of
Slidard &podsm ~ ham
y infmtion lhat is not milable to btingsSauiceS. Standard ti P d s has c s t a b l i pOr& and
to mainlain Ihs mnfidenliakity of mwbliiinfarmatinnreceived during lho ntbp
m.
Raiings SeMm ieceivescompnsation fw its ratings. Such m m p w l i o n is mmIly wid cithcr b tho issuers of mh
strcufitiesor third panies panidpating in marknting Uln s m r i t i w Whifo Standad & Pods resc~ycsLa right todiseminam he
m t i q it receives no payment fordoing so. c x t ~ pforsthuiptinns
l
to ils publications.Mditiorul informalon about our nlings
fees is nnilabfo at ~ . r t a n d a r d a n d p a o c r . m ~ ~ r a l i n j r f ~
Pmissiwrr To reprint, translatn. PI quotn Srandard & FWs pWntionr, mnlxl:
ClienlSa-Vim. SSwatEr smt "YOIk NY twt:ll)2IZ-m-%23 W ~ Y Ilo:l d3equcstmtandardandpoorrmm
EXHIBIT RVHP
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Contents
Standard & Poor's Ratings-AndTheir Role lnThe Financial Markets
7
Our Rating Process
16
Analytical Methodotogy
20
20
Overview
Country Risk
Industry Risk
Competitive Position
How Company Management Influences Susiness And Financial Risk
Accounting And Financial Reporting
Cash Flow Adequacy
Balance Sheet And Asset Protection
Liquidity
24
26
30
33
37
41
43
45
Ratios And Adjustments
Key Ratios And Glossary OfTerms
Incorporating Adjustments IntoThe Analytical Process
Encyclopedia Of Anatytical Adjustments
52
Rating Each Issue
Notching Down: Notching Up
Reflecting Recovery In Issue Ratings
Recovery Methodology For Industrials
88
Commercial Paper
Starrdard & Poor's
a
Corporate Ratings Criteria 2008
52
54
55
89
90
96
105
5
EXHIBIT RVH-2
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Standard & Poor‘s RatingsAndTheir Role InThe
Financial Markets
Ctandard & Poor‘s Ratings Services traces its history back to
1860. It currently is the leading credit rating organization and
a major publisher of financial information and research services
on U.S. and foreign corporate and municipal debt obligations. We
now rate many trillions of dollars worth of bonds and other financial obligations of obligors in more than 50 countries. We rate and
monitor developments pertaining to these issues and issuers
from an ofice network based in 22 worId financial centers.
Snndard 8c Poor’s \vas an indcpcndcnr, publicly owmd corporation until 1966,whcn all
of ia common stock was acquircd by
McCrawv-Hifl Inc., a major publishing company. Standard & Poor‘s is now a business unit
of McGnwv-Hill. In mattcrs of crcdit analysis
and ratings, Standard & Poor’s Crcdit Market
Scrviccs opcmtcs cntircIy indcpcndcntly of
McGraw-Hill. Other units of Standard &
Poor’s providc invcstrncnt, financial, and t d ing information, dam, and analyscs-incIuding on cquiry sccuritics-but operate
scpantcly from thc ratings group. Standard &
Poor’s opcmtcs with no govcmmcnt mandatc
and is indepcndcnt of any invcsmcnt banking
company, bank, or similar organization.
What Is Standard &c Poor‘s?
WCarc an organimtion of profcssionds that
provides analytical scrviccs-high-quahy,
objcctivc, due-addcd analytiml information-to thc worId’s financial markets.
Starldnrd & Pour’s
=
Wc opcratc undcr thc CON values of:
Indcpcndcncc;
Objectivity;
a
Credibility; and
Disclosurc.
Our recognition as a rating agcncy ultimatdy dcpcnds on invcsroo’ willingness to
acccpt our judgment. Wc bcIicvc it is important that all of our ratings uscrs undcrstand
how wc arrivc at t b s c ratings, and \vc rcguIarly publish rating rcsmrch and dcrailcd
reports on ratings criteria and methodology.
Wc bcgan rating thc dcbt of corpomtc and
govcmmcnt issucrs dmdes ago. Our crcdit
rating critcria and mcthodology haw grown
in sophistication to kccp pacc with a morc
dynamic world, and tlic introduction of ncw
financial products. For cxamplc, Standard &
Poor’s w a s thc first major rating ngcncy to
asses thc crcdit qualiry of, and assign crcdit
n t i n g to, thc claims-paying abiIiry of insurancc cornpanics (1971); financial guamntccs
(1371kmortgage-backcd bonds (1975);
Corporate R a t h g s Cdtctla 2008
7
EXHIBIT RVH-2
Page 39 of 139
Standard & Poor‘s Ratings-AndThetr Role Inrho Financial Markets
mutual funds (1983h assct-backcd sccuritis
(1985); and sccured Ioan rccovcry (1003).
Ovcr thc years, thcse crcdit ratings haw
~chicvcdwidc invator acccptancc as casily
usable tools for diffcrcntiating crcdit quality.
The Rating Process
Has Many Facets
Many of thc practiccs dcscribcd bcrc arc govcrncd by spccilic statcrncnts of policy, which
can bc lomtcd on sandp.com/Ri.itingsForm
NRSROlExhibits 2,3, and 7.
Standard & Poor’s provides ratings onIy
whcn thcrc is adequate information ilvailablc
to form a mdiblc opinion, and only after
applin blc quanti tauve, qualimtivc, and lcgal
analysts arc pcrformcd. Thc a n d y t i d ftamcwork is divided into scvcml categories to
cnsnrc that saIicnr quditirivc and quantitativc issues arc considcrcd. For cmmple,
regarding industrial companics, thc quahativc categories arc oricntcd to busincss analysis, such as thc company’s compctitivcncss
within its industry and the calibcr of managerncnt; thc quantitative mtegorics rclatc to
financial risk-
Thc rating proccss is not limitcd to an
examination of various financial measurcs.
Proper asscssrncnt of credit quality lor an
industrial company includcs a thorough
rcvicw of busincss fundamcntaIs, including
industry prospccts for growth and vutncratility
to tcchnoIogim1 changc, labor UIITCSC, or regufatory actions. (Other scctors emphasize factors that arc especially rclcvant to cntitiu in
that sector. For cxamplc, public financc rati n g involvc an evaluation of thc basic underlying cconomic strcrigrh of the public cntity,
as wcll as thc cffmivcncss of thc govcming
pwccss to address problems. In financial
institutions, thc rcputation of the bank or
company may havc 3n impact on rhc future
financial pcrformancc and thc institution’s
ability to rcpay its obligations.)
Wc ;~sscmblca t a r n of anaIysts with appropriatc cxpcrtisc to rcvicrv information pcrtincnt to thc rating. h Icad analyst is rcsponsiblc
for conducting thc analysis and coordinating
thc rating proccss. Mcmbcrs of thc analytial
r a m nicct with tlic ntcd cntity’s mmagcmcnt
tu revicw, in dcnil, kcy factors thzt could
8
wwl.corporatecriterh.standardandpoors.com
affca on tlic rating, including opcnting and
financial plans and managcmcnt policics. Thc
mccting also hclps analysts dcvctop thc qualin t i v c mcssmcnt of mnagcrncnt itsclf, an
important baor in many ming dccisions.
Following thin rcvicw and discussion, P rating committcc mccting is convcncd. At tlic
mccting, thc committcc discusscs the Icad
analyst’s rt~ommcndationand thc facts and
expcctations supporting thc rating. Finally,
thc voting mcmbcrs of thc commiitcc vote on
thc rccomrncndation.
TIic issucr subscqucntly is notified of the
rating and thc major considerations supporting ir. A rating can bc appcdcd prior to its
publication-if rncaningful ncw or additiona l information is to bc prcscntcd by thc
issucr. Obviously, tlicrc is no guarantcc that
any ncw information wil1 altcr thc rating
committcc’s dccision.
Oncc a final rating is assigncd, it is disscminatcd to tlic pubIic via RatingsDirccr,
S&P.com, and d ~ ~cC I V S nicdia, togcthcr with
thc mtionaIc and othcr commentary.
In thc U.S., Standard & Poor’s assigns and
publishcs its ratings irrapcctivc of issucr
rcqucst, if the financing is a public dwl. In
thc msc of privatc tmnsictions, thc company
has publiution rights. In most markcts outside thc US.,ratings arc assigncd only on
rcqucst, so thc company mn choose to makc
its rating public or to kecp it confidential.
(Confidcntial ratings arc disdoscd by us only
to parties designated by thc ratcd cntity.)
Surveittance And
Review Are Ongoing
All ntings are rnonitorcd, including continual
rcvicw of ncw financial or cconomic information. Our survcilhncc is ongoing, mwning IVC
staying abrcast of all currcnt dcvclopmcnts.
illorcovcr, it is routinr to schcdulc annual
rcvicw mectings with managcmcnt, cwn in
the abscncc of thc issuancc of ncw obligations or apparcnt rcason to qucstion the
cxtant rating or outlook. Thcsc rncctings
cnablc anaIysts to discuss potcntia1 problcm
arms and be appriscd of any changcs in tlic
issucr’s plans.
As a rcsult of the sun’ciIlancc proccss, it is
somctimcs ncccssary to rcasscss thc rating or
B H I B I T RVH-2
Page 40 of 139
outlook. Thc Imd analyst initiatcs il rcvicw,
conducted in a similar fashion to the initid
ming asignnmcnt proccss. In thc intcrirn, wc
pIacc thc m i n p on CrcditWatch, if \vc bclicvc
thc likclihood of a rating chngc is sullicicndy
higfi. Thc rcvicw cnmils a comprchcnsive
analysisincluding, if wamntcd, 3 mccting
with managcmcnt-nd
a prcscntation to 3
rating commitrcc. The rating cornmince cvduat= thc circumsranccs, arrivcs at dccisions on
ratings and outlooh, notifics thc issucr, and
cntcrtains an appeal, if onc is madc [and mccts
our policy for ampring appeals). Aftcr this
proms, a11 rating and outlooks-whcther
changcd or alfirmcd-rc announcd.
Issuers' Use Of Ratings
It is common for cornpanics to structure
financing transactions to rcflcct rating crircria
so thcy qualify for higher rating. Howcvcr,
thc actual structuring of a givcn issue is tlic
cvclusivc function and responsibility of an
issucr and its advisors. Wc dcvctop and publish critcria as ncw financing altcrnativcs arc
proposed. Wc will also rmct to a proposcd
financing, apply and interprct critcria for a
typc of issue, and outlinc thc rating implimtions for thc bcncfit of an issucr, undcnvritcr,
bond counsel,or financial advisor-but wc
do not function 3s an invwmcnt bankcr or
financial advisor. Adopting such a rofc uttimatcIy would impair thc objcctivity and crcdibility that arc vital to our continued
pcrformancc as an indcpendcnt rating agcncy.
Our guidance also is sought on sundry crcdit
qudity issucs thar might affm the rating
opinion. For example, cornpanics solicit our
vicw on hybrid prcfcrrcd stock, thc monctimtion of asscts, or othcr innovativc financing
tcchniques beforc putting these into pmcticc.
Nor is it uncommon for Jcbt issucrs to
undcrtakc spccific and sometimes signifimnt
actions for thc salic of maintaining thcir rating. For cxampic, onc Iargc company bccd a
downgmdc of ia 'A-1' commcrcial papcr rating bccausc of a growing componcnt of
short-tcrm, floating-mtc dctt. To kccp its rating, thc company chosc to ratructurc its debt
maturity schcdule in a way consistent with
our vicw of what \vas eonsisrcnt with thc
profilc of an 'A' mtcd crcdit.
Some cornpanics go onc stcp furthcr, iricorpomting spccific raring objcctivcs as corpomtc goals. Indccd, taming an 'A' rating, or at
Imr an invcstrncnt-gndc rating, affords conipanics a rnmsurc of flexibility and may bc
~vorrhwhilcas part of an ovcmll financial
strarcgy. Bcyond thnt, w c do not cncoumgc
cornpanics IO mmagc thcmsclvcs with an cyc
toward a spccific rating. Thc mom appropriate approach is to opcmtc for thc good of the
busincss as manaprncnt SCCS it and to Ict thc
nting follow. Ironimly, managing for a vcry
high rating c3n samctimcs bc inconsistcnr
with thc company's uttirnatc b a t intcruts,
if it means bcing avcdy conscrvativc and
lorgoing opportunitics.
SeveralTypes Of Credit Ratings
A Standard & Poor's credit rating is our
opinion of thc gcncml crcditworthincss of an
obligor [issucr crcdit ntindcorporntc crcdit
nting), or the ucdit risk associatcd with il
particular dcbt sccurity or othcr financial
obligation (issue rating).
11 rating do= not constitutc a rccommcndation to purchasc, scll, or hold a pinicular
sccurity, In addition, a rating docs not commcnt on thc liquidity of tfic mtcd instrum c n t 4 r any othcr clcmcnt affccting
suitability of an invcstment for a particular
invcstor (including currcncy, intcrcst mtc, and
prcpaymcnr risk).
Crcdit n t i n g arc bucd on information furnishcd by the obligors or obtained by us from
other sourccs IVC mnsidcr rcliablc. Although
wc look at information wc rcccivc with P criti d eye, IVC do not perform any kind of audit
(of financial smtcments or transactions) in
conncction with any crcdit m i n g - a n d may,
on o m i o n , rcly on unauditcd financial information. Crcdit ratings may bc changcd, suspcndcd, or withdrawn as a rcsult of changcs
in, or unavailability of, such information.
Wc maintain scpantc and wcll-csrabtishcd
rating sulcs for long-tcrm and short-trrm
instnimcnrs. (A scpantc scdc for prclcrrcd
stock was intcgmtcd with thc Jcbt smlc in
Fcbruary 1999. Thcrc is an additional s u l c
CxclusivcIy for mcdium-rem municipal nois,)
In non-'AAK t n n s k r and convcrtibitity
n&C) zoncs, wc assign both forcign- and
Smtdnrd & Pour's a Corporate Ratlngs Criteria 2008
9
EXHIBIT RVH-2
Page41 of139
Standard & Poor‘s Ratings-AndTheir Role lnThe FinaoclaI Markets
foal-currcncy issucr crcdit ratings. Wc also
havc introduced sevcrd nntionaI smlc ratings,
appliable in specific countries, and rccowry
rating, which opinc on loss givcn dcfault.
Long-term crcdit n d n g arc dividcd into
scvcrd mtcgorics, ranging from ‘AAA’rcffccting thc strongcst crcdit quality--to ‘D’,
rcflccting thc lowcst. Longtcrm ratings from
‘M’ to ‘CCC‘ may bc rnodificd by the addition of 3 plus or minus sign to show rclativc
standing within thc major rating ategorim.
A short-rcrm crcdit rating is an asscssmcnt
of an issucr’s crcdit quality with rapcct to an
instrumcnt considcrcd short tcrm in thc relcvant mnrkct. Short-tcrm ratings mngc from
‘A-l’, for thc highcst-quality obligations, to
‘D’,
for the Iowcst. T h c ‘A-1’ rating may also
bc rnodilicd by a plus sign to distinguish thc
strongcst ucdits in that mtcgory.
Issuer Credit Ratings
Wc providc issucr crcdit mting-n
opinion
of thc obligor’s ovcmll capacity and willingness to m e t its financial obligations as thcy
come duc-whcther mtcd or not. Dcfmlt on
any of thcsc Icads to an issucr rating of ‘D’
or ‘SD’(see De(inihirs, p a p 1 lj.
Howcvcr, if payrncnt is withhdd duc to
dispurcs (as may pcrtain to operating or
Icasc obIigations), \vc do not dccm this to
bc a default. Our issucr credit rating is not
spccific ro any particular financial obligation, bccause it docs nor takc into account
thc spccific nsturc or provisions of any particular obligation. Such ratings do not takc
into account recovery prospccts or statutory
or rcgulatory prcfcrcnccs, nor do thcy take
into account thc crcdinvorthincssof guanntom, insurcrs, or other forms of crcdit
cnltanccmcnt that may pcrtain to a spccific
obligation. (Howcvcr, when w c bclicvc that
supporr from a third party-such as an
afliliatc or govcrnmcnt-would bcncfir the
issucr-in ways that makc thc o\~cmllrisk of
dcfauIt mort rcmotc, such support is fzctorcd into thc rating.)
Countcrparty ratings, corpomtc crcdit rating, and sovcrcign crcdit ratings zrc all forms
of iaucr crcdit ratings. Bcmusc a corpontc
crcdit rating providcs an ovcmII asscssmcnt of
a company’s crcdinvorthincss, it is mcd for a
10
mriccy of financial and commercial purposes,
such as ncgotiating Ionptcnn Iwscs or niinimizing thc nccd for a Icttcr of m d i t for vcndors. If rhc crcdit rating is not assigncd iti
conjunction with a ratcd public financing, thc
company a n choosc to mikc its rating public
or to kccp it confidential,
Crcdit ratings c m bc cithcr long or short
?
term. Short-tcrm rating arc assigncd to thosc
obligations considcrcd short tcrm in thc rclcvant rnarkct. In thc US., for cxamplc, that
mmns obligations with an original maturity
of no mow than 365 days, including commcrcial papcr. Commcrcial papcr rating p c r
rain to tlic program cstablishcd to sell thcsc
nota. Therc is Iirnitcd rcvicw of individual
notcs. Noncthclcss, such program rating
ctiancterizc thc nota as %tcd papcr.”
Short-tcrm ratings aIso arc uscd to indicate
thc crcditwoahincss of an obligor with
respcct to put fcarurcs on long-tcrm obIigations. Thc rcsult is a dual rating, in which
thc short-tcm rating ddrcsscs the put fmturc in addition to thc usual long-term mting, Mcdium-tcrm notes { M T N s ) arc
assigncd longtcm ntings. A rating is
assigncd to thc MTN program and, subscqucntly, to individual nom, as thcy arc idcntificd-nd as applimblc (in tcrrns of rcnor,
seniority, and currcncy).
Issue-Specific Credit Ratings
Our issuc crcdit mung is a curccnt opinion of
thc crcdit risk pcrtaining to a spccific financial
obligation, a spccific class of financia1 obligtions,or a spccific financial program. This
opinion rcffccts, whcrc applimblc, thc crcditworthincss of guarantors, insurcrs, or othcr
forms of crcdit cnhanccmcnt on rhc obligation, and takcs into account statutory and
rcgulatory prefcrcnecs. On a global:basis,
Standard & Poor’s jswc crcdit ming critcria
h a w Iong identificd thc addcd country-risk
factors that givc cxtcrnal dcbt a liighcr dcfauh
probability than domcstic obligations. (In
1992, wc rcviscd our criteria to dcfinc cxtcrn d mthcr than domestic obligations by currcncy instad of by markct of issunncc. Tliis
led to thc adoption of thc I o n 1 currcncyllorcign currcncy nomcnclamm for issuc crcdit
ratings.) Bcc~uscrating covcngc iiorv has
MHlBlT RW-2
Page 42 of 139
cxpndcd to a growing nngc of emcrgingmarkct countria, and b w u s c Organindon
for Economic Co-opcnrion and Dcvclopmcnt
(OECD]-bssed cornpanics incrmsing1y havc
cxpandcd to cmcging msrkca, thc anaIysis of
politid, cconomic, and monctary risk factors
arc cvcn mow imponant.
Definitions
Our long-term issue ratings (‘MA’ through
‘D’) arc assigncd to nota, notc programs,
certificatc of dcposit programs, bank Ioam,
bonds and dcbcntures; shelf rcgistntions
(prclirninary}, equipmcnt trust certificate.,
and prcfcrrcd stock and othcr hybrid sccuritics. Ilcbt rypcs includc sccurcd, senior unsccurcd, subordinarcd, junior subordjnatcd,
and dcfcrrablc paymcnt debt.
Short-tcrm issuc ratings (‘A-I+’ through
‘D’)
apply to commcrcial papcr programs
and put bonds. (Thc rating typc is dctcrmincd by the initial tcnor; oncc a long-tcrm
rating is applicd, the approach of thc maturity docs not lead to rc-rating with a shorttcrm rating.)
Issuc and i s u c r crcdit ratings usc thc
idcntical symbols, but thc dcfinitions do not
complctcIy correspond ro cich othcr: Issucr
mtings-and short-tctm issuc ratingsrcflcct only tbc risk of dchult, but longtcrm
issuc ratings also incorpomtc a vicw of loss
givcn dcfauIt (cithcr via a spccific recovery
maIysis or by rcflccting relativc position of
thc obIigation in thc cvcnt of bankruptcy,
rcorganizarion, or othcr arrangcmcnt undcr
rhc laws of bankruptcy and other Iaivs
affccting creditors' rights.)
Junior obligations typically arc ntcd Iowcr
than thc issucr crcdit rating, to mflcct the
lowcr priority in bankruptcy, a5 notcd abovc.
Debt that providcs good prospccrs for ulrimarc rccovcry, such as wcll-sccurcd dcbr, is
ntcd highcr than thc issucr crcdit rating.
Rccovcry ratings (‘1+’ through ‘6’) arc our
opinion of a specific isuc’s prospccts rcgarding loss givcn dcfaulr. Wc g c n c d y assign
thcsc ratings to thc dcbt of spccuuhtivc-gradc
compania. Whercvct wc assign 3 rccovcry
rating, that raring forms tlic basis for notching tlic issuc crcdit Mting rclativc to thc
irrucr rating.
Stmrlurd B Poor’s
1
Long-term ratings definitions
‘AAA’: An obligation mtcd ‘ M A ’ his rhc
highcst ndng m c assign. Thc obligor’s mpacity to mcct its financia1 comrnitmcnt on thc
obligation is cxtrcmcly strong.
‘At\’: An obligation mtcd ‘AN diffcrs from
thc highcst-rmd obligations only to B small
dcgrcc. T h c obligor’s capacity to mcct its
financial commitmcnt on thc obligation is
w r y strong.
‘A‘: An obligadon rated ‘R‘ is sorncwhat
mare susccptiblc to thc advcrsc cffccts of
changcs in circumsmnccsand cconomic conditions than obIigatbns in highcr ratcd mtcgorics. Howcvcr, the obIigor’s eapacity to
mcct its financial comrnitmcnt on thc obligation is still strong.
‘BBB’:An obligation mcd ‘BBB’ cxhibits
adcquate protcction paramctcrs. Howcvcr,
advcrsc cconomic conditions or changing circumsmnccs arc morc likcly to l a d to a wcakcncd eapaciry oE the obligor to mccr its
financial comrnitmcnt on thc obligation.
Obligations ratcd ‘BE’, ‘B’, ‘CCC‘, ‘CC’,
and ‘C‘arc rcgardcd as having signnifimnt
sprmtacivc chamctcristics. ‘BB’indium thc
Imst degree of spcmlation, and ‘C‘ thc higha t . WhiIe such obligations likely will havc
somc quality and protcctivc chamctcristics,
thcsc may be outwcighcd by largc unccrtnintics or major cxposurc to adwrsc conditions.
‘ B E An obligation ratcd ‘BI1’ is lcss vuInerable to nonpaymcnt than othcr spcculativc issucs. Howcvcr, it faccs major ongoing
unccrtaintics or cxposurc to advcrsc business, financial, or cconomic conditions that
could Icad to thc obligor’s inadequate
capacity to mcct its financial commirmcnt
on thc obligation.
‘E’:An obligation ratcd ‘B’is rnorc vulncmblc to nonpaymcnt than obligations mtcd ‘BB’,
but the obligor eurrcntly has tlic mpcity to
mcct its financial:comrnitmcnt on thc obBp
tion. i\dvcrsc bmincss, financial, or cconomic
conditions likcly will impair thc obligor’s
upacity or willingnm to mcct its financial
commitmcnr on thc obligation.
‘CCC’:
An obligation ratcd ‘CCC‘ is vulncnblc to nonpaymcnt within onc ymr, and
dcpcnds on favonblc busincss, tinancid, and
cconomjc conditions for thc obligor to mcct
its financial comrnitmcnt on thc obIigatioii.
Corporate RatIngs Criteria 2008
11
MHlBlT RVH-2
Page 43 of 139
Standard & Poor’s Ratings-AndTholr Role InThe Financial Markets
In thc cvcnt of ndvcrsc business, financial, or
cconomic conditions, the obligor is unlikcly
to haw thc mpacity to rncct its financial
comrnitmcnt on thc obIigation.
‘CC’: An obligation mtcd ‘CC‘ currently is
highly wlncmblc to nonpayment.
‘C‘;Thc ‘C‘rating is also uscd when P
bankruptcy pctition has bccn filcd or simirar
action has bEen takcn but payrncnk on this
obligation arc bcing continued. ’C’is also
uscd for a prcfcrrcd stock that is in m u m
(as wclI as for junior dcbt of issucrs mtcd
‘CCC-‘
and ‘CC’).
‘D’: Dchulr; ‘SD’: SeIcctivc dcfault. Thc ‘D’
and ‘SD’ rating, unlikc 0 t h ratings, arc not
prospmtivc; rathcr, thcy arc uscd only whcn a
dcfault actualIy has occurred-not when
dcfzult is only cxpcctcd.
Standard & Poor’s changcs ratings to ‘D.:
= On thc day an intcrest andlor principaI
paymcnt is duc and is not paid. An wccption is mdc if thc instrumcnt provides for
a gracc period and we bclicvc a paymcnr
will bc mndc within that pcriod, in which
msc thc nting a n bc mainmind;
m Upon voluntary bankruptcy filing or simiIar action. (An cxccption is made for a
spccifie issuc if w c c q m t dcbt-scrvicc
payments wilI continuc to t c madc on that
issuc.) In thc ibscncc of P pqmcnt dcfmlt
or bankruptcy filing, a tcchnial default
[e,g., covcnant violation) is not sufficicnt
for assigning a ‘D’rating;
Upon cornp1aion of a distrcsscd
cxchange offcr, whercby some or all of an
issuc is cithcr rcpurchnscd for an amount
of cash or rcplaecd by other sccuritics
having a tom1 value that clcarIy is less
than par (cvcn though thc offcr is wcI1 in
cxccss of the sccurity’s current rnarkct
pricc); or,
= In the u z c of ratings on preferrcd stock or
dcfcrmblc payment securities, upon nonpayment of thc dividcnd or dcferml of thc
intcrcsr payment.
With respcct to issucr crcdir ratings (ix.,
corpomtc crcdit ratings, countcrparty ratings, and sovcrcign ratings), failure to pay
any financial obligation-mtcd or unratcdlcads to either n ‘D’ or ‘SD’ raring.
Ordinarily, an issuer’s distrcss lcads to gencra1 dcfauIt, arid thc rating is ‘D’.‘SD’ is
12
assigncd whcn an issucr can bc cxpcctcd to
dchu1t scIcctivcly, i.c., continuc to pay ccrrain issucs or cIasscs of obligations wliilc nor
paying othcrs. ‘Illis fact pattcrn normally is
associatcd with sovcrcign govcrnmcnt
dcfautts. In tlic corpomtc contcxt, sclccrivc
dchult might appIy whcn a company conducts a disrrcsscd or cocrcivc cxchangc with
respect to onc or sornc issucs, whifc intcnding to honor its obligations regarding othcr
issucs. (Infact, it is not unusual for a company to launch such an offcr prcciscly with
such a striitcgy-to restructure part of its
dcbt to kccp thc company solvent.)
Nonpaymcnt of a financia1 obIigation subjcct
to P bona lidc commcrcial dispute or P
misscd prcfcrrcd stock dividcnd docs nor
c w s c thc issucr crcdit rating to bc changcd.
Plus (+) or minus (-1: Thc ratings from
‘RA’ to ‘CCC’ may bc modificd by thc addition of a plus or minus sign to show rclativc
sranding within tlic major rating categories.
In 1994, IVC introduccd a symbol to t c
addcd to an issuc crcdit rating rvhcn thc
instrument couId have significant non-credit
risk. Thc ‘r’ was addcd to such instrumcnts
as intercst-only mips, invcrsc floatcrs, and
instrumtnts that pay non-futcd amounts st
maturity, c.g., amounts bawd thc valuc of a
particular cquity or a currcncy or stock
indcx. T I C ‘r’ was intcndcd to dcrt invcstors
to non-crcdit risk and cmphasizcs that an
issuc crcdit rating addrcsscd only the credit
qudity of thc obligation; i t was dismntinucd
in July 2000.
Short-term ratings definitions
‘A-1’: A short-tcm obligation mtcd ‘A-1’ is
in thc highcst catcgory me mtc. Thc obligor’s
=pacity to rncct its financial commitmcnt on
rhc obligation is strong. Wtliin this mtgory,
certain obligations arc dcsipnatcd with a plus
sign (+I. This indicates that thc obligor’s
capacity to rncct its financial commitmcnt on
rhcsc obIigadons is cxtrcmdy strong.
‘A-2’: A short-tcrrn obligation mtcd ‘A-2’
is
sorncwhat more susccptiblc to thc adtwrsc
effects of changcs in circumstanccs and cconomic conditions than obligations in h i g h
rating utcgorics. Howcvcr, tlic obligor’s
capacity to mcct its financial commitmcnt
on thc obligation is satisfactory.
EXHIBIT RW-2
Page 44 of 139
'&EA short-tcrm obligation mtcd 'A-3'
cxhibits adcquatc protcction pararnctcrs.
Howcvcr, advcrsc cconomic conditions or
changing eircumstancfs arc mom likcly to lmd
to a wmkcnd a p a a t y of ihc obIigor to mcct
its financial commiuncnt on thc obligation.
'W;A short-tcrm obligation rated 'B' has,
in our vicwv, significant spcculntivc chanctcristicl;. n c obligor currcndy has thc mpacjr).
to mcct its financia1 commirmcnr on thc obligation; howcvcr, it f3ccs major ongoing
unccrnintics that could Imd to inadcquatc
upacity to mcct its financial commitmcnt on
thc obligation. W c cxpandcd thc 'D'shortIcrm rating arcgory in 2004 by dividing it
into 'B-l', 'M'
and
, 9-3'.
IC': A short-tcrm obligation ntcd 'C' currcntIy is vuIncratIc to nonpaymcnt and
dcpcnds on favonblc businas, financial, and
cconomic conditions for thc obligor to mcct
its financial commitmcnt on ilic obfigan'on
'D': T h e samc 3s thc Ions-tcrm rating dcfinition for 'D'.
Invcstmcnt-gmdc, short-tcm n r i n g arc
highly correlatcd with long-tcnn rating
(SCC Corrrmcrcial raper diapicr of this Irook].
Spcculativagmdc short-tcrm rating rcflcct
IESS constraint rcprding iinkagc to
long-tcrm rating.
A4
0-2
B-3
C
StunrInrd&Poor's
Investment And Speculative Grades
T h c tcnn uinvcstmcnt gradc" originally was
uscd by various rcplatory bodics to connotc
obligadom cIigiblc for invcstmcnt by institutions such as banks, insurancc companics,
and savings and loan associations. Ovcr
tirnc, it gaincd widcsprcad usc throughour
thc inwstmcnt community. Issucs mtcd in
our four highcst utcgori-'RM',
'AN, 'A',
and 'BBB'-gcncralIy arc rccognizcd 35
invcstmcnt gmdc. Dcbt rarcd 'BB' or bcIow
gcncnlly is conridcrcd "spcculativc g d c "
(Thc tcrm "junk bond" is mcrcIy an irrcvcrcnt cxprcssion for this catcgory of more risky
dcbt; "high-gradc" and "high-yicld" dcbt arc
common tcrms, as well.] Nomcnelaturc
asidc, wc takc no vicw as to which sccuritics
arc worthy of invcstmcnt, bccausc an
invcstor with a particular risk prcfcrcncc
m i y appropriatcly invcst in sccuritics that
arc not invcstmcnt gradc.
Corporate Rs:lngs Cdteria 2008
13
WHIBtT RW-2
Page 45 of 139
Standard & Poor’s Ratings-AndTheIr Rolo InThc Financial Matkets
Ratings continuc as a factor in many rcguIations, both in tlic U.S. and sbrozd, notably
in Europc and Japan. For cxamplc, thc SEC
rcquircs invcstmcnt-gradc status in ordcr to
rcgistcr dcbt on Form-3,which, in turn, is
onc wny to offcr dcbt via P RuIc 415 shclf
registration. Thc Fcdcnl Rcscrvc Roard
allows rncrnbcrs of thc Fcdcml Rcscrvc
Systcm to invcst in sccuritics ntcd in thc
four highcst cmgorics, just as thc Fcdcrd
Homc Loan Dank Systcm pcrmiw federally
chartcrcd savings and loan associations to
invcst in corporatc dcbr with thosc ratings,
and thc Dcpartmcnt of Labor allows pension
funds to invcst in commcrcial papcr ratcd in
onc of thc tlircc highat mtcgorics. In similar
fashion, California rcgularcs invcstrncnts of
munidpalitics and county trcasurcrs; Illinois
limits collatcral acceptable for public
deposits; and Vcrmonr restricts invcstmcnts
of insurcrs and banks. Thc Ncw York and
Philadclpliia stock cxchangcs fix margin
rcquiremcnts for rnortgagc sccuritics dcpcnding on rhcir ratings, and the sccuritics hairCUE for commcrcial papcr, dcbt sccurities,
and prcfcrrcd stock that dctcrmincs nct
capital rcquircmcnts is also 3 function of thc
ratings assigncd.
1
Currency
Wc dcviscd nvo types or ratings in ordcr to
commcnt on thc risks associarcd with pay-
mcnt in cummi= othcr than thc cnrity’s
homc country. Such paymcnts typidly
arc madc outsidc thc company’s homc
country, so the risks encompass borh
transfcr and contwrtibility.
I
I,:
AAAM
0.0
0.0
0.1
0.0
0.1
0.1
02
02
03
03
0.7
0.9
I3
0.8
A
BBB
BB
0.1
02
1.1
3
5.0
I12
0.7
12
3.1
10.9
19
5.6
8.0
2.6
10.1
54
17.5
2O.E
15.9
19.8
22.6
30.4
35.0
~~
-.
5
IO
15
sarep.sgp~XEGWI&t~tWf
I4
A lml currency rating is our currcnt opinion of an obligor’s ovcmlI mpacity to gcncrntc sufficient Im1curancy r m u m to
mcct its h a n a a l obligations (both forcign
and Imlcurrency), atscnt thc risk of dircct
sovcrcign intcmcntion rhat may constrain
payment of forcign currcncy dcbr.
Dcpcnding on thc location of a company’s
opcntions, such intcrvcntion could rclatc to
morc thin onc govcmmcnt. Loclf currcncy
d i t rating arc providcd. on our global
s d c or on scpamtc national smlcs, and may
l
x citlicr issucr or spccific issuc crcdit mtings. Country or mnomie risk considcnrions factorcd into loul-currcncy mung
indudc thc impact of govcmcnt policics on
thc obligor’s busincssand financial cnvironmcnt, including factors such as the mchangc
mtc, inrcmt rata, inflation, Iabor market
conditions, taxation, regulation, and infmm m r c . Horvcvcr, thc opinion docs not
addrrrs tnnsfcr and othcr risks rclatcd to
dircct sovcrcign intcn’cnrion to prcvcnt thc
timely servicing of cross-border obligations.
A forcign currcncy crcdit rating is our eurrcnt opinion of an obligor’s ovcmll capacity
10 mcct all financial obligations-including
its forcign-crurrcncy-dctiominatcdfinancial
obligations. It may takc bc cithcr an issucr
or an issuc crcdit ming, As in thc u s c of
loa1 currcncy crcdit ratings, a forcign currency ucdit opinion on our gIobal =IC
is
bawd on thc obligo,or’sindividual acdit
chamctcristics,including thc influcncc of
country or cconomic risk factors. Horvcvcr,
unlikc l o a 1 currcncy rating,a forcign currcncy crcdit rating includcs tmnsfcr and
otlicr risks rclarcd to sovcrcign actions that
wrvrv.corporatccril%tia.standardandpoors.com
~
03
0.5
0.7
1.9
2.8
7.9
CCClC
263
34.7
404
432
462
51.8
9.6
=HIBIT RVH-2
Page 46 of 139
may directly affcct PCC(TS to thc foreign
cxchangc nccdcd for timely servicing of thc
mrcd obIigdon. Tmnsfcr nnd otlicr dircct
sovcrcip risks addrcsscd in such ratings
includc rhc likclihood of forcign-cxchangc
controls and tlic imposition of othcr rcstrictions on the repayment of forcign dcbt.
(Scc A rralytical n~e~ltodoio~/Cotrtilry
Risk
sectioit of this 6ook for a disc~issiorrof die
rclaiionship of ihcsc ratijigs to ratings ott
tlrc pertimzrt sovereign.)
National Scale Ratings
Wc producc nationd suIc ratings in a numbcr of countrics across throughout thc world.
Thcsc ratings arc cvprrsscd with the traditional lcttcr symbols, but thc nting dcfinitions do not conform to those cmploycd for
thc global s d c . The rating dcfmitions of
mch national smlc and its corrclation to
global m l c ratings arc unique, so thcrc is no
basis for comparability across national scalcs.
Creditwatch Listings And
Rating Outlooks
Our mrings cwImtc dcfault risk ovcr thc Iifc
of a debt issuc, incorporating an sstssmcnt of
all fumrc C V C ~ I Sto the extent thcy are known
or an be andcipatcd. But ivc also rccog~~ize
thc potcntial for fumrc pcrformancc to differ
from initial cxpectacions. Rating ourlooks and
Creditwatch listings addrcss this possibility by
focusing on thc sccnarios that could result in a
rating ckngt. Ratings (both issucr and issuc
raring) appmr on CrcditWatch when an event
or dcviation from an evpcctcd trcnd has
occurrcd or is cxpccrcd such that thcre is a sip
nifimnt chance (roughly 50% or mom) of
rcquiringilrating change, and additional
information is ncccsrary to nkc a rating
action. For cxampIc, an h e is placed undcr
such spcciaI survcillancc as thc rcsult of mcrg
crs, roapitdimdons, regulatory actions, or
umnticiparcd opcrating dwclopments.
We attcmpt to rcsolvc CrcditWatch
rcvicws within 90 days, unlcss thc outcome
Standard & Poor's
=
of a spccific cvcnt i s stili pcnding. A Iisting
docs not mcan a rating chmgc is incvitablc;
howcvcr, in somc CPSCS, it is ccrrain that 3
rating changc wiIl occur, and only thc magnimdc of thc changc is unclcar. In such situations, mc irnmcdiatcly Iowcr thc
corpomtc crcdir rating to thc highcst-concciwblc ourcomc, or upgrade it to thc Iowcst-conccivablc outcomc, whik also listing
thc rating on CrcditWatch for potential
additional actions. In thosc instanccs-md
gcncrally, whcncvcr possibIc-wc commcnt
on the rangc of altcrnativc ratings. An
issucr cannot automatically appcal P
CrcditWatch listing, but our analysts arc
scnsitivc to thcir conccrns and tlic fairncss
of the proccss.
Rating changcs also a n occur without thc
issuc appmring on CrcditWach bcforchand.
In fact, if aII nPcesslry infomation is wailablc, r a t i n g should immcdiatcIy be changccd to
rcflca tlic changcd circumsmnecs; dicrc should
be no dcfay rncrcly to signal via a CrcditWatch
listing that a ratings changc is to occur.
A nting outIook is assigncd to a11 longt c m dcbt isrucrs and asscsscs thc potcntid
for an issucr rating chmgc. Outlooks h a w a
longcr umc fnmc than CrcditWatch listingtypically, two ymn for invcsmcnt-gmdc cntitics, and onc year for s p l a t i v c - g n d c
c n t i t i e a n d incorporate trcnds or risk with
lcss certain impIjarions for crcdir qaaIity.
(Radngs that arc listcd on CrcditWatch, by
dchition, have no assigned outlook.)
A ncgative, dcveloping, or positivc outlook
is not ncccssarily a prccursot of P rating
changc or a CrcditWatch listing.
CrcditWatch dcsignnationr and outlooks may
bc POSitiVC, meaning the rating may bc
raiscd, or ncgativc, meaning it may bc lowcrcd. DcvcIoping is uscd for thosc unusual
situations in which future cvcnts arc so
unclcar that thc rating couId bc raised or
Iowcrcd. A stable outIook is assipcd whcn
ratings Iikcly wilt not bc changcd within thc
applimblc timcframc, but it should nor bc
confmcd with cxpcctcd stability of thc
company's financial pcrformnncc.
Corporate Ratings Criteria 2008
75
~ H l B r RW-2
r
Page 47 of 139
Our Rating Process
M
ost corporations approach us to request a rating prior to
the sale or registration of a debt issue.That way, first-time
issuers can receive an indication of what rating to expect. Issuers
with rated debt outstanding also want t o know in advance what
affect issuing additional debt will have on the ratings we already
have assigned. (As a matter of policy, in t h e US., we assign and
publish ratings for all public corporate debt issues over $100 mit-
lion-with or without a request from the issuer. In these cases, we
contact the issuer to elicit its cooperation.)
Thc analysts wizh thc greatest reIevmt indostrylcountry cxpcrtisc arc assigncd to cvaluatc
thc crcdit and comrncncc sumcillance of thc
company. Our analysts gcncmlly eonccntmtc
on onc or ovo industria, cowing the entirc
spcctrum of credits within thorc industria.
Such spccialimtion allows thc analysts to
accumuIatc cxpcrtisc and cornpctitive information bcttcr than if junk-bond issucrs wcrc
follorvcd scpamtcly from high-gndc issucrs.
Whilc onc analyst ~ k c thc
s Icad in following
a givcn issucr and typically handles day-today contm, a t c m of cvperjenccd analysts-including a back-up andyst-is
always assigncd to thc rating relationship
with tach issucr.
Meeting With Management
A mccting with corpomrc rnanagcmcnt is an
integral part of our wing proms. Tlic purposc
16
w,corporatecriteria.stnndardandpnors.com
is to rrm’ew in dctd thc company’s kg opmting and financial.plans, management politics,
and orhcr crcdit factors that bavc an impact on
thc ntiq. Managcrncnt mcctings arc critical in
hcIping to mch a bahnccd asscssmcnt of a
company’s circumsmnca and prospects.
Participation
T h c company typially is rcprcscntcd by its
chicf financial officct Tlic chicf cxccutivc ofliccr usually participates whcn stntqjc issucs
arc revicwcd (usually the msc at thc inin’al
mting assignment). Opcnting cxceurivcs ohcn
pmcnt dctailcd information rcprding business scgmcnts. Outsidc advisors may bc hclpful in prcparing an effcctive prcscnration. W c
ncithcr cncouqe nor discoungc thcir USC: It
is cntircly up to nianagccmcnc whcthcr ndvis o n assist in thc prcpamtion for mccting,
and whcthcr thcy attcnd thc mcctings.
MHIBIT RVH-2
Page 48 of 139
Scheduling
Managcmcnt meeting usually arc schdutcd at
least scvem1 rvccks in advance, to m a r c muma1 maiIability of h e appropriatc participants
= if amilablc, a draft registration statcmcnt
and to alIorv adquatc prcpamtion timc for
our andysts. In addition, if a rating is h i n g
sought for a pending isswncc, ir is to thc
issucr's advanmgc to allow about rhrcc \vccks
following a mccting for us to complcte thc
rcvicw proccss. M o a timc may ~JCnccdcd h
ccmin ma,if, for cx3mplc, cxtcnsivc revjnv
of documcntation is nccemty. Howcvcr,
whcrc spcciaI circumsnnm cxkt and a quick
rumround is nccdcd, we cndcavor to mcct
the rcquircmcnts of thc marketplacc.
While not mandatory, writtcn prcscnmtions
by managcrncnr oftcn hclp providc a framework for thc discussion. Such prcscntations
rypimlty mirror the format of thc rnccting
discussion, as outIincd bclow. Whcrc a writfcn pmcntadon is prcparcd, it is particuldy
uscful for our tmm to rcview it in advancc of
the mccting.
Thcrc is no nced to try to anticipatc all
quatiom that might arisc. If additional informan'on is ncecssary to dady spccilic points,
it a n bc providcd subscqucnt to rhc mccting.
In m y msc, our crcdit analysts gcnerally wilI
haw followv-up qucstions that arisc as thc
information cowrcd at tlic managemcnt
mccting is furthcr andyzcd.
Fa ciIity Tou rs
Touring major facilitics a n bc wry helpful
for 11sto undcrsmnd a company's businus.
Howcvcr, it gcnccllly is not critical in assigning a nting to a givcn company. Considcring
tIic timc consmints that typimlly arise in thc
initial raring cxcrcisc, amngiing hcifry tours
may not bc feasible. As discusscd bcIow, such
tom may wcll bc a useful part of thc subscqucnt survcillance proccss.
Preparing For Meetings
Corpomrc managcmcnt should fd frce to contact its d c s i p r c d Srandard & Poor's d i t anaIyst for @dance in admncc of thc meeting
-ding
thc p n i d a r arcas that will bc
cmphasizcd in the mnatytic proctss. Pubhhed
ratings critcria, 3s wll as indusay comrncnmry
and articles on pccr companics, may also help
mmacmnit appredate thc andfie pqxd've.
Providing dcnilcd, writtcn lists of quations tcnds to consrnin spontancity and nrtificially limit thc m p c of the mccting.
Thcrcforc, some of our pmcticcs prcfcr not to
do so, while othcr pnctices endeavor in othcr
ways to avoid such outcomes.
WCrcquest that thc company submit background matcrials wcll in advancc of thc mccting, (iddly, scvenl sets), induding:
fivc p r s of auditcd annuai financia1
smtcmcnts;
thc Inst scvcmI intcrim finincia1 statcmcnts;
namtivc descriptions of opcmtions and
products; and
.
Stmiarldurd & Poor's
or offcring mcmorandum, or cquiwlcnt.
Apart from company-spccificmatcrisl, rclcvant industry information aIso is uscful.
Confidentiality
A substantial portion of thc information scc
forth in company prcscntitions is highIy scnsitivc and is provided by the issucr to us s o b
ly for the purposc of arriving at ratings. Such
information is kcpt strictly confidcntial by thc
n t i n g group, on a nccd-to-know basis.
(Obviously, if informadon is knorvn to us or
corn= to bc known from othcr sourccs, thc
company a n n o t cxpcct us to treat this information confidcnrially.) It i s not to bc uscd for
any othcr purposc, nor by any third party,
induding othcr Standard & Poor's units.
Smndard 8c Poor's mainnins 3 "Chincsc
WalI" bcnvccn its nting activities and its
cquity information scrviccs. Evcn if il public
nting is subscqucntIy assigncd, any ntionaIcs
or othcr information wc pubIish about thc
company will rcfcr only to publicly aviilablc
corporate information. In thc samc win, if
w e changc a rating or outlook tascd on confidciitial information rcccivcd, wc til1 tnkc
pains to avoid disclosing that information in
our publishcd materiab.
Conduct Of Meeting
In a typial mccting with issucr ninnagcrncrit,
wc typically addrcss:
= industry ctnironmcnt and prospects;
Corporate Ratlngs Criteda 2008
17
EXHIBIT RW-2
Page 49 of 139
Our Ratlng Procass
an ovcrvicw of major busincss scgmcnrs,
including opcmting statiscia and comparisons with compctitors and industry norms;
financial policcs and financial pcrformancc
gods;
a
1
distinctive accounting pmcticcu;
projcctions, inchding incomc and u s h flow
smtcmcnts and hlancc shcets, togcthcr
with thc undcrlying markct and opcmting
assumptions;
mpital spcnding plans; and
financing a l r c m a ~ w
and contingency plans.
It should bc undcrstood that our n t i n g
arc not bascd on thc issucr’s financial projcctions or managcmcnt’s vicw of what thc
futurc may hold. Ruhcr, ratings arc bascd on
our asstssmcnt oE the company’sprospccrs.
Horvcvcr, managcrncnt’s financial projcctians
arc a valuablc tool in thc rating proccss,
becausc thcy indicatc managcrncnt’s pIans,
how managcment asscsscs thc company’s
challcngq and how it intends to dm1 with
problcms. Projcctions also dcpict thc company’s financial smtcgy in tcrms of antkipatcd
rcliancc on intcrnal a s h flow or outside
funds, and thcy heIp articulatc managcrncnt’s
financia1 objcctivcs and policics.
Managcmcnt mccdngs with companies ncw
to thc rating process typimlly last two to four
hours, or Iongcr if thc company’s opcmtions
arc paniculady compfcx. If the issucr is
domiciled in a country ncw to ratings or parricipatcs in P new industry, morc timc is usually rcquircd. When, in addition, there are
major accounting issucs to bc covcrcd, mcctings can last 3 full day or two.
Shorr, formal prtrcntations by managcmcnt
arc wch1 to introducc arcas for discussion.
We prefer mcctinp to bc interactive and
Iargcly informal, with amplc timc alIorvcd for
qucstions and rcsponscs. (At managcmcnt
meetings, as at 311 othcr timcs, wc wclcomc
the company’s qucsn’onsrqarding our proccd u m , mcthodoIogy, and andytiul critcria.)
Rating Committee
A cominittcc is aIways convcncd to assign a
ncw issucr mting. Rating cornmittccs normalIy consist of five to scvcn voting membcrs,
and P chairpcrson rcvicws thc suitability of
thc committcc participants.
78
www.corporatecriterla.standardandpoors.com
A prcscntation is made by tlic Icad analyst
to thc rating committcc, which has bccn providcd in advancc with appropriatc financial
statistics and cornpantivc analysis. TIic prcscnmtion fo1Iow thc mcthodology as outlincd
in thc methodology sccrion bclow. It includcs
andysis of rhc company’s busincss and its
opcmting cnvironmcnt, cmluation of its
stntcgic and financial managcrncnt, accounting ~ S ~ C C Wand
, financial sndysis. Whcn n r ing a spccific issuc, thcrc is additional
discussion of the proposcd issuc and tcrms
of thc indmturc.
Oncc thc ratings arc detcrmincd, the company is notified, and told of thc major supporting considcmtions. Wc alIow rhc issucr to
rcspond ro the rating dccision prior to its
pubhtion by prcscnting ncw or additional
data. Wc cntcrtain appmls in thc intercst of
having availablc thc most information possiblc nnd, thcrcby, the m o a accuriltc ratings. In
thc casc of a decision to changc an cxtant rating, any appcil must bc conductcd as cxpcditiously as possiblc, i.c., within a day or two.
The comrnittcc rcconvcncs to considcr thc
ncw information.
Aftcr notifying tlic company, thc rating is
disscminatcd via the mcdia, or rclcascd to thc
company for disscmination in tIic a s e of primtc pIscements or corpomtc credit mings.
To maintain thc integrity and objcrtivity of
our rating proccss, our intcrnal dclibmtions
a d thc idcntitics of those who sat on a rating committcc arc kcpt conlidcntial, and not
diseloscd to thc issucr.
Surveillance
Corporarc ratings on publicly distributcd
issucs are rnonitorcd for at Icast onc ywr. Thc
company can thcn eIca to pay us to continuc
survcillancc. Rating assigned at thc company’s request haw thc option of survcillancc,
or being on a “point-in-timc“ basis.
SurvciIIancc is pcrformcd by thc mmc
industry analysts that work on thc assignmcnt of thc ratings. In fact, wc strivc to provide continuity of thc lmd analyst and ii
portion of thc rctcvant rating committcc
[some mcrnbcrs do rotarc, though, IO allorv
for frcsh pcnpccrivcs, and thc l a d analyst
roIc must rotate altcr fivc ycars). To bcilimtc
MHlBlT RVH-2
Pago 50 of ’I39
survcillancc, cornpanics put thc l a d analyst
on mailing lists to rcccivc intcrim and annual
financia1 statcmcnts, press r c l m q and bank
domrncnts, including compliancc ccrtilicatcs.
Thc lud analyst is in pcriodic contm with
tkc company to discuss ongoing pcrformancc
and dcvelopmcnts. Wlicrc thcsc vary significantly from cxpcctatiom, or whcrc a major,
ncw financing tnnsaction is planncd, an
updatc rnanagcmcnt mceting i s appropriatc.
1% abo cncoumg cornpanics to discuss
hypothctimIIy-qpin, in strict confidence
tmnsactions that pcrhaps arc only bcing contcmpfatcd (LE., acquisitions, ncw financing),
and, wherc pmcticabIc, w c cndcavor ro provide frank fccdback about thc potcntial rati n g impliations of such transactions.
In any cvcnt, mamgcmcnt mcctings routincly arc schcdukd at 1mst annually. Thmc
mcctings cnablc analysts to kcep abrcast of
managcmcnt’s Y icw of current dcvcbprncnts,
discuss busincss units that haw pcrformed
diffcrmtIy from original cxpmtions, and bc
appriscd of changes in plans. As with initial
managcment mcctings, w c willingly providc
gujdancc in advancc regarding ims we
bclicvc warrant cmphasis: Thcrc gcncnlly is
no necd to drvcli on basic information covcrcd a t the initial mceting. Apart from discussing rcviscd projcctions, it is hclpfui to
rcvisit thc prior projcctions and to discuss
how acmal pcrformancc varied, and why.
i\ Si@ifimnt proportion of mceting with
company officials taka pIacc an thc company’s prcmiscs. Therc arc scvcnf ccitsons: to
fadtitatc incrciscd cxposure to managcrncnt
pcrsonncl-particularly at thc opcrating Icvel;
obtain a first-hand vicw of critical facilities;
and achicvc ;L bctrcr understanding of thc
company by spcnding rnorc timc rcricwing
the busincss units in dcpth. Whilc wc activcfy
cncoumgc mectings on company prcmises,
rime and schcduling constraints on both sides
dinatc that arrangcrncnts for these mcctinp
be madc somc timc in advancc.
3cc;rusc thc staff is organizcd by spccialty,
crcdit analysts typicalIy rncct cach ycar with
most major companics in their assigned a m
to discuss thc industry outlook, tusincss
stratcgy, and financial forccms and policia. This way, compctitors’ forccasts of
markct demand can be comparcd with onc
Stutldard
a Paw’s
anotbcr, and W E can assess implications of
compctitors’ stmtcgics for thc cntirc industry, Our analysts Gin judgc managcmcnt’s
rclative optimism regarding market growth
and rdativc aggrcssivcness in approaching
thc markcrplacc.
Importantly, thc analyst comparcs business stratcgies and financial plans ovcr timc
and scclis to understand how and why thcy
changcd. T h i s cxcrcisc providcs insights
rcgarding managcmcnt’s abilitics with
rcspcct to forcmsring and impfcmcnting
plans. By mccting with diffcrcnt managcmcnts ovce thc coucsc of a ycnr, and tlic
samc managcment ycar iftct year, analysis
a n distinguish bcnvccn managcments with
thoughhtfu1, rcnlistic ngcndis and tliosc with
wishful approachcs.
Mmagcincnt crcdibility is achicvcd to thc
mtcnt thc rccord demonstma rhat a company’s actions arc consistcnt with its plans and
objectives. Oncc c a r d , crcdibility hclps support continuity of a particular rating Iwcl,
lxausc mc c=in rcIy on managcmcnt to do
what it says to maintain and/or rcstorc crcditworthiness whcn faccd with limncia1 strcss or
stratcgie cliallcngc. Oncc lost, crdibility is difficult to rmorc. Thc nting pcoecss tcncfits
from thc uniquc pcrspccrivc on crcdibility
gaincd by cxtcnsivc cvduation of managmcnt
plans and financial formsts ovcr many p r s .
Rating Changes
As a rcsuIt of the survcillanccprocm, it
somctimcs bccomcs apparcnt that changing
conditions rcquirc rcconsidcmtion of the outstanding rating. WIvn this OCCUTS, thc analyst
undcrwkcs a prcliminary rcvicw, which, aftcr
intcrnal deIibcration, may Icad to a
Creditwatch listing. This is foifowcd by a
comprchensivcanalysis, communimtion with
managcmcnt, and a prcscnration to thc rating
committcc. Thc ming committcc cvaluatcs
thc mancr, arrivcs at a raring dccision, and
notifics thc companydftcr which wc publish
thc rating changes, if any, and thc ncw outlook. Tllc proccss is cxacdy thc samc as thc
rating of a ncw issuc. Rcflccting this surveillance, thc timing of rating changcs dcpcnds
ncithcr on thc salc of nmv Jcbt issucs nor on
our inrcrnil schcdulc for rcvicrvs.
Corporate Ratings Criteria 2008
19
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Page 51 of 139
Analytical Methodology
ur rating methodology is based on fundamental analysis.
0
Our model has evolved over time to reflect greater com-
plexity and volatility facing companies. Current ratings anaIysis
puts much greater emphasis on cash flow adequacy and liquidity
than in the past. Our profitability analysis was part of OUT financial
risk review, but we now emphasize its role as part of our business
risk and competitive assessment.
Overview
Ovcr the past fivc or SLY years, \vc haw paid
signifiantly more attention to accounting
considcmtions and corpomtc govcmancc.
Whilc managcmcnt’s risk oricntation has
3Iways bccn a cririal part of our rating dccisions, thcrc is a morc complcx corporatc bndsmpc now-including the availability of cvcr
morc cornplimcd smritics and transactions.
Accordin&, w c necd to drill dccpcr into managcrncnt pncticcs and polidcs, including il
mngc of Issucs, from oivncrship to board
indcpcndcncc ta off-balance shcct stnwgcms.
Business riskrfinancial risk matrix
We striive for tmnsparcncy around thc rating
proccss. Howcvcr, i t is criticaI to rcalizand it should be apparcnt-rhat the ratings
proccss cmnot bc rcduccd to B cookbook
approach: Ratings incorpontc many subjcc-
tivc iucigmcnts, and rcmain as much an art 3s
a scicncc.
Our corpontc nnalytiml mcthodology
orpnizcs thc analytimI proccss according to a
common fnmcwork, and it dividcs the task
20
mnrw.corporatscritcrin.standardandpoors.com
into scvcrnl utcgoorics so that a11 salient issues
arc considcrcd. Thc first mtqorics involve
fundamcntd busincss analysis; thc financial
analysis catcgorics foloiv. (Crcdit ratings
oftcn arc idcntificd with financial adysiscspccially ratios. And IVC publish ratio statistics and bcnclimarks both for scctors and
individual companies. But ratings analysis
starts with thc asscssmcnt of thc busincss and
cornpctitivc profile of thc company. Tivo companics with idcntid financia1 mctrics arc
ratcd very dilfcrcntly, to tlic c m n t that thcir
businas challenges and prospecrs differ.)
Wc dcvclopcd thc matrix in tablc 2 to
makc cxplicit thc rating outcomcs that arc
typical for various busincss riskllinmcial
risk combinations. Thc tabb illustrates thc
rclationship of busincss and financial risk
proliIcs to thc issuer crcdit rating. T h e foIlowing illustrates how thc tablcs can bc uscd
to bcttcr undcrsrand our rating conclusions.
Thc hypotltctical u ls c of cotirpmry A8C
Company ABC i s dccmcd to haw a satisfactory
busincss risk prolilc, t y p i d of P tow
D(HlB1T RVH-2
Page 52 of 139
invcstmcnt-gndc industrial issucr. If its financia1 risk wcrc ‘intcrmcdiatc”, thc cspcctcd
rating ourcomc shouId bc ‘DBB’.
ABC‘s ratios of cash flow to dcbt (35%)
and dcbt Icvcmgc (total dcbt to EBITDR of
25x1 om indccd chmctcristic of intcrmcdiate
financial: risk. (Thc asscssmcnt of financial
risk rcally is not so simplc: It cncompasscs
financia1 policics and risk tolcmncc, volatility
and risks to fuwc perlomancc, scsm-d pcrspcctivcs on a s h flow adcquaq-including
frcc msh flow and thc dcgrcc of flexibility
rcgarding mpital cxpcnditurcs, and various
mmsurcs oE Iiquidiy-including c o r ~ n g of
c
short-tcrm manuitics.)
Company ABC can aspire to an upgmdc
to ~ h ‘A’
c category by rcducing its dcbt burden to thc point thzt cash flow to dcbt i s
morc than 60% and dcbt lcvcragc is only
1.5~.Convcrscly, ABC may choosc to
bccomc morc financidy aggrcssivc-pcrhaps i t dccidcs to rcward sharchoIdcrs by
borrowing to rcpurchasc its stock. Thc
company can cxpcct to bc ratcd in thc ‘BB’
catqory if its cash flow to debt ratio is
20% and dcbt lcvemgc rcmains at 4x-and
thcre is a commitmtnt to kccping i t s
finances at thcsc Icvcls.
The rahg matrix is a guideline,
trot
I M i f f C J t it1 StO#lC
The rating matrix is not mcant IO bc prccisc.
Tlierc can aIwys bc small positivcs and ncgativcs that would Iad to a notch highcr or
Iorvct than thc typical outcomc.
Mmcovcr, thcrc wilI alrvays bc mccpt i o n s q s c s that do not fit nwtIy into this
analytiul framcwork. For cxampIc, liquidity
conccm or Iirigation could pose overarching
risks. Also, thc matrix docs not nddrcss thc
lowcst r u n g of thc crcdit spcctrum (he,
thc
‘CCC’ arcgory and Iorvcr). Thcsc ratings, by
dcfinition, rcffca sonic impending crisis or
extraordinary vulncmbility, and tlic balanccd
approach that undcdics thc matrix Immcrvork
just docs not lend itsclf to such situations.
Corporate Credit
Anatysis Categories
Thc atcgorics undcrlying our busincss aird
finalwid risk asscssmcnts arc:
Business Risk
.
I
8
e
Countryrisk
Industry factors
Compctitivc position
ProfitabilityPccrgroup comparisons
--Financial risk profilBusiness risk profile
Minimal
Modost
Intermediate
Aggressive
Hiyhfy Leveraged
A
hlnerabla
BBB
BE
BBC
0t
3B*
b
68.
B
B
E-
Minimal
Madast
Intermediafe
Assressivo
Hishlv Leuorasad
financial risk
Indiealive ratios.
Siatldurd & Poor’s
Corporate Ratlngs CtItetIa 2008
21
D(HtBlT RVH-2
Pagc 53 of 139
Anatytlcal MethodoloOy
Financial risk
G o v c r n a n d s k tolcnncfinancid
policies
Accounting
8 G s h flow adcquacy
Capital strucntrdAsset prorcction
LiquiditylShort-tcrrnfactors
Norc thzt wc do not have any prcdctcrmined weights for thcsc citcgoril.s. Thc signifiuncc of spccific factors ~ r i c from
s
situation to situation.
Btrsiiiess risk corisiderations
Cormtry risk. Thc opcnting cnvironmcnt in
thc particular country-including, irnportantIy,
haw an
any sovcrcign-rclatcd T-SI
avcnvhclming impact upon company crctlitwrthincss, both dircct and indircct. Sovcrcign
crcdit rating suggest gcncral risk faccd by
loa1 cntitics, but t h y may not fully c;rpnuc
risk npp1imblc to tlic ptivatc scctor. As a
-It, whcn rating corpontc or infmtnicturc
cornpanics or projms, ivc look bcyond the
sovcrcign ratings to cvaluare thc specific cconomic or country risk that may impact rhc
caity’s crcditworthincss. Such cconomic or
country risk pcmins to the impact of govcmmcnt policies upon thc obligor’s busincss and
financial, cnvironmcnt, and a company’s abitiry
to insulatc itself fromtlicsc risks.
Irrdrrstry factors. AI1 rating maIyscs incotporatc an asscssmcnt of hc company’s burincss cnvironrncnt. Thc dcgrcc of opcnting
risk facing a company almost atways dcpcnds
on thc dynamics of thc industry in which it
partieipatcs. Our industry analysis focuscs on
thc strcngh of industry prospccts, as ~vctlas
thc compctitivc factors affecting that industry.
Thc many factors asscsscd includc industry
praspccts for growth, snbility, or dcclinc,
and thc pattern of business eyclcs. It is &tid,for exampIc, to dctcrminc vuIncrability to
tcchnotogicdchangc, labor unrat. regulatory
intcrfcrcncc, or changcs in thc supply/dcmand
balance. Our honowlcdgc of the invcstrncnt
plans of thc major playcrs in a giwn indtlsuy
offcrs a uniquc vmtagc point with rcspcct to
the future industry’s profitc.
The industry risk asscssment SCD the s t q c
for andping spccific company risk
f a c t o d c y s to succcss and establishing thc
priority of thcsc factors in thc OVCMII
evalua-
22
www.corporntccriteria.standardandpoors.com
tion. For cmmplc, if rcchnolom is ;1cridml
cornpctitivc factor, R&D prowess is strcsscd.
If thc industry produccs a commodity, cost of
production is of major importance.
Still, for any partimutar company, onc or
mom factors a n hold spccial signifimncc,
cvcn if that bctor is not common to the
industry. For cxamplc, thc ba that a company has onIy one major producrion facility
normally is rcgardcd as an a m of vuIncrabi1ity. SimilarIy, rcliance on onc product crcattx
risk, even if the product is highly successful
{c.s., a pharmaccudml company with only
onc blockbustcr dmg that is subjcct IO cornpctition and patcnt cxpiration).
Conrpctiiive position. Compctitivc position
rcprcscnts ilcritical input in rissming a cornpany’s Icvcl of bllsincss risk in our analysis,
and can oftcn havc a significant impact on
thc dcbt rating for an iuucr. To dctcrminc a
givcn issuer’s compctitivc position, IVC look at
kcy fzctors pcrtincm to rhc spccific industry.
A kcy factor for a phnmi3ccutimI company,
for emmpIc, might bc rcscarch and dcvclopmcnt, whcrcas markcting wouId bc a particularly important considcration for a eonsumcr
products company.
Company sizc and divcrsifiation oftcn
plays rolc. WhiIc we haw no minimum size
criterion for any givcn rating Icvcl, company sizc tcnds to bc significantly cotrclatcd
to rating Icvcls. This is bcmusc largcr companics oftcn bcncfit from cconomics of
scde andlor divcrsification, tnndating into
3 strongcr compcririvc position. Small companies arc, aImost by dcfinition, morc conccntratcd in tcrms of product, number of
customcrs, and geography. To rhc cxtcnt
that markcts and rcgional cconomics
changc, a broadcr scopc of husincss
affords protcction.
Small cornpanics arc somctimcs toutcd
for rhcir grcatcr growth potcntial.
Howcvcr, fast growth oftcn i s subjcct to
poor cxccurion (cvcn if the idca is wcll
conccivcd) and czn also tcmpt a company
into ovcr-ambitiousncss, which couId
involvc nddcd risk.
Matlagmirent evaiiratiort. 1Managcmcnt is
asscsscd for its rolc in Jctcrmining opcntional,
succcss and also for its risk tolcnricc. T h c
first aspccr is incorpomtcd in tlic business risk
MHl6lT RVH-2
Page 54 of 139
analysis; thc sccond is wcighcd as a financial
policy factor.
Subjcctivc judgmcnts hcIp dctcrminc cadi
nspcct of managcmcnt cvalmtion. Opinions
formed during the rncctings with scnior managcmcnt arc as important as mmagcrncnt’s
track rccord. Whib a track rccord may sccm
to offcr il mow objcaivc basis for evaluation,
it oftcn is difficuIt to detcnninc how results
should bc attributcd IO rnanrigcrncnt’s skills.
Managcmcnt plans and policics arc judgcd
for thcir rmlism. How they arc impIcmcntcd
dctcrmincs thc vicw of managcmcnt consistency and credibility. Statcd policics oftcn arc
not followcd, and a rating may rcflcct skcptieisrn until managcment has csrablishcd crcdibility. Crcdibility a n bccomc a airical issuc
rvhcn a company is faccd with s t m s or
rcstrucnrring, and \vc must decide whcthcr to
rcly on managcmcnt to carry out plans for
rcstoring crcditwonhincss.
Profitabili~/Pcergroitp cartipmisotis.
Profit potentia1 is a critical dctcrminant of
crcdit protcction. A company that gcncratcs
higher opcnting margins and rcturns on capital has a grmtcr ability to gcncmtc cquity
upiral internally, attract capital e?itcmlty,
and withstand businws adversity. Earning
power uftimtcfy atmts to thc valuc of thc
company’s assets, as wcIf.
Morcovcr, conclusions about profitabiliry
also scwc as a good sanity chcck on our
asscssmcnt of bwincss risk: h company’s
profit performancc offcrs a Iitmus t a t of its
fundamcntd ludth and compctitivc position.
In this regard, comparing pecr companies on
kcy profit mctrjcs i s most mcaningful.
Fitrancid risk comidcrations
Having cvaluatcd thc issucr’s operating cnvironmcnt and competirivc position, thc analysis procccds to s c v m 1 financial catcgorics. To
rcitcmtc, thc company’s busincss risk profdc
dctcrmincs dic lcvcl of financial risk approprim far any rating category. financia1 risk
is ponrqcd Iargcly through quantititivc
rnmns, particularly by wing financia1 nrios.
Scvcral analytid adjustmcnts typidly am
rcquircd to calculate ntios for an individua1
company (set Etzcyciopedia of Atialytical
Adjirstiricrzts, bcloru). Cross-bordcr comparisons rcquirc additionaI carc, givcn thc dilfcr-
Smdard & Poor’s m Corporate
cnccs in accounting convcntions and local
financial systcms.
Fitraricial policy. 1% attach grcat imporI ~ R C Cto mamgcmcnr’s philosophies and policies involving financia1 risk. A surprising
nurnbcr of cornpanics have not givcn this
question serious thought, much lcss rcachcd
strong conclusions. For many orhcrs, dcbt
lcvcmgc (alculatcd without any adjustment
to rcporrcd ligurcs) is thc only focnl point of
such policy considcrations. Morc sophistiatcd busincss managcrs havc thoughtfuf polidcs
that rccognizc a s h flow pararncrcrs, thc
intcrplay bcnvccn busincss and financial risk,
and thc nccd to adjust financial data to
reflect diffcrcnt nccds and pcrspcctivcs. ,
R c n thosc cornpanics that havc sct goals
may not have thc whcrcwirl~al,disciplinc, or
management commitmcnt to achicvc thcsc
obicctivcs. Lcvcragc gods, for cmmplc, nccd
to bc viewed in tIic conrcxt of an issucr’s past
rccord and the financial dynamics affecting
thc busincss.
Accou?iting charactcristics and itrfontiutiori
risk. Financial statcmcnts and rclarcd disdosura scrvc as our primary sourcc of information regarding tlic financial condition and
financial pcrformancc of industrial and utility companies, Thc analysis of financial s t m mcnts bqins with a rcvicw of accounting
eharactcristics. The purposc is to dctcrminc
whcther ratios and statistics dcrivcd from the
statcmcnts can bc uscd appropriarcly to
rncasurc a company’s pcrformincc and position rclativc to both its dircct pecr group and
thc hrgcr univcrsc of eorporatc issucrs. Thc
rating proccss is, in pan, onc of comparisons, so it is important to liavc a common
frame of rcfcrcncc.
Analytical adjustmcnts arc midc to bctrcr
portray rcaliry and to lcvcl thc diffcrcnccs
among companics-although it nrcly is
possiblc to complctcly rceast a company’s
financial sratcrncnts. Evcn whcrc thc ability
to adjust is Iimitcd, it is important to at
lcast have somc notion of thc mtcnt to
which diffcrent financial. incasurcs arc
ovcrstatcd or undcrsratcd.
Apart from thcir importancc to thc quantimtivc aspccts of the analysis, conclusions
regarding accounting cbanctcristics and
financial tramparcmy a n also influcncc
Rathas Criteria 2008
23
EXHIBIT RVH-2
Page55oi139
AnaIyticat Mcthodology
qualitativc aspccts of thc analysis, such as the
nsscssmcit of managcmcnt.
G 5 h flow adcqwq. Intcrcst or principal
payrncnts mnnot bc scwiccd out of mrning,
which is just an accounting conccpt; paymcnt
has to bc made with a s h . Although thcrc
usuaIIy is a strong rclationship bcnvccn ash
flow and profitabiliry, many transactions and
accounting mtrics affcct onc and not thc
othec AnaIysis of cash flow pattcrm a n
rcvml a lcvcI of dcbt-servicing cllpability that
is cithcr strongcr or ivcakcr than might bc
apparcnt from earnings.
TIic analysis oftcn focuscs on IcvcIs of
funds from opcntions (FFO), but ivc pIay
cIosc attcntion to working capital swings,
upiral spcnding rcquircmcnts, and sharcholdcr distributions to complctc thc picture with
rcspcct to a s h flow adcquacy.
Cash flow analysis is usually thc singlc
most c r i t i d aspect of crcdit ming dccisions. I r rakcs on addcd impormncc for spcculativc-grade issucrs. Whilc cornpanics with
invcstmcnt-gradc ratings gcncralIy hnvc
rcady icccss to cstcrnal financing to cowr
tcmpomry ash shortfalls, spcculativc-gradc
issucrs lack this dcgrcc of flexibility and
haw fcivcr drcmativcs to intcmally gcncmcd cash for scrvicing dcbt.
Capital stmcturc arid asct protectiotr. A
rcvicw of an issucr’s capital stmctum rcprcsmts an important part of our finnnciaf
rcvicw. Thc rcvierv encompasscs borh thc levcl
and mix of dcbt cmploycd (Le., hcdlvariablc
mtc, manuity, currcncy, smrrcdlunsccurcd).
This analysis hcIps us dctcrminc 3 company’s
financial flcuibility, and h o w l e v m g d it is.
Of coursc, whcn we look at Icvcmgc, our
analysis go- bcyond rcportcd debt on the
balancc shccr and includcs such itcms as k i t
cs, pension and retircc medical Iiabilitics,
p m n t c c s , and contingcnt Iiabilitics.
In addition, a company’s assct mix is a
cririal dctcrminant of the appropriatc Icvcrage for a givcn lcvel of risk. Asscrs with srable cash flows or market values justify
grmtcr use of dcbt financing than thosc with
cloudcd markcmbility. Accordingly, ivc
bclicvc it is critical to anaIyzc mch typc of
busincss and nsscr c l ~ ins its own right.
Whilc thc Financial Accounting Standards
Board (FASB] and Intcrnationil Accounting
24
www,corporatecriteria.standardaodpoors.com
Standards (IAS) now rcquirc consolidation
of nonhomogcnous busincss units, ivc ana-
lyzc cach scparatcIp
Liqt~idi~lsl~ort-rcrm
factors. Sundry considcntions that do not lit in 0 t h atcgorics
arc cwrnincd Ivrc. Thc potcntial impact of
contingcncics is considcrcd, along with thc
company’s contingcncy plans. Thcsc include
scrious lcgal problcms ,Iac6 oE’msurancc covc q c , or rcstrictivc covcnanw in loan agrcemcnts that placc rhc company at thc mcrcy of
its bankcrs. Acuss to various capita31 markcts,
affiliations with othcr cntirics, and thc ability
to scll asscts arc important factors in dctcrmining il company’s options undcr stress.
Debt tmtiirity sclredriles arc scnttitzizcd.
FIcxibility can bc jcopardizcd when an
issucr is ovcrly rcIiant on bank borrowings
or commcrcial papcr. Issuing commcrcial
papcr without adcquatc backup facilitics is
a big ncgativc.
As going conccms, cornpanics should not
bc cxpcctcd to rcpay dcbt by Iiquidating
opcntions. Clmrfy, thcrc is little bcnclit in
sclling natural rcsourcc propcrtics or manufacturing facilitics if thcy must bc rcpfaccd in
a fcw ycars. NoncthcIcss, thc ability to gcncrate cash through assct dispods cnhinccs P
-
company’s financial ffcxibility.
Country Risk
Country risk-thc risk of doing busincss in
a particular country-is a criticd componcnt of many ratings, particularly for companics in cmcrging markcts. Tlic Iargc
numbcr of corporm dcfsiults in Argcntina
during tlic 2001-1002 crisis was rclatcd to
a combination of macrocconomic factors,
such as scvcrc currcncy dcprcciation and
wcak cconomic activity, and govcrnmcnt
actions such as rhc ‘pcsifmtion’ [convcrsion to pcsos from foreign currcncy) of
financial obligations, utility tariffs, and
most othcr doIlar-dcnominatcd contracts
at an unfworablc cxclimgc ratc from a
crcditor’s pcrspcctivc.
Country risk dillcrs from sovcrcign crcdit
risk-thc risk of rhc sovcrcign dcfidting on
its commcrcial dcbt obIigations. Country risk
is oltcn corrclatcd with sotwrcign crcdinvorthincss, but not always.
nHt3tT RVH-2
Page 56 of $39
Dcpcnding on thc industry smtor or individual company’s financial strcngth, a company
may bc bctrcr or lcss able to withstand macro-
economic shocks or ohcr country-rcIatcd
risks. For instance, scvem1-bur not allBwzitian exportcs performcd wcll during
2002 dcspitc a scvcrc crcdit crunch in thc markctplacc, giwn govcmmcnt rciucnncc to intcrfcrc with cxport financing. CommcrciaI b a n b
and smtc dcvelopmcnt banks continucd to
providc I i n e of crcdit ro major cxportcrs, cvcn
though the sovereign suffered credit stress.
Most Rllssian cornpanis continucd to perform
and to scrvicc cxfcrnal, wprt-backcd dcbt in
1398-1999 whcn thc sovcrcign was in dcbuIt.
On thc othcr hand, strcngrhcning crcdit
quality of tlic sovcrcign state docs not IIECCS-
sarily improve the business environmcnt-ur
the rclcvant country risk. For m m p l c , wliitc
Russia’s sovcrcign credit quality has bccn
improving, the opcmring environrncnt
rcmains risky. All ratings on Russian cornpanics factor in uncertainty about enforccmcnt
of rcguIatory and lcgal norm and thc stillrvmk corporatc govcmmcc cnvironmcnt.
Ccrnin industria tcnd to bc mow affccrcd
by sovcrcign issue than otbcrs. Banks and
utilities arc greatIy affectcd by thc rcgularory
framcmork and by thc g c n c d condition of
thc cconomy. On thc oppositc cnd of thc
s p m r u m are cxport-oricntcd companics,
which arc lcss affcacd by local cconomic
conditions, and gcncrally bcnctit from currcncy dcpreciation. NevertheIess, cvcn exponcrs
arc cxposcd IO country risk. For instancc,
thcy arc subjcct to I o d ruks on labor and
domutic input sourcing, and couId suffcr a
disruption in Financial markct acccss bceausc
of sovcrcign-dated invcstor pcrccptions.
Rcsourcc narionalisrn can also makc cxport-
oriented commodity industdcs more likcly
targets of sclcctivc sovcrcipn intcrvcntion.
Exposum to country risk may cvcn diffcr
on it company-bysompany basis. For
instancc, in Russia, thc largc oil and gas producers may mch bc subjccc to diffcrcnt r i s k
of govcmmcnt intcrfcrcncc.
Govcmmcnt-rclatcd cornpanics gcncrally
cnjoy somc govcrnmcnt support, but facc
gcncnl country risks as wll. Whilc sclcctivc
sovcrcign intcnrcntion is hardly an issue for
thcm, in t c m s of outright cxproptiarion,
StatrdnrdBr Paar’s
thcy arc still subjcct to the country’s tax and
rcguhtory risks, infrastructurc constraints,
or cxchangc rate movcmcnts. Thcrc m c plcnty of cxamplcs in which thc sovcrcign 113s
induccd thc govcmmcnt-owned cnrities to
rcduce capital invcstmcnt budgets,i ncrmsc
thc tax burdcn, or pxy cxtraordinary dividcnds whcn cconomic prcssurcs havc risen.
Country risk methodology and
interaction with the sovcrcign rating
Thc main soccrcign and industry-rclatcdrisks
affccting and somctimcs constmining rhc crcdit quality of cornpanics in P ccrtain jurisdiction
ineludc mrious cconomic, financial, rcgulatory, and industry-rclatcd risk that can affcct
day-to-day opcntions, lons--tcnninvcstmcnt
decisions, and, of coursc, paymcnt cilpacity.
Wc dividc thc main country risk factors that
could affcct thc private scctor into hvo ate
gorics: konomidpolitid and industry risks.
Ecotiontic risks:
growth prospccts of a country;
its busincss cycb;
w
=
=
=
=
=
politid factors influcneing tlic busincss
cnvironmcnt;
currcnt and projcctcd inflation Icvcls;
forcign mchangc risks affccting tlic flow of
imports, cxports, and thc balance ofpaymcnts;
ilic pzymcnt system and thc strcngth and
dcpth of thc banking system;
intcrcst mtcs and spmds;
thc dcpth and liquidity of thc Iocal capital
markets; and
acccss to thc cross-border markets far cammcrcial or financial tnnsacdons.
Indtlsity-rclatcd risks:
labor markct constmints or inccntivw,
thc strcngth and political dircction of labor
unions;
labor cost and strikc cxpcricncc;
* condition of gcncrd infmstructurc in tbc
countqLwith potcntid constraints on
water suppIy, cost of cJcctricity, and pricc
and availability of oil and gas;
poor transportation scrviccs in roads,
ports, and airports;
accounting and rcporting rmnsparcncy in
thc country;
Corporate Ratlngs Cn’tcria 2008
25
MHIBIT RVH-2
Page 57 of139
Analyllcol Methodology
fcdcrd and starc govcrnmenr IegaI systcrns;
regulatory risk for utilities, banks, and
other cntitics undcr rcguktion;
mistcncc or potcntial for hmvy tmtion; and
corruption-rclatcd risks affccting day-today opcrations.
Pasr mperictrcc
The main country risk factors that havc afkctcd financial: pcrformancc and nuscd corpomtc
dchdts in the past arc the fol!orving:
Currcncy mismatch on opcntions and
financial obligations combincd with sliarp
Ioclll currcncy dcprcciation;
Pricc controls combincd with drastic mw
matcrial incrmscs;
Suddcn contraction of Iiquidiry, combintd
with a gcnemI wcakcning of thc financial
system and a possiblc fxrcning of bank
dcposits;
hrgc incrcass in thc cost of funds by
financia1 intemediarics, if available;
Dclaycd paymcnts from d o m d c customcrs, including sovcrcigns thcnmIvcs or
sowrcign-owncd cntitics;
Hikes in export tariffs or nxcs;
Rolongcd labor strikcs with cvccssivc
.
dcmands;
Unfriendly chnngc in rcgulatiom,
= GDP contraction and rcduccd domestic
dcmand far scvcml months or ycars;
* Sovereign ratriaions on access to forcign
cxchangc nccdcd for dcbt scrvicc; and
= Forccd conversion of forcign mrrcncydcnominarcd obIigations into local currency.
implicit or cxplicit support from 3 highlymtcd parcnt in nnothcr jurisdiction, a d o r
thcrc is significant cash-flow diversity dcrivcd
from opcrations in scvcm1 countrics.
Forcign currcncy ratings of an cntity
would bc usually eappcd by thc transfer and
convcnibiliry (T&C)asscssmcnt for a given
country-ordinarily, highcr than thc sovcrtip forcipcurrcncy rating. (See “Rafiirgs
Above The Soucrcigrr: Foreigtt Crtrrctrcy
Rating Criicriu Update,” prilrlishcd NOH 3,
ZOOS, on RntirrgsDircct. ihc real tiwe Webbused sottrcc far StmrLrd & Poor’s crcdit
rafiirgs, rcscard, arid risk artalpis.
Assessrttc~rsof T&C risk arc prrblished o ~ nt
tiiorithly basis for all rated s0vereigtw.j
Ncvcnhdcss, P company’s forcign currciicy
ratings can cxcccd tlic TPCC assessment in
instincts of: vcry strong crcdit mctrics and
busincss prospccts, as projcctcd tvcn through
a sovcrcign default sctnario; strong inccntivcs to scrvicc forcign dcht [links to globnl
trading systcm); or n projcctcd ability to gccncmtc cnough forcign currcncy a s h flow to
comfortably covcr forcign currcncy outflows.
As of 1007, thc lorcign currcncy ratings
of 68 cntitics in 21 countrics cxcccdcd thc
sovcrcign rating of thc country of domicilc,
(See “Transfer Arid Cortueriibiliiy
Ass~s~nrcttt
Histoy Sitzcc Nouctriber 2005”
prrblished / r i m 7,2007, oir RafittgsDircct.)
Only a handful, howcver, cscccdcd thc
TPrC asscssrncnt.
Industry Risk
Ratiirgs abowc the sovereign
Undcr our methodology, ratings on P company may excccd thosc on thc sovcrcign, if
wc cxpcct it would eontinuc to pcrform
and fuIfiIl its financial obligations, cvcn
during a sovcrcign Iocal andlor forcign currcncy dcfitult sccnario. Thc company must
dcmonstratc that it is significilndy shcltcrcd
from sovcrcign and country risk factors,
bascd on past cxpcricnec and probabIc scenarios. Wlicrc such potcntial exists, w c
would pcrform additional sovcrcign and
country risk srrcss sccnarios as part of thc
rating anaIysis.
in addition, rating abovc thosc on thc sovcrcign arc possiblc whcrc thtrc is strong
26
www.corporatecritet1a.s tandardandpoors.com
Industry risk analysis sccs the stagc for company-specific analysis. Thc god is to dcvclop
3 robust undcrsnnding of thc company’s
cxtcrnal busincss and opcrating cnvironment.
lndustry anaIysis focllscs on thc industry
prospccts, as wclI as identifying tlic competitivc factors, risks, and challcngcs affecting
participants in that industry. Oncc kcy industry and countiy risk considcmtions arc idcntificd, thc crcdit analysis proccss procccds to a
sccond phasc-compmy-spccilc analysis.
Industry chanctcristi-nd
thc mix of
opportunitim and risks they rcprcscntincludc the scctor’s growth and profit potcntial, dcgrcc of cycIiality, MSC of cntry, naturc
and dcgrcc of compctitim, capital intcnsity,
OCHlBlT RVH-2
Page58of139
opcmuonal and cost strucmrc, rcplation, and
rcchnology. Cornpanics bat-positioned to
takc adwnmgc of rhcse kcy industry drivcrsor IO rnitigatc associatcd risks morc cffcc.t i d y , posscss a compctitivc advsntigc--and il
strongcr busincss risk profilc.
Evaluating an i n d u s t ~ srisk profile
\WIc chamctcristics pcrtincnt to crcdit risk
3cross industrics broadly arc similar, thc
impact of thcsc factors can vary signnifiuntly
benvccn industria. Tablc 3 highlights how a
common s c t of industry ehamcrcristicdmctria can bc applicd to identifying thc rclativc
crcdit impact of kcy industry factors across
somc major industrim in thc U.S.
Some industries arc morc highly affcctcd by
nation$ factors than otbcrs. Thc naturc and
impact of kcy chamctcristics a n vary
markcdy bctwccn countrics for il givcn
industry. Utilities, ~clccom,and rcmil tcnd to
bc morc affcctcd by national chamctcrjstics.
By contrast, oil PC p s , chcmimls, and rcchnology scctors arc more global in naturc, 3s
mtionaI factors tcnd to bc less influcntial.
An exampIe of country-specific
influences:Tetecom
Whilc thc tclcmrn industry rcccntIy has k c n a
primary drivcr of globalization, and thc technology pIatforms and connmivity pmvidd by
tclccommunimtion compmiE form tlic undcrpinning of thc global ncnvork for voicG darn
video, and Intcrnct scrviccs, it docs not liavc a
uniform globd crcdir profilc. A fcw Imding
opcntors haw divcrsilicd intcmationilly by
building ncnvorks in multiplc rcgioiu and
countrim, although none can bc said to bc
global. h major impcdimcnt to thc crmtion of
truly global playcrs is that many govmmcnts
vicw tlic industry as bcing of national stmtcgic
impomncc; so, 3s in the msc of utilities, barriccs to cross bordcdglobal cxpansion and divcrsifiution oftcn arc matcrial. Thc high cost of
cross-bordcr cnrry includcs availability and
cxpcnsc of ~oovcnimcia-~nciioned
frcqucndcs
and Iiccnscs, ncnvork-construction capital
rxpcnsc, and, in crncrghg rnarkcts, oftcn thc
rcquircmcnt to sliirc profits and managcmcnt
dccisions with loml partners. Tlic dcgrcc of
competition in tclecom is in inany countrics a
dirca function of govcmmcnt policy mnd rcguIation, as wcll ns othcr factors, such as population 3nd busincss dcnsity. National markers
with thc highcr tclccom crcdit risk tcnd to bc
thosc with a high dqrcc of compctition,
whcrc gowth prosptcts arc limitcd by markct
maturity,and govcrnmcnt and rcgulatoty policy or xtions have spurrcd cornpetition, and
hstorimlly bccn inconsistcnt: Thc U.K. is an
cmmplc of onc such markct. Con\*crscly,in
rnarkcrs with Iowcr lcvcls of compctition
Credit risk irnpnct Hish (H]; Medlum [MI; Low IL)
Capital
Tachnnlngy
Regulatory/
Energy
Risk lactor
Cyclieality
Competition
intensity
risk
govornment
sansilivity
lndustw
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H
H
L
MI
H
Aidinos W.S.)
n
H
M
hl
I1
Autos'
ktosupplien'
High Wnology'
H
M
I
lm
II
H
ti
M
1
Chemials lbulkl'
H
A
L
H
1
Shinnfo'
I1
n
H
H
M
1
1
I1
Holets'
11
H
H
11
MPI
Minino'
M
I1
M
t
M
H
H
H
H
H
Staidnrd & Poor's
H
M
n
Corporate RatIngs Criteria 2008
L
M
M
27
EXHIBIT R W - 2
Page 59 of 139
AnoIytlcal Mcthodology
(often bmwc of govcrnmcnt poIiacs and r c g
ulations that aim to support pticc Icvcls and
profit margins, and a m surplus a s h gcncm
tion to fund infrastructurc spcnding by incumbents), and growth prospccts arc high, thc
scctor crcdit-risk prolilc u n bc mudl marc
bvonblc. A p r i m cxampb of the Iattcr markct is China. Kcy rating mctrics, such as opcrating margins, EBITDA eovcngc, and levcngc
mios for Chim’s dominant incumbent rvirclinc and wircIcss cornpanics rcflcct this adwntqc, and arc among thc strongm of any ntcd
tclccom. Howccvcr, in thc cast of China, our
ratings on rhcsc cornpanics arc mnstmincd by
sovcrcigdcountry-risk considerations. Markets
whcrc cornpctition is limitcd by govcrnmcnt
policy arc obviously susccptibIc ovcr timc to
policy c h a n p leading to grcatcr markct libcralization. Wile thc possibility of a major policy U-turnin China mrrcntly appwrs low, it is
csscntiaf that any likclihood of chartgE that
would fastcr greater compctition t c factored
into the analysis in markcts wherc thcrc is a
high dcgrcc af govcmcnt protcction.
High-risk ittdttstries
Ccrnin scctors historiully haw cxpericnccd
highcr dcbult ~ C and
S do~vnwnrdtransition
bchavior. This a n bc linkcd to kcy high-risk
indmtry cIianctcrisdcs. R a t i n g within such
industrics tcnd to clurtcr, bcausc compctitivc
diffcrcntiation is often hard to aeliicvc and
financing nccds are rcfativcly simihr.
Still, it is critical not to paint an cntire
industry with thc sarnc brush. In fact, thc
stress of many cornpmics in a particular
industry can rcsulr from the supcrior cxccution and pcrformancc of thcir rivaIs.
Such compctitivc divcrgcnce should bc mirrorcd in a bifurcatcd ratings profile for
that industry.
Factors with a high Icvcl of impact on
crcdit risk arc cyclicality, dcgrcc o f eompctition, capital intensity, tcehnologicnl
risk, rc~ulationldcrcgulation,and cncrgy
cost scnsitivity.
Maturc industries thtr arc wry competitive
oftcn havc longanblishcd cornpanics wirh
inflruibldlqacy cost structum (arising from
labor, pcnsion, andlor cnvironmcntal issues,
among othcrs). Industrics in this mtcgory
includc autos, aidincs, and intcgratcd stccl.
28
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Cycliuriity
Industry cycIcs rcsuIt not only from fluctuating demand, but, importantly, also from
swings in supply apacity. (Such addinon of
ncw apacity oftcn occurs in rcsponsc to
cyclimI upswings in dcmand.) Ovcrbuitding
of production capacity miccrbatcs compctitivc and mmings prcssurc, cspcciilly in thc
cvcnt of a downturn in dcmand (emmplcs of
this dynamic: bulk chcmjmls and shipping).
A company’s busincss a n bc so impaircd
during a downturn that it runs out of
funds-or its compctitivc position may bc
pcrmancndy altcrcd. In thc cxtrcme, P company will not survivc a cyclical downrum to
participatc in thc upturn. So, a11 cIsc cqual,
cornpanics subjcct to qcliuiity arc mtcd
lowcr than non-cyclical cornpanics.
Wc attcmpt to avoid assigning high n t i n g
to a company at its pwk of cycliml prospcrity, if that pcrformancc lcvcl is cxpectcd to bc
only tcmpomry. SimilarIy, wc may not Iowcr
ratings to rcflcct wcakcning pcrformancc
bcause of ~ ) ~ l i m
factors,
I
if the downturn is
IikcIy to bc only tcmponry or thcrc arc good
prospccrs for managcmcnt to rcrpond to the
changcd circumstances.
It is not that ratings arc not adjustcd with
the phnscs of a qclc: Rathcr, thc mngc of thc
ratings would not fully mirror the amplitude
of thc company’s cyclicill highs or lows, given
thc cxpcctadon that a cycliml pattcrn will
pcrsist. T h c tspectation of changc from thc
curccnt performancc IcvcI-for bcttcr or
worsc-tcmpcrs any rating action.
Wc do not-and mnnot-aim to Urate
through thc qclc” cntircly. Rating through
thc q c l c rcquircs an ability to prcdict the
qcliml pattcm-usually cxtrcmcly difficult
to do. Thc phases of ilcycIc probably will br
Iongcr or shoncr, or stccpcr or lcss severe,
than just rcpctitions of cadicr cyclcs.
Intcmcuon of cyclcs from diffcrcnt parts of
thc globc and the convcrgcncc of sccular and
cyclical forccs arc furthcr complications.
Morcovcr, evcn prcdictablc qcles a n
affect individual companies in ways that haw
a lasting impact on ercdit quality, As noted, il
company may biI during thc qcIiml downturn. Convcrscly, a company may accumuIatc
cnougli cash in thc upturn to mitigatc dic
risks of thc ncxt downturn.
MHlBlT RVH-2
Page 60 or 139
Furthcrmorc, invcstor scntimcnt about
cyclical crcdits may fluctuatc ovcr thc coursc
of a cycle, with important ramifiwtions for
financial flc?tibility. Whatevcr our own views
about thc long-tcrm staying poivcr of a
givcn company, thc dcgrcc of public eonfidcncc in thc company’s financial viability
dctcrmincs i t s acecss to capital rnarkcts,
bank cccdit, and ctwn tradc credit-for bcttcr or worsc. Accordingly, thc psychology
and the pcrccptions of capital providcrs
must bc mkcn inro account.
Semitivity to cyclical factors-and ratings
stnbility-dso varics considcrably dong thc
rating spcctrum. As thc credit quality of a
company bccomcs incrcasingty marginal, thc
natucc and timing of ncar-tcrm changcs in
rnarkct conditions arc morc likely to mcan
thc diffcrcncc betwvecn survival and failure.
A cyclical downturn may involvc tIic thrcat
of dcfauft bcforc thc opportunity to participate in thc upturn that may follow. In such
situations, cyclical fluctuations usually will
Imd dircctly to rating changes-possibly
evcn scvcrd rating chmgcs in a relarivcly
short pcriod. Converscly, a cycIica1 upturn
may givc companies a brcathcr that may
warrant a modest upgradc or two from
thosc very low Icvcls.
In contrast, cornpanics vicrvcd as having
strong fundarncntatr (k,thosc enjoying
invcstmcnt-gndc ratings) arc unlikely to
scc significant rating changcs bccausc of
factors dcemcd to bc cyclical, untss thc
cyclc is cithcr substantially diffcrcnt from
thar cxpectcd, or thc company’s pcrformancc is somchow exccpdonal relativc to
that cspectcd.
(Rating stability for a company throughout
a qcIc also p m m c s consirtcncy in busincss
strategy and financial policy, In rdity, managcmcnt psychoIogy is oftcn suongly influcnccd by tbc coucsc of a qclc. For cmmpfc,
in the midst of a prolongrd, highIy bvorablc
q c l i n I rcbound, P givcn managcrncnt’s
rcsohc to pursuc a conservativc growth strategy znd financial policy may bc rvcakcncd.
Shifts in minagcrnent psychology may affcct
not just individud compmics, but cntirc
industries. Favorabfc market conditions may
spur industry-widc acquisition activity or
capacity cxpansian.)
Sraldurd & Pour’s
a
Capital iritrlisify
To thc dcgrcc that a busincss is capita1 intcnsivc, rcturnlbrcak-cvcn horizons arc oftcn
furthcr our, bcausc of thc nccd to invcst
hcavily in fixcd assctdproduction capacity.
Opeming Icvcmgdmpzcity utilization adds
to the risk profilc.
Scctors that arc both mpital intcnsivc and
hwc a high dcgrcc of compcrition (c.s.,
autos, shipping, forcst products, and mcwls &
mining) are especially scnsitivc io thc nccd
for high mpacity utilization. Noncthcless,
upitd-intcnsivc scctors oftcn ham a hidl
propcnsity to ovcr-cxpand upacity in growth
periods, Imding to surpIus capacity, intcnsc
pricc compctition, and eroding margins.
Pcrhaps ironimlly, such cornpanics also tcnd
to havc aboveavenge financia1 risk, nr
financing nceds oftcn arc substantial and Iong.
Rapid clmgc
Industrim undcrgoing rapid changc bcausc
of tcchnoIogi~~l
innovation andlor dcrcptation tcnd to liavc higher lcvcls of industry
risk. Barricrs to cntry can bc subsmntially
rcduccd, alowing an cntry to nciv compctitors that may not bc burdcncd by Iqacy business rnodcl~,tcchnobgics, and thc cost
stmcturcs of incumbents.
Thcrc is grcatcr porcntial lor industry pccrs
sorting thcmsclvcs into winncrs and loscrsas cornpanics pursuc diffcrcnt blrsincss rnodcIdstntegics. Thc quality of management is
particularly important in such industria.
Risks in iriaruriiig or dcciinirrg irrdiufrics
Maturing cconornic and dcmographic mvironrncnt can lcad to rnarkct satuntion (cas.,
anemic growth rates in Wcsrcrn Eumpc and
Japan for autos and stccl). Tcchnofogid
changc may spur substitution (furcd-wirclinc
phoncs by rnobildwirelcss; traditional mcdia
advcrtising by Intcrnct ads; pharmaccurial
mcdimtions by bio-mcdicrtions; and print
medidncws by Intcrnct news scrviccs). Ncw
bmincss mod& mn lead to disintcrmcdiation
(local rctaifcrs by mcga rctailcrs, and tmditional airlincs by low-cost mrricrs).
Stagnant or dcclining revcnucs rcquirc costrcduction to maintain profitability. Product
diffcrcntiation also tcnds to bc difficuIt in
maturing industry cnvironmcrirs, as thcrc is a
Corpmate Ratings Criteda 2008
29
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Annlytlcel Methodology
high dcgrec of corrdation bcnvccn industry
maturity and product commoditization
(brands do afford cornpanics protcction from
commoditiwtion in somc scctors). Industry
consolidation oftcn is chdlcnging-both for
thc cornpanics making thc acquisitions-and
thosc Icft to compctc with thcm.
Risks iir rapidly groiuiiig,
iiiittratirre ittdtistries
Thc promisc of ncw technologies and ncw
busincss models-while a thrcar ro thc existing mmpanics-is not a panacca for the
innovators cirhcr (c.g., Intcrnct and dor.com
companics). High-growth industrics, partieulady thosc drivcn by tcchnoIogid changc,
tcnd to haw Iong inwstmcnt brcakevcn horizons, cspccialIy if thcy arc capita! intcnsirc.
Thcir carly pcriods arc associatcd with losscs
and ncgativc a s h flow.
Unproven comrncrcial viability of 3 ncw
tcchnology andlor busincss rnodcl dso makc
thcm poor cllndidatcs for obtaining crcdit.
Ncw industrics notrnally arc fundcd in rlicir
mrIy phases through venmrc mpita1 (c.g.,
biotcchnology).
Somc high-tcchnologylhigh-growth
industries arc vicwcd as having cconomic and
political importmcc to national governmcnrs,
which may protcct tlicm from markct competition in an attempt to srimdatc their devclopmcnt (as notcd with China's tclccoms).
Barriers to cntry crcctcd by govcrnmcnrs in
thc form of licensing, franchise auctioning,
and Iavs barring competition and acquisition
by nomnctioncd cntirics arc used to provide
a protcctcd cnvironmcnt. Hawevcr, as thcsc
industrics maturc, govcrnmcnts open thcm up
to varying degrees of eompctirian by allowing
ncw cntrmts or rcmaving monopolistic priviI c p incumbents had prc:viauslyenjoycd.
Oncc dcrcguIntcd, such industrics normally
bccornc much riskier from a crcdit pcrspcctivc, becausc incrczicd compctition crodes
industry profit margins.
"Old" itrdtrstries can bcconie
rcjirvctiatcd in cnicrgiizg markets
Not all industry high-growth opportunitie
arc crcatcd by ncw technology or busincss
modcls. CurretitIy, thc npid industrialization
of dcvcloping countrics (notabIy China and
30
www.corporatecri tar1a.standardandpoors.com
India) is crcating growth industrics for
mature products-including auto manulacturing, capital goods, and stccI. hi addition,
countrics sccking to attract forcign participants offcr protcctcd cnvironmcnts and/or
assistance and induccmcnts.
Such smtw a n provc tcmpting for forcign
companies establishing opcmtions, birt mrly
forcign entrants oftcn find it hard to maintain
adequate profitability oncc rax hoIidays cnd
andlor ncw entrants arc in placc. {Agin,
China offcrs a good cxamplc: thc govcmmcnt's
d&ion to allow thc cntmncc of additional
Wcstcrn, Japancsc, and Komn auto manufncturcrs bas crated a high dgrcc of cornpition
with rapidIy doclining profit matgins, dcspirc
very npid rnarkct and sal= growth.)
PotentialIy oncrow govcrnmcnt regulations, poIicics, and rcquircmcnts, 3s wcll toIcmncc of illicit activity--sucli IS proprictmy
tcchnology tnnsfcrdpincy, arc additional
risk clcmcnts that nccd to bc considcrcd.
Competitive Position
Competitivc positioning is thc comcrstonc of
busincss risk analysis. W i l c thc industry
environment, whcthcr bvorablc or unhvorablc, will strongly influcncc tIic business risk,
diffcrcnccs in compctitivc positioning mn justify substantial diffcrcnccr in mdit standing
among industry playcrs. A strong businas
profilc scorn can only be aehicvcd through a
vcry compctirivc position. Such status supports rcvcnue and mh flow stabiliv-and
generally gocs in tandcrn with supcrior profimbiIiry measurcs. A compmtivcly wcak
compctitivc position--cvcn in thc most favorable industry cnvimnmcnt-is unlikcly to
rcsult in a solid crcdit standing.
SustainabiIity is key
T h c sustainability and trcnd of 3 compctitivc
posirion arc critical rating factors.
Sustainability of compctitivc advantage is
ohm dctcrmincd by cost lcadcrship or product diffcrcntiation. A broadcr cvaluation
would look at:
= Product positioning (quality, pricing) and
brand rcpumtion;
* hlarkct sharcs, dic insrallcd custoiiicr basc,
and gcograpbie covcmgc;
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Distribution mpabilitics;
Customcr rclationships;
T c c h n o f o ~ ~ / m ~ n u ~ c mpabilitics;
turiq
and
Mcmingful bmicrs to cntry, such as tnnsportation, m p i d or rcchndogy intcnsivcness, and rquktion.
Thc assessmcnt of thcsc factors must, of
coursc, bc forward looking; wc wic historical
data only to the mtcnc that they providc
insight into future trcnds.
Scvcml othcr factors aIso arc c r i t i d in
dctcrmining tIic strcngth and sustainability of a
company’s competitivc position. Vertiul intcgran‘on, for insmnoe, oftcn cnablcs a scrongcr
compctitivc positiotMlthough not ncccssirily
highcr rcwm on upital cmploycd-protcction
of thc mtomcr basc, and pricing powcr, as
wcll as bcncr ability to adjust to technology
dcvcfopmcnts. That said, it is of utmost impornncc for a company to have thc strongcst grip
on that part of thc valuc chain that comprises
thc highrrr valuc addcd.
Market share analysis can be a critical
component, hut onty when weighed in
the context of industry dynamics
In noncomrnodity sectors, m d c t s h a m
analysis oftcn providcs important insight into
a company’s compctitivc strcngth. A brgc
s h m , howcvcr, is not alrvays synonymous
with a compctitivc ndmntigc or with indwtry dominancc. If an industry has a numbcr
of simifarly largc participants, nonc may h a w
a particular advantagc or disadvanmgc. (This
is the a s c of thc rnaturc U.K. mobilc teIephony markcr, which, dcspirc having four compcrirors with roughly similar largc markct
shares, is chamctcrizcd by intcnsc compctidon, yiclding rclativcly low margins for aII
markct participants.) Evcn duopolics (such as
the aircraft manufacturing indusrry) do not
ncccssariIy cnsurc high and stablc margins.
Highly fmgmcntcd industries (such as tnnsportatior+with airliiics being a good warnplc) may Iack pricing Imdcrship potcntial
alrogcthcr. Thcsc mamplcs undcrlinc thc limils of markct sharc analysis without undcrstanding thc industry contat.
Global industrics typiml1y arc characterizcd by gradual niarht consolidation and
thc risk of product comriioditization; only
largc. cost-ctficicnr playcrs with vast
Slatrditrd B l’oor’s
1
rcscarch and distribution mpabilirics arc
ablc to sustain or rcinforcc thcir busincss
positions and profitability.
In contrast, cornpanics opcriltjng in Ioml
industrics may bcncfit from tnnsportation
barriers, long-term rcgulatory advantap, or
a lomlly largc imtallcd assct or customcr
base. This is somctimcs thc msc for food
rctaiIcrs, which a n cnjoy a11 thcsc advantages, hcIping tlicm achicvc rclativcly solid
busincss risk profiIcs, b a d on cntrcnchcd
and wclt-mansgcd local positions.
Comparing mature and
fast-growing markets
An erncrging or fast-growing markct offers
considcrablc growth prospects, but compctitivc positions in such rnarkcts arc likcly to bc
morc volatilc. Conrpanics niay r a p substantia1 bcncfits ovcr a rclativcly short pcriod of
tirnc but find it diflicuIt to managc ovcr thc
long haul. (Morcoucr, fast-growth companics
oftcn tcnd to main high-risk financial politics as thcy agrcssivrly pursuc cvcc mocc
ambitious objcctivcs, tlicrcby limiting potcntial crcdit quaIity.) Tlic prornisc of small companics a n fadc vcry quickly on
growth-rclatcd risks, including manigcrncntk
cxpcriencc and maurccs to cntcr ncw markcts, or to intcgratc acquircd companics.
A m a w c markcr, although pcrhaps not
appealing from an earning growth standpoint and possibly cxposcd to risks of pricc
commoditimtion ur revcnuc dcclinc, a n
mmn grcatcr protcction for mirkct sham.
L r g c cornpanics in rnaturc markcts h a w substantid staying porvcr. Thcir simblc staff,
vast army of disposable asscrs, and oltcn-significllnt rcstrucruring potcntial can positivcly
influcncc thcir btcs.
Gcncrally, WC would rhcrcforc favor a
solid, establishcd position in a rnaturc, consolidatcd industry, which would havc
greatcr ability IO offcr prcdicrabIc rcvcnuc
and carnings streams, and to protccr a company’s capacity to scrvicc its dcbt over tlic
long tcrm.
Diversification can enhance the
businnss risk profita
I-Javing il divcrsc rmgc of products, CUStomcrs, andlor stipplicrs hcIps cushion a
Corporate Ratings Criterla 2008
31
EXHIBIT RVH-2
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AnaIytIcal Methodology
Accordingly, small or modcst sizc gcntmlly
is a ncptivc rating lactor if thcrc is signifia n t divcrgcncc in skc and markct sliarcs
bcnvccn tbc markct lmdcrs and smaller playCIS. h’cvcnhclcss, small and rnidsizc cntcrpriscs can sunivc end pcrform satisfactorily in
sufficicntly uncorrcIatcd.
industries dorninatcd by companies with largc
When a company opcmtcs in morc than onc
markct slmcs, providcd rlicy an build
busincss, \vc andyzc mch scgmcnt scpmtcly.
ddcndablc markct positions in nichc SEE1% thcn form a compositc from these building
nicnts of thc industry. Gcrman sports car
blocks, wcighimg mch clcmmt according to its
dcsigncr and manufacturer Porschc AG (not
impomncc within thc o v c d oqpnimtion.
ntcd) has succcssfulIy dcicndd and cxpand(Dctcmination of imponancc a n vary; wc
cd its strong position in luxury sports a m
o h usc mrnings contriturion, cspccidly if
with rcspcct to compctitors owned by largc
scgmcnt ash flow data are unavailable,)
u r manufacturers.
Divcrsifidon that inchdcs il good comt\s notcd, largc cornpanics in highly fmgpctitivc position in scvcral industry scgmcnts
mcntcd industries m y find it difficult to
is thcn considcrcd ils P positive crcdit factor.
cxcrt iducncc ovcr pricing; instmd, all
Thc businrss profilc of a company solidly
industry playcrs arc wposcd to intcnsc compositioncd in an army of cash-gcnentivc
petition. This is thc msc in thc scmiconductor
busincsscs with diffcrcnt industrial cyelcs is
industry, for c.uamplc (with thc cxccption,
strongcr in terms of crcdit quality than cich
perhaps, of thc microprocusor sqrncnt),
of thc but-nnkcd stand aIonc compctitors.
wlicrc nonc of thc largc playcrs has dcmonHowcvcr, rvc gcncrally arc cautious with
sttrtcd a Iongtcrm ability to diffcrcntiatc
rcspcct to thc bcncfits of busincss divcrsifithcmsclves in a Iighly compctitivc cnvironcation rclatcd to tvcakcr compctitivc posimcnt. Thc transportation and logistics industions or activities cxposcd to a vcry difficult
tria arc othcr good cxamplcs.
industry cnvironmcnt.
Lrgc sizc also is oftcn positivcly corrclntcd
GIobal conglomcirtcs gcncnlIy achievc
with low cost. Economics of s n l c in purchassomc of thc h $ m t n r i n g among corporarc
ing, manufacturing, and distribution can proissucrs. Imprmivc gcogmphic sprmds, balvide lacgc companies with bcitcr cash flow
anccd exposure to qcIimI industrics and EOchancrcrisrics, which is of particular inipornomic conditions, and oftcn w r y simbjc
tancc at thc downside of thc cyclc. In some
markct s h a m in consolidamd , well-protcctcd
u s = , likc form products, group size may
markets arc common fmturcs of some of thc
not bc thc mosr critjcai zspect of cost advanworld’s largcst conglomcmtcs, such ts US.based Gcnml E l h c &. (hhAIStablr/A-l+). ragq rathcr, thc sizc of thc individual production units-in particular thc sizc of thc
machines-is critical.
Size and ratings end up being
Also, small cornpanics are, almost by dcfihighly correlated
nition, mom conccntmtcd in t c r m of prod\ n i l e wc havc no minimum size criterion for
uct, number of custonlcrs, and gcogmphy. In
any givcn rating Icvcl, size and ratings do cnd
dfcct, thcy lack ccrrain clcmcnts of divcrsifiup bcing comcImd, givcn that sizc o h procation that can benefit Inrgcr companies. To
vidcs a rncasurc of divcrsification, andlor
thc cxtcnt that markcr and rcgiond
affccts compctitivc positioning.
cconomics clianp, it broadcr business smpc
It is r c h d v m o t absdutosizc that is cmaffords protcction.
cia1 in detcrmining rnarkct position, w e n t of
In addition, thc impetus IO grow dramatidivcrsilimtion, and financial: flc?ribiIity. Small
u l l y tcnds to be liighcr for playcrs aiming to
cornpanics also can cnjoy thc cornpctitivc
icccss the industry’s first ticr than for indusadmnmgcs that accompany a dominant martry giants that alrcndy achicvcd that status.
kct position, although such P situation is not
Ambitions growth stratcgics oftcn entail sigcommon.In this scnsc, shccr mass is not
nificant financial and implcmcntation risks.
important; JciiiorwnbIe markct advanmgc is.
company against advcrsity.
Geographic
sprclld can also afford some protcction
nginst advcrse changcs in rcgional markcts
and cconomics, to thc cxtcnt that thc markcts for a company’s products or scrviccs arc
32
WHI8IT RVH-2
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Accordingly, wc pay much attention IO
mnnagcrncnt’s plans for achicving caming
growth. Can misting busincsscs providc satisfactory growth, cspccially in a lowinflation
cnvironmcnt, and to what extcnt arc acquisitions or diveuturcs necessary to achicvc COP
porate gods? At first glanec, a mawc,
cash-gcncmting company offcrs B grmt dcal
of Londholdcr protcction; but w c prsumc a
company’s ccntraI focus is to incrcasc shamholdcr MIUC ovcr thc long run. In this context, a Iack of indimtcd earnings growth
potcntial is considercd a wvcakncss.
How Company Management
Influences Business And
Financial Risk
Managcmcnt evaluation is an input for
both busincss risk and finaneid risk profiIcs-rcflccting tlic fact that managcmcnt’s
smtcgy, decisions, and policics affcct a11
aspccts of a company’s activity. Thc cvdualion includcs 3 rcvicw of the crcdibility and
rcaIism of managcmcnt’s stratcgy and projcctions, its opcrating and financial track
rccord, and its appetite for assuming
busincss and financia1 risk
Our judgments &ing
mmqcmcnt’s stratcgy and opmcing tmck rccord hclp dctminc
our vim of compctirivc position, a kcy cIemmt
of thc businrrs risk profilc Wc try to ass=
management‘s wmpctcn-nd
irs rolc in
dctcrmining stmtcgic and opcratioml.s u m .
iVc bcar in mind that succcss can bc rnorc
difficult to achicvc in somc indusrrics than
othcrs, simply bccausc of thc inhcrcnt risk
charactcristics of thc busincss. Various airline
cxccutivcs, rcffccting on thc puiodic and
damaging prim wars cndcmic to thc U.S. airIinc industry, havc obscrved that uyou arc
only as smart as your durnbcst compctitor.”
Managcmcnt’s rcputirion within an industry
compIcrncnrs our evaluations.
Each industry has i t s own spccific chdh g c s and constitucnck that mmagcmcnt
must dml with. Heavily unionized industrics,
such as automzkcrs, steel, and aidincs, may
b c c difficulr labor relations-nd how managcmcnr handlcs unions and cmployccs can
Jctcrminc a company’s h t c in cases whcrc a
strike could bc fatal to opcmtions. Rclations
Stairdnrd & I’ottr‘s
with replators or govcmmcnt officials am
important in otIicr scctors, such 35 utilitis.
Corporatc govcrnancc and financial poIicyincluding its risk tolcnnc-rc
part of our
financial risk cduation.
Strategies and plans
We comparc managmcnt’s fumrc pIms and
assumptions with thosc of pccr cornpanis
and with our own cssrirnatcs. Jmplausiblc or
ovcdy oprimistic projcctions can indicatc
poor internal planning capabiIitics or an
insufficicnt grasp of thc challcnga (or opportunities) facing that compmy-cspccially if
managcmcnt fails to considcr factors thar
pccr cornpctitors arc focusing on. Indccd, onc
bcncfit of our access to managcrncnt 3s part
of the nting proccss is dic opportunity to
comparc pcrspcctivcs of various participants
in an industry,
How stmtcgy, plans, and policies arc
implcmcntcd hclps dctcrminc our vicw of
managcmcnt consistcncy and crcdibility. In
that acrcisc, dctcrmining why actual rcsults
fail to mcct cxpccmtions is important. For
cxamplc, mccting or cxcccding projccrions
could bc the rcsult of unantidpatcd good formnc, rather than a rcflcction of manage
mcnt’s capabilitics.
Accordingly, whcn rcvicrving projjmions or
secmrios that arc pmcntcd by mamgcmcnt,
\vc also nrivc to undcrsmnd what could must
pcrformancc to dcviatc Wc undcrstind that
formsting is rnorc difficuIt in some industria
than othcrs, and that unformcn factors outside of managcment’s control mn upset rhc
besthid plans. A clndid acknorvlcdpmcnt of
risks and undcmndingof how various factom
couId a f k mming and a h flow is hclpful
for our inrcrnd drlibcmtio-nd
may rcflca
fmorabIy on mmagcmcnt‘s acdibility.
Convcrscly, a rccord of abrupt or frcqucnt
c h n p in busincss mtcgy, includinguncxpcctcd acquisitions, divcstitum, or mtmmring, dcfinircly would nisc our conccm.
Acquisition strategy
Acquisitions dtcn play a significant rolc in
managcrncnt’s stratcgy. Although almost all
mcrgcrs involve risk, wcll-cxccurcd acquisitions
a n makc stntcgicscmc. W c try to btliorn the
compmy’s acquisition critcria with rcspcct to:
Corporate Ratings Criteria 2008
33
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Analytical Methodology
Stntcgic "fit";
= Divcrsifimtion objcctivcs;
.
.
Markct sharc gains;
Availability of cxccss cash
rcsourccs; and
VaIuation considcntions (cash flow
multiplcs, intcrnaI rate of rcturn,
mrnings accrction).
(Somcof thcsc considerations also rcffcct
on managcment's ovcrall risk colcmncc and
financia1 policy, which arc discwcd LcIow in
thc contcxt of financial risk.)
Managcment's approach and pIans for
poorly pcrforming business units or thosc
that no longcr malic stmtcgic scmc arc a
rclaad arcs for invcstigtion. Objcctive
appnisnls of busincsscs unirs and disciphcd
approaehcs to dealing with undcrperformcrs
(divestiturc, mtructuring, or discontinuing
bwincsm arc among thc options in such
a s e s ] arc vicwvcd positiwly.
Corporate governance and its
relationship to credit analysis
Our cvaluation of governance 3s part of crcdit analysis is not focuscd on misappropriation
of funds, lack of accountability, or othcr misdeeds. Rather, it covers a broad 3rmy of topics rclating to how a company is managcd; its
rcfationship with sharcholdcrs, crcditors, and
othcrs; and how its intcrnal proccdurcs, policia, and pncdccs can crcatc or mitigate risk.
Thc starring point is to identify thc ownccs
of thc company. T h c namrc of the owcre.g., goavcrnnicnt, family, hoIding company, or
stmtcgically linked bwincs-n
hoId sipnifiu n t implicitions for both busincss and financial aspects of the ratcd cntity. Owncrship by
strongcr or rvwkcr parcnt companies un
subs~ntinllyaffcct the credit quality of rhc
ntcd cnticy. Cross-sharcholdingof industrial
groups and famiIycontro1Icdnctworks, commonplacc in certain parts of the world, can
h v c positivc or ncg3tir.c implications,
depcnding on thc spccific situation. Wc ncvcr
mtc corpomtc cntitics on a standalonc basis.
Thc corpomc govcrnancc of family-owncd
businesscs, for wimple, introduccs a d d 4
complcxitics. Do thc various family sharcholdcrs agree on stmtcgy? Havc tlic otvncrs
hircd profdona1 managcmcnt and atlawcd
thcni sufficicnt authority and nutoliomy to
34
carry out thcir mission? What about m a n a p
mcnt succession, ot othcr involvcmcnt by
diiIJrcn of thc foundcr or orvncr? \#hat
about tlic possiblc dcsirc to liqucfy vduc in
sliarcholdings through dividends or an IPO,
and what arc thc implications of w a t c planning? Still, family owncrsliip a n hold ccrnin
advantages, in tcrms of adhcrcncc to Iongtcnn stmtcgic goats and cornmitmcnt of family rcsourtcf to a busincss.
Ownciship by privarc cquity firms has
bccomc morc common rccently in thc U.S.
and Europe. Such owncfs typimlly arc much
morc icrivcIy involvcd in managcmcnt than
public sharcholdcrs, and w e scck to undcrstand privatc cquity owncrs' stratcgy for thc
company bcing rated. Is thc company n platform for organic growth, industry consolidation, or a cash cow? What is the typical
holding pcriod and cxit stratcgy for thc owncrs? Repaying dcbr (oftcn incurrcd in a Icvcragcd acquisition of thc company) and
cvcntually sclting ro a strategic buycr or
through an IPO is likcIy to bc a morc crcditorfriendly stmrcgy than dcbt-financcd dividcnds. Somc of thc lagcr private equity
companics own multipIc ratcd companics,
giving us a track record by which to judgc
thc owncrs' shtcmcnts of inrcnt wlicn a ncw
inwstmcnr of thcirs is bcing mtcd.
Thc cxistcncc of morc &an onc otvncr
introduccs thc potcntial for conflicts ovcr
control. Joint owncrs might disagrcc on how
to opcratc thc businas. Evcn minority awncrs a n somctimcs cxcrcisc cffcctivc control
or at Icast frustratc thc will of tIic majority
oivncrs. Whcncvcr control is disproportionatc
to thc undcrlying economic intcrcst, the
incentivcs for tlic stakeholdcrs could divcrgc.
This could rcsult from cxistcncc of cIasscs of
sham with supcr voting rights or from owning 51% in wch of rnultiplc laycrs of holding
companics. In cithcr cunmplc, control might
rcst wid1 a party that holds only il relativcly
small cconomic stakc.
(Convcndonal, cquity-micntcd corpomtc
govcmancc analysis is w r y scnsitivc to s l i m
structure-for cxampfc, whcthcr cach typc
of sham providcs rcprcscntational votingout of conccrn that nianagcmcnt or majority
mvncrs will act to the dctrinicm of minority
sharcholdcrs. Although this conccrn is not
MNlBm RVH-2
Page 66 of 139
thc dircct focus of our crcdit analysis, thcrc
is a pcnalty for cornpanics considcrcd abusive to minority holdcrs. Pcrccpa’on of such
conduct would, obviously, impair thc company’s acms to invcstmcnt mpinl. Funhcrmorc,
if a company mistmtcd onc group of stakcholdcrs, thcrc mould bc scrious conccrn that it
could latcr try to shonchangc othcr snkcholdem,including crcdirors.)
Our m l u a t b n of corporate govcmancc is
sensitivc to potcnrial organizational p m b
Icms. Thcsc includc sinrations wvherc:
Thcrc is significant orpniwtiond rcIiancc
on an individual, espccially onc who may
bc nearing rctircmcnt;
Thc tmsition from cntrcprcneutiaf or family-bound to profcssional rnanagcment h35
yct to bc accomplishcd;
= Managcrncnt compcnsation is cxccssivc or
poorly aligned with thc intercsts of stakeholders;
There is cvccssivc managcmcnt rumovcr;
Thc company is invofvcd in Icpl, rcgulatory, or MX disputcs to a signihcandy grmter
merit than its pcers;
= T h c company has 3n CxcESsivcly complex
I c p I structurc, perhaps cmploying inrriclltc
off-balancc-sheet strucnrrcs;
Thc rctationship bchvccn oqanizationd
structurc and managcrncnt stratcgy is
unelcar;
The financc function and finance considcratians do not rcccivc high organizational
rccognition; and
= Thc company is pardatarly aggrcssivc in
the application of accounting standards, or
dcmonstma a lack of opaqucncss in its
financial reporting.
And rccent cxamplcs of poor corporatc
govcrnance hnvc comribotcd to impaircd
crcdinvorthincss. These u s c s included:
Uneontrollcd dominant owncrship influcncc that applicd company rcsourccs to
pcrsonal or unrclatcd USC;
Uncontrollcd c?tccutivccompensation pro-
3
grams;
~Managcmcntinccntivcs thar compromised long-tcrm stability for short-tcrm
gain; and
Inadcquatc oversight of thc inrcgrity of
financial didosurc, which rcsultcd in
hcightcncd funding and liquidity risk.
Sratdurd & Pow’s
Stil, board strumrc and involvcmcnt has
not figured promincndy in thc rating pmcss.
Of coursc, if it is cvidcnt a company’s board of
dircctors is passivc and docs not cvcrcisc thc
normal orcrsight, it wmkcns thc chccks and
balanccs of thc orpnimtion. Dut considcntiom such as thc proportion of indcpcndcnt
mcmbcrs on thc board of dircctos, prcscncc of
indcpendcnt directors in thc boJrd-IcvcI audit
mnmittcc, and thc compcnsation of d i m o r s
and scnkr rnanngcmenr rams haw limitcd rclwancc. It a n bc difficult to dctcrminc ob+
tivcIy whcthcr a sivcn Icvcl of compcnsntion is
excmivc, or wivill rcsuft in a company stmcgy
diac is ovcrly aggmsivc or mainly f m c d on
short-tcm pcrfomancc.
Indccd, strong corporatc govcmancc-it1
thc convcntional scnsc, dcmonstmcd in part
by the prescnce of an m i v c , indcpcndent
board that participates in determining and
monitoring the control cnvironmcnt4ocs
not by itscIf provide cnhanccmcnt to crcditwonhincss. Govcrnancc qualitics cannot
ovcrcomc a wcak busincss or finincia1 risk
profifc, although thcy mi& contributc to
protccting an aIrcady strong busincss.
Financial policy and risk tolerance:
managing the balance sheet and more
We asscss financial policics for aggrasivcn~~dconscrvati~rn,
sophistiution, and consistcncy with busincss objcetivcs. W c attach
g m t importmcc to managmcnt philosophics and policics invohing financial risk.
Accounting practim, capital spcnding ~ C Y C ~ S ,
dcbt rolemncc, mcrgcr activity, and ilssct s d c
frequency arc a11 aspccts of a managcrncnt’s
financial pdicies (scc ‘Credit FAQ: K~iotuitig
Tltc Imwstors It1 A CuiiipanyS Debt
Arid Eqitity, ” prrllished April 4,2006,
O H RatirrgsDirccfj.
Policy diffcrcnccs bcnvccn cornpanics u n fx
drivcn by various factors,incIuding manrigcrncnt prekrcnccs, busincss rcquircmcnts,
andlor sharehoIdcr MIUC considcntions.
Policics should optimize for thc typically divcrgcnr interests of thc company’s s t a k c h o l d c ~
shardddcrs, creditors, mtomcrs, and
cmployccs, among othcrs. Spccifimliy, thc
cornpsny’s goals with rapcct to its crcdit mtins abo nccd to bc consistcnt with thc blancing of thosc intcrcsts.
Corporate Ratings Criteria 2008
35
EXHIBIT R W - 2
Page 67 of 139
Analytical Mathodotogy
Sophistiexcd busincss nianagcrs havc
thoughtful policics that targct a varicty of
financial rncnsurcs and acknowkdgc tlic
intcrpIay bcnvccn busincss 3nd financia1
risk. But il surprising nwnbcr of companics
have not givcn their financial policy serious
thought, much Icss rcachcd strong conclusions. For many othcrs, dcbt Icvcmgc
(cithcr dcbt to capital or debt to EBTCDA,
cafcuIatcd without any adjustrncnt IO
rcportcd figurcs) is thc only focal point of
such policy considcrations.
In all cascs, what corpomtc mmagccmcnt
says it will do must be vicwcd in thc contcxt of what ic actually does and what
rnakcs scnsc for rhar entity to do. For =ample, an organization’s lcvcragc 6021s should
bc judgcd rcfativc to its past rccord and
futurc busincss rcquircmcnts. A company
that is incrcasing its capiral spcnding
beyond what can bc mct from intcrnal cash
flow should not be forccaning dcclining
Icvcragc unlcss thcrc is a corrcsponding plan
to scll BSSCCS or common cquity. A skcptical
analyst would qucstion managcmcnt on
how cxactly it plans to achicvc both goals.
Thc answcrs, and thc company’s subsequcnt
pcrformancc, rcflcct on managcrncnt’s risk
tolcrancc and crcdibility,
The analyst must considcr thc rcalistic
choiccs availabIc to management and how it
rcsponds. Similarly, dcbt usage and sharchoIdcr r m r d s nccd to bc judgcd within rhc
contcxt of the company’s ash-gcncnting
capabilities and thc stability of thosc cash
flows. 1% vicw a dcbt-financcd dividcnd as
vcry risky for a weak company with volatilc
cash flows, but such a move could bc msonablc for a company that is gcncmting substantia! frcc cash flow and has zlrcndy
achicvcd a solid bilancc shcct.
Wc do not cncoumgc cornpanics to rnanagc thcmsclvcs with an cyc toward a spccific
nting. T h c rnorc appropriatc approach is to
opcmtc for thc good of thc busincss as managcmcnt sccs it, and let tbc rating follow.
Certainly, prudcncc and crcdir quality sliould
bc among thc most important eonsidcmtions,
but financial policy should bc consistcnt with
thc nccds of thc busincss, mthcr than an
arbitrary constraint. If managcincnt forgocs
attractivc busincss opportunitics mcrcIy to
36
avoid financial risk, the company may bc
making a poor stntcgic dccision, sacrificing
long-tcrm ercdit quality for mar-tcrm balance shcct considcmtions.
In any cvcnt, pursuit of thc highcst nting
aitainablc is not ncccsmrily in thc company’s
b a t intercsts. Wiilc ‘AAA’is our highat rating, \vc do not suggest that it is drc “tcst”
rating. TypiulIy, a company with virtually no
financial risk is not optima1 as far as mccting
thc nccds of its various constimcncics. An
underlcwmgd company is not minimizing its
cast of apital, thcrcby dcpriving its owncrs of
potcnrially grmtcr wluc for thrir invcstmcnt.
In this fight, P corpontc objcctivc of having
its dcbt ntcd ‘ A M ’ or ‘AA’ is ordinarily swpccr. Whatcvcr a company’s financiil track
rccord, an analyst must be skcptid if corpomtc goals arc implicitly imtional. A company’s uconscmativcfinancia1 philosophy” must
bc consistent with its ovcmIl goals and nccds.
A high crcdit rating usually i s morc inipor
tam for financial institutions than industrial
companics. For cornpanics with solid busincss
risk profilcs and dit financial mpacity to target rating within invcstmcnt gmdc, various
motivations can affcct financia1 policy. Two
cvamplcs arc thc balancing of financial risk
against cost of apital and rcliablc acccss to
commcrcia1 pipcr markcts. Thc formcr oftcn
lmds to a targct raring in thc rangc of ‘IZBB+’
ro ‘A’. T h c lattcr may suggcst sccking a ’BBB’
or ‘EBB+’rating, which typimlly eoincidcs
with an ‘12-2’ cornrncrcial papcr rating.
Customcr pcrccption mn k anothcr motivating factor. Somc dcfcnsc cornpanics say maintaining an investment-gndc rating is
important tvhcn sclliflg wmpons to govcrnmcnts outsidc thc US.
Tolcrance for risk cxfcnds bcyond Icvcrngc.
T h c mixture of f w d m t c and ffoatinp-ntc
dcbt (including usc of dcrivativcs to mnagc
that) offcrs an cxarnplc. Gcncnlly spmking,
long-tcrm asscw such as factories arc bcst
financcd using fixcd-nte dcbt, whilc shortmrm working capiml financing may bc
accornplishcd using floatingrate borrowing.
Managcmcnt shouId dcvclop an appropriatc
maturity schcdufc and liquidity targcts.
For companics with dcfincd-bencfit pcnsion plans, manngcmcnt makcs choiccs
rqnrdiq tlic mix of invcstmcnt ~ S S C ~ STIic
.
WHIWT RVH-2
Page 68 of 139
proportions of cquity, fixed-income, and
orhcr invcstmcnt asscts should bc dcvclopcd
with a vicw to thc rclativc volatility of diosc
invcstmcnt ;1sscw. We review such investmcnt
choiccs and comparc assumptions (c.g., discount mtc) with thosc of othcr cornpanics in
thc same industry. 0 t h porcntial sourccs of
carnings and cash flow voIatility arc exposure ro forcign cxchangc or commodity pricc
movemcnts. Usc of derivatives to mmagc
such cxposurc is revicrvcd as part of our
ovcnIl financia1 risk asscssmcnr, but thc
choiccs madc by managcment also reflcct on
its appctitc for risk.
Accounting And
Financial Reporting
A company's financial rcports arc thc starring
point for thc financial anaIysis of a ratcd cntity (or issuc). Such anaIysis must considcr thc
accounting basis ilcompany USE to preparc
its financial rcports and tlic impliations of
thc varying mcthodologics and assumptions
on thc rcponcd amounts.
Undcrstmding thc impliations of thc
accoundng basis uscd-c.g,, htctnanond
Financia1 Rcporting Standards (FRS),U.S.
G c n c d y tlcceptcd Accounting Principfcs (US.
GAAP),or otlicr local or st;ltutory GtWP
bas:ki-is highly gcrmanc 10 our corpomtc mting mcthodology. But r t n d y t i d chaltcngcs
&st cvcn for cornpanics using h e s m c
accounting basis, bcc?usc accounting rula
oftcn providc optional trmtmcnc for ccmin
itcms (e.&, LIFO mthcr than FIFO to account
for invcntory undcr U.S. GAAP, optional hcdgc
accounting, or optima1 rcmluauon of ccndn
CIS or liabilities mdcr IFRS]. Momvcr, as
busincss rmsactions haw k o m c incrmsingly
cornpIcx, related accounting rulrs and conccprs
haw compondingly grown morc comp1mand in many cases, subjcct to grcatcr rcliancc
on cstimtes and judpcnts.
Accounting failurcs in thc carly 2000s
highlighted several fundamcntaI shortcomings of thc financial rcporting proccss and its
ability to comprchcnsiwly addrcss thc information nccds of financial statcincnt uscrs.
Shortcomings indudc both recognition and
rncnsitrcmcnt issucs (c.g., undcr what circumstmccs an itcm such IS a spccial-parposc
Standard & Pour's
entity, or a 'synthctic lcasc" shoufd bc
rcflcctcd on or off P company's bilancc
S~IECI, and at what Y ~ U C ) , and transparcncy
issucs (c.s., what a company shouId disclosc
about thc nature of off-balancc shcct commitments, compcnsrtion arrmgcments, or
rcIatcd-party transactions).
Thcsc hilurcs also rcinvigoratcd the
dcbatc on thc mcrits of using a principlcsbased, rathcr than a ruIcs-based, accounting standards framework, and scrvcd 3 s a
catdyst for cxpcditing convcrgcncc of
global accounting standards. RcIativcly
rapid mtcs of accounting m1es changcs
havc occurrcd-oftcn hampcting meaningful period-ovcr-pcriod comparisons. In
addition, thc broader conccrns about darity and accuracy of financial reports haw
bccn cvidcnccd by a considcraltlc incrcasc
in rcstatcmcnts.
To addrcss thcsc challcngcs, wc havc
incrcascd and systcmatizcd rhc cmphasis wc
pIacc on thc undcrstanding of issucrs'
accounting chamcrcristics. \Vc supplcmcnt
our analysis with cnhanccd financial s t a t e
mcnt anaIysis both in tcrms of qualitativc
and qumtitativc considcrations. Our ratings critcria incIuJc numcrous quantitativc
adjustmcnts \vc ofrcn makc to rcportcd
financial rcsuhs to incrcasc consistcncy
among pccrs, and to bcttcr align with our
vicw of thc undcrlying cconomic rcdity of
a particular circurnstancc or transaction.
Our nndysts also cmpIoy adjustmcnrs to
portray what w c vicw as 3 rnorc appropriarc dcpietion of rccurring activity. For
examplc, wc may adjust financial mcasurcs
to cxcludc gains or Iosscs that wc vicw as
unsustainatlc or nonrccurring.
As part of our ongoing survcilhce
proccss, \vc considcr thc impact of chanps
in accounting standards and thc impact of
spccial evcnts or itcms rcportcd by an
issucr (c.s., acquisitions, dispositions,
writc-offs, intcrnal control mattcrs, rcstatcmcnrs, and rcgulatory actions). As thc
amount of discIosurc in financial s t m mcnts varics by company and by jurisdiction, w c CngagC in diffcring lcvcls of
intcmction with our issiicrs to ohtail1 additional data bcyond what is rcportcd in thc
company's financials.
Corporate RatIngs Criteda 2008
37
EXHIBIT RVH-2
Page 69 of 139
Annlytical Methodology
Evatuating accounting characteristics
in the rating process
Our nnaIysis of an issucr's financial smtcmcnts bcgins with a rcvicw of tlic accounting
chamctcristics. to dcterminc whcthcr thc
ratios and statistics dcrivcd from the statcmcnw a n bc uscd appropriatcIy to m m u r c
thc nrcd issucr's pcrformancc and position
rclativc to both its pccr group and thc largcr
c rating
univcrsc of corporatc issucrs. m
proccss is, in pan, onc oE comparisons, so it
is important to h a w a common framc of rcfcrcncc.] In doing so, w c takc an analytic
m h c r than forcnsic approach.
Thc rcccnt adoption of, or moves KO
adopt, IFRS in many countries-including
Australia, Canada, and across thc EU-as
~ v c l as
l the ongoing cffort to convcrgc U.S.
GAAP and IFRS,continues to lurthcr
cnhancc comparability among companics.
Howcvcr, this ought not bc sccn as a
panacea. Within IFRS, U.S. GARP, and the
scparmc national accounting systcms, companics may clioosc among dtcrnativc
accounting mcthods-for cmmplc, historic d or amortized cost, as opposcd to fairvaluc methods-and
thc rcsulring
diffcrcnccs can hwc a significant cffcct on
comparability among pcca. In addition,
cvcn in appIying thc samc mcthads within
thc same accounting frameworks, companits show varying dcgrccs of aggrcssivcncss
in thc undcrlying estimatcs and judgmcnts
thcy employ. Morcovcr, the carrying valuc
of asscis and liabilitics can bc grcatly influcnccd by rhc tiistorid dcvclopmcnt of a
company-for cxampfc, whcthcr i t has
grown primarily through intcrnal dcvclopmcnt or through acquisitions, or whcthcr it
prcviously undcrwcnt a lcvcragcd buyout or
bankruptcy rcorganization.
A company's scope of consolidation is an
cxamplc of a kcy accounting charactcristic
that w c considcr to dctcrminc rhc rclcvant
cconornic cntity for anaIytica1 purposcs. Wc
look at whcthcr thcrc arc non-consolidatcd
atfiliatcs, incIuding joint vcnturcs, whcrc
thc company docs nor cxcrt a high dgrcc
of control but which \vc fccl should bc consolid:ircd for analytical purposcs (given our
;isscssmcnt of tlicir stmtcgic iiiiportancc,
including oivncrship positions. thc sizc of
38
wwrv.corporatecriteria.standardandpoors.com
thc invcstrncnts and whcthcr a uniquc,
intcrdcpcndcnt customerlsupplicr rclationship cxists) C Y C ~though t h y may bc pmpcrly cxcludcd from consolidation for
accounting purposcs. Considcr Thc CocaCola Co. and PcpsiCo Inc., mhcrc ccrtain
key unconsolidatcd botding cornpanics arc
vicwcd as part of an cntirc cconornic sysrcm: Wc accordingly consolidatc t h a t cntitics for analytical purposcs. The convcrsc
may be true whcn w c dcconsolidatc an cntity that is ptapcrly consolidatcd for
accounting purposcs. Thcrc arc many
cxamplcs of industrial companics or divcrsificd hoIding cornpanics that consolidatc
financial or insurancc subsidiarics; for amIyticai purposcs, IVC usc thc cquity mcthod
for such nonhomogcnous business activitics, to avoid thc distortions that would
pcrtain as rcpartcd.
With rcspcct to a company's licdging and
risk managcmcnt policics and rclatcd
accounting for dcrivativc instcumcnts,
accounting results vary widcIy among companics, and comrnonIy fair to aduquatcly
dcpict rhc undcdying cconomics. Our
fmmcwork for analyzing dcrivativc USC
focuscs on the business, financid, liquidity,
controlslrisk managcment, and financia1
statcmcnt risks. This analysis includcs a
Jcttrmination of whcthcr a company is
using dcrivativcs for trading andlor risk
managcmcnt purpom, and whethcr a cornpany avails itsclf of spccial hcdgc-accouncing trcatmcnt. As this arca is both complty
and fraught with inadcquatc disclosurc by
many issucrs, our rcvicw oftcn cntails intcraction with rnanagcmcnt to propcrly asscss
a company's dcrivativc USE and risk rnanagecmcnt pracriccs.
Thc accoundng charactcristics wc rcvicw
and the crnphasis plnccd on cach dcpcnd on
thc nature of, and activity in, thc industry
in which thc cntity opcratcs. For w ~ m p l c ,
analyzing invcntory and rclatcd considciation may be important for it manufacturing
company, but lcss rclcvnnt for a hotcl managcmcnt company: Likcwisc, thc analysis
of oil or natural rcsmrcts rcscrvcs or
thc wc of pcrcciitagc of complcrion
accounting is rclcvant to only a handful
of industrics.
EXHIBIT RW-2
Page7001139
Analytical adjustments to
financial statements
Making anoIytimI adjustmcnts to amounts
rcportcd in thc financial: statemcnts of thc
companics wc m c traditionally has bccn a n
integra1 part of our rating proccss. Wc make
analyticai adjustments to bcttcr portray cconomic rcality and ro IcvcI the reporting difto arrive a t
fcrenccs among companics, q.,
mmurcs we beIicvc cnablc morc mcmingful
peer and pcriod-ow-period comparisons;
bcttcr rcflcct undcdying economics; bcttcr
rcflcct creditors' risk, rights, and bcncfits;
and bcilitatc morc robust financial forccasts. It is rarcly possible to complctcly
r c w t a company's financial statcrncnts, but
making thcsc sndytiml adjustmcnts
irnprovcs thc analytical rcl cvancc and consistcncy of thc financial ratios that ivc usc in
our crcdit analysis.
(Although our adjustmcnts revisc ccrtain
amounts rcportcd by issuers undcr applicable
ncccptcd accounting principlcs, that does nor
imply that wc &allcngc thc application of
mid principtcs by the issucr, thc adcquacy of
its audit or financial rcporring proccss, or thc
appropriatencss of thc accounting basis uscd
to fairly dcpict thc issucr's financial position
and rcsults for otlur purposcs. RatIicr, our
mctliodoIogy rcfJccts a fundamcntal diffcrcncc bctwccn accounting and analysis. Thc
accountant ncccssarity must find onc numbcr
to usc in prcscnting financial data. T h c analyst, by definition, picks apart thc numbcrs.
Good andysis looks at mulriplc pcapcctivcs,
tlicn uses adjustmcnts as an analytical tool to
dcpict a situation diffcrcntly for a spccific
purposc or to p i n anothcr vantage point,)
Examplcs of common adjustmcnts indudc:
= Tradc rcceivabh sold or smritizcd;
* Hybrid srmritics;
SurpIus ash and "ncar cash" invcsrrncnts;
Gpidizcd intcrcst;
Sharcbbascd cornpcnsation cxpcnscs;
Captive financc activity; and
3 Assct rctircmcnt obligations.
(See "Ratios Atid Adjitstirrc~ts"&pier
for B f d l list and rliscussioiz.)
Changes in accounting standards
As part of our survciIIancc proccss, wvc ironitor thc potcntial i m p x t of rcccnt atid pending
Starrdard & Poor's
changcs in accounting and disclosure standards, and othcr Icgislation sffccting information includcd in financial rcports.
Accounting changcs should not haw any
dirCct impact on crcdit quaIity unlcss thcy
rcvcaI new information about a company,
which thcn nccds to bc bctorcd into our
understanding of the company. (For~xamplc,
the ntings for a fcrv U.S. cornpanics wcrc
Iowcrcd following the irnplcmcntation of
ncw accounting for rctircc mcdical liabilitics
in the cady 199Os, bcuusc IittIc information
\vas prcviously available about thcsc obligations.) Howcvcr, accounting changcs w n
producc indircct cffccts. Thcsc include triggcring of financia1 covcnmt violations; rcgulatory or rax conscqucnccs; or advcrsc
markct reactions as a r d t of chnngcs in
markct sentirncnt about thc company's
ipparcnt lcvcmgc, profitability, or c i ~ p i t d i ~ ~ tion; and, accordingly, a n cvcn influcncc
changcs in businm bdiavior.
Considcr thc cxampIc of U.S. accounting
standard SFAS No. 158,which rcquim fulI
rccogaition of pcnsions and othcr postrcdmmcnt obligations [c.g., rctircc hmIthmrc) on
thc sponsoring cmpIoycrs' balnncc shcct.
Bccausc wc liavc Iang rcflecrcd an issucr's full
postrctiremcnt liability by virtue of our
adjustmcnts to Icvcngc and cllpi~limtion
ratios, thc adoption of this pronounccmcnt
has no direct mings implications. Howcvcr,
the potcntid ancillary clfccts could bc cqually
important to our considcntion: h B rcsuIt of
thc ncw standard, many companics will
rcport substantially lowcr sharcholdcrs' cquity and will appcar morc Icvcragcd-and
codd affcct dividrnd policics. In addition,
many cmpIoycrs arc changing thc strumrc
and funding lcvcls of thcir postrctircmcnt
plans as a conscqucncc of changcs in Icgislation and aCCOUntin6 standards, resulting in
potcntial changcs to amounts and timing of
rclatcd cash florvs.
Anothcr cvamplc of chmgcs in accounting
standards that m u s d pronounwd bchavionl
shifts: SFAS No. 123R,rcquiring thc cxpcnsing of stock-options and othcr sharobascd
paymcnts. In aiiticipiltion of that changc,
many cornpatics diosc to accclentc thc wsting of cmpIqrc stock options in the ymr prior
to adoption. Tlic cffcct of such accclcmtion
Corporate RatIngs Criteria 2008
39
EXHtBlT RVH-2
Pago 71 of 139
Annlytiml Mcttdology
was to mow compcnsation cxpfnsc that
would hwc becn rccognizcd in 2006 and
futurc ycilrs to a prc-adoption p r . (Such
rccognition w a s not rcquircd; only pro forma
fwmotc disclosum of thc cxpcnsc \vas
rcquircd undcr prt-SFAS No. 123R rulcs.) In
addition, many cornpanics havc rcconsidcrcd
thcir usc of sharcbascd pay as a rcsult of thc
cspcnsing rcquircmcnt, and haw madc
changcs to thcir cmpIoycc compcnsation
plans-rcsulting, for somc, in rcd changcs IO
m h flows.
Information risk, restatements, and
disdosure of significant events
To thc cxtcnt wc bclicvc information risk
mists, it a n influcnce our dccisiori to main-
tain il rating, assign a rating in thc first placc,
or thc Icvcl of thc rating assigncd. In m5cs
whcrc tIic information risk is so significant
that it prccludcs mmningful analysis w e
would dcclinc to assign a rating, or, whcrc a
rating is aIrcady migncd, withdraw or suspcnd that mting.
Howcvcr, wc ordinarily rcly on thc issucr's
auditcd financia1 sntcmcnrs and thc inhcrcnt
chccks and bilanccs in the financia1 rcponing
proccss. Our analytid proccss docs not
includc an audit, nor docs it incfudc a proccss
of Uvcrification.n
A rating can somcrirncs bc assigncd cvcn in
thc abscncc of audircd financial smtemcnts.
This cspccially is the casc whcn a ncw company is fomcd from a division of nnothcr
company that did produce auditcd financial
stattmcnts. In other u s e s , thcrc may be
unzuditcd dan-uch as oil-production
data-that corroboratcs company rcsuIts.
Further, much additional information that
is providcd to us by managemcnt is unauditcd, including prclirninary financial dam,
quartcrly financial statcmcnts, pmjcetions,
opcmilting data, pro-forma financia1 s t m mcnts, cash flow dam, and various scenario
analysts, to n m c il fcrv. Wc incorpontc such
d m at out discrction, making judgmcnn
about thc rcIiability of mch input.
Thcrc have k c n many situations-cspccially
rcccntly-whcrc mtcd cornpanics h a w dclayd
filing tlicir financial reports lor various rmsoils, somctimcs for sipiiliunt pcriods of timc.
Such tcporting dclnys, too, rcquim jadgmcnt
40
www.corporatecriterin.stnndardandpoors.com
rcgarding thc impIications, if any, for crcdit
quality. IVc havc no monolithic approach to
such situations, rather, additional intcnaion
with the company ir rcquircd, as part of our
survcillancc proccss during thc pcriod in which
formally issucd and auditcd financial statcmcnts arc lacking, Our intcmction indudcs
detcmining thc muse for thc dclay and potcntial conscqucncm,obtaining intcrim financial
reports, discussing how the company is
addressing cnsuing qulatory or covcnant
rnattcrs, discussing liquidity prospects, and
inrcrnaI controI rnatfcrs, among othcrs.
Fling dcIays happcn for many rcasons: In
some c a w , b m u s c of a rcsmtcrncnt of priorycar financials; in othcrs, from il rcvicw of an
d c g c d financial-sratcrncnt irrcgdnrity, or
issues discovcrcd with a company's intcrnal
controls proccss.
In any went, wc arc cognizant that
lengthy rcporting dclays can rcsult in
advcrsc rcgdatory rcaetions and covcnmt
compliancc unecrrainry. Dclays, rcstttcmcnts, matcrial I V C ~ ~ ~ ~ C S Sand
C S , rclatcd
invcstigations also can lcad to othcr advcrsc
rcsuIts, sucli as auditor changcs, pcrsonnd
chngcs, l~wsuits,managcmcnt distraction,
incrcascd compliancc costs, and chalIengcs
in acccssing thc capital market-thc impact
of which must bc closcly cvaIuatcd in our
ratings proccss. T h c i m p m thcsc cvcnts
havc on a nting dcpcnds on tlic uniquc facts
and circumsmnccs of cach MSC.
With rcspccr to violation of covenants, a
liquidity crisis could rcsult. Tcchniul and
actual dcfnlts (including cross dcfauIts)
rcquirc waivcts undcr dcbt agrccmcnts, and
somcdmcs rrsult in a company rccciving a
notice of dcfaulr. Somctimcs thc qucstion of
whcthcr or not a filing dclay rcsuIts in a
dehuIt is not immcdiatcly clcar wvhcn thc
dclay is announccd, or during thc pcriod of
dclay. In somc mscs, dcrailcd information
may not bc avaihblc for some time, and \vc
will r c x t as wc dccm approprintc, bascd on
our andysis o€thc bcst nvaihtlc inlormqtioii,
~hroughCrcditWatch actions and intcrmcdiP ~ C
mting changcs, or-in cxtrcmc castswithdmrvnl of thc rating.
In gcncral, thc inipnct of thc itatanccs
involving financial-statcmcnt irrcgularitics is
hard to prcdict. Thc undcrlyiiag rcdity a n
EXHIBIT RW-2
Pago 72 of 139
mngc from an almost trivial problcm to a
campfctc audit and financial failure.
Omsionally, 3 smaIl problcm c3n turn into 3
lzgc one, as hcadlinc risk taka 3 to11 on thc
company’s ~ C C C S Sto financing. We criticdy
wigh how pcrvasivc thcse issucs arc, how
thcy affcct thc cntcrprisc’s rcpntation and its
ability to conduct futurc busincss, and broadIy how pmactivcly managcmcntand thc
board approach rcsoIution to thcsc matrcrs.
Cash Flow Adequacy
Cash flow anaIysis ~OCLISLSon undcrsmnding
and forcasting how cash is gcncratcd and
spcnt by P busincss. It incorpomtcs idcntifying a company’s cash flows, dctcrmining
trcnds and sustainability, distinguishing opcrating from investing and financing flows,and
undcrsnnding potcntial SOUKCS of distonion
and futurc volatiIity.
All this must bc considcrcd in thc contcxt
of a company’s individualchancrcristics,
such as, whcrc it is in its lifc cyde. T h c tbiIiry
to gcncmtc ash is dctcrmincd by a firm’s
busincss prospects-ornpctitivcncss, markct
dynamics, cconomic cnvironmcnt, ttc., whiIc
its nccd for msh is a consequcncc of tlic bdancc-shcct stmcturc, managcmcnt’s financial
stratcgy, and strarcgic nccds.
An cntcrprisc’s capacity to pzy dcbts or
any othcr obligation, thc cow undcrlying
conccpr of 3 crcdit nting, is dctcrmincd by
thc ability to gcnemtc cash-not mrnings,
which is an accounting conccpt. Although
therc is gcncralIy il strong corrclation
bcnvccn operating cash flow and profitability in thc long run, many transactions and
accounting cntrics may affccr one and not
thc othcr during it sprcifjc pcdod.
Aggressive accounting poIicics, for cxarnplc,
rcgirding rcwnuc and cxpcnsc rccognition,
assct writc-downs, or adjustrncnts to dcprcciation schcdulcs, can liavc a matcrial
impact on carnings and nonc whatsocvcr on
actual cash gcncmtion.
Liquidity prcssurcs mn arise cvcn whcn 3
company rcpom robust mrnings-q., whcn
gins not rmlimblc in msh for a lcngthy pcriod comprisc P significant componcnt of camings or wvhcrc tlic cntcrprisc f x a I q c capital
cxpcnditurc rcquimmcnu. Accordingly, cash
Stmdard & Poor’s
=
ffow adcquacy i s t y p i d y thc singlc most criti
d aspcct of crcdit rating analysis.
Measuring cash flow
Discussions of cash flow oftcn suffer from
lack of 3 uniform definition of tcrms. Our
analysts use nurncrous a s h flow mcasuccs in
thc crcdit dccision pmcas, and rhc tcrms wc
WC to definc spccific a s h flow conccprs arc
summarizcd hcrc.
We begin to mmsurc an issucr’s opcmting
msh flow gcncratim using its funds from
opcntions {EO),which is dcfincd as nct
income from continuing opcrations adiustcd
for dcprcciation, amorrimtion, and orlicr
nonush and nonrccurring itcms such as
dcfcrrcd tax=, wvritc-offs, p i n s and Iosscs on
asset stlrs, for+
cxchangc pins and Iosscs
on financial instrumcnts, and undistributed
cquiry carnings or Iosscs from joint vcnturcs.
Thc av.vnilabitityof a s h for dcbt scrvicc for
cornpanics on a high growth spurt is ordinarily
bcttcr apprcciatcd afrcr bsd;ing out rlic
changcs in working capital, and arriving at thc
opcnting msh flow (00).
TIic usc of thc
FFO metric for some rqdatcd utilities, for
insnncc, can bc mislading as it d m not capturc tlic variation in rcplatoty ~ S S C ~orS liabilities. In Bnzit, for csamplc, miffs arc rcvisctl
ody annually: thc timc p p bchvccn whcn thc
actual cash rcvcnucs or costs occur and thc
rccognition in thc income smcmcnt is subsnnrial and might a f k t diffcrcnt h a 1 p r s .
SimilarIy for working mpital-intcnsivc indusvics such 3s rctailing, OCF may bc a bcttcr
indicator of rhc firm’s a m a l a s h gcncmtion.
Working capinI, on thc othcr hand, could k
rnmgcd or manipulatcd by managcrncnt
dcpcnding on its liquidity or aaonnting nccds.
Accordingly, €TOhas bccn frcqucntly uscd 3s a
comparativc indiutor of cash from opcmtions.
As OCF tcnds to bc morc volatilc, FFO is oftcn
uscd to smooth pcriod-avcr-pcriod variation in
working eapiral. It is uscd as 3 bcttcr proxy of
recurring u s h flow gcncnrion mthcr than the
actual msh flow gcncntcd by thc ability to
rnanagc working CilpjmI.
By dcducting capital cxpcnditurcs from
OCF wc arrivc at frcc opcmting a s h flow
(FOCF), which can bc uscd as a proxy of il
company’s cash gcncratcd from corc OPCMtions. W c sonietimcs cxcIudc discrctionnry
Corporate Aatlngs Cdteda 2008
41
EXHIBITRVH-2
Page 73 of 139
Analyticat MathodotoDy
capital cxpcnditurcs far capacity growth
from thc FOCI:calculation, but in pmcticc,
it is oftcn difficult to discriminate bcnvccn
cxpansion and replaccmcnt. And, whilc
cornpanics do havc somc flcxibility to manage thcir capital budgct to weather down
cyclcs, such flcxibility is gcncrally tcmporary and unsustainabIa in light of intrinsic
requircmcnts of thc business. For c.mmplc,
cornpanics can bc compcllcd to increase
thcir invcstmcnt programs bccausc of strong
dcmand growth or tcchnological cbangcs.
Rcgulatcd entitics (c.g., tclccommunication
companics) might also hcc significant
investment rcquircmcnts rcfntcd to their
eonccssion contracts.
WCcalculate a company’s discrctionary
cash flow by subtracting cnsh dividcnds
(incIuding to minority inrcrcsB) from FOCE
Thc diserction in dividcnd payout wilI
dcpcnd on a company’s financial stratgy.
Cornpanics with aggrcssivc dividcnd payout
t q c t s might bc rcluctant to rcducc rhc lcvcl
of dividcnds cven undcr somc liquidity prcssure. In addition, dividcnds of invcstmcntgmdc companics arc Icss likcly to bc rcduccd
following somc rcvcrsal-Ithough
thcy
ultimatcly arc discrctionary
Finally, cash uscd for acquisitions andor
rcccivcd from assct disposals and othcr miscellancous sourm and uscs of cash arc subtmctcd or addcd to discrctionary cash flow,
and picfinancing cash flow is tlic cnd rcsuIt.
This mctric rcprrscnts tlic cxtcni to which a
company’s u s h flow from all nonfmancing
sourccs has bcen sullicicnt to cover aIl intcrnal nccds, including thc paymcnt of dividends. 1% dvn reconcilc prcfinancing cash
flow to various mtcgorics of cxtcrnal financing activity, such as borrowing or rcpaynicnt,
cquity iauancc, and to changcs in thc company’s a s h balanccs.
Whilc EBITDA i s a widely uscd indicntor
of cash flow, it has significant limitations.
Bcmusc EBlTDA dcrivcs only from incomc
smtcmcnt inputs, it can bc distartcd by thc
~ a m caccounting issucs that limit the usc of
earnings as 3 basis of cash flow. Dcsidcs,
EBlTDA ovcrlooks bafancc shccr items that
might bc tying or frccing up a s h . It is bcttcr
suited for niorc cstablislicd companics, cspcciilIy in rclation to industry benchmarks.
42
w . e o r p o n tccritcria,standardandpoors.com
Potential distortions affecting cash flows
Distortions to cash flow may arisc from
timcfincss of incomc or cxpcnsc rccognition,
classiftation of itcms, and othcr accounting
issucs. For cximplc, tIic pcriod in which
cornpanics dmosc to rccognizc incomc and
cxpcnscs (such as thc chargc-off of uncollcctiblc itcms, asscr disposals, repairs and
maintcnancc, ctc.) dcpcnds on s p p h b l c
GAAP,which may bc subicct to cstimatcs
and msnagcmcnt’s discrction.
Beausc cash flow is an indimor of a
company’s hmlth and prospccts, thcrc is a
bias to cnhancc appnrcnt a s h gencntion by
trcating ash inflows as operating in nature,
and cash outflows 3s invcsting or financing
in nature. But loosc classification of flows
into opcrating, investing, or finaricing Gin
distort thcir t u c n m r c . Classification of
invcstmcnts as trading, a~ilallc-for-sale,or
hdd-tomaturity dictatcs if rclatcd cashflows are trcatcd as opcmting or invcsting.
Opcrating margin hcdging progrnm r e d s
arc t m t c d as financing-whilc thcy rcflcct
opcntional stmtcgics.
Anothcr sourcc of distortion is translation of
forcipamncy. Swings in working apiml
may o d y rcflm the volatility of thc forcign currcney, and not thc actual a s h in thc origind
currcncy. We would prcfcr to a m l p working
a p i t d in thc original currcncy-md rcflcct
mnrlation cffccts in a scpamtc ash-flow c n q .
Cash flow ratios
AnaIym arc cncoungcd to Iook a t mom than a
single mmsure, to dcvclop sevcnI pcrspmivcs.
A company’s individual chamctcrisrics and its
busincss qclc wilI lx h t t c r apmrcd in ccmin
ratios than in others.
Whcrc long-tcrm viability of n company is
mom ccrtain (i.c., for more highly mtcd c d its), thcrc a n bc gmtcr analytical rctiance on
FFO and its rcIation to ton1 dctt burdcn. In
addition, mom mddishcd, hmlthicr cornpanics
usually liavc a wividcr a m y of financing possibititics to covcr potcntial short-tcrm liquidity
nccds and to rcfinancc upcoming maturities.
For mom marginal sifdons, thc focus shifts to
frcc a s h florvllltcr thc various uscs Imc bccn
subtnctcd-nd
this is mom dirccdy rclatcd to
c u m t dctt scrvice. Sonic of thc ash-flow
rnctrics most uscd by nttr amlysts inclttdc:
EXHlBK RVH-2
Page 74 of 139
Debt payback ratios
Funds from operations (FFOlltotal dcbt:
thc most frcqucntIy uscd crdit rncasurc in
industrial mtings;
a Opcrating cash flow (OCP)/tord dcbr: captures working capital rcquircmcnts;
DcbtEBmA: uscd as a proiy of dcbt
rcpaymcnt capacity for high-yicld issucrs; it
can ovcrstatc rcpaymcnt capacity by
excluding interat burdcn-usurtIIy high lor
spcculativc rating;
= Total dcbtldiscrctioniry u s h flow: providcs an indication of how many ywrs
would bc rcquircd to repay outstanding
dctt using currcni cash flows, but is sub
jcct to changcs in dividcnd policy;
= Frcc operating cash flow (FOCF)/ronl
dcbt: indiatcs 3 company’s capacity to
pay dcbr with intcrnal opcrating cash flow;
it is morc critical whcn analyzing wcakcr
cornpanics, bcmusc spcculadvcgmdc
issuers typically facc nmr-tcrrn wlncnbilitics that arc bcttcr mmsurcd by frcc cas11
flow ratios.
Debt service ratios
Inrcrprctition of ratios is not straightforward, and carcful andysis always is
rcquircd, because a similar ratio might lcnd
to differcnt conclusions, depcnding on company spccifics. A company scrving a lowgrowth or dcclining markct may exhibit
rclativcly strong frcc cash flow bccausc of
diminishing fixcd and working capital
nccds. Growth cornpanics, in contrastl
exhibit thin or cvcn negative frcc cash flow
because of thc investmcnt nccdcd to support
growth. For the lowgrowth company, crcdit
analysis weighs tlic positive, strong currcnt
cash flow against the dangcr that this high
lcvcl of protcction might not be sustainatlc.
For the high-growth company, thc opposite
is truc: Wcighing thc ncptivcs of a currcnt
cash deficit against prospects of cnlianccd
protcction oncc currcnr invcstmcnts bcgin
yiclding cash bcnclits.
Thcrc is no simplc cormlation bcnvccn crditworthincss and currcnt lcvrls of msh flow.
Evcn for pcct cornpanics with vcry similar
cash flow covcragc ratios,thc rating outcomc
can Lc vcry diffcrcnt, dcpcnding on thcir othct
busincss and financia1 chanacristics.
EBITDiVintcrcst cxpcnscs: uscfuufb m u s c
of its sirnpliciry, wide usngc, and industry
rcfcrcncc (pcer comparisonsl financial
covcnants, cte.);
FOCF + intcrcst cxpcnsdintcrcst cxpcnscs:
similar to thc EElTDAlintcmt ratio, but
morc comprchcnsivc (aftcr taws, working
apiral and capital cxpcndimrc) and with
lowcr porcntial for distortions;
FOCF + intcrcst cxpcnsdnrcrcst expcnscs
+ 12-month debt maturitics: mcasurcs the
ability to pay intcmt and principal out of
frcc cash flow; mom appropriate for projccts and cnritics with amortizing dcbts.
Financial flexibility ratios
FFOfmpital cxpcnditurcs: indimtcs 3 company’s internal flexibility to m e t its capital
budgct;
CapiraI cxpcnditurcldcprcciation expense:
a low ratio (typically, Icss than 100%)
could indimc problcrns in tlic ratc of
rcplaccmcnt of plant and cquipmcnt-a
strong ntio may indicatc high-growth
industrics, and is nccdcd to kccp up with
thc cornpctition.
Stuitdurd R Poor’s
Balance Sheet And
Asset Protection
Ttic main ratio we usc for lcvcrage analysis is
t m I debdtoml dctt + equity.
What is considcrcd %bt” and “cquity”
for thc purposc of ratio cdculation is not
always so simple, and rcquircs cxrcnsivc
analytical inpur. Our computation of tom1
dcbt includes various off-baIancc shcct Iiabilitics and andytiml adjustrncnts, as notcd
in the scction on cash flow analysis.
SimiIarly, the amount of cquity is adjustcd
for hybrid sccuritics in all thcir variations.
(See Hybrid irtstruirrcrrts section of
“Ratios Arid Adjrrsfrrrcrifs” c h p l c r /or our
ndjusttiimts atid
bow rue cuafcithtc d m t t . )
Wc somctimcs cafculatc supplcmcntal
ratios that incorpomtc thc markct valuc
equity. Thcsc can h a w cspccial rclcvmcc in
comparing cornpanics with significant intangible asscts. Traditional mmsurcs focusing
on long-term dclrt hive lost much of thcir
significancc, bccausc cornpanics rcly incrcasiiigly on short-tcrm borrowings. It in now
Corporate Ratlngs Criteria 2008
43
UHIBIT R W - 2
Page 75 of 139
AnnIyticaI Methodology
cornmonplacc to find pcrmancnt laycrs of
short-tcrm debt, which financc not only scasonal working capital but also m ongoing
thc debt may bc so largc in rclation to tlic
orvncr’s invcsnncnt that thc inccntivcs to sup-
the assct base.
Gmcnlly, w c do not nct out cash from thc
dcbt nmounr; however, wc adopt a ‘net
dcbt” approach in somc situations, EspcciaIIy
in countrics (such as Japan and in Europe)
whcrc local pmm-1‘~~
is to maintain a largc
portfolio of nsh and markctablc smritics.
(In thcsc situations, wvc aIso focw on cash
flow to ncr Jcbt.) B c h situation is analpcd
on 3 asc-by-casc basis, subjcct to additional
information regarding a company’s liquidity
position, normal working cash nccds, naturc
of short-tcrm borrowings, and fundinl: philosophy. Funds mmarkcd for futurc use,
such 3s an acquisirion or a capital projcct, arc
not ncttcd out. This approach afso is uscd in
thc CISC of ash-rich U.S. phamaceutid
cornpanics that cnjoy t m mbitrapc opportunities with rapm to thcsc cash holdings.
In the m c of hybrid sccuTitics, roo, thc
analysis is bascd on thcir spcu’fic futurcs-floc
thc accounting or the nomcnclaturc. For debt
that is convcnibb at the discrction of thc
invcstor, dcpcnding on thc funrrc value of thc
common sham, it would bc somcwhat prcsumptuous for us to prcdict wvhctlicr and whcn
conwrrsion will occur, so IYC ordinady givc little, if any, wcighht to thc convcrsbn potential,
Original-issue discount dcbt, such as xcro
coupon debt, k indudcd at t t u accrctcd
valuc. Horvcrcr, sincc t h e is no sinking fund
provision, thc dcbt incmscs with timc, mating
a moving ngcr. (Thcnccd, cvcntually, to
rcfinancc this growing amount reprcscnts
anothcr risk.)
Nonrccouac dcbt is oftcn included in thc
ulcdztion; morcovcr, cvcn nanrccoursc dcbt
of a joint vcnturc may be attributcd to thc
parcnt companies, cspccidly if thcy havc il
stmtcgic tie to thc opcntion. Thc analysis
may burden onc parent with a disproportionPIC amount of thc dcbt if that parcnt has thc
grcatcr stmrcgic intcrcst or operating control
or its ability to scrvicc rhc joint-vcnturc debt
is greatcr. Othcr considcmtions that affcct a
company’s willingness to walk arvay from
such drbt-and othcr nonrccoursc debtinchdc s h a d banking rcIationships and
common country lmtion. In some instmccs,
mss, howcvcr, the company Iikcly would
invmt additional nmounw bcforc dcciding IO
abandon thc vcnturc. Accordingly, adjust-
portion of
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port the dcbt arc minimizcd. In virtuaIly at1
ments would be made to rcflcct thc orvncr’s
currcnt and projcctcd invcstmcnt, cvcn if thc
dcbt were not a d d 4 to thc (parcnt) company’s bdancc shcct.
Morc fundamcnnlty, thc nnturc and valuation of a company’s s s c t mix is c r i t i d to
dctcrminiq the appropriatc Icvcmgc for a
givcn IcvcI of risk. Assca with stablc cash
flow or markct vducs justify greatcr usc of
dcbt financing than thasc with cIoudcd marketability. For emmplc, grain or tobacco
invcntory arc vicwcd positivcly, comparcd
with npparcl or clcrtronicsinvcntory; transportation cquipmcnt is vicrvcd morc favorably than othcr cquipmcnr, givcn its
suitability for usc by othcr cornpanics.
Accordingly, IVC bclicvc it is critical to anafyzc mch vpc of busincss and asset class in
its own right. Whifc M S B and US now
rcquirc consolidation of nonhomogcnous
busincss units, ivc analgc c a d scpantcly.
This is the basis for our mcthodology for
analyu’ng aptivc financc cornpanics.
Asset valuation
Knowing appropriatc v3lucs to assign a
company’s asscts is kcy to our analysis.
kvcmgc as rcportcd in thc financial statcmcnts is mmnindcss if thc asscts’ book valucs
arc rnitcriaIIy undcrvalucd or orwvalucd rclarive to cconomic value.
W c considcr thc profitability of an m c t as
an appropriatc basis for dcrcrmining its cconomic mluc. Markct vakcs of n company’s
~ S S C I Sor indcpcndcnt nssct appraisals cnn
offer additional insighhts. Horvcvcr, thcrc arc
shortcomings in thcsc mtthods of valuation-just as thcrc arc with historicai cost
accounting-that prcvcnr rcliancc on any
single mcasurc. [Similarly, using thc markct
vduc of a company’s cquity in calculations
of fcvcragc has its drawbacks. Thc stock
markct cmphasizcs growth prospccts and
has a short time horizon; it is influcnccd by
changcs in altcrnatirrc invcstmcnt oppormnitics and can bc vcry volatilc. A company’s
MHlWT RVH-2
Page 76 of 139
ability to scrvicc its dcbt is not affcctcd
directly by such hetors.]
Thc a n a l y t i d challenge of which valucs
to usc is espccially cvidcnt in thc msc of
mcrgcd and acquircd companics.
Accounting standards allow thc acquircd
company's assets and cquity t o be writtcn
up to rcflcct tttc acquisition prjcc, but rhc
rcvnlucd nsscts havc thc samc carning
porvcr as bcforc; thcy cannot support rnorc
dcbt just bceausc il diffcrcnt numbcr is uscd
to rccord thcir valuc. Riglit aftcr the transaction, thc andysis can takc thcsc factors
into account, but down thc road thc picturc
bccomcs muddicd. Wc attempt to normalizc
for purchasc accounting, but thc ability to
rclatc t o prc-acquisition financial state
rncnts and to makc comparisons with pecr
cornpanics is limitcd.
Prucncc oE a rnatcrial goodwill account
indimtcs thc impact of acquisitions and
purchasc accounting on a company's equity
bast. Intangiblc assets arc no less 3 a l u able" than rangiblc oms, but comparisons
arc stilI distorted, bccausc othcr cornpanics
cannot rccord thcir own valuablc busincss
inrangiblcs, i.c., thosc that h a w bccn dcvclopcd, rathcr than acquircd. This alonc
rcquircs somc andytical adiustmcnt whcn
measuring Icvcmgc. In addition, analysts
arc cntitlcd to bc more skcptical about
csming prospects of an acquisitivc company whcn thcsc rely on turnaround stratcgics
or "syncrgistie" mcgcrs.
Preferred stock
Prcfcrrcd stocks can qualify for trcatmcnt as
cquity or bc victvcd 3s debt-m somtthing
bcnvcen dcbt and cquity4cpending an
thcir fcaturcs and thc circumstancw.
Prcfcrred stocks with a maturity rcccive
diminishing cquity credit as rhcy progrcss
toward maturity.
Prcfcrrcd stock that may cvcntudly bc
rcfinanccd with dcbr is vicwcd as ;1 dcbt
cquivdcnt, not cquity, all dong. Whilc
"pcrpetual" on tlic sacface, thcsc sccuritics
oftcn arc mcrcly a tcmporary dcbt altcrnative for companies that arc not current taxpzycrs, umi1 thcy oncc again can bcncfit
from tax dcductibiIiry of inrcrcst cxpcnsc.
RcdccmabIc prefcrrcd stock issues may bc
S l a d r d B Pour's
1
cxpcctcd to be rcfinanccd with dcbr oncc an
issucr bccomcs a taxpayer. Prcfcrrcds that
a n bc cxcliangcd for dcbt at thc company's
option also may bc vicwcd as dcbt in anticipation of thc cschangc. However, thc nnaly-
sis also would takc into account offsctting
positives associatcd with thc chingc in tax
status. Oftcn thc triggcr prompting an
cxchangc or rrdcmption wouId bc improvcd
profitability. Then, the addcd dcbt in thc
capita1 structure would not neccssarily
imply Iowcr crcdit qudity. Thc impIications
arc diffcrcnt for many issucrs that do not
pay tnxcs for various othcr rcxons, including avaihbility of tax-loss carryforwards or
forcign tax crcdits. For thcm, a changc in
taxpaying smms is not assaciatcd with bctrer profitability, whilc thc incmtivc to turn
thc prcfcrrcd into dcbt is idcntical.
Auction prcfcrrcds arc cvcn morc probIcrnatic, givcn that thc hoIders of thcsc prcfcrrcds would prcssurc for rcdcmption in
the cvcnt of a failed auction or cvcn a
raring dotvngradc.
Liquidity
Gradual erosion in a company's fundarncnrab
can dtimatcly Itad to liquidity problcms. Yct,
cvcn a company with a soiid busincss position
and modcmtc debt usc, cm,whcn faccd with
sudden advcrsity, cxpcricnce an actual or
porcnthl liquidity crisis, or an inability to
access public dcbt mirkcts. PorsibIc mwcs of
such adversity includc:
A dramatic sctback in thc busincss clluscd
by, for cxamplc, a crisis in consurncr
confidcncc, such as thc precipitous markct
downturn following thc tcrrorist attacks of
Scpt. 11,2001, In particular, this cvcnt had
il signifmat ncgativc impact on tlic airlinc
and tnvcl-rclatcd industries.
= A largc, advcsc litigation judgmcnt.
Rml or alIcged managcmcnt impropricty,
including accounting a b u m such as thosc
at Enron Corp. in 2001, and Tyco
Intcrnationai Ltd. in 2002.
1 k r g c dcrivativcs or trading losscs.
Sovcrcign intcrvmtion, for csamplc, in tbc
form of foreign currcncy controls, controls
on bank deposits, or pricing contmls, such
as those in Argentina in 2007.
-
Corporate Ratings Criteria 2008
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Analytical Methodology
Wc considcr thc chnllcnp a company confmntcd by a shock or triggering cvcnt would
bcc concerning irs d t i n g dcbt niatutitia, its
ability to mzkc intcml adjustrncnts to maxim i x nmr-tcnn u s h gcnenuon, nnd its ilcccss
to cxtcmal sourca of liquidity and clpital.
Analyting 3 company’s ability ro cope with
such mordinary challcngcs i s a rnaticr of
w i n g its liquidity or iu options undcr strcsf.
Our analytical focus hcrc is on rhc downside: whcrhcr the company a n mcct its obligations on a rainy day, nrhcr than just undcr
thc cxpcctcd circumsmnccs. Spccubtivc-gradc
issucrs are morc susccptiblc to liquidiry criscs,
which, in thcir situnrions, a n stem from
upcoming intcrcst and principd payments,
financial cclvcnants, and availabiky on
rcvolving crcdit hcilitics.
In thc context of a Iiquidity crisis, a company‘s businis position unnot bc considcrcd a
constant: Thc ncrvoumcss of customcrs andlor
supplicrs mi& t impair the company’scompctitive standing, contributing to a downward spiml in its fortuna. Industrial compmirs with
fimncc opcmtions may bc particularly wlncrabIc, givcn tfic funding rcquid for such opentions. Cornpanics with trading opcrations arc
doubly vuInerablc, given thc riskavcrx: inclination of tnding countcrjmtics, couplcd with
hmvy funding nccds.
O h ,thc cffccr of such advcsitics is compounded by the triggcring of contingcnt provisions includcd in crcdir lincs, bond
indcnturcs, countcrpmy agreements, or opcrating zgrccmcnts. Triggcrs can change minor
advcrsity into a major crisis for thc company
(and, 3s such, wc do not vicw ratings or
othcr triggcts favorably). Thcsc provisions
take many diffcrcnt forms, with the trigcr
bascd on rating downgradcs, rhc violation of
financial bcnehmarks or ratio Icvels, ‘marcrial advcrsc changes* (as intcrprctcd by thc
crcdimr), shire prim dcclincs, or owncrship
changes. Thcy may set off default, accclcmtion, put, or collatcralizationrequircmcnts.
In any cvcnt, the starting point of Iiquidity
analysis is thc rnaturiry schcdulc for dcbt and
othcr long-tcrm obligations. Nmr-tcrm maturitics includc commcrcial paper; sinking fund
paymcnts and final maturity paynicnts of
long-tcrtn dcbt; borrowings undcr bank crcdit hititics with qiproaching cxpir.itltion
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datcs; and mandatory
rcdcmptions of prcfcrrcd stock. Otlicr signifiunt financia1 obligations may also nccd to bc considcrcd, for
cxnmplc, lwsc obligations, contingcnt obligarions such as lcttcrs of crcdir, requircd
pcnsion fund contributions, postrctircmcnt
cmploymcnt paymcnts, and tax paymcnts,
Evcn whcn anaIyzhg highly crcditrvonhy
companics, it is ncccssary to bc a w m of thc
ovcnll maturity structure and potcntial for
rcfinancing risk.
Cash is king
The bcst sourccs of liquidity arc surpIus crtsli
and nearash on thc bafancc shcct. This
includes asli in the bank, cash cquivalcna,
and short-and longtcrm markcmtlc securitics. (Indecd, wc aIso Iook to somc companics
to maintain high cash balanccs against potcntial liquidity criscs; thcsc incIudc bonding
rcquircmcnts in thc me of U.S. cigarcttc
companics, and qcliuI rcvcrsab in thc msc
of capital intcnsivc rn3nufacturcrs, such a thc
auromobilc companics.)
Of coursc, not all msh is surplus. Virtually
cvery company has somc basc amount of
msh necessary for day-to-day opcrationswhich may bc quitc Inrgc, if tlic company is
subjcct to widc swings in working mpital.
Cornpanics with seasonal borrowing nccds
may build up largc msh balances for usc during the smsonal peak.
Additionally, rcstrictcd a s h (discIoscd scparatcly} is unwvailab1e for cvcryday funding
and should not bc kctorcd into a liquidity
analysis, bmusc tIicsc funds havc bccn sct
aside to satisfy a spccific obligation. A
subsidiary’s loan agrccmcnts an also rcsvict
dividends and upnrcam advanccs. This poscs
a problcm for a holding company that would
rcly on such dividcnds or upstmm loans to
~ C C C S Sa s h at thc subsidiary IcvcI.
Bank overdrafts shouId ako be dcducrcd
from availabIc a s h balanccs. Offshort cash
may bc subject ro a repatriation MX, in which
msc it shouId bc discounted accordingly. For
companics in cmcrging markets, it is important to consider whcthcr thc company’s liquid
asset position is hcId in Iocd govcmmmt
bonds, lorn1 banks, or local cquitics, and
mhctlicr thc issuer will havc ~ C C C S SIO thcsc
mcts at timcs o f strcss on thc sovcrcigtt.
EXHlBm RVH-2
Page 78 of 139
To fulIy bcnclit from a s h and nmr-cash
holdings from a liquidity pcrspccrive, thcsc
assets must be rmdily acccssibb and availablc
to support thc company’s imrncdiatc nccds.
Somctimcs the company may not haw frcc
~ C C C S Sto all thc u s h shown on the consolidated balancc shcet. For cuamplc, offshore
cash may not bc availablc for a fcw busincss
day-pccially
if it has to be converted
from a foreign currcncy.
Other Internal sources of tiquidity
Any compny f a d with scvczc liquidity pmsum mn bc cxpfftd to mkc intcrnal adjmtmcnE to mmimiu: nmr-term a s h flow.
Considering a company’s flesibility to do so is
an cxtcnsion of normal u s h flow analysis.
Thcrc arc scvmI possiblc options for doing this.
Cash a n bc exmctcd from working wpitai by monctizing rcccivablcs through bctoring or sccuritimtion, Iiquidating unnccdcd
invcntorics, or strctching out paymcna IO
supplicrs. Horvcver, if, for cxamplc, no hctoring or securitization facilities arc alrcady
in place, thcsc may takc scvcral months to
cstablish. If nggrcssivc discounting is ~ C C C S sary to scll invcntory quickly, such liquidations could have scvcrc implidom for thc
company’s fururc pricing porvcr and brand
image. In strctching paymcnt tcrms to supplicrs, rhc company runs a risk of sprmding
alarm about its situation and, ultirnatdy,
making supplicrs unwilling to ship goods.
Cornpanics gcncrdly havc somc flexibility
to rcducc czlpital cxpcnditurcs from planncd
Icvcls, at l a s t tcmpondy. As such, wc look
at maintenancc, rathcr than discrctionary
mpital spcnding p h i s . hhintenanec capital
spcnding may includc plant rcfurbishing, and
ordinary rcpair work and is ncccssary for thc
company to sustain normal operations.
PolIution control projects nccdcd to rncct regulatory rcquircmcnts haw little dcfcrnl
potential. Presumably, mpcnditurcs relatcd to
growth initiarivcs could be put on hold, and
arc discrctionary in nature. In any msc, it
may takc sornc timc to rcducc cxpcnditurcs
to thc maintcnancc IcvcI if thc company had
alrcady cntcrcd into contractual comniitmcnrs
rclatcd to its planncd investmcnts.
Thc busincss impticridons of rcdticing a p i tal spcnding niusr abo bc considcrcd.
Slniidurd & Pmrk
Continucd dcfcrrd of spcnding may makc thc
company less compcritivc and morc prom to
optmtionaI problems, Additionally, bcyond a
ccrtain point, managcrncnt might rationally
concludc that sccking protcction from crcditors through a bankruprcy filing mould bc
prcfcrablc to pcrmancntly impairing thc business by ncglccting capital spcnding.
Curtoiting operations with negative
cash flow and divestitures
Discrctc busincss units or product lincs that
arc pcrforming poorly or in a start-up modc
could bc suspcndcd. Shutdown costs must bc
ncttcd against thc ongoing cash saving.
Again, the impliations of such actions for
thc busincss must a150 bc rveighcd.
A company may choosc to scll cntirc opcrations or lincs of busincss to raisc cash.
Thcsc could incfudc undcrpcrformcrs as well
as strong busincsscs. Additionally, wc considcc thc company’s ability to rcalizc vduc in
light of rnarkct conditions for such asscts,
incIuding thc availability of intcrcstcd buyccs, as mcll as thc likcly tinic pcriod for
cffccting transactions. Assets sold in a Brc
salc o h do not rccapturc thcir fuIl vnfuc.
Dumping largc blocks of stock may dcprcss
thcir valuc.
Assct salcs may havc mixcd imptications
for the remaining busincss mix.For cxarnplc,
thc salc of a profitable, ush-gcnenting opcration that had becn tbc company’s bcst businus could fiavc a negative impact on thc
company’s busincss risk prohIc.
Altcmativdy, ii rnoncy-losing unit with hcavy
mpiral requircmcnts codd improvc thc busin u s risk profilc whilc bringing in somc much
nccdcd cash.
Dividend dcfcrrds offcr a quick source of
cash savings. But, dividcnd cuts ofrcn arc visiblc signals of distress, and the ncgntivc pcrccption in thc capital rnarkcrs that may result
must also bc considcrcd: Ar thc vcry lcasr,
such actions may hindcr funhcr cquity
issuance. Additionally, cxtcndcd dcfcrrd of
prcfcrrcd dividcnds may crcatc P growing
liability on tlic baIancc shcct.
External sources of liquidity
t i company’s ability to tap cxtcmaI sourccs of
funding may bc jcopadi7xd whcn it is ovcrIy
Corporate Ratings Criteria 2008
47
D(H1BIT RVH-2
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Analytlcat Methodology
reliant on onc SOUKC of financing. rn general,
;1 company's cxpcricncc with diffcrcnt financial instruments and mpitd markets givcs
manigcment dtcrnativcs if conditions in a
particuhr markct suddcnly sour.
Company sizc and recognition can play 3
roIc in whcrhcr it a n misc funds in the public dcbt mmkcts. Similarly, a company's rote
in thc national cconomy-particularly outside thc U.S.--can cnhancc its acccss to bank
and public hnds. h r g c issuers in P rclativcIy
small country oftcn arc favorably positioned
to attract financing from that country's
banking system.E?ctcrnal sourccs of liquidity,
including commercial p a p , bonds, bank
crcdit bcilitics, and cquity issuancc arc
discusscd bclorv.
Of all thc sourccs of dcbt fundingycornmcrcial paper is thc !cast rcliabfc. Usc of
cornmcrcial papcr to fund short-rcm a m t s
[typimlly, inventory and rcccivablcs) or as a
small componcnr of a company's Iong-tcrm
funding is fairly common. Howcvcr, whcn
bccd with S C V C ~ Cadvcrsc c i r m s t m c a ,
companies oftcn will not bc abfc to rolI ovcr
outsmnding commcrcial papcr as it
mturcs-lct alone nisc additional sums.
Typically, only cornpanics viewed as having
a strong crcdit snnding can 3 m s thc markct. Thc rnarkct for commcrciil papcr rawd
'A-2' or Iowcr is much smilfcr than thc markct for that ntcd 'A-l' or 'A-l+'y in part
bcausc of SEC rcguulation 7147, which
scvcrcly rcstricrs holdings of Iorver-mtcd commcrcial papcr by US. moncy market fun&.
Thc U.S. markct for commercial paper ratcd
'A-2' or fowcr in 2007 was atimarcd to total
about $72 billion, cornpard with thc
approxirnatcly $1.7 trillion of 'A-1' and
'&I+' paper outstamding.hiorcovcr, the
'12-2' markct is subject to significant prcsrurc
during acdit crunches.
When market fcars buifd rcgarding a particular issucr, thc term of cornmcrcial papcr
thc issucr a n placc typically shrinks to a fcw
days, thcrcby hcightcning refinancing risk.
Markct confidcncc a n bc Iost wry quickly.
T h i s \vas cvidcnt following Altria Inc.'s loss
of access to thc commcreial papcr markccs
following an unhvomblc vcrdict and $12 billion bonding rcquircmcnt in tbc Pricc class
action lawsuit. And, in addition to Icgitiitratc
48
www.corporatecriferia.standardandpoors.wm
concerns about a dcclining crcdit. thc markct
can bc spookcd by univamntcd fcm. For
cxamplc, Columbia Gas Systcrns Inc. unapcctcdfy fiIcd for bankruptcy pmtcction in
1991 bccausc of oncrous natunl gas take-orpay obligations. Suddcnly, othcr natural gas
pipclinc cornpanics, many of which had minima1 takc-or-pay cxposurc, found it difficult to
selI commercial: paper.
Backup Iiquidity
Givcn thc commcrcial papcr market's amtc
semitivity to credit quality, and thc spccd with
which confidcncc can bc Iost, wc considcr it
prvdcnt for a m p m i = that issuc comrncrcial
papcr to makc arnngcmcnrs in advancc for
backup sourccs of liquidity. Backup Iiquidity
protccts a company from dcfmlting if it is
unablc to roll ovcr maturing papcr with ncw
nota bmuse of shrinkqc in thc oucmll commercial papcr markct, or an issucr's inability
to access the cornmcrcial papcr mirkct
bcmusc of company-spccific iaucs.
Backup for commcraal papcr p e r a I I y is
providcd by committcd crcdit hcilitiw, yct
somctimcs may nkc the form of cliccss a s h
that is spcciliclllly committcd for this purposc.
(For a diisctrssionof our corttirrercial papcr
tackzip policies, see "Coiiirrtercial Paper,n)
Bonds
Thc public bond markct is far lcss riskavcrsc than thc cornmcrcial papcr markct.
Most investrncnt-gradc cornpanics in the
US. can gain ~ C C C S Sto the public dcbt markct for a new bond issuc at a rcasonablc
ratc. In othcr, Icss-dcvclopcd countrim, thc
public bond rnarkct may at timcs bccomc
inacccssibk for cvcn thc most crcditworthy
cornpanics (c.g., South Korea in carly
2001). Plicing dcbt is easicst for il company
that has regularly tapped thc markct and
rhar can issue dcbt in largc amounts-rhcrcby providing invcstors with a morc liquid
sccondary markct.
Afthaugh thc rnzrket for spccubth'c-gmdc
dcbt is wry largc, this markct is much mom
volatilc. Spcculativc-gndc cornpanics, espccially thorc on a dctcriowting trcnd, may
wcll hivc only intcrmittcnt PCCW to this
markct, dcpcnding on market sentirncnts and
liquidity. Thcrc liavc bccn timcs whcn cvcn
EXHIBIT RW-2
Page 80 of 139
‘CCC-ratcd dcbt found rcady buycrs, but
thcrc havc also becn pcrio& rvhcn thc cntirc
junk bond markct w a s cffcctivcly shut dorm.
Whatcvcr tfrc gcncrnl rnarkct conditions,
cvcn invcstmcnt-gradc cornpanics may have
difficulty issuing public dcbt if onc of thc
typcs of shocks discussed abovc has
occurrcd. In theory, a company should bc
abIc to issue dcbt at some pricc, bur in practiw, dcbt issuancc may wcll not bc fcasibIc
if thcrc is considcmblc unccrtainty in thc
markct about 3 company’s situation and
undcnvritcrs are, thcrcforc, undcFstandatIy
ncrvous about undcrtaking a transaction on
bchalf of thc company.
Thc pricc of outstanding bonds may bc 3
good gauge of markct scntimcnts-dtliough
tcchniml factors can aIso influcncc pricing.
Obviousty, if cxisting bond sprcads havc
widencd significantly rclatiw to thc markct
and arc rcsponding wifdly to thc day-to-day
dcvclopments at a company, prospcets for an
additional public dcbt issuancc arc poor.
(We monitor bond sprcads as pan of our
ongoing survcillancc.) T h c bond markct has
also becn inacccssiblc during periods of
ovcnll markce uncertainty following cconomic tvcakncs~,poIitica1 changcs, and
terrorism actions or thrcats.
Bank credit facilities
Bank crcdit gcncrdly is a company’s most
rcliablc sourcc for dcbt capital. Whcn a
company Ioscs acccss to thc commercial
paper and public debt markcts, banks are
ofren thc Icndcrs of last rcsorr. It is typical
for banks to providc a portion of a hcnhhy
firm’s company’s regular financing.
Spcculativc-gdc cornpanics tiavc abo
icccsscd thcse markm mort frcqucntly in
Iicu af traditional public subordinatcd dcbt
offcrinp. In somc countries (including
almost all Icss-dcvcIoped rnarkcts), banks
arc thc major souccc of capital for both
short-and longtcrm nccds.
Banks offcr various typcs of crcdit facilitjcs
that diffcr widely in thc commitment to
adwncc c3sli undcr all arcumsnnccs.
Wmkcr forms of commimcnt, although Icss
costly to issucrs, givc banks great flexibility
to rcdircct crcdit at their discrction. For
cxaiiiph, uncomrnittcd lints arc littlc morc
Stmdard & Poor’s
than an invitation to do busincss at somc
luturc datc, and arc givcn littlc to no crcdit in
our liquidity analysis.
Thc strongcst hcilitics arc those r i m arc in
place and confirmcd in writing, or committcd
facilities. In thc US.,fully documcntcd
rcvolving crcdits rcpracnt such contractual
mnmitmmts. In thc abscncc of P contmctual
comrnimcnr, paymcnt for the facilitywhcthcr by fcc or balanccs-is important
bccausc it gcncmlIy crcatcs somc mom1 commitmcnt on tlic bank. Gcncnlly, a solid business rclationship is kcy to dctcrminiq
whcthcr a bank will stand by its clicnt.
Dcpcndcncc on just onc or a fcw banks
hciglitcns risks. Apart from the possibility
that thc bank wit1 not havc adcquatc a p a c i ~ y
to Icnd, it d s o may not bc willing to Icnd to
thc issucr. Having scvcml bmking rcIarionships divcrsifics thc risk that a single bank
will losc confidcncc in tlic borrorvcr and hcsitatc to providc funds.
AIthough lcss common anyrnorc, in somc
casts, cornpanics csnblisli scpamtc crcdit
agrcemcnts with mch of thcir hnks, which
can mikc it unwicIdy to quickly rcncgotiatc
rerms of thc qgrccrncm in P crisis. A group of
lcndcrs liming prc-cstabIishcd lcnding comrniuncnts undcr P common crcdit agrccmcnt is
gcncr;llly morc practical, cffcctivc, and pmdicrable, Evcn hcrc, though, same fmturcs of
thc agrccmcnt could gmtly hindcr the rcncgotiation proms-for mampIc, a rcquirc
mcnt [hat the agrccmcnt a n be modificd onIy
by unanimous conscnt.
Conccntmtion of banking kciliticr; also
rcnds to incrcasc the amount of an individual
bank‘s participation. As thc amount of thc
exporun: incrcascs, the bank may bc morc
reluctant to mcct its commitmcnt. In addition, thc porcntial rquircrncnt of high-Icvcl
authorizations at thc bank for tbc rclcasc of
funds could create logistid problcms for thc
issucr in quickfy accming funds. On thc
othcr hand, a company will not bcncfit if it
sprcads i s banking busincss 50 thinly that it
lacks a substantial rclationship with any of its
banks. WCm p c c t banks thcmscIvcs to bc
financially sound, and do not favorably vicw
marginally invcstmcntgmdc banks.
As with any sourcc of dcbt fiindiiig, rlic analyst must considcr thc tcrm strucuicc of bank
Corporate RatIngs Cdtcda 2008
45
=HIBIT RW-2
Page 81 of 139
Analytical Mcthodotogy
ercdit facilitics. Rclianu: on short-tcrm facilities
poscs obvious risk. Evcn mdtiycar hcilitim
will providc mmrnirnimtsfor only 3 short time
as thc cnd of thcir terms approachcs. 1% closely monitor a company's cfforts to smngc for
tfic continuation of its banking hcilitics wcll
bcforc they lapsc. In normal situations, bank
facility cxpintions may bc vicwvcd as "soft"
mxuritics bcuusc rhc facititics arc routindy
rcncrvcd. But, if thc company is undcr s t m s
and thc hnks havc Iost confidence in thc company's prospects, thc banks might usc thc cxpiration to dcmand rcpaymcnt.
Financial covenants and triggers
In assessing a company's access to bank a p i tal and othcr sourccs of dcbt financing, thc
analyst must consider triggers that can block
access to additional funding, accclcmtc thc
rcpaymcnt of clristing dcbt, or crcatc ;L cross
dcfault with other dcbt obligations. Thc most
common such triggers arc financia1 covenants
in rhc form of ratio benchmarks. In ccrnin
a s c s , invcstors may mkc comfort from
bowing that covcnants (c.g., Icvcragc tats)
impose discipline on an othcnvisc financially
aggrcssivc minigemcnt by prohibiting Jchfinanccd acquisitions and special distributions
to sharcholdcrs. In scvcrc adversity, howcrcr,
tight covcnants could impcril crcdit quality
by provoking a crisis with Icndcrs if thc
covcnants arc violatcd: thc fcndcrs nwdd
ham thc Jiscrction to accclentc thc dcbr,
musing a dchu1t that might othenvisc haw
bccn avoidcd. Triggcrs may also bc in the
form of crcdit rating changcs thcmsclws, for
cxamplc, a change in d n g from invatmcnt
grade to aon-invcsmcnt gndc.
In considcring just how thc issucr's risk
profilc is affcctcd by such provisions, thc
kcy eonsidcmtions are: How closc rhc company is to thc trigger thrcsholds; how SCVCIC
and immediatc thc conscqucnccs arc; thc
amounts involved; and how rnntcrial thc
amounts arc in thc contcxt of thc spccifie
company. Borrowing agrccmcnts, cvcn of
crcditwortliy companics, arc somctimcs
structurcd with tight covcnants. Thc initial
cxpcctation is that lcndcrs will routincly
rcncgotiate thc tcrms 3s thc issucr's circumstnnccs changc. Evun hcrc, though, thc cxistcncc of covciinnts can bc problcriiitic if, for
50
www.corpora tscritoria.standardandpaors.com
cxamplc, thc lcndcrs' stratcgics climgc and
thcy wish to rcduec thcir cvposurc to rhc
borrowcr, or if a company is uriable to mcct
its financia1 forccasts that wcrc used as a
basis of sctring thcsc covcnants.
Violation of covcnmts in public dcbt issucs
aIways is scrious, givcn thc cumbcaomc proccdurc the company must follow ro obtain
waivcrs or to modify the covcnants. In alI
MSCS, it is jmportnnt to monitor thc pcrformancc of ilcompany against its most rcstrictirc
financial covcnilnts. (Wc obtain hank loan
covcnilnt complizncc rcports dirmdy from
issucrs, givcn thc nonpublic information
nccdcd to cornputc thc covcnmt vducs.)
Mntcrial advcrsc change (MAC) clauscs
rcprescnt another form of trigger. Rcrncdics
incfudc tlic full rmgc of possibilitics that also
apply to financia1 covcnants. T h c M ~ U Cdcfinition of such cIauscs Imws mudl discrction
to lcndcrs. Still, casts of MAC clauscs actually bcing invokcd against corpomtc borrowcrs
arc cxrrcmcIy m e . Tlic bank's rcputation
would suffcr if it was not judicious in invoking rhc clausc-and it would bc subjcct to litigation. Thcrc undoubtcdly haw bccn
instanca, though, whcn cornpanics haw bccn
dissuaded from tapping thcir crcdit facilitics
by thc & r u t of a MAC cIausc bcing invokcd.
Springing licns aIso can bc problcmanc
rcgarding financing flexibility. Somctimcs,
Icndcrs may rcquirc thc company to post coIIatcnl aftcr a downgmdc-which is providcd
for in thc loan docurncntation. When asscssing thc impact of a springing lien, wc considcr how dosc thc company is to rhc triggcr;
for cxamplc, if thc company is mcd 'BBE-'
with a ncgativc outhok, ic is prctty cIosc IO 3
licn that gorrs into effcct upon dropping to
speculativc grade. (With rcspcct to rccovcry
andysis, wc always assume that a springing
Iicn has bccn activatcd. T h c contmt for
rceovcry andysis is a dcbult s c c n a r i m n d
wc assumc that thc triggcr would haw bccn
brcachcd in advancc of dcbult.)
Equity issuance
In tticory, cquity issuance is anotlicr sourcc
of cnpital; in pmcticc, this sourcc cannot bc
rclicd on in a crisis sccnario. Ttic public
cquity markcts arc crtrcmcly ficklc. Scllirig
ncw common stock gcncrally is fcnsitlc
'
onIy if the company is wen as having at
Ieast dcccnr prospects and the overali stock
market is favorable. Morcover, accessing
the common stock market may primarily
depcnd on management’s willingncss to
accept dilution. We therefore do not give
companies credit for potential equity
issuances until such transaction has
tccn completed.
Selling preferred stack may be more
acccptable to management bccausc this
avoids diIution of thc common shareholdcrs’
carnings, but this usually is vhbIe only if thc
company’s continuing ability to meet its prefcrrcd dividend requircmcnts i s apparent.
Cornpanics owned by other corporate or
government entities can scek fresh capita1
from thesc owncrs. Ofren a strong parcnt or
equity sponsor is available to provide much
nceded capital during a Iiquidity crisis.
Staidnrd & Paor’s
The management factor
FinalIy, managcment’sskill in coping with a
liquidity crisis can makc the differcnce
benvcen corporatc life and dcath. Prudcnt
financial managers will:
8 Avoid excessive short-tcrm dcbt;
Spread debt maturities ot’er rimc;
= Maintain cordia1 relations and ercdibility
with banks, during bad times and good;
m Negotiatc bank loan covenants with ample
cushion whiIe the company is RnancialIy
-
strong;
Anticipate potentia1 covenant defaults
before thcy occur and renegotiate covenants
on a timely basis with rhc bank group;
Maintain hank lines in excess of anticipated needs, and bcgin negotiating rencwals
well beforc expiration; and
Fully draw credit lincs at the onset of
major difficdties.
.
Corporate Ratings Criteria 2008
51
EXHIBIT RVH-2
Page 83 of 139
Ratios And Adjustments
Key Aatihs And Glossary OfTerms
Ralio
Formula
Opnting inwrne before depeciation
Operating i m m o bofonm dsprxialinn and a m o r l i m l i ~ ~ m n u c s
and ammilation l o m u e s
DIT intclest U M I ~ I ~ Q
EBlTOA interest m r w a
EBlTfinterest
EBli'DMntemt
EO. plus interest paid. minusopcratingleaso adjustmen! 10
Return on npi?al
demiationhlintmst*
-.r
-.
-. . .
__.
EBfrlavefaflebqinniq of yeat and end of year wpitd
RO to deb!
FFU/&bt
TO rill
Iletinition
Capital
Debt plus noncurrent delcned tam. pIw cquily
cam Wmmm ~upcxl
Cash flmv from operations
52
www.corpowtecriteria.standordandpaors.com
FLUKlsqf!rbkd toacqLimamtop m@l&andminintangiblo
wts It ~KMB
tho cost of aequisitionof assetsthwh l e a r n
and similar amngementsoand m1udos CapiraIirCdmsts mt vm
eqmm as an snslytiwl aqmtment
This rneawre reflects cash flw Imm o p t i n g zdvilios. Mt
imEstmentandfi~rriq
activitia. It includl?~inlemt rmived
ad paid, dnidends maivcd. and bxes p i d in Iha priod.
Additinnalty. for m e items such postrcliremcnt benafils and
asset retirmcnnl obligations.wo ineldothe (neilcart for tho
pcriod raher than actual cash outllcws. in odar to sewram
v.+utWB Gmv as fWq of lhere obli@iom fmm Iho operating
cos1c o r n p e n t
BHIBIT RW-2
Page 84 of 739
Term
Definition
Debt
Tola1 shon- and longterm bonm'ngs of IhO c o m ~ ( i n c l u d i n j
rnalurilies). adjusred by addim a variety of on- andofl-billanco
shmt financing arrangements pursuant to OUI aflustmont
methodology. and subtnctiq rwplus cash.where applicable.
!hmi~ammmntdatarmMastFiddi-gnmmuwnl
upon change in mmeiship of thr!imeflFpmigncunenry
unhdged bormwings am measuredat each periwknd spot m t a
Cash flmfmm operations minus wpcx. minus dvidcnds paid.
Dimetinnary ushflow
Omdcnds
Widendspaid lo c a m and p r o f o r d shareholders and to
minorib interest shmhofhis ol consolidated s u b i f i u i m ,
EEliUA
Operating profits borooro i n t m t income. tntercst oxpwro.
immo taxos. depreciation.amodiiation. and a t Impairment.
bludes undistnhtcd ci-iuily earnings of affiliates Whih at
times EEITDA i s considered a prmy for wsh earnings. dranges in
acmunting mako this imsingly anamual-lnscd earnings
masure. The diflorenea btvreen EBmA end operating inurms
bcfom depialinn and amwtization Is in Ihe adjustments ml
make [or operafing leases. 8*ploration apxpcma and stockhied
curnpcrwlion. Explorationcxxposo isadded hck lo EBlTD&
rather than being treatd as ao operating wst TIID openting
leaseadjustment to BllDA increases for the implicit i n t m t
m p o n c n t of mt eqmm krt not b tho d q m a t i o n amponeit
FiIwtly, tho charge to earnings for shardsed cornperdm is
revoaed in calmlating E3JTDk
Equity
Cornrnnnequity and equity iiybrids, and minorily intcrert
Equitykfbrids
The portion of hybrid instruments atuibuted to equily ptnsuaot 10
our rnothdolwv for classiMns such sfmitie%
bsh fforv from OpCntioW miflus C
am
Operating profits Itomwnlinuing opm-ations. after plus
depredation and amttimtIon.phs deferred i m m o l
apfus
other majw nxumrq normsh i t c m
The gross amount of i n t c m t incurred(including arnmlf wpital
ilcdl. aflusted for chrgas dated to items lhat weadd Io debt:
no subtraction of intcrast inmo, arcept ivhwoderiwl from
mets struc~vnllylinked t o a bomUing.
FFO minw dividends.
A m m m of opemring profitabilitythat mludas deprecialion
and ammilation. to prtly neumliio capital intensity as 8 lacroi
amen mmuarinstho mofitabilitvolmmmic.
TOMd e s and o h r menua WE consider to bo opcfaliq.
I
i
FOCF
FFO
tnlcrcst
Net cash Rmv
Operaling inmrnn befnro dcpreciatir & ampnilation
I
. - .
I
bmucs
Srurrdurd & Poor's
Corporate Ratlngs Criteria 2008
53
MHIEIT RVH-2
Page 85 of 139
Ratios And Adjustments
Incorporating Adjustments
IntoThe Analytical Process
Our analysis of financia1 statcmcnts bcgins
with a rcvicrv of accounting charactcristics IO
dctcrminc whcthcr ratios and statistics
derivcd from thc stitcmcntri adcquatcIy mmsurc a company’s pcrformancc and position
rclativc to both its dircct pccr group and the
largcr univcrsc of industrial companies. To
thc wtcnt possibIc, our anaIytiu1 adjustments arc made to bcttcr rcflcct rmlity and to
minimizc diflcrcnccs among companies.
Our approach to adjustments is mcmt to
modify mmsurcs used in thc analysis, m h c r
than fully recast thc cntirc sct of financial
smtcmcnts. Furthcr, it oftcn may bc prekrablc or morc pmctiul to adjust scpantc
parts of the financial statcmcnts in diffcrcnt
ways. For cmmple, whilc stock-options
cxpcnsc rcpmcnts a cost of doing busincss
that must bc considcrcd 3s part of our profitability analysis, fully rmsting thc us11
impliations associatcd with thcir grant on
opcmting a s h flows is neithcr pmcticd nor
feasible, given rcpurchascs and complexities
associatcd with tax laws driving thc dcduction timing. Similarly, the analyst may prcfcr
to dcrivc profitabiIity mcarurcs from LIFObased invcntory accounting-whilc rctaining
FIFO-bascd mcilsura whcn Jooking at rhc
vduation of balancc shcct mcts.
Gmin adjustmcnrs arc routinc, as thcy apply
to many of OUT isnrcrs for all pcriods (c+g., opcrating h c , srmritizations,and pension-rciatcd
adjustmcnts). Othcr adjustmcnrs arc made on a
spific industry basis (cg., adjustmcnts madc to
reilcct -I
retircmcnt obli&ons of rcguhtcd
utilities and voIumcm’c production payments of
oil and gas p d u c i n g compnics).
Bcyond that, w e cncoumgc usc of nonstandard adjmtrncnts that promote thc objccrivcs
outlincd abovc. Individual situations rcquirc
crcativc appIiution af analytial tcchniquesincluding adiusmcnts-to cnpturc thc spccific
fact pattcrn and its nmnccs. For mmplc,
rcniI dmlcr stock sometimes has thc charactcristics of manuhcturcr invcntoq-notwithstanding its IcgnI snIc to tlic dmIcr. Subtlc
diffcrcncw or diangcs in thc fact pattcrn
(such as financing tcrms, lcvcl of invcnrory
rclativc to sdcs, and swsond variations)
wouIJ influcncc thc analytical pcrspcctivc.
54
uuww.corpora tacri toria.standardandpoors.com
IVc rccogiiizc that thc usc of nonstandard
adjustments involvcs an inhcrcnt risk of
inconsisrcncy. Also, somc of our constitucnc i a want to bc able to casiIy rcp1imtc and
cvcn anticipatc our andysi-nd
nonstmdard adjustmcnrs may frustmtc that ability.
Norvcvcr, for us, thc paramount considcmtion
is producing thc bcst possibIc quaIity analysis.
Somctimcs, onc m u t acccpt thc tmdcolfs that
my bc invokcd in its pursuit.
In many insranccs, scnsitivity analyscs and
r a n g cstimatcs arc morc informativc than
choosing a singlc numbcr. Accordingly, our
analysis at rima is cxprcsscd in tcrms of
numcrid nngcs, multipfc sccnarios, or tolcrincc Icvcls. Such an approach is critical: whcn
cvduating highly discrctionary or potcntinlly
varied outcomes, whcrc using exact mcasurcmcnt is oftcn impossibIc, impnctiml, or cvcn
imprudcnr (c.s., adjusting for a major Iitigation wlicrc thcrc is an cqual probability of an
adversc or a fzvoratlc outcomc).
Similarly, in somc cascs, tlic analysr must
cmluntc financial information on an adjustcd and an unadjustcd basis. For cxampIc,
most hybrid cquity sccuritics fa11 in a grcy
arca that is hard to apprcciatc mcrcly by
making numcricd adjustments. So, whilc
wc do cmploy a standard adjustmcnt that
splits thc amounts in two, wc also prcfcr
that our analysts look at mcnsurcs that
m a t tlicsc instruments cntircty as dcbtand cntitely as cquity.
In any cvcnr, adjustments do not aI\vays
n c d y allow onc to gain full apprcciation of
financial risks and rcrvards. For cxamplc, a
company that clccts to usc opcmting Imscs
for its corc asscts must bc comparcd with
pccrs that purchasc tlic same m c t s (c.g.,
mail storcs), and our Icasc adjustmcnt hcfps
in this rcspcct. But mc aIso rccognizc the
flexibility associated with thc lcascs in thc
cvent of potcntial downsizing, and would
not trcat thc company i d c n t i d y with pccrs
that txbilit idcntid numbcrs. Likcwisc, in
a rcccivablc sccutitization, whilc rhc salt of
thc rcccivablcs to tlic sccutitiwtion vchiclc
gcncmlly shirrs somc ofthc risks, oftcn tlic
prcdorninant share remains with thc issucr.
Bcyond adjusting to iiicorporiltc thc asscts
and rclarcd debt of thc sccuritization vchiclcs, analysts must apprcciatc tlic funding
EXHlBlTRVH-2
Pago 86 of 139
flcxibility and cfficimcics rclatcd to thcsc
vchiclcs and thc limitcd risk tnnsfccrcnce
that may pcrtain.
Apart from thcir importance to thc quantitntivc aspccts of thc financis1 analysis, qualimtivc conclusions rcgarding thc. company's
financial data an also influcncc othcr
aspccts of thc analysis-including thc asscssmcnt of managccmcnt, financia1 policy and
internal controls.
Communicating our adjustments
and related criteria
We traditionally have incorporatcd analytical
xljustmcnts to thc ratings proccss. Our publishcd kcy ratio smtisn'cs arc also adjusted to
rcffcct many of thc adjustmcnts madc.
Sincc 2003,wc hmc published accounting
scctions that outIine our vicw of the issucr's
accounting chzncrcristics, incIuding thc
undcrIying considcntions and kcy adjustmcnts ma& in our publishcd industrial companics' issuct rcports. T h c purposc is to
apturc in onc phcc the major accounting
issucs that affcct an issucr's financials, heir
rclatcd analytical significancc, and the adjustmcnts ma&; it is not intcndcd to bc a summary of cvcry accounting policy.
Wc providc a rcconciliation rablc in our
crcdit analysis rcports on corpontc issucrs
(Scc "New Recoiiciliatioii TaLie Shows
Smdard k Poor's Adjirstitzctits To
Corripany Reported Amotrtits, pirlrlislrcd
Oct. 3, 2006, on Ratings Direct). It is a
bridgc bctwcen P company's rcportcd
arnounrs and various Standard & Poor's
adiustcd mcmccs. Thc rcconcilation tabIc
bcgins with company rcportcd amounts lor
a range of balance shect, mrnings, and cash
flow mcasurcs, thcn lists adiustmcnts to cach
mcasurc by topic and our total adjustcd
mcilsurc. Not all adiustmcnts 3rc includcd as
of yct in thcsc rcconciliation tables. W c arc
modifying our sofnvare to incorporarc additional adjustments-but somc adiustmcnts
may not bc includcd, as thcy do not lcnd
thcmscIvcs to precision or standardization
[C.S., litigation or othcr contingcttcics).
Omsiondly, adjustrncnts arc bascd in
wholc or in part on nonpublic information
providcd to us during tlic rating proccss. Our
ming analysis, cvnliiatjon, and cornrncntary
Stadurd S. Pour's
incorpontc considcntion of this information,
but our putlislicd data rcfcr cxclusivcly to
publicly available information.
Our critcria govcming financi il 1-statcrncnt adjustmcnts arc subicct to ongoing
rcvicw and occasional rcvisions ncccssnry
to addrcss cliangcs in accounting rulcs and
in rcsponsc to cmcrging financiaf products
and structures--Consistcnr with our broad
objcctivc of maintaining a dynamic critcria
frarncwork capabIc of addressing cvolving markct conditions in a timcly and
comprchcnsivcmanncr.
Whcn considcring significant critcria
cIinngcs {incIuding ratio adjustrncnts), wc
solicit public input and conmicnts. In addition, w c cncoumgc ongoing dialopc with
markct participants rcgarding a11 critcria
rnattcrs. W c rcgard this diaioguc as an
important hcct of maintaining a robust
critcria frarncwork, rcsponsivc to thc nccds
of those who USC our ratings and othcr
rnarkct participants.
Encyclopedia Of
Analytical Adjustments
'fic following sections outlinc thc spccific
adjusttncnts wc usc in analyzing industrial
cornpanics. Ar thc cnd, w c includc our kcy
ratios and thcir dcfinitions. Tlic list of adjustmcnts, in olphabctical ordcr, includcs:
= Accrucd Intcrcst And Dividcnds
Assct Rctircmcnt Obligations
= Capitalized Dcvclopmcnt Costs
= Capitalized Intcrcst
* Clptiw Rnancc Opcmtians
Exploration Costs
Forcign Currcncy Exchangc GaindLosscs
.
Guarantces
m
Hybrid Instrurncnts
LWOAWO: Invcntory Accoirnting
Mcthods
Litigation
Nonrccoursc Dcbt Of Affiljotcs (Scopc Of
Consolidation)
Nonrecurring ItcmdNon-corc Activitics
Opcmting Lcascs
* Postrctircmcnt Emplopc Bcncfitacfcrrcd
Cornpcnwtion
= Po~vctPurcbasc Agrccrncnts
= Sham-Dascd Conipcnsntion Erpcnsc
Corporate RatIngs Criteria 2008
55
EXHlBlT RVH-2
Page 87 of 139
Ratlos And Adjustments
Stnndcd Costs Smritirntions Of
RcguIatcd Utilirics
Surplus Cash
T r d c Rcccimblcs Smritiwtions
Volumctric Production Payment
Workers CompensationlSclf Insumncc
.
1
Accrued interest and dividends
Acerucd intercsr that is not alrcady includcd
in rcportcd dcbt is rcclassificdas debt. This
adiustmcnt aIlows morc consistent comparisons of companics’ financial obligations, by
clim’nitingdiffcrcnccs arising from thc frcqucncy of paymcnts-for cxamplc, quarterly,
mthcr than annunlly--or calcndar d a t a of
specific payments-for cxamplc, January 1 or
Dccembcr 31.
In n similar vcin, accrucd dividends on
hybrid cquity sccuritics are tmtcd as dcbt,
irrcspcctivc of thc cxtcnt of rhc securities'
cquity contcnt. (Dcfcrrcd amounts-whcthcr
thc dcfcrm1 was optional: or mandatory-are
also usually trmtcd as dcbt, givcn the nccd to
pay tlvm in a rclativcIy short tirnc. Obviously,
IVC would not inchdc amounts that arc noncumulative, which ncver will bc paid.)
A djitsftriart procediires
Balance shcct: Accrucd inrcrcst and dividcndn accrucd on hybrid sccuritics arc
rcclassificd as dcbr. Thcrc is no adjustmcnt
necdcd to cquity.
Cash flow statcrncnt: Bccausc the impact
usually is quitc limitcd, no adjustrncnt is
perfomcd to FFO or OCF. Annual cash
flow is not affcctcd by paymcnt frcquency
or datcs, cxccpt in thc ycar a particular
sccurity is issucd or rctircd.
-
Asset retirement obligations
We t r m assct rctircmcnt obligations
(AROs)as debt-likc linbilitics. AROs arc
l q a l commitrncnts, assumcd whcn commis-
sioning or operating long-livcd ilsscts, to
incur rcstoration and rcmovd costs for disposing. dismantling or dccomrnissioning
thosc ~ S S C ~ Skamplcs
.
includc thc costs of
pIugging and dismantling on-and off-shorc
oil and gas hditics; dccommissioning
nuclcar powcr pIants and rccycIiiig or storing uscd nuclcnr fucl; and capping mining
and waste-disposal sitcs.
56
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Thcsc commitmcnts arc indcpcndcnt from
thc lcvcl and timing of any cash flow gcncmtcd by thc usc of thc ~SLSSCIS.
In ccnain insmnccs,
ivc mpcct ARO costs to bc rcimburscd to thc
cntity through rates or assumcd by 0 t h partics. Whcn thc asct opcmtor’s cosw arc rcimburscd by the govcrnmcnt ot via a ntc-sctting
proccss, thc cntity bars far diffcrcnt and lcss
opcn-cndcd cconomic r i s k a n d may not
rcquirc debt imputation. Wc liavc rcndd to
vicw AROs rclatcd to nuclar powcr plants of
ntc-rcplatcd US.utilities in this light.
Scvcral chanctcristics distinguish AROs
from convcntional dcbt, including timing and
mcmrcmcnt unccrtaintics; tax implimtions;
and thc standing of daimants in b a n h p ~ c y .
ARO mcasurcmcnt involves a high dcgrcc
of subjcctivityand rncasurcment impcision.
Our stming point is thc rcportcd liability
amount, which may bc adjustcd for anticipatcd rcimburscmcnts, assct salvage valuc, and
PX rcdunions, furthcr adjustcd for any
assumptions wc vicw as unrcalistic.
lMost M O s involvc obligations to incur
costs that may cxtcnd wclI into tlic futurc.
Unccrtaintics inhcrcnt in tlicir crtirnation
includc:
T h c amount of thc ultimatc cost of a b m
donmcnr, which will dcpcnd on tlic rclcvant country’s laws and assct-spccific
cnvironmmtal rcylations at rctircmcnt;
thc condition of thc markcts for thc spccific asscts’ rctircmcnt scrviccs; possiblc
cconomics of SUIC for thc opcntor; and
whcthcr thc activitics ultimatcly arc pcrformcd by thc opcmor or by a third party.
a The timing of assct rctircrncnt, whidi is
subjcct to assumptions that a n change
materially. For cxampb, in cmmctivc projCCS, funrrc pn’cc cxpcctations for hydrocarbon or mincnls affcct thc cconomic lilc
of thc PSSC~S.For powcr gcncrators, nssctrctircmcnt timing dcpcnds notably on Iocnl
regulatory dccisions. l i c k impact might bc
favomblc (i.c., in the a s c of an opcmting
liccnsc cxtcnsion) or unfavomblc (ix., in
thc msc of an mrly rnandatcd closurc).
a Thc discount ratc IO bc uscd in ttic prcscnt
valuc calculation. U.S. G M P rcquircs thc
usc of an cntity-spccific discount riltc.
Hcncc, thc strongcr tlic entity’s crcdir, thc
lorrw thc discount mtc--nnd thc h i g h thc
EXHIBIT RVH-2
page aa of 139
liability. SimilarIy, thc pcriodic accretion
rate is lowcr for strongcr crcdits, and highcr for wukcr crcdirs. If nothing clsc, this
hindcs compambiIity across cornpanics
using US. GAAP, as wcll 3s to IFRSrcporting companics, which usc markctrclatcd r a t s idjustcd to risk-spceific
factors aniibutablc to thc liability.
AROs arc rccordcd on a p r e w basis undcr
most accounting standards. Any cxpcctcd my
bcncfits gcnemlly arc rcflcctcd as a scparatc
dcfcrrcd tax asset on thc bilancc shcct
(lxmusc thc ARO-rclatcd m c t is dcprcciatcd).
Tax savings, whcn thcy mincidc with thc
ARO paymcnts (as opposcd to thcir pravisioning), rcducc thc nct cash cost, which w c
factor in our andpis to the c w n t wc cxpcct
thc company to gcncratc taxable income in
thc p a f i i d z r jurisdiction.
Thc obligation, net of any dcdicatcd rctircmcnt-fund asscts, mlvagc KIIUC, and anticipatcd tm savings, is added to debt. \Vc
gcncmlly adjust for rhe nct aggrcgarc funding position, cvcn if somc spccific obligations arc undcrlundcd and others arc
.
ovcrfundcd.
1
Adjustmcnts arc madc on a mu-clkctcd
basis in a s c s whcre it is likcfy thc company wiII bc ablc to u c thc dcductions.
Thc accrction of thc obligation rcflccts thc
rimc v;rluc of moncy m d is akin to nonu s h intcrat--similar to postrctircmcnt
bcncrit (PRB)intcrcst charges. Accordingly,
wc rcclassify it (nct of earnings on any dcdi m c d funds, if applimbIobut ncver Icss
than zero] 3s intcrcst a p s e for both
incomostatcmcnt and ush-flow sratcmcnt
analysis. \Vc kecp thc nct prcscnt v d u c of
thc obligations ncrvly incurrcd during tlic
pcriod (analogousto PRB scrvice costs)
within operating cxpcnscs. If dcdicntcd
funding is in placc and thc rclatcd rcturns
arc not cnrircIy rcffcctcd in rcportcd camings and ush ffow, thc unrccognizcd portion of thc rcrum on thcsc asscw is addcd
and thc rccognizcd porrion is rcclsssificd to
intcrcst cxpcnsc and opcnting msli flow.
Cash paymcnts for sbandonmcnt and
contributions into dcdicmd funds that
cx-cccdlarc Icss than thc sum of: ncwly
incurrcd obligations plus accretion of
cxistiiig obligations arc rcclassilicd RS
rcpaymcnrlincurrcncc of a dcbt obligation; this incrcasddccrcascs operating
cash flow and funds from opcrations by
thc diffcrcncc.
For U.S. ratc-rcgulatcd utilirics that own
nuelcar powcr plants includcd in ratc
base, w c Invc concIudcd that thc dccommissioning Iiabiliry should nor bo vicwcd
as il dcbt-cquivrrlcnt liability. This is
bccausc of thc safcguards that cnsurc
funding sufficicncy and collection of
dccornmissioning costs in rata. Funding
through customcr ratcs and thc probablc
nature of rccovcry rcsult in il substantive
liability dcfcasancc.
Adjwtitretit
proccdtrrcs
Data rcquircmcnts
= Thc cstimntcd x s c t rctircmcnt obligation
(ARO), bawd on financinl mtcmcnt disclosure or analyst cstirnatc.
= Any associatcd zsscts or funds sct nsidc for
the ARO.
ARO intcrest costs, whcthcr chargcd to
opcmting or financing costs.
= Nciv provisions (incrcascsin liability dura
ing thc pcriod).
Gain or loss on asscts set asidc for funding.
Cash paymcnts for AROs.
~lntlntions
= Subtract asscts sct asidc to fund assctrctircmcnt liabilities from rhc ARO IO crcate a nct ARO.
= Multiply this nct obligation by (1 thc tax
ntc) to dcrivc ARO adjusuncnt lor dcbt.
= Subtract both thc gain [loss)on asscts sct
3sidc from thc sum of ncw provisions and
intcrest cosrs and cornpan: this amount to
thc mdi paymcnts rnadc to irrivc at thc
wccss contributionkhorth11,
Multiply his cxccss contriburionlshortf~l1
by [l the
ntc) IOarrive at tIic ARO
adjutmcnrs to funds from opcntions and
u s h flow from opcntions.
Proccdurcs
= ARO dcbt is addcd to rcportcd dcbt.
= ARO intcrcst COSIS (nct of All0 fund camings] arc rcmovcd from opcmring cxpcnsa,
if thcy arc inctudcd in thcsc, nnd addcd to
intcrcst cxpcrac.
1 Thc All0 adjusmcnt LO FFU is iddcd
to FFO.
1
Standard & I'oar's a Cotporate Ratlngs Criteria 2008
-
-
57
MHlMT RVH-2
Page 89 of 139
Ratlos And Adluslmcnts
(Please scc “Asset Retircrrtcnt
O.hligutions: How SFAS I43 Affects U.S.
Utilities OiuninK Mtrcleur Pfarrts, ” prrblishcd
March 3I, 2004, arid “Corporate Ratings
Criteria, 2006 cdition-Corporate AssetRefircttrcrrt Ohligufiotzs,” on RatirigssDirect.)
Capitatired development costs
Costs rclating ro the conccptual formulation and dcsign of products for salc or lcasc
commonIy arc cspcnscd on tlic income
statement-while costs incurred subscqucnt
to cstablishing the technological fcasibiliry
of thcsc products arc capitalizcd. Ttic
asset is thcn amortizcd over its cstiniatcd
cconomie lifc.
Dcfining fcasibility involvcs substantial
subjcctivity. Accordingly, thc trmmcnt of
product or m c t dcvclopmcnt cosrs somctimn v a r i substantially
~
among cornpanics
or iccounting rcgimcs. For cxamph, many
U.S. sofnvarc companics do nor mpitdize
any softwarc dcvclopmcnt costs (an malytid I y conscmtivc approach), rvhilc nthcrs
upitalizc certain cupcnditurcsand stmortizc
thcm ovcr futurc pcriods.
Ikpcnsing, n t h c r than capitalizing, can
hivc il mcaningful impact an a company’s
financial statcmcnrs and crcdit rnctrics,
making pccr comparisons difficult.
Automakcr accounting for tooling poscs
simitar cornparability issucs rclating to
varying c a p i t a h t i o n policies.
Whilc it is acccptablc undcr the nppIimbIc
accounting ruIn for a company ro capitalizc
ccrrain dcvcfoprncntcosts, in orclcr to facilitatc companbitity, ivc adjust rcponcd financia1 stfitcmcnts. Thc amounts capitalized arc
trcatcd as if thcy had becn cxpcnscd. To thc
cxtcnt that thc amortization of past capiralimtion cquals currcnt dcvclopmcnt spcnding,
therc is no impact on opcmting cxpcnscs,
opcmting profit, or EBm, but thcre is an
impact on EBITDA and opcming profit
bcforc dcpreciation.
This approach hctps makc companics’
operating pcrformancc mom transparent and
conipanblc, rcgardfcss of thcir stancc an capitalizing softwarc and simiIar devclopmcnt
COSIS. Norc, that with rcspcct to cncrgy
cxplomtion costs, w c rakc the oppositc
approach (sce adjfistnretit/or cxploratiorr
58
www.corporatccritaria.standardandpclors.com
costs), givcn thc objcctiw of comparability
with most cornpanics in that industry and die
pragmatic aspccrs of doing so.
A company’s position in its product lifc
cyclr has B grmt cffcct on its currcnt spcnding rclativc to thc amortimion of past wpitdirntion of dcvclopmcnt costs. Howcvcr, as
a practical mattcr-in thc abscncc of morc
accurate figurcs--wc usc thc annual amanimtion figurc rcportcd in thc financial stztcments as n proxy for thc currcnt ycar’s
dcvclopmcnt costs. Wc rmli~c,too, that thc
amount amortizcd is not cntircly comparabIe
across companics, as thc amortization pcriod
for thcrc assets may vary. For e?mnipIc, in thc
case of soltwarc, it t y p i d l y mngcs from two
to five ymrs.
Adjrtstiiiciit procedures
Data rcquircmcnts
= Amount of dcvclopmcnt costs incurrcd and
upitalizcd during thc pcrid.
Amount of amortization of rcfcvant =piralizcd costs.
GImlations
= EBITDA, opcrating profit bcforc dcprcciation, and capita1 cxpcnditura: subtrxt tlic
amount of nct mpitdizcd dcvclopmcnt
costs, or, altcrnativcly, thc amortimion
amount for that pcriod.
EBIT and opcmting profit aftcr dcprcciation: subtract (or add, as tlic m e may bc]
the diffcrcncc bctrvccn thc spcnding and
amortimion in rhc pcriod.
IT0 and capita1 cspcnditurcs: Subtmcr thc
amount capitalizcd in thc pcriod.
= hlancc shccr accounts: Wc do not u r r y
through tlic adjustment to thc cumulativc
asset (and equity) accounts, wcighing thc
complcxity of such adjustmcnts against thc
limited impact that can bc cxpcctcd in
most cascs on amounts that arc sccondnry
to our analysis.
( P I C ~ S Csee “Accomirg ISSJ~U
in Thc US.
High Techtology Grorrp,” prrlfidicd Juri. 3,
2007, otz RntirtgsDircct.)
Capitalized interest
Wc factor in apitalizcd intcrcst as cxpcnsc in
rhc pcriod whcn incurrcd. Thc valuation of
propcrty, plant, and cquipmcnt (PP&E]
itsludcs, under somc CAW, a cast of arry
MNIBIT RVN-2
Page 90 of 139
cIcmcnt rclatiq to mdti-pcriod projcct
cxpcnditurcs. Patt of thc mionalc is that thc
company must factor thc mrrying casts whcn
deciding on a project's cconornies, but this
obscures the amount that actually must bc
paid during thc period. Cornpanics may also
havc signifiunt discrction with rcspccr to rhc
amounts thcy capitalize, making comparisons
difficult. Accordingly, we prcfcr to locus on
total intcrcst cost.
As a rcsuIt, wc rcvcrsc intcrcst capitdimtion and include thc amount as an wpcnsc.
In thc mli flow snrcmcnr, IVC rcdassify mpimlizcd intcrcst from investing to opcmting
cash flow. T h i s corrcspondingly reduces funds
from opcrations and apital expcndirurc
amounts. Frcc msh Ootv rcmains unchangcd.
Wc do not adjust for thc mmulntivc grossup of PP&E resulting from intcrcst capitdimtion, tax cffccts, or fururc deprcciation
clfccts. That is, wc do not rry to idcntify thc
portion of PP&E aaributabk to past intercst
npitalimion, in ordcr to rcducc PP&E by
thc amount thar would corrcspond to thc
cxpcnsed vicw nkm on such intcrcst upiralizcd in tlic past. It would bc impmcticd to
attcrnpt to do so, givcn the lack of data available. Morcovcr, the morc matcrial impact
tends to bc to covcmgc and profitability
rnmsuccs, not to assct or cquitybasd ratios.
A djifstirrerrt procedures
Data rcquircrncnrs
Thc amount of npiralizcd intcrcst during
thc period.
Calculations
Intcrcst cxpcnsc: add amount of mpimlizcd
interest; and
Capital cupenditurcs, FFO, and opcmting
a s h flows: rcducc by amount of apitalizcd interest that is rcclassificd as opcmting
u s h flows.
3
.
.
Captive financc operations
A captivc financc operation (captivcl fuunctions primarily as an cxtcnsion of a eompany’s markcting activitics. The mptiue
Iacititatcs the salc of goods or scrviccs by
providing financing (in thc form of loans
or Icascs] to thc company’s dcalcrs andlor
cnd ctlstomcrs. The captivc can bc structurcd as a IcgdIy scparxc stibsidiary, or as
Shtdard & Paor’s
a distinct operating division or busincss
Iinc of tlic company. Captiw finnncc units
orpnizcd as scparatc subsidiarics arc ratcd
thc simc as thcir parcnts in thc overwhelming majority of cases, mcaning IVC
vicw rhcir dcfault risk as indistinguishabb
from rhat of thc parcnt.
Whatcvcr tbc Icgd/organimtional struct w c , thc two busincsscs arc not analyzed on
3 consolidatcd basis. Rathcr, wyc scgrcgatc
financing activitics from corporatclindustrid
activitics and analyzc cach scparatcIy, rcflccting thc diffcrences in busincss dynnmics and
cconomic charactcristics, and tbc approprintcncss of difkrcnt financial mwsurcs. Our
approach is to c m r c a pro forma criptivc
unit ta cnablc financecompany annlytiml
tcchniqucs to bc ipplicd to tlic cllptivc
financc activity, and corrcspondingly appropriatc analytical tcchniqucs to thc purc
industrial company.
Financc nsscts (c.s., loans rcccivabIc and
Icascs+aIong with appropriatc amounts of
financial dcbt and cquity-rc
allmtcd to
thc pro forma finincc company; all othcr
asscts and liabilities arc incfudcd in thc parcndindustrial balanec shcct. Similarly, ody
linancc-rclatcd rcvcnucs and expcnscr arc
incIudcd in thc pro forma linancc company
incomc starcmcnr. Thc dcbt and cquity of thc
parcnts and thc captives are apporrioncd so
rhat both cntitics will rcflcct, in most casts,
idcntial crcdir quality.
In our analytical rncthodoIogy for captivc financc opcrations, \vc attributc d c t t
and cquity to the pro forma financc company bascd on our asscssmcnr of thc quality of tlic financc asscts, taking account of
factors such as undcrwriting standards,
charge-off policy, quality of thc collatcral,
and portfolio conccntiation or divcrsity.
Thc adiustcd financial rncasurcs arc highly
scnsitivc to assumptions wc mnkc about
the Icvcrap appropriatc to thc financc
asscts in qucstion. Wc conrinuc to rcfinc
our lcvcmgc guidclincs for major financc
1ssct typcs,
AdjJf5~!~lCllt
proccdrrcr
Notc: In almost all insnnccs, financial state
mcnts hl1y consolidate majority-owncd n p tivc linancc opcrations: I-Icrc, consolidntcd
Corporate Ratings Criteria 2008
59
EXHIBIT RVH-2
Page 91 of 139
Ratios And Adjustmcnts
financial statcmcncs arc assumed as thc smrtjng point. When: scpanrc financial stmrncnts arc also awihble for thc finance unit,
inforniation from thcsc can bc uscd to rcfinc
thr. adjustmcnt.
Data rcquircmcnts
1 On-balancc-shcct financc rcccivablcs and
lcascs, nct;
Finance rcccivablcs and lmscs sold or SKUritizcd-rricd
off-balancc-shcct;
Financc company rcvcnucs (if actual
financc rcvcnucs arc unavailablc, we use
15% of tom1 financc rcceivabIcs);
Financc company administrativc aupcnscs (if actual financc company cxpcnscs
arc unavaiIabIc, wc usc 3% of total
finnncc receivables);
1 Dcbr to cquiry ratio: dctcrmincd to rcffcct
our view of thc "1cvcragability"of thc mptivc's nsscts Ion- and off-baIancc-shcet
Iinancc rcccivablcs and Icascs);
intcrcst mtc (thc ar"~gcratc cxpcricnccd
by thc company); and
3 Rcquircd Eixcd charge covcrag-n
intcrcst coverage appropriatc for rhc rating.
(Oltcn, 1.25~is uscd.)
Glcu~ations
= Totnf financc nsscts = on-balancc-shcct
financc rcccivablcs and Imscs + finance
rcccivablcs and Imscs sold or sccurirircd
(mrricd off-balancc-shcctl.
= Financc company EBtT financc coiiipany
rcvenucs nonintcrcst cxpenscs.
3 Fininancc company Jcbr = Total linancc
asscts times the debt-to-equity m i 4 1 +
dcbt-ro-cquity ratio). This u n ncvcr bc
morc than rcportcd consolidatcd debs if so,
tlic debt to cquity ratio should k adjustcd.
(Scpamtcly, eonsotidarcd dctt also is adjustcd to rcflcct rhc dcbt cquivdcnt of sccuritizcd ~ S S C I Sand hybrid sccuritics.)
= Financc company cquity = total financc
asscts linancc company dcbt.
Finance company intcrcst = most recent
two-ycar linancc company dcbt x intcrcst
-
-
ClfC.
Financc company rcquircd EBIT = Rnancc
company intcrcst x rcquircd futcd charge
covcngc.
= Tnnskr paymcnt = financc company EB1T
financc coiiipany rcquircd EBIT (which n n
bc pmitivc or ncgitivc}.
-
Subtract financc company rcvcnucs from
rota1 rcvc~tucsto dcrivc ndjustcd indusmial
company rcvcnucs.
Subtract financc company opcmting
cxpcnscs, including dcprcciation, from total
opcmting cxpcnscs to dcrivc adjustcd
indusaial company opcmting cxpcnscs.
Industrial EBlT adjustcd rcvcnucs
adjustcd cxpcnscs + tnnsfcr paymcnt.
= Rcducc rcportcd intcrcst by linancc company intcrcst, if rcportcd mptivc Cinancc company's intercst is includcd in consolidatcd
opcnting cxpcnscs; othcnvisc, no adjustmcnt is rcquircd.
RcJucc rcportcd dcbt (adjustcd for smritizcd asscts) by linancc company dcbt.
Rcducc rcportcd cquiry by financc company cquity ( a h incmsing total rcponcd
cquity by thc minority intcrcsts in thc captivc financc company's cquity, if thc mptivc
is not fully owncd, and its rcporrcd cquity
cxcludcs minority intcrcsrs).
= Remove rhe financc company's a s h flows,
inchding capital cxpcnditurcs, from rcported cash flows.
(Please sce "Criteria: Rcqwst for
cmrrmcrrf: Risk -8ased h i m w o r k for
Asscssiq tlic Grpital Adcqitacy of Fitzattcid
Institrttioirs, " published Jatf. 12, 2007;
"Critcria: Gptiuc Fitraticc Operatiom,
ptrllished April 17, 2007; arid Fiiiatrcc
Bthidinrics' RUtiiJgL i d To Parciit, iit
"Corporate R u t i ~ g sCritcria 2006 " edition,
011 RatitlgsDircct.
1
-
Exploration costs
Undcr somc accounting systcms, oil and gas
exploration and production (E&P) compank
may choosc bctwccn nvo altcrnativc accounting mcthods, full cost and succcssful cfforts.
Thcsc accounting mcrhods diffcr in what
costs thcsc cornpanics mpitaIizc or cxpcnsc.
A succ~~ful-cfforta-reporting
company
cxpcnscs thc costs of unsucccssful exploration
drilling (dry-hobcosts) and mplontion
costs, such as gcologic and gcophysical
expcnditures (scismic surveys)and thc costs
of carrying and retaining undcvclopcd propcrdcs. In succcsshl-cflorts accounting, only
csptomtory drilling costs that r d t in thc
discowry and dcvc1opcnt of a commcrcial
oil and gas ficld may bc apitdizcd nrtd
EXHlBm RVH-2
Page 92 of 139
amortizcd bascd on tlic ficld's provcd rcscrycs
on 3 unit-of-production basis; all dry-hole
cxpcnditurcs arc cxpcnscd 3s incurrcd. Using
thc full-cost accounting mcthod, all cxploration and dcvclopmcnt cxpcndimrcs arc upitalizcd and amortizcd ovcr rhc rcscrvcs of
thc rclntcd pool of propenics.
Anothcr diffcrcncc is thc s i x of thc cost
ccntcr uscd to amortizc apitalizcd costs.
Succcssfd-cffons cornpanics usc smallcr
cost ccntcrs, such as a PartiCUlar I C ~ S Cor
ficld; fuI1-cost companics gcncnlly usc largcr cost ccntcrs, which may bc 3s largc as an
cntirc country.
IVc vicw successful-cffortsaccounting as
morc appropriate, givcn thc highhly risky
niltllrc of hydrocarbon cuploration.
Successful-efforts accounting docs not haw
tlic potcntial to inffatc cquity and smooth
mrnings to thc samc dqrcc as fullsosr
accounting. In gcncmI, largc campanics (c.g.,
maior integntcd companics) use thc succcssful-clforts mcthod, while smallcr companies
(c.g., indcpcndcnt E&P cornpanics) usc tIic
fulI-cost sysrcm.
Howcvcr, our analysis of evplomtion costs
rcquircs making comparisons bcnvccn companics that USC diffcrcnt accounting mcthods,
which can bwt be accompIishcd by adding
back cxploration cxpcnsc to E5lTDh for
successful-cffort companics. Whilc wc prefcr
thc sucecssful cfforts approach, tlicrc is no
p m c t i d way to adjust full cost uscrs to a
successfuI cfforts method.) EYpIoration
cxpcnsc ususlly is discIoscd on thc b c c of
tlic incomc statcment of successful cfforts
eompanics. This number ofrcn is rcfcrrcd to
as EDmAX.
Givcn our prcfcrcncc for succcsslu1
cfforts, we Iimit this adjustmcnt to EBITDA
mcasurcs-nd do not wrry tIic adjustmcnt
through to a11 rclatcd accounts or to othcr
ratios. Adjusting E B m R usually sufficcs
for comparativc purposcs. And, adjusting 3
succcssful cfforts company's baIance shect to
rcflcct what i t would look likc if it had uscd
thc fulI-cost mcthod+r vicc vcrsa-is not
rcdly fcasibIc. (Apart from thc diffcrcnccs as
to what cornpanics a n mpitalizc undcr tlic
two mcthods, tlic rulcs for assct impairrncnt
tcsts also diffcr. T h c MI-cost impairmcnt
rcst, mllcd thc ccilirig t a t , gci~cmllyis casicr
S~urrdurdSr Pour's
1
bccausc of highcr assct carrying
its triggcr rncchanism. (If thc book
valuc of isscw falls bclow tlic discountcd
prcscnt valuc of cash flows, a chargc may bc
ncccssary. T h c trigger for ordinary impairment is rclatcd to thc undiscoiintcd futurc
cash flows.)
to violatc
costs and
Adjiistnictit proccdtrm
.
Dam rcquircmcnts
Exploration cxpcnscs (only applics to E&P
cornpanics using thc successfu1-cfforts
rncthod of accounting).
Glculations
m
Adjwtmcnt to opcnting incornc bcforc
depreciation, dcplction, and amortization
to cdeulatc EBITDA: 1% add cxploration
cxpcnsc back to opcnting incomc bcforc
dcprcciation, dcplction, and amonimtion
in thc EBlTDR alculation. This incmscs
EDITDA and opcnting incomc bcforc
D&A by thc cntirc amount of cxplomtion
cxpcnsc.
(Plcasc sce "Credit FAQ: Ecplorittg
Starrdnrd dr Poor's Oil A d Gas Coalpatty
Recotrcilidotr Tablcs, pnblishcd Feb. 12,
2007, on RatitlgsDircc~j
Foreign currcncy exchange gainsflosses
Forcis currcncy cxchangc giiindosse a n bc
related to transactions or translations:
Transaction gaidosscs arisc from tnnsactions that arc dcnominatcd in a currcncy
othcr than thc mtity's functionaI currcncy
[ g c n c d y thc currcncy in which thc cntity
principally transacts). Examplcs incIudc
buying and sclling goods or scrviccs WIIOSC
priccs arc dcnominatcd in a foreign currcncy, borrowing or Icnding in a forcign currency, or othcr confmctual obligations
dcnominatcd in a forcign currcncy. A
changc in thc cxchangc rate will incrcasc or
dccrcasc tlic amount of functiona1 mrrcncy
nccdcd to scttlc thc account bcnvccn thc
timc the transaction i s rccordcd in thc
hnaional-currcncy accounts and the timc
ir is scttlcd, Imding to cxchangc gains or
losscs. \Vhcn translating thc rclatcd
accounts (c.g., loans rcccivablc, accounts
payatlc, and dcbt) into thc rcporting currcticy, such gains and losscs arc rcconizcd
in thc ittcomc statcmcnt as incurrcd.
Corporate Ratings Criten'a 2008
61
EXHIBIT RVH-2
Page 93 of 139
Ratios And Adlustmnnts
Translation ginsflosscs occur wIicn translating financial stat~mcntsoft subsidiary
from il local currcncy to the reporting currcncy of tlic cntcrprisc for consolidation.
Translation gains or losscs arc includcd in
sharchotdcrs’ equity (undcr U.S. G A M ,
inchdcd in othcr comprchensivc incornc
for thc pcriod and in accumdarcd othcr
comprchensivc income in the owncrs’ cquity scction of thc balancc shcct).
Forcign currcncy transaction gainsllosscs
rccognizcd in thc incomc smtcrncnt nisc
qucstions similar to those in Nonrccurring
ItcmslhToncorc Activity (5cc below). To prcscnt il rcprcscntativc vicw of opcrating pcrformanec and financial ratios, IVC typiully
adjust company incornc statcrnents to cxclude
nonrccurring and othcr unusual transaction
gains and losscs.
Currency transaction gains and losscs may
bc vicwcd as rccurring or nonrecurring. Wc
rcview transaction gains and losses and dctcrmint whcther or not to adjust for thcm. Wc
may adjust rcportcd financia1 r d t s far currcnq gains and Iosscs that rauIt tram onctime or infrcqucnt tnnsactions: for cmmplc,
wc may adjust (or exdudc) forcign currcncy
g i n s or Iosscs rcsuIting from the inlrcqucnt
purchase of a rpcciaIitcd capita1 assct papblc
in a forcign currcncy.
Whcn thc gains or losscs rcsult from recurring or ongoing tnnsactions, rvc do not
adiwt. WCconsidcr tnnsaction gains and
losses as ongoing whcn thc company has a
history of cntering into tnwcrions dcnominatcd in forcign currcncics. The purchasc of
inventory that is paid in a forcign currcncy is
an cxamplc. Dcbt dcnominatcd in a f o r c i e
currcncy codd also result in rccurring forcign
currcncy gains and losscs thzt wc would not
adjust for.
Cornpanics may not rcport currcncy p i n s
or losscs scpamtcly for rmrring and nonrecurring transactions. Conscqucntly, wc may
not mikc adjustmcnts if thc data arc not
nvaiIablc, or if du amount is immatcrial. Our
analysis must also n k c into account tlic
potcntial for changcs in actual cash flaw
that niny t c rcquired to sctttc a trmsxtion
dcnominatcd in n forcign currency.
Translation gainsllosscs arc not includcd in
dctcrmining net incomc, but arc includcd in
1
62
www.corporatccritetia.standardnndpoors.com
shircholdc~scquiry (and, undcr US. GRtIP, in
othcr comprchcnsivc incomc) ils mcntioncd
abovc. Cornpanicsgmcrally tmiistatc ~SSCIS
and Iiatilitics using thc cxchangc mtc at thc
balancc shcct dart. Thc incomc statement is
tmnslatcd at the cxcIinngc mtc in cffcct at thc
timc fcvmu~s,cxpensm, pins and Iosscs arc
rccognixd. Thc cadi flow smtcmcnt is tnnslatcd using thc mchangc mtc in cffm at the
timc of thc cash fIowv. As a pnctical martcr,
cornpanics oltcn usc an avcngc cxcliangc mtc
for thc reporting pcriod for both incomc and
a s h flow statcmcnts. 111 addition, the msli
flow statcment rcports thc clfccts of cxchangc
rate changcs on a s h baIanccs hcld in forcign
currcncics on 3 scpantc Iinc. \Vc do nor
adjust thc balance shcct, rlic incomc statcmcnt, or thc msli flow statcmctit for tnnslation pins or Iosscs includcd in othcr
comprchcnsivc incornc.
11 a parcnt liquidatcs its invcstmcnt in n
forcign subsidiary (orinvcstmcnt), tlic
amount of forcign currcncy gains or Iosscs
buiIt up in equity arc removcd from equity
and includcd in nct inconic for thc pcriod.
This amount shouId bc cxcludcd from
incomc as a nonrccurring itcm [as woiild
gcncmlly apply to thc gain or Ioss rcsulting
from the salc].
A djirstwctic proccdrrrcs
D m rcquiwmcrits
= Amounts of nonrmrring (analytically
dctcrmincd) forcign currcncy cvchangc
transaction gains and Iosscs.
6lculations
* Thc amount of nonrccurring forcign currcncy gain or Ioss is 3dJcd to or subtracted
from opcrating income bcforc and aftcr
D&A, EIIITDR, and EBIT.
G u a mtees
The accounting for p a m r c a a n vniy grcatlp In many instnnms, a guarantee to support
borrowings of unconsolidarcd affiliata or
third partics is nor rccordcd on thc guamntor’s consolidmcd balancc shcct until it mcets
ccrrain t m s rcprding probability of paymcnt.
Altcrnativcly, ir may be mordcd a t thc lowf i t amount in R mngc of possiblc outcomcs or
at a statistically mlculatcd cxptctcd wluc (cg.,
undcr IFRS,a contingcnt &ligation tnay IC
MHIBIT RVH-2
Page 94 of 139
mmsurcd at a probability-wcightcd figurc of
porcntial paymcnt amounts). To ilhstratc, if
the company cstimatcs a 70% chancc of having to pay nothing and it 30% chancc of having to pay El million, thcn thc company
oblipion would bc rncmmd at €300,000, an
amount that has no probability of bcing paid.
W c may rakc a diffcrcnt approach, to
rcflcct our own asscssmcnr of thc risk of ultimarcly bcing rcquircd to pay (upon thc
dchult of thc othcr party).
W c add thc yanntccd amount to thc guarantor’s tom1 dcbr, unless thc othcr party is suflicicntly crcdinvortliy (i.c,investment-&e)
in its orvn right, or if w c mess thc likclihwd
of paymcnt at D Iowcr amount. {Intcrcst is not
impurd on such adjustment items, sincc thc
potcndal obligation m a y materiatizc far in thc
futurc, and therc is no currcnt nccd to scrvicc
tlut potcntial obligation)
In the msc of an affihtc, \vc considcr thc
possibility of support for thc borrowcr‘s dcbt
cvcn abscnt il formal guulnntcc.
Pcrfomancc guamntccs arc trmtcd diffcr
cntly, bcmusc tlicrc should bc littlc impact 3s
long as thc company mainnins its work or
product quality. Construction cornpanits
oftcn providc pcrformancc guunmntccs as a
condition in work contracts.
A company’s tnck tccord of paymcnts for
pctformancc guilmntccs COUIJ
be 3n indimor
of d v amount of potcntial futurc liability.
Only if thc track rccord gives us spccifie rcason for conccm would wc atrcmpr an cstirnatc
of thc liability-nd
add that amount to dcbt
for ratio a!culations.
Adjirshnert proccdrrrcs
Data rcquircmcntr
= Dctcrminc thc valuc of the guuamnrccs on
and off the balance shcct to be addcd to
dcbt, nct of tzy bcncfit, as applimtlc.
Calculations
Dcbt: Add thc amount of off-bafanccshcet dcbt-cquivalcnt; rcclassify as dcbt
thc amount of on-baIancc-shectIiabiIity.
1 Equity: Subtract amount of off-balanccshcct dcbt-cquiv;llent.
Hybrid instruments
Hybrid instrumcnts hnvc somc charactcristics
of dcbt, and somc of common cquity. Tlic
Slandard h P o d s
1
morc wight thc lattcr urrics, thc morc cquity contcnt \vc nttributc to thc instrumcnt. 1%
classify corporate hybrids’ cquity contcnt as
minimal, intcrmcdiirc, or high.
H o w to rcflcct hybrids in crcdit ratios is not
a simple question. For many y m s , w c did nor
divide the nmonnts involvcd in proportion to
thc cquity contcnt of thc spccific sccurity,
bclicving thc rcsulting numbcrs could bc misIcading. As an t~atnplc,a company might pay
thc stipularcd pcriodic amount or dcfcr ir;
undcr no sccnario would it dcIcr a fraction of
thc payrncnt: Thcrcforc, calcuIatinga h c d charge covcngc ntio with a fractional
amount has little intuitivc mwning.
For hybrids with intcmcdiatc cquity content, w e instcad compurcd financial ratios
both ways-vicwcd aItcrnarivcly, as dcbt and
as cquity. Two scts of covcmgc ratios \vcrc
alcdatcd-to display dcfcrnblc ongoing
paymcnts (whcthcr tcchniclllly dividends or
intercst) cntircly as ordinary intcrcrt and,
dtcmativcly, as an cquity dividcnd. Simlarly,
hvo scts of hlancc-shcct ntios wcrc alcufatcd for thc principal amount of thc hybrid
instrumcnts, displaying thosc amounts cntircIy
as dcbt and cntircly as cquity.
For hybrids, analytiul truth Iics somcwhcrc
bctwccn thesc two pcrspcctivcs, and analysts
havc bccn-md arr--cncoungccd to continuc
viewing hybrids from ail pcrspccrivcs-i.c.,
computing ratios with tIic sccurity as dcbt
and, altcmarivcly, as cquity; to intcrpolatc
benvccn thc SCIS of ntios 10 arrivc at thc most
mcaningful dcpiction of an issucr’s financial
profilc; and notc and give cffcct to mch morcequity-likc or Icss-cquity-likc fwturc of various hybrids in thc samc mtcgory, although
such nunnccs play, at rnosr, a vcry subrfc roIc
in thc ovcnll rating analysis.
However, wc Jiangcd our mc~lmdologyin
2006 bmusc it provcd too challenging to
communimtc our previous, more abstract
approach-nd issuccs, in particular, had m u blc apprcciating thc potcntial impact on our
vicrv of thcir financial profile, Notwjthstmdjng
thc issues mentiond abovc, wc adoptd thc
following adjusuncnts (afrcr adjusting conrw-tiblc debt issucd by I F E rcporting cornpanics
as dcscrihd bclow):
For Iiytrids in thc irtarmrdiatc catcg~ry,we
mlcuhtc ratios with outstanding atiiounts
Corparata RatIngs Critedo 2008
63
EXHIBIT RW-2
Page 95 of 139
Ratios And Adjustmcnts
(cxcluding unpaid accrucd rcmuncmrions)
split 50-50: Onc-half of thc principal is carcgorizcd as debt and onc-half = cquity; onehaIf of rhc pcriod pqmcnts is trarcd as
common dividends and onchIf 3s intercst.
(Thcrc is no adjustmcnt to uxn.)This sct
of ntios is uscd as thc basic adjustcd musurcs, nnd d i m arc thc ratios wc publislr.
Hybrids with minimal cquity conrcnt arc
trated entircly as dcbt for mtculating ratios.
I Hybrids with high cquity contcnt arc [ r a t cd cntirrly as cquity for mfculating mtjos.
I Unpaid dividends that have accnrcd, prior
to pcriod cnd, arc vicwcd as dcbt-cvcn for
equity-likc sccuritics.
ConvcrtibIc dcbt is not trcatcd as a
hybrid-unlcss thc conversion is mandatory,
or it fcaturcs appropriatc tenor, subordination, and dcfcrability charactcristics. WhiIe
IFRS and othcr accounting rcgimcs split rlic
issucd valuc of a convcrtiblc d c t t obligation
bcnvcen irs purc dcbt coniponcnt (the fair
vduc of a similar dcbt obligation without
rhc convcrsion fcaturc), accountcd for 3s
dcbt, and thc cmbcddcd convcrsion fcmrc
(rhc diffcrcncc bcnvccn thc dcbt componcnt
and thc issuc price), accountcd for 3s cquity,
such convcrtiblc debt gccncmlly docs not
attract any cquity crcdit in our mcrhodology. Rathcr, wc adjust rcportcd dcbt by the
value of thc convcrsion option includcd in
sbarcholdcrs’ equity. Cash-bascd mcasurcs
such 3s lT0 continue to rcflcct only the
actual cash cost of thc convcrtibk dcbt,
bascd on thc coupon ratc.
Adiitstmctit
procedttres
Data rcquircrncnts
Amount of hybrid instrumcnt in the balancc sIvct and sharcholders‘ cquity;
Amount of associatcd wpcnsc and paymcnts in thc pcriod; and
Amounts of accrucd unpaid intcrcsd
dividends.
Calculations
1 A high-cquityxontcmhybrid repond as
cquity is mtcd as rcponcd, as arc its associa t 4 dividcnds. Howcvcr, accrued dividcnds
1
64
arc includcd as dubt.
A high cquity contcnt hybrid rcportcd as
debt is rcmovcd horn dcbt and addcd to
cquity. Thc nssocimd intcrcst clinrgc is
www.corpomtecriteria.standardandpoors.com
rcmovcd from intercst cxpcnsc and trcatcd
as a dividcnd. Additionally, intcrcst paymcnts arc also adjustcd 3s dividcnds in thc
FFO and opcratiflg a s h flow ulculations.
An intcrmcdiatc cquity contciit liytrid
rcportcd as cquity (c.s., prcfcrrcd stock]
has 50% of its vaIuc rcmoved from cquity
and addcd ro debt. Also, 50% of tlic dividcnd amount is rcmovcd and addcd to
interest mpcnsc and intercst paid, impacting thc FFO and OCF alculations.
= A n intcrmediatccquity contcnt hybrid
rcportcd as debt has 50% of its YIIUC
rcmovcd from Jcbt and addcd to cquity.
Also, 50% of the associatcd intcmt is
removed from inrcrcst cxpcnsc and jntcrcst
paid and addcd to dividcnds.
= A minimal cquity content hybrid rcponcd
as cquity is removcd from cquity and
added to dcbt. Its associated dividcnds arc
addcd to intcrcst cxpcnsc and intcrcst paid,
thcrcby aIso rcducing FFO and OCE
3 A minima1 cquity contcnt hybrid rcportcd
as dcbt is trmtcd as rcponcd, 3s is its associatcd intcrcst.
Thc acuucd unpaid chargcs on hybrid
instrumcnts arc atcgorizcd as debt.
Narc: For optionally convcrtiblc instrumcnts, prior to thc rcclassificntions abovc,
wc rccombinc thc instrurncnt’s issucd
amount (amortizcd cost) if it tins bccn
bifurcatcd (as dcscribcd abovc, notably for
IFRS-rcporting campanics). W c d s o adjust
thc pcriod’s cxpcnsc, rvhcrc nccc~xtryand
pmcticablc, to cqual tlic instrumcnt’s dcbt
componcnt multiplicd by thc company’s
rcfinancing mtc, at thc convcrtiblc’s
issuance date, for thc cquivalcnt nonconvcrtiI11c instrumcnt.
(Plcasc see “Criteria: Eqrriry Credit For
Corporate Hybrid Scctrritics, pirllishcd Mny
8, 2006, O M RatitrgsDircct;” “Crircria:
Chri/icafiort Regarding Srcp-Ups Used hi
E p i t y Hylrrids, AUK. 9, 2007; arid "Criteria:
Standard & Poor’s Aiitioirrrccs Scucraf
Rcftiicrirciib To Its Hybrid Capital Crireria,”
Oct. 30, 2007.)
.
LIFOIFIFO: fnventory accounting methods
Thc choicc of invcntory accounting nicthods
undtr U.S. GRAP bctwccn first-in, first-out
(FIFO);last-in, first-oat (LIFO);rvcighrcd
MHIBIT RVH-2
Page 96 of 139
avcngc; and spccilic idcntifimtion c m provide dramarially diffcrcnt r d t s for pccrs
that cngagc in thc samc undcdying acdvidcs.
This issuc is marc pronounccd in scctocs that
arc invcntory-intcmivc, and in particular,
where invcntory priccs fluctuatc signifimntly.
Thc chaltcngc of comparing pccrs incrcascs on a gIobal dimcnsion. Similar choicc of
accounting options cxists in gcncmlly
acceptcd accounting smndards other than
U.S. GAAP-whilc LIFO,widely uscd in tlic
U.S., is not pcrmissible undcr many othcr
accounting standards, including IFRS. Tax
frcarrncnt of pcmissiblc invcntory costing
mcthods is a kcy drivcr in managcmcnt’s
dccision to clcct P mcthod, and varics signifimnrIy by jurisdiction. (For cxamplc, LFO
is prmittcd for tax-reporting purposcs in
the US., and thosc who ckcr LIFO for tax
purposes must also use it for tlicir financial
sratcmcnt rcporting.)
Morcovcr, somc cornpanics use G combination of costing mcthods. For cxampIc, managcment may clcct to usc the LIFO method
for 1 portion of invcntory in which priccs arc
wpcctcd to risc and FIFO for tIic balancc. In
other instanccs, invcntory rcportcd on P consolidatcd liriancial statcment can includc
invcntory balanclr of sutsidiarirs in diffcrcnt
countrics, mch of which USC diffcrcnt
accounting mcthods.
Thc grcatcst potcntial disparity of financia1
rcruhs is bctwccn FIFO and LIFO accounting
mcthods. In a pcriod of rising priccs, thc
LIFO rncthod rcsults in a lowcr incomc than
FIFO,bcciusc thc most rcccnt costs flow
into cost of goods sold on ilic income statcmcnt, and thc oldcst costs arc reflectcd in
invcntory on thc baIancc shcct. Furtlvxmorc,
a s h flows arc tcmpomrily improvcd,
bmusc currcnt incomc ~ Y C arc
S
lowcr as a
rcsult of thc Iowcr incomc. Apart from intcrcompany comparisons, diffcrcnt ntcthods a n
skcw thc pcapcctivc of corpomtc pcrformm c c . For cxmplc, LIFO providcs LI bcttcr
rcflcction of matching costs against rwcnucs
on thc incomc statcmcnt, but crcates a balancc-shcct distortion by having oldcr costs
rcsiding in invcntory. TIE FIFO mcthod, on
thc othcr hand, providcs a mom currcnt valuntion of invcntory on thc batancc shccr, but
can significndy undcrstntc cost of goods
Stairdud 8c Poor’s
4
sold in a pcriod of rising prices, rcsulring in
artificially ovcrstmd incomc.
Balancc shcct: WLcrc significant to our
a n a l y t i d proccss or csscntiaI for pccr
comparability, w c add back thc LIFO
rcscrve to invcntory amounts on thc balancc shcct for companics that USC thc
LIFO mcthod. This cnablcs us to rcflcct
invcntory balanccs at approximate current mirkct value. (Compsnics that apply
the LIFO mcthod arc rcquircd to disclosc
w h a t thc invcntory valuation would bc
undcr FIFO, through an account callcd
thc LIFO rcscrw, which rcprcscnts thc
cumdativc cffcct on gross profit from
the usc of thc LIFO rncthod.) A corrcsponding adjustmcnt. net of tax, is
made to cquity.
Incomc smtcmcnt: \Vc do not adjust t I u
incornc stlitcmcnt whcn companics USC
LIFO,bclicving thc LIFO rncthod rcsuIts iti
costs of goods sold that arc more indiativc
of rcptaccmcnt-cost vaIucs, and tlic h t
matching to rcvcnucs. Whilc it might bc
dcsimblc to adjust for thosc cornpanics that
usc FIFO or avcragc costs mcthods, thc
data generally arc unavailable.
* W ~ c na company using tlic LEO mcthod
has invcnrory balanccs that dccrwsc ovcr a
pcriod of timc, LIFO liquidation may
r d t . It mwns that oldcr, lcss-rcccnt laycrs
of invcntory are tumcd into cost of goods
sold as a rrrutt. [Tlicsc arc oldcr in tcms
of thcir accounting, not ncccssariIy in any
physial sensc.) Assuming an inffationary
environmcnt, cost of goods sold is rcduccd,
and 3s a rcsult, incornc incmscs bmusc of
LIFO liquidarion gains. To captom tfic true
sustainablc profitability of a company, thc
gains gcncntcd from LiFO liquidation gcncmlly arc cxcIudcd from our currcnt profimbility mcasurcs and ratios.
= G s h ffows: Wc typically do not adjust thc
cash flows, but wc considcr, qualitativcly,
thc boost to ash flows thc LIFO mcthod
affords Juring pcriods of prim inflation
(via tilxcs dcfcrrcd to Iuturc pcrjods).
A djttsfmatt proccdtrrcs
Data rcquircmcnts
* For thc balancc-shect ndjustmcnts:
LIFO rcscn’c.
Corporate Ratlngs Criten’a 2008
65
BHIBIT RVH-2
Page 97 of 139
Rotios And Adjustments
For thc inmmc mtcment adjustmcnrs:
LIFO Iiquidation gains.
Glalations
Thc balancc shcct adjustments affcct invcntory (assets) and cquity.
a LIFO rcscrvc is addcd to invcntory (assets).
Equity is incrmscd by thc LIFO mcmc
(aftcr-tiu)
Thc incomc swtcmcnt adjustmcnt alfccts
opcrating incomc beforc and afrcr D M , and
.
E B m A and EBIT.
= LIFO liquidation p i n s arc dcductcd from
opcrating income whcn dcuJating opcnting incornc beforc and aftcr D W ,and
EBITDA and EBIT.
Litigation
\Vc rnakc c~-c-by-ascjudgments rcgarding thc
probability of a ncgativc outcomc, thc poten-
tiaI financia1 cffcet, and its timing, incIuding
duration of any a p p d s pmcss. Wc also rcplady obtain additional dam from thc company
involvcd, on a confidcntial basis, to cmblc a
morc mcaningful analysis of pfausiblc sccmrios. Thrrc might includc any llvllilabIc l q a l
opinions and rcsurch; thc company’s I c p I
stnrcgy; and thc numbcr, size, and status of
claims. To assist us, \vc may consult Icpl
counscl to cvduarc likcly sccnan’os. TIiis
indudw in-housc 1 4 smff, cxtcrnil cound,
andlor industry-rclatcd counseI.
To thc mtmt that n rnoncnry judgmtnt is
prcdicnblc, wc sizc thc amount that will bc
paid and tmt it as P debt-cquivalcnt. If paymcnt is not imminent--if, for cxamplc, thcre is
an emmhxl appcds proctss--wve would atimarc thc timc untl actual payment, and discount the crcntud paymcnt amount unlcss
intcrcst will bc addcd. T h c adjustcd dcbt ratios
arc mfculatcd including thc ptcscnt mluc of
thc cstimatcd payout, on an aftcr-tax basis.
Whcrc npplimblc, w c subtract any cxpcctcd
imumncc rccovcrics.
It usudIy is vcry challenging to sizc Iitigation ourcomcs. Prcvious casts of similar
n m r c a n scrvc as benchmarks. Subjcctivc
judgments rcgmding tlic rncrits of a msc may
also inform our vicrv of possiblc outcoims.
Somctimcs, thc company’s litigation
rcservcs rccordcd in its financial statemcnts
a n offcr insighr. Cornpanics must rcscnw for
litigation t h y a n quantily. In pmcticc, iiiost
66
wmnnr.corporntccritoria.standard,lndpoors.com
companics tcnd to minimizc Icgd rcscrvcs
(aItliough somc companics~pccially
Europcm companics-will ow-rcscrvc to
cnablc srnoorhing of futurc arnings).
Thcrcforc, to thc cxtcnt that a company docs
CCSCTYC, one may ordinarily concludc thcn! is
a high likclihood that rcquircd payments will
bc at lcast that amount. Thc company’s
rescrvc is not 3 rcliablc indicator that thc ultiinatc IiibiIity will not cxcccd that amount. In
any cvcnt, providing mc~vcsis mcrcly an
accounting recognition of thc liability; it
docsn’r mcan [hat the company has pur asidc
a s h to fund thc liability. \Vc would still nccd
to adjust thc dcLt figure to rcflcct tlic mh
impact h a t a payment would cntail. (On thc
othcr hand, thcrc ofrcn will bc a Icngtthy pcriod until: payment is madc, so IVC also eonsidcc tlic company’s ability to gcrvmtc a s h in
thc intcrim.)
A dass-action suit pcrmiw a Iargc numbcr
of individual claims to Lc cornbincd and tricd
as one lawsuit. W c vicw cIass-action lawsuits
as thc most troublcsomc type for crcdit quality bmusc of rhc potcntial sizc of awards.
Class-action suits must bc ccrtificd by a court
to procccd to trial; howcvcr, oncc ccrrificd,
thc lawsuit oftcn takcs yciirs to wind through
thc litig3tion proccss.
Outsidc thc US., litigation is lcss signifiu n t as a credit risk than in the U.S.
TypicaIIy, thcrc is no award of punitivc dnniP ~ C S class
,
actions arc limitcd, andlor trials
may not come bcforc juri- that a n rmct
unprcdicnbIy to thc litigation.
kcausc the spccific financial cffcct of a Iawsuit is diffimlr IO quantify accumrcly, wvc may
rcly on anaIytim1 tcchniqucs such 3s nlculating m n p of outcomtx or performing scnsitivity analysis. This a n bc vcry hclplul if it allows
us to conclude, for cmmplc, that thc cornpny
an manage cvcii thc morc dirc potcntial outcomB without materially affming its financial
proftlc. AItcmativcIy, if signiliclnt uncertainty
rcmains, wc might mnsidcr il downgmdc hscd
on a vcry Iargc risk cxposurc.
Litigation posts scvcml important, potcntially troubling considcmtions bcyond any
dircct financial conscqucnccs. \Vc considcr
thc potcnrial damage to a cotlipany’s rcputation or ability to conduct nonnal tiisincss
opcntions. For cxaniplc, product IiabiIity
MHIBlT RVH9
Page 98 of 139
mscs somctimcs rcsult in thc product's bcing
rcmovcd from thc rnarkcr. Substantial litigation may rcquirc an inordinate amount of
rnanagcmcnt tirnc and crcatc quitc ildistmc-
tion from running thc busincss.
Morc broadly, lawsuits mn nffcct a company's rcplrtation andlor its ability to pmcr
furthcr busincss or raisc mpitaI. Public mistrust and a ngativc pcrccption of the company's operating stmtcgy would dcfinitcIy bc of
conccrn.
Lst, but not least, bonding rcquircmenrs
can posc 3 trcrncndous liquidity chalIenge,
crpcciatIy in jurisdictions that haw no bonding ups. Bonding mn tic up cash that could
othcnvisc be invcrtcd in the busincss, cvcn if
it docs nor post an immcdiare t h a t to solwncy. (Naturally, in the msc of litigation
cxpcetcd to bencfir thc company, similar
adjustments apply, in rcvcrsc.)
Adjifsttmiitpro ccdrms
Data rcquircmcnts
3 Dctcrminc thc mluc of thc litigarion wposum to bc addcd to dcbt.
CaIcuIations
Dcbr: Add thc amount of dcbt cquivalcnt
(nct of tax bcncfit, as nppIicnblc) to Jcbt;
and
= Equity: Subtract tlic amount of off-balanccshcct dcbt cquivalcnt, nct of tax.
(Plcase scc "How LitigdoJi Risk Affects
Corporate Ratings, " ptrblishcd Nov. 28,
ZOOS, O M RatiqsDircct.)
Nonrecourse debt of affiliates
(scope of consolidation)
In thc context of corpontc dcbt andysis,
non-rccoursc debt ofrcn rcfcrs to a situation
in which an affilim or subsidiary of a company borrows funds, possibly pledging ics
ilsscts as collateral, whilc thc parcnt company and 0 t h subsidiarics in the corporatc
strttcturc hnvc no Icgd obligation to perform
undcr thc borrowing agrccmcnt. If an cvcnt
of dcbuIt occurs, thc Icndcr's claims arc limitcd solcIy to the subsidiary that borrowcd
thc moncy.
Non-rccottrsc dcbt may m i s t for a varicty of
rcasons. t i company may want to Icgally isoIatc thc bankruptcy risk of a subsidiary, for
cxamplc, bcctusc thc subsidiary's bilsiness
prospects arc more unpmlictablc. than thosc of
the parcnt. Also, non-rccoursc dcbt may rcsult
from a particular jurisdiction's Icgl rcquircment to opcmtc Iomlly through a scpantc
Icpl cntity- In othcr mcs,a company may
own only a portion of P subsidiary, maybc
cvcn a minority inrcrcst, and tIic company
may bc unwilling to pur itsclf on the hook to
fund thc obligations of thc joint venturc,
In non-rccoursc stmcturcs, thc parcnt company has thc Icgal right to walk away from
the troublcd (or bankrupt) subsidiary. This
oftcn is a by-product of cotpomrc Iaw and
rclatcd Itgal isolation doctrincs rcIafcd to
entitics structured 3s corporations or othcr
lirnitcd-Iiabiliry structures. Notwithstanding
thc thcory, history has shown this okcn is not
thc way things play out. Thc parcnt company
oftcn cads up providing cconomic support to
thc subsidiary, dcspitc thc non-rccoum
naturc of Llic obligation.
In a d p i n g thcsc situations, wc attcmpt to
undcrstand thc relationship bchvccn thc parent and subsidiary, and mnkc a judgrncnt
about whcthcr tlic parcnt would bc incIincd to
step in (and to what cxtcnt). Whib prcdicting
thc outcomc of such a scenario is nor an cxact
sdencc, w c bclicvc that considcring plausibb
scenarios is supcrior to d y i n g solcIy on thc
Icgd framcwork, and ignoring thc cconomic
rclationship cxnnt bctwccn thc cntitia.
Thc rclmionships bcnvccn thc affiliated
cntitics a n vary grcatly. T h c cntity issuing
the dcbt considcrcd to bc non-rccoum may
simply rcprcscnt a non-corc, non-stmtcgic
invatmcnt; if so, tlic parcnt is not burdcncd
with thc subsidiary's dcbt obligations.
At thc othcr cnd of thc spectrum, thc subsidiary's opcmtions may bc cliamctcrixcd as
an intcgntcd busincss. T h c analysis would
thcn fully consolidatc thc subsidiary's financial starcmmts, including dcbr. Furrhcrmorc,
the risk profilc of thc subsidiary's apcmtions
wouId bc intcgmtcd with thc ovcmll tusinfss
risk analysis of irs parcnt.
O h , thc subsidiary issuing thc dcbt may
not fall ncatly into cithcr catcgory; it may
lie somcwhcrc in thc middlc of tlic spcctrum. Somctimcs we usc a pro rata consolidation to rcncct this niiddlc ground. For
cxamplc, w c would apply pro rata consolidation to joint vcnturcs bctwccn parmcrs of
Sratrdurd L Poor's = Corporate Ratlngs Criteria 2008
67
EXHIBIT RVH-2
Page 99 of 139
Ratios And Adjustments
comparablc capacity and wvillingncss to support for thcir rcspcctivc stratcgic rcilsons.
Evcn in cascs that do not call for anaIytica1
consolidation, wc prcsumc thcrc will bc
additional invcstmcnt in thc non-rccoursc
entity, i.c., thc moncy thc conipany l i k d y
wouId spcnd to providc support or b nl‘I out
thc unit in which it inwsrcd.
No singlc factor dctermincs thc analytical
vicw of thc rclationship with thc affilimc;
rathcr, scvera1 factors, mkcn togcthcr, will
lcad to one chamctcriwtion or anothcr,
including:
= Stratcgic imponancc-intcgratcd lincs of
busincss or critical suppIicr;
Pcrccntagc owncrship (eurrcnt and
prospcctivch
Managcmcnt control;
= Sharcd corpomtc namc;
Domicilc in samc country;
1 Common sourccs of capital and
lcnding relationships;
Financial apacity for providing support;
Signifiuncc of amount of invcstmcnt;
Invcstrncnt rclativc to amount ofdcbt nt
thc vcnturc or projmt;
a Nature of any othcr owners (smtcgic or
financial; financial capacity);
a Managcmcnt’s statcd posrurc;
Track rccord of parcnt company in simiIar
circumstanecs;
3 Thc nature of potential risks;
Sharcd collcctivc bargaining agreemcnts;
and
Jurisdiction’s banhptcy-law regime,
-
.
Adjiisttirctir procediires
Thcrc is no standardized sdjustmcnt, givcn
the multiplc faa pattcrns and subjcctivc
naturc rclaring to subsidiariEslprojcctoint
vcnturcs. As cvplained sbovc, some consolidntcd cntirics-ad
thcir liabilitim-might bc
dcconsolidatcd, whilc somc noncomolidatcd
cntitics may bc consoIidatcd.
Anothcr possiblc adjustmcnt is pro rata
consolidation. This approach is not uscd
too frcqucntIy, and typically applics onIy
wbcn both owncrs havc similar financial
profiles and rnorivations with rcspcct to a
joint vcnturc.
Notc that CVCII in cam wticrc IVC conclude
that tlic liablity will not ultiiiiatcly bc sup-
68
www.corporatecrit0ria.s tandardandpoors.com
ported, IVC could wcll cxpcct that tlic owncr
wouId cvtcnd partial support to thc vcnmrc
or subsidiary, inchding additional: invcstmcnts to attcmpt to rcscuc it. Wc would try
to sirc such ndditional wpcnditur-nd
imputc that amount as dcbt to thc parcnt.
(Please sec “CorporateRatings Criteria,“
2006 ediiiorr: f’arertt/Subsidiary Liirks, and
“Credit MQ: Knoiuitrg Thc Investors Itt A
ContpatryO Debt Attd E p i t y , ” p i i t l i s ~ ~ c d
April 4. ZOO&
011
RntitrgsDircct.)
Nonrecurring itemdnoncore activities
1%typically makc adjustincnts to il company’s rcportcd opcrating incomc and cnsli
lIow to rcmove itcms wc considcr nonrccurring and inchdc thosc wc considcr recurring, so the historical financial ratios will
bc morc indicative of futurc pcrformancc.
Tlicsc adjustrncnts cover itcms including
discontinucd opcmtions; cffccts of natural
disastcrs; gains or Iosscs on assct snlcs and
saIdlcasebncks; and onc-time chargcs for
msct writc-downs, rcstructuring and
plant shutdowns.
\Vc rcviciv MCII porcritid nonrmrring
itcm, and dctcrmine whethcr to adjust lor it.
Our vicw of tbmc itcms may diffcr from thc
company’s vicw, as prcscntcd in financial
statcmcnts or footnotes.
Wc may vicw somc supposcdly onc-timc
restructurings as ongoing for a particular
company. Taking such a view may rcncct 3
company’s history of rccurring rcstructurins chargcs, or thc pcrccieed nccd to
address citlicr company-specific or industry-wide compctitivc issucs (for cxarnplc,
rhc nccd to movc bcilitics offsliorc in ordcr
to bc cost cornpctitivc).
Wc may also vicrv ccrtain othcr itcrns that
company mnnagcmcnt eliamcrcrizcs as onctimc itcms as noma1 operating costs: In thc
rcmil industry, tvc do not typically view
invcntory rvritc-downs or high stoic prcopcning COSE from a npid expansion pmgram ns unusual itcms.
In a similar vcin, w e often distinguish
bcnvccn a company’s corc busincss activity
and otlar, ancilIary aaivitics-cspccially if
tlicre is some qucstion atour tlic lattcr’s sustainnbility. A aianiifacnrrcr may cam moncy
from tmding activity; i t may cvcn sct up iis
EXHIBIT RVH-2
Page 100 of 139
treasury opcmtions as a profit ccntcr, but wc
may isofatc, reclassify, and scpimtcly anaIyzc
thc results of thosc opcmtions.
For incomc dcrivcd from thc snlc and
liccnsing of corporatc asscts, wc similarly
distinguish tctwvccn sustainabIc, ongoing
salcs and thosc that arc more opportunistic.
Ancillary activitics can distort mmsurcs of
core opcrating pcrfomancc, and pccr analy.
scs that rcly on comparability of data,
unless adjustmcnts arc madc. An analogy
can bc drawn to thc analytical scgrcgation
of non-homogccnous activity. Some G A M
rules may rcquirc consolidation if a company owns both manufacturing and linancc
subsidiarics: W c wouId scparatc rhc nvo for
analyticd purposcs.
Thcsc adjutmcnrs rcquirc an apprcciation of industry-specific contexts. For
cxmplc, in tbc high-tcchnohgy industry,
cornpanics dedicatc substantid amounts of
capital IO rcscarch and Jcvclopment cflorts
and accumulatc intdlccrual propcrry in thc
form of patcnts, tndc sccrcts, domain
namw, ctc., which may bc sold or liccnscd
to complcmcnt rcvcnucs gcncratcd from
core opcmtions.
1%considcr rcvcnuc gcncmtcd from thc
Iiccnsing of intcllemd propmy to bc a part of
opcnting incornc, and thcrcforc a cornponcnt
of EBtTDA, bcausc this nmngcrncnt allows
for P rclativcIy prcdictabIG r a r i n g s o w of
rcycnuc. Horvcvcr, rcvcnuc gcncmtcd from the
salc of intcllcctual property is not considcrcd
part of opcnting incornc. Whilc thcrc may be
advanraga in seIIing intcllmxil propcrty,
nthcr than l i c c n s i n g ~ . Ihc
~ , rcceipc of
grurcr upfront procccds or thc dimination of
futurc rcsponsibilidwhis arnngcmcnt normally is tmtcd as non-apcmtinginromc.
In othcr situations, the silc of ~ S S E ~may
S
bc considcrcd rccurring. For mi~mplc,companits that lmse or rcnt auromobilcs or indwtrial cquipmcnt routincly and pcriodidy
disposc of thcsc assets via auctions andlor
othcr salts
A ~ ~ J H ~ Jproccdrrres
H C I ~
Data rcquircmcnts
Amounts of incomc, cxpcnsc, and a s h
flows to t c rcclassificd (incIuding nonrccurring itcms rcportcd as optrating, and
Srnndnrd & Poor’s
rccurring items not rcportcd as opcmting).
Thcsc amounts arc judgmcntally dctcrmined, bascd on information discloscd and
our asscssmcnt.
GlcuJations
1 Add or suttnct amounts from rcspcctivc
mmsurcs, (e.g., rcvcnuc, opnting incomc
bcforc and afrcr D M ;D&A; EBTT; EBTI)& operating a s h flows and FFO)to
rccIassily as appropriatc. Bccllusc opcming
cash flows and E O arc post-tax mcasurcs,
&cy abo arc adjusted to rcffcct r b tax
cffccfs, wlicrc fcasiblc.
Bcyond thc standard adjustment, additional
insights may bc glmncd by adjusting individual linc itcms within cost of goods soId
or sclling, gcncml, and administrntivc
( S G M ) cxpcnsc, if tlicrc is sufficicnr dam
to rcflcct adjusrmcnts at such IcvcIs.
Similarly, ancitIary activitics data arc scgrcgated and scparatcly a n a l p d , ro thc
cxtcnt pnctimblc with availnblc data.
Oparating leases
Cornpanics commonly usc lasing 3s a mcans
of financing. T h c accounting for Icascs distinguishcs bcnvccn opcrating and linancc Imscs.
Financc Iascs (also rcfcrrcd to as capital Icascs) arc accountcd for in a rnanncr similar IO a
dcbt-financcd acquisition of an asscr, wliilc
many opcnting lcascs arc rcflcctcd in thc
accounts on a pay-as-you go basis. Wc vicw
the accounting distinction bcnvccn opcnting
and capital Icascs as substantially artificial. In
both u s e s , thc lcsscc contracts for thc use of
an assct, cntcring into n dcbt-Iikc otligtion
to makc pcriodie rental paymcnts.
Our Imse adjustmcnts scck to cnhancc
companbPity of rcponcd rcsults (both opcrating and financial) and financial obligations
among companics whcthcr thcy lcmc asscts
undcr Icascs accounrcd for 3s operating or
financing lmscs, or usc dcbt to rinancc assct
acquisition. Thc opentinglc~sc-adj~tmcnt
modcl is intcndcd to bring cornpanics’ financia1 ratios closcr to tIic undcrIying cconomics
and morc comparablc, by taking inro considcmtion all financial obligations incurrcd,
whcthcr on or off thc balmcc shccr. Thc
modcl improvcs our nnaIysis of how profirably a company crnploys its Imscd and
owncd assets.
Corporate Ratlngs Crltcrin 2008
G4
EXHIBTT RVH-2
PagelOtof139
Ratios And Adjustments
Our modcl docs not fulIy rcplimtc il sccnario in which a company acquircd an assct
and financcd it with dcbt: rather, our
adjustmcnt is narrowcr in scopc: It attcmprs
to capturc only thc dcbt cquivalcnt of a
company’s leasc contracts in placc. For
cxamplc, rvlicn a company lease 3n assct
with a lo-ycar productivc Iifc for fivc ycars,
thc adjustmcnt picks up only thc payments
rcIating to thc contractcd lcasc pcriod,
ignoring thc cost of thc cntirc ilssct that
rvould have bccn purchascd4nd dcprcciatcd--by a company that chosc to boy instead
of Icasc. Wc havc choscn not to usc aItccnativc mcthodofogics that capitalize thc cntire
issct bcmusc thcy cntail various dara and
intcrprcration challcngcs. In mscs wlicrc thc
company has an cconornic necd to usc tlic
asset far longcr than thc lcnsc tcrrn, w c tikc
zccount of this qualitativdy; howevcr, if thc
I c m is vicrvcd as artificially short, and
thcrc is adcquatc information, such as for
snlclfcascback transactions, wc capitalizc
thc cntirc sale amount.
disclosurc-docs nor capturc how futurc
paymcnts may dcdinc in thcsc y~=trs.
Futurc Icasc payrncnts arc considcrcd nct of
sublmsc rcntd only whcn tlic Imsc and
sublcasc tcrms match, and thc sub-Icsscc is
sufficicntly ctcdihvorthy.
= Tlic discount factor is detcrmincd in ono of
the following ways: idcalIy, thc imputcd
discount mtc associatcd with rhc Imsc
would bc uscd, but rarcly is availablc, and
unlikcly to bc a d a t h c for a11 cornpanics
in an industry; use thc avcmgc mtc on the
company’s sccurcd dctt; andlor USC il ratc
imputed from the company’s ton1 intcrcst
q m s c and avcngc dcbt.
= Annual opcmting-lcasc-rclatcdcxpensc is
somctimw avail~blcin tlic note and will
bc used. Whcn thc amount is not scpamtc
1y discloscd (c.s., wlicn prcscntcd with conringnt rcnt and orhcr amounts, or
incorpomtcd with othcr costs), it is cstimatcd using rlic awmgc of thc first projcctcd annual paymcnt at thc cnd of thc most
ccccnt and prior ywr.
Glculations
Adjitstiiiettt
proccdttres
Data rcquircmcnts
Minimum Icasc paymcnts: Noncancclablc
luturc Imsc paymcnt strcam [and rcsidml
valuc guaranrm if not includcd in minimum lwsc payments); discount factor;
annuaI Imsc-rclatcd opcrating mpense for
thc most reccnt ycil~;and dcfcrrcd gains on
s d c lcascback transactions that rcsuIrcd in
Icx~scsaccountcd for 3s operating.
Future-Imsc paymcnt d m arc found in the
n o t a to thc financia1 statcmcnts. Annual
payments for thc coming five ymrs (itcmizcd by ycar) and thc aggregate amount for
subscqucnt ycars arc pravidcd undcr U.S.
GMP. Our modcl assumcs that futurc paymcnts for ycars bcyond the fifth ywr
approsimatc &c fifth-ycar amount. Undcr
IFRS, cornpanics arc pcrmittcd to discIosc
amounts paynblc in y c m two through four
in a single combincd amount, insrcad of
disclosing scpantc amounts for cich of thc
nmt fivc ycars. In this casc, WC issumc a
flat I c w l of paymcnts in ymrs nvo through
four, bascd on thc total rniniriiuni Icasc
payment discloscd for thcsc thrcc ycars.
This npproxirnarbn-aiscd by tltc liniircd
1
Dcbt: Thc prcscnt vaIuc of thc paymcnt
strcam, determincd using thc discount
factor, is addcd to dctt. (Lcasc dcbt is
not tax-effected bccausc its t a x a will
ncvcr rcflcct tlic analytical construct
undcrlying our adjustmcnt. Thc company
is, in fact, gctting thc tax trcatmcnt
affordcd to Imscs-assuming G M P and
tax ircatmcnt as opcming lcnsc is tlic
same. Thc actual tax amounts arc those
incIudcd in ttic accounts-and gcncrally
rcquirc no adjustmcnt. This contrasts
with PRB and ARO adjustmcnts-which
may bc tax-cffccted. Thosc adjustmcnts
are bascd on thc anticiparion that taxdcductiblc rccognition of thc obligations
wil1 uhimitcly be rcquircd.)
Opctnting incomc and a s h flow mcilsurcs:
T h c operating-lcasc-rclatcdwpcnsc is
apponioncd to intcrcst and dcprcciation
components, ns dcscribcd bclorv. T h c cffcct
is to incrcasc opcrating incomc mmsum:
SG&A--by tlic cntirc amount of thc
cxpcnsc; EBlT-by thc implicit inrcrcst
portion; EBITDr\--by tlic implicit intcrcst
portion; and WO-by thc itliplicit dcprcciation portion. In addition, opcmting
EXHIBIT RVH-2
Pago10201139
incomc wouId bc adjustcd to rcvcrsc gain
or loss on m1dmscback transactions.
Intcrcst cxpcnsc: Intcmt cxpcnsc is
incrmscd by thc product of thc discount
ratc rnulriplicd by thc a\rcragc first-ycar
projcctcd paymcnt for thc currcnt and
prcvious ymrs.
1 Dcprcciation: Opcmtingbasc dcprccbcion, Le., thc operating-Imsc-rclatcd
cxpcnsc amount Icss thc caIcuIatcd lease
intcrcst, is sddcd to dcprcciation cxpcnsc.
(Wc dclibcntcly crtlculatc EBlTDA without adding back thc imputed dcprcciation
compancnt, dcspitc thc apparent dcfinitional conflict. Thc cash flow chamctcristies of Icasing do nor nmt1y conform with
thc dtcmative of borrowing IO acquircvcn though our adiustmcnt attcmpts to
cquatc thcm. Lcasc payntcnts rcprcscnt
ongoing a s h outflows-quite diffcrcnt
than dcprcciation, or cvcn omortimtion of
assct acquisition-rclrrtcddcbt.)
* Capital cupenditurcs: C a p i d cxpcnditurcs
arc iticrcascd by an implicd amount alcuIatcd as thc year-ovcr-year changc in opcrating lcasc dctt plus annual opcratiq lwsc
dcprcciation. This amount cannot bc ncgarive. Capital cxpcnditurcs arc also adjustcd
in the same fashion for capital lcascs.
= Propcrty plant & cquipmcnt: Opcmting
Imsc dcbt is addcd to PP&E to approximate thc dcprcciatcd nssct cost.
Postretirement employee
bcnefitsldcferredcompensation
Dcfincd-bcncfit obligations for rctirctx,
including pensions and hcdth mrc covcragc
(collcctivcly rcfcrrcd to as PRB), and other
forms of dcfcrrcd compcrtsation arc financial
obligations that must be paid avcr timc, just
as dcbt must bc scrviccd, so ivc includc thcm
in dcbr ratios. A company may pic-fund thc
obligation or part of it (and cornpanics often
do prc-fund thdr pcnsion obligations), which
offscts thc financial burdcn. Our objcctivc,
thcrcforc, is to rcflca thc IcvcI of undcrfunding of dclincd-bcncfit pcnsion obligations, as
wcll as typically nor-fundcd hcaIth care obligations and rctircc lump-sum pnyynicnt
scIicrncs, and othcr forms of dcfcrrcd compcnsadon. In arriving at adjustcd financial
mcasurcs, \vc must undo accounting short-
Stardad & Poor‘s
1
comings that affcct bdancc shcets, a s h flow
statemcnts, and incomc stntcmcnts (undcr
most currcnt GAAP). T h c adjustmcnrs pcrrain to obligations alrcady incurrcd, without
trying to capture future lcvcls of IiabBity.
When PRB obligations consritutc a major
rating considcmtion, we dclvc morc dccply
into thc company’s panicular circumsrancts
and its lxncfits plans. Abo, for somc cornpanics, funding and liquidity considcmtions surrounding rctircc obligations a n bc much morc
impornnt to thc crcdit profdc thin imputing
dcbt to thc financial ratios. Tliis situalion typically pcmins to spcculntivc-gmdccornpanics
that tcnd to have fnvcr availablc rcsourc= for
a s h rcquircmcnts, including mccting mandatcd funding of PRa obligations.
\Vc do not include in dcbt any amounts for
dcfincd-contribution plans, b m u s c thcy
cntail no obligations or risks to tIic sponsor
rclatcd to past scrviccs bcyond tlic currcnt
pcriod’s payments. Wc also haw a slightIy
diffcrcnt position regarding multi-cmpIoycr
plans, not othcnvisc dcaIt with I:crc. (Scc
“Standard & Poor’s Approach To Atralyzitig
Birploycrs’ Pmticipatiorr br U.S. MdriE~~iploycr
Petision Plans, ” prrlrlishcd May 30,
2006, oti RatiitgsDirectJ
A kcy dilfcrcncc bcwccn dcbt and PRB
obligations is thc inherent mcisurcmcnt
unccrtainty, as thc bcncfits and rclatcd ~ S S C W ,
to thc cxtcnt t h y arc fundcd, arc variable.
Quanrifying PRD abIigations rclics on numcrous assumptions, including:
u EmpIoycc turnovcr ntcs and lcngtli of
scwicc, according to which bcncfits vary;
* Mortality mtcs and dcpcndcncy
s t a d o n g v i t y assumptions,as thc cmploycc and hidhcr dcpcndcnts’ lilcspan dctcrminc how long tlic bcncfit will Lc paid:
= Future compensation lcvcls, to thc cxtcnt
wages prior to rctircmcnt arc a factor in
dctcrmining thc atnount of thc tcncfit;
I Hcaltli cam cost inflation, USC, and dclivcry
pattcrns; and
I I)iscount mtc assumptions rcquircd to mlcuIatc 3 prcscnt vduc of thc future
rcquircd cash outflows.
Standard financial adjtistrncnts cannot m i ly factor in dcviations from norma1 assumptions on thcsc mtilsurcmcnt drivcrs. Howcvcr,
for somc factors, thc analysis can, at IC~SC,
Corporate Ratings Criteria 2008
71
EXHIBTT RVH-2
Page $03 of 139
Ratlos And Adjustments
gaugc thc scnsitivity to chnngcs in thosc
assumptions. For cnmplc, il rough rule of
thumb is that for mch pcrccntagc point
incrmsc or dccrcasc in rhc discount mtc, thc
liability dccrcascs or incrcascs by at Icast
IO%, and oftcn by 15%-20%.
morc
mature the plan, or thc highcr thc markct
inrcrctst rata, thc Icsscr tlic impact.)
To simplify thc numcricd analysis, we
cornbinc all rctircc bcncfit plan asscts and
liabilitics, for pcnsion, hcdth, and othcr
obligations, nctting thc positions of a cornpany’s plans in surplus against tliosc that are
in deficit.
In tlicory, and ovcr thc Ions tcnn, companits with mu1tiplc plans should bc able to
curtad contributions to ovcr-fundcd plans
and rcdirccr contributions to under-fundcd
plans. In thc ncar tcrm, horvcvcr, funding surplum arc oftcn hard to t a p - m d may havc
me
advcrsc tax conscqucnctrs if dmwn-cvcn
wliilc cash contribution rcquiremcnts may bc
onerous on othcr, undcr-funded plans. But, if
rnccting nmr-tcrm cash rcquircmcnrs is an
imporrant issue foro particular company, its
ercdit profilc IikcIy will bc drivcn by liquidity
comidcrations, whilc dcbt ratio Ievcls would
bc of sccond~ryimportancc,
Wc focus on thc mmsurc of tlw obligation
that rcfIccts a going-conccm vicw. For c?Implc, undcr US. GAAP for pensions, this is thc
projcctcd bcncfit obligation (PBO), or an
cquivalent actuarial mcasurc of tlic ultimatc
liability. T h c goingconccm view of thc company incIudcs thc cffcct of cxpcctcd wage
incrascs if the bencfir attributable ro past
cmploymcnt scrviccs is tied to cmploycc compcnsation according to snmc formula.
Howcvcr, for mlIcctiwIy bargaincd hbor
contracts, thc PBO d m not ukc account of
cxpcctcd rvagc incrcascs bcyond rhc tcrm of
thc &sting contract,
Wc do not usc thc accumulated bencfit
which takes into account
obligation (RHO),
only the bcncfiw payablc upon plan tcrmination at pcriod cnd, or thc vcstcd bcnclit
abligation [which is no Iongcr discloscd
undcr U.S. GARP),bccausc thcy rcfIcct a
shutdown valuc pcrspectivc, rathcr than an
ongoing firm pcrspcctivc. SimiIarly, in thc
U.K., w c do not focus on tlic vaIuc of bcncficiarics’ claims based 011 a hi1 bugottt basis
72
wwrv.corpon tccriteria.standardandpoors.com
(ix., bawd on thc prim prcvailing on tlic
annuity markct, whcrc dcmrnd is currcntly
insufficicntly covcrcd by supply), which
oftcn considcnbly cxcccds tlic amount
cquivalcnt to PI30 uridcr IFRS or U.K.
GAAP. (Thc A B 0 and full buyout vduc arc
morc appropriatc mcasurcs in our rccovcry
and subordination analysts.)
For othcr postrctircmcnt obIigationsincluding mcdical liabilitics, wc USC a
nicasurc cquivalcnt to thc pcnsion PBO.
For cxamplc, undcr U.S. GARP, this is
thc accumdatcd postrctircment bcncfit
obligation (APBO).
Wc tax-cffcct our PRB adjustmcnts-unlcss
thc rclatcd tax benefits hnvc alrcady bccn, or
arc unlikcfy to be, mlizcd. \Vc use thc r a t a
applicable to thc company’s plans, or, if this
is unavaiInblc, tbc currcnt corpontc ratcvcn whib recognizing that fiscal reality may
bc mom cornplcx or dynamic as thc company’s fortuncs changc over time. In thc typial
situation, tbc company has crcdiblc prospccts
of gcncnting sufficient futurc t m b I c income
to takc advantagc of PRB-rclarcd dcductions
and rcducc futurc tax payments. Wlicn a
company’s ability to gcncmtc profirs is indccd
dubious, \vc would not taxcffcct. Morcovcr,
in such cascs, thc company likcly would bc so
prcssurcd that liquidity-nthcr than mpitdimtion or covcmgc Icvds--rvo~~ldbc the
ovcrriding a n d y t i d focus.
&pita1 stntctiwe
Wc adjust capitalization
€or PRB cffccts by
adjusting both dcbr and cquity, whcrc applicable. Debt i s grosscd up by thc company’s
tax-cffcctcd unfundcd PRB obligation.
Equity is adjustcd by thc diffcrcncc bctwccn
tlic amount accrucd on rhc corporatc balance shcet and thc amount of nct
ovcrlundcr-fundcd obligation (nct
surplusldcficit), ncr of tax.
Cornpanics following U.S. GAAP rmntly
ndoprcd SFAS 158, and rccord thc unfundcd
PRB obligation on thcir balance shccts; companics following F
R
S havc the option to fully
rccognizc actuarial gains and Iosscs on thcir
balancc shccts. AccordigIy, our cquity adjustmcnt is no longer rcquircd in many insrmccs.
Dcbt i s not adjustcd down for nct surpluscs, sc1 nct owr-funditig (surplus)Imvcs dcbt
EXHIBIT RVH-2
Pagn 104 of 139
unctmngcd. Equity can bc adiusrcd up (if thc
nct rccognized asset is lcss than thc pretax
surphs) or down. \Vc do not split thc dcbt
adjustmcnt bcnvccn short- and long-tcrm.
Whilc thc surplus is not trcatcd as a a s h
cquivalcnt, it noncthclcss can bc of value,
cspccially to obviatc futurc contriturions.
Somctimcs it bccomcs cvidcnt that thc
amount is unrccovcrablc or cannot bc uscd to
offsct h m r c contributions. Givcn inconsistcnt
accounting JiscIosurc rcprding the rccovcrability of surpluses, \YC rcIy on inquiria to
company manngcmcnt.
caslt potu
Wc try t o idcntify ntch-up contributions
madc to rcducc unfundcd obtigations, which
wouId artificially dcprcss rcportcd opcnting
cash flows. Wc vicw thcsc contributions as
akin to dcbt amortization, which rcprcscnts
a financing, rathcr than an opcmting cash
flow. Spccifimlly, cash paid (plan contributions pIus bcncfits paid dircctIy to bcncficiaries) cxcccding the sum of currcnc-pcdod
scrvicc and nct intcrcst C O (that
~
is, intcrat cost nct of actual or cxpcctcd rcturns on
plan asscts) is addcd back to FFO on a taxcffcctcd basis. W c look at actual invcstmcnt
rcmrns for tlic pcriod and returns normalitcd for potcntially nonrcmrting, unusuaIly
high or low pcrformancc.
Convcrscly, if tlic company is funding
powrctircmcnt ot1iptions ar a lcvcl subsrantially bcloiv its net c.rpcnse (scrvicc cost and
nct intcmt cost), \vc intcrprct this as a form
of borrowing that artificially bolstcrs reported ash flow from opcradons.
In ordcr to appropriatcly intcrprct adjusrcd
nurnbcrs, notc [hat our a s h flow adjusrmenr:
1 Redloares to the period certain costs
(scrviccand inrcrcst) that oftcii diffcr from
the a s h impact in thc pcriod;
= Ignorcs prior scrvicc costs and otlicr itcrils
such as curmilmcnts, scttlcmcnts and spccia1 tcriination bcncfits, and forcigncxcliangc variations;
Ignores any incomc or charge {wlicthcr
through incorncstntcmcnt or dircctly rccognizcd into cquity) that rcflcctcd thc rccognition of actuarial gains and losscs; and
Until mrly 1006. \vas nppcd n t 7xru (no
lmgcr tltc casc).
9utidard & Poor’s
itlcomc statalrcrrl
In nnaIyzing profitability {including opemting
profit and EBITDA), ivc disaggrcgatc tbc bcncfits-cost componcnts that may bc Iumpcd
into opcmting incomc and cxpcnscs, nllomrc
thc amounts to opcmting and financial componcnts, and climinatc thosc componcnts IYC
bclicve havc no cconornic substancc. TIv
pcriod’s currcnt scrvicc cost-rcflccting thc
prcscnt valuc of futurc bcncfits camcd by
cmployccs for scrviccs rcndcrcd during thc
pcriod-is thc soh itcm w c kccp as part of
opcnting cxpcnscs.
Thc componcnts, if any, that rcprcscnt
accounting artifacts and stciii from thc
smoothing approach of thc accounting
rulcs-c.g., nmorriwtion of variations from
previous cxpccmtions rcpriding plan bcncfits, invwmcnt pcrformancc, and actuarial
cxpcriencc-arc eliminatcd from our income
mc~surcs.As a result of thcsc adjustments,
prc-ta?r and aftcr-tax incomc no Iongcr
match rcporicd amounts.
Intcrcst cxpcnsc, which rcsiilts from
applying tlic discount ratc to thc tcginning-of-pcriod obiigation t o accrctc thc liability with thc passap of timc for tlic
rcporting pcriod, is csscntially a finance
chagc--and is rccIassificd as such, if
rcportcd diffcrcntly.
Tlic cxpcctcd rcturn on plan ~ S S C I S rcprc-
scnts managcrncnt’s subjcctivc, long-miigc
cxpccration about thc pcrformancc of thc
inrwtmcnt portlolio; in some accounting systcmf--nlcli as U.S. GAAI-it may bc
applicd to a srnootl~cd,mark-rclatcd valuc,
rathcr than tlic fir-markct valucs of thc
asscts. Wc may choosc instcad to apply il
smndardizcd rcmrn, to g~ugcwlint multiycar
avcrqc rcturns mn bc cxpcctcd. W c note thc
r i s k in the asset mix, but only subjcakcly.
(In rhc futurc, wc may find a way to rcflcct
thc risk profilc of tltc portfolios in a morc
quantirativc manncr.)
Eithcr way, thc rctiirn on plan P S S C ~ Sis
ncttcd against PRB-rcIarcd intcrcst expcnsc
up to thc amount of tlic intcrcst cxpcnsc
rcportcd, but not bcyond, as thc cconornic
bcnclits to bc dcrivcd from such ovcragc
arc limitcd. If, horrwcr, thc actuaI rcturn is
ncgativc, thc lull niiiount is trcatcd as an
d i t i o n to iatcrcst cxpcnsc t r t x ~ s cthc
= Corporate Ratings Criteria 2008
73
EXHIBIT RW-2
Page 105 of 139
Ratlos And Adjustmants
rcsulting cconomic dctrimcnt
company is quirc tangible.
to
thc
Atfjilitrrrerit procediires
Dara rcquircmcnts
For thc incomc and cash flow adjustmcnts,
arnounrs for thc pcriod of:
1
Scrvicc cast;
Intcrcst cost;
.
Expcctcd rcturn on plan asscrs;
Actual rcmrn on plan asscts;
ActuarinI gaindosscs (amortimtion or
immcdiarc recognition in mrnings);
Prior scrvicc costs (amount incIuded in
wmings);
a Othcr amounts includcd in camings (c.s.,
spccial bcncfits, scttlcmcntslcuttailmcnts);
Tom1 bcncfit costs; and
= Tlic sum of cmploycr contributions and
dircct payments made to participants.
For tlic balaiicc-shcct ndjustmcnts:
PRB-rclatcd asscts on thc balnncc shcct,
inchding intangible nsscts, prepaid or
noncurrent asscts, or any othcr assets;
3 PRB-rclatcd Iiabilitics on thc balance shect,
including currcnt and noncurrcnt Iialilitics;
PRB-rckcd dcfcrrcd tax asscts (ortax mtc
appliabIc to PRB costs);
= Fair vduc of plan asscts; and
TOMIplan obligations.
Note: Rclcvanr pcnsion and otlicr postrctircmcnt bcncfir amounts are combined for
a11 pkns.
.
Calculations
Incornc-statcincnt adjustmcnts includc
adjustments to cxpcnscs and inrcrcst.
= TOMIPRB costs chargcd to opcmting
incomc, less thc scrvice cosr, yiclds thc PRB
adjustmcnt to opcmting incomc. T h i s is
addcd to opcmting incomc bcfore and aftcr
3
D&A, EBK, and E3lTDA.
Inrcrcst cost I t s rhc cxpccrcd mum is PRB
intcrcst. In somc cilscs, wc may adjust
cxpcctcd rctums to normalizc it nt a morc
rcalistic Icvcl. If net PRB intcrcst is a cost,
wc includc it in adjusicd intercst cvpcnsc
(wc do not rcducc intcrcst cxpcnsc if
cxpcctcd rctums cxcccd intcrcst cost). This
PRB intcrcst is addcd to reported intercst
whcn thc nct tcnclit costs arc inctudcd in
opcmting inconic. If rcportcd intcrcst
alrcady incIudcs an intcrcst component for
wwwcorporatccri toria.standardandpoors.com
PRBs (cog.,as may bc thc msc undcr FRS),
wc adjust it, if ncccssary, to cnsurc it
reflccts thc amount of PRB inrcrat cosr. A
similar cdculation is made using thc actual,
mthcr than cxpccrcd, rcturn on plan PSSC~S.
T h c ndjusmcnt to funds from operations
stam with it alculation of cxccss contributions or PRB borrowing:
= TOMIcmploycr contributions (incIuding
dircct paymcnts to rctirccs), Ic5s scrvicc
costs, lcss intcrcst costs, plus cxpcctcd
rcturn yictds thc cxccss contribution, if
positivc, or PRB borrowing, if ncptivc. (A
similar c3Iculation is madc using actual,
mthcr than cxpcacd rcturn.)
Thc cxccss contribution or PRB borrowing
is rcduced by t a x a at thc mtc appliablc to
PRB costs. That is, rhc amount is muItipIicd by (1 tax ntc) to m a t e thc PRB
adjustmcnt to WO.
T h c e~ccsscontribution on PRB borrowing
is addcd or subtracrcd to or from FFO.
Ric balance-shcct adjustrncnts allcct nsscts,
dcbr, and cquity.
Plan obligations Icss ascts cquals tlic nct
pcnsion and postrctircmcnt fundcd status
Idcfidt or surplus).
= Thc nct balancc shcct assct (liabihy] position is dctcrmincd 1s thc bilancc shcct
asscts lcss Iiabilitics. For thc adjustmcnt to
dcbr, if nct pcnsion and postrctircrncnt
hndcd srams is 3 surplus, dctr is not
adjustcd. If thc nct pcnsion and postrctircmcnt is il dclicit, this amount is rcJuccd by
thc cxpcctcd tax shicId, that is, thc amount
is multiplicd by (1 tax mc].
= In some jurisdictions, thc M X bcncfit is
rcalixcd in advancc of funding the dcficit
or paying bcncfits, for cxamplc, whcn thc
IiabiIity is accrucd for r i x purposcs. Tlic
cxpcctcd tax shicld uscd in our calculation
only rakcs into account amounts that havc
not yct bccn rcccivcd. The adiustnictit to
cquity also considers cxisting baIancc
shcct amouiits.
Equity is adjustcd for tlic tax-cffcctcd diffcrcncc bcmccn thc dcficidsurplus and lhc
nct bafancc shcct assctsfliabilitics, i.c., multiplicd by (1 mx nrc].
Unlikc tlic adjustmcnt to dcbt, thc
adjustmcnt to cquity m n bc ai1 incrcasc
-
-
-
or dccrcasc.
EXHBIT RVH-2
Page1060f139
ing thcsc contracts may bc providcd ro us by
thc company.
Power purchase agreements
\Vc vicw purchascd powcr supply agccrncnts
[PPAs]3s creating fixcd. dclt-likc, financial
obligations that reprcscnt substitutes for
dcbt-financcd mpital invcstmcnts in gcncration capacity. In a SCMC, a utility that has
cntcrcd into a PPA has contnacd with a supplicr to makc thc financial invcstmcnt on its
bclialf. ConscquentIy, by adjusting financial
mctrics to incorpontc PPA fixcd obligations,
w c achicvc grmtcr compam.ti1ity of utilitics
that financc and buiId gcnemtion capacity
and thosc rliat purchasc capacity to satisfy
cunomcr nccds.
P P h do bcncfit utititics by shifting various
risks to thc supplicrs, such as consmction
risk and most of thc opcnting risk. T h c principal risk bornc by P utiIity that rclics on
PPhs is rhc rccovcry of thc costs of thc financial obligation in ratis. Diffcrcntiating tbc
risk profiIcs of utilities that take divcrgcnt
approaclics i s incorpomtcd in our qualitative
buinas-risk asstssmcnrs.
Ivc calculate tbc prcscnt value (PV) of thc
futurc srrcam of capacity payrncnts undcr
thc contracts as rcportcd in thc financial
stntcmcnt footnotes, or as supplicd dircctIy
by thc company. Thc discount m c uscd is
c q u i d c n t to thc company's avemgc cost of
non-sccuritimtion dcbt. For U.S. cornpaniu,
n o m to thc financial statements cnumcmtc
capacity paymcnts for tlic coming fivc years,
and a thcrcaftcr pcriod. Wc oftcn hivc
access to company formsts that show tlic
dctail undcrlying thc thcrcafter amount; othcnvisc, wc dividc thc amount rcportcd as
tiicrcaltcr by thc avcragc of thc capacity
paymcnts in the prcccding five ymrs to
derivc an approximation of annual paymcnts
aftcr year fivc.
In calculating thc m o u n t wc add to dcbt,
w c also considcr ncw contracts that will commcncc during thc formst pcriod. Such contracts arc not rcffccrcd in thc notes to tlic
financia1 statcmcnts-but information regard-
S~ardardB Poor3
a
If thcsc contracts rcprcscnt atcnsions of
existing P P h , t h y arc immcdiatcly includcd
in the PV dculation. Howcvcr, a contract
sornctirncs is cxccutcd in anticipation of
incrcmcntal futurc nccds, so thc cncrgy will
nor flow unti1 some Iatcr pcriod and thcrc arc
no intcrim paymcnts. In thcsc instanccs, wc
incorporate that contract in our projections,
starting in thc ycar that cncrgy dclivcrics
bcgin under thc contract, just as if tlic company had porchascd a plant at that juncturc.
That way, thc dcbt imputation is vicwcd in
the contcxt of a11 thc rclatcd activity, incIuding rcvcnuts and cash flow from tIic forcust
dcmand. (Of
coursc, tlic projcctcd PPA dcbt
i s indudcd in projcctcd ratios. That way, tlic
futurc PrA fipm as a ciirrcnt mting factor,
cvcn if it is not includcd in thc currcnt-ycar
ratio aIculations.)
T h c mledarcd PV is adjusrcd to rcflcct thc
bcncrits of rcgulatory or lcgislativc cost
rccovcry mcchanisms. Thc adiusmcnt
rcduccr the dcbt-cquivalctitnmoiint by muttiplying thc PV by il spccific risk factor that
pcrmins ro tach contract. T h c strongcr thc
rccovcry mcchanisms, tbc sniallcr tlic risk factor. Thcsc risk factors t y p i d y nngc bcnvccn
0% and 50%, but a n bc as high as 100%A 100% risk factor wouId signify that substantially all risk rcktcd to conuamal obligations rats on thc company, with no
mitigating rcplatory or Icgislativc. support.
For c.mmpIc, an unrc-gulatcd cncrgy company
that has cntcrcd into a tolling amngrncnt
with n third-party suppIicr rvouId bc assigncd
a 100% risk factor. Convcrscly, a 0% risk
factor indimtcs rliar thc burdcn of thc contractua1 paymcnts rcsrs solcIy with ra~cpaycrs. This fact pmcrn frcqucndy is found
among rcgulated utiIitics that act as conduits
for the ddivcry of a third party's clecaicity,
and csscntially Jclivcr porvcr, collcct ctiargcs,
and rcmit rcvcnucs to ttic supplicrs. Thcsc
utititics typically hauc bccn dircctcd to divcst
thcir gcncndon PSSCIS; arc barrcd from dcvcloping ncw gcncration asscts; and the powcr
supplicd to thcir C U S ~ O ~ Cis~sourccd
S
through a state auction or third partics that
act as intcrmcdiarics bctivccn mail customcrs
and cIcctricity supplicrs.
Corporato Ratinas Criteria 2008
75
EX(HI3TTRVH-2
Page 107 of I39
Ratios And Adjustments
Intcrmcdiatc dcgrccs of rccovcry risk arc
prcscntcd by a numbcr of rqtiIatory and lcgishtivc mcchanisms. For cmmpIc, w c cmploy
P SO% risk factor in u s c s whcrc regulators
USC a utility’s mtc msc to establish basc mcs
to providc for thc rccovcry of thc lixcd costs
crcatcd by a PPA. Iwlilc IYC v i m this type of
mcchanism as gencnlly supportivc of crcdit
quality, thc utility still nccds to obtain
approval to rccovcr costs and thc prudencc of
PPA mpacity paymcnts in succasivc mtc
a s c s to cnsurc ongoing rccovcry of its fircd
costs. If a rcguIator has cstablishcd a porvcr
cost adjusmcnt mccbanism that rccovcrs all
prudent PPA costs, a risk factor of 25% is
cmploycd, bcmusc thc rccovcry hurdle is
lowcr than it is for a utility rhat must litigatc
timc and again its right to rccovcry costs.
In ccrtain jurisdictions, truc-up mcchanisms
arc morc bvorablc and frcqucnt than rhc
rcvicw of k s c mtcs, but still do not amount
to purc fucl adjustment clauscs. Such rncchanisms may bc triggered by financial thrcshoIds or passngc of prcscribcd pcriods of timc.
In thcsc instances, a risk factor bchvccn U%
and 50% is cmpIoyed.
LcgisIativcly cmtcd cost-rccorwry mcchanisrns arc longlasting and nrorc rcsilicnt to
change. Conscqucntly, such mcchanisms Icad
to risk factors bcnvccn 0% and 1596,
dcpcnding on thc Icgislatiec provisions for cost
rccovcry and thc supply function bornc by thc
utility. Lcgislativc guamntccs of complctc and
timcIy rccovcry of costs arc p;lrticuIarly important to actdcving thc lowat risk factors.
WCdo nor imputc dctt for suppIy arrangemcnts if il utiIity acts mcrely as a conduit lor
the dclivcry of powcr. tis an cxamplc, Ncw
Jcrscy’s vcrtimlly intcgntcd utility cornpanics
wcrc transformcd into purc transmission and
distribution urilitics. Tlic statc commission,
or an appointcd proxy, Imds an annual PUCtion in which supplicrs bid to sent tbc starc’s
rcnil customcrs, and thc utilitics arc protcctcd from suppiicr dchuIt. Thc sntc’s utilitics
mcrcly dcfivcr powcr and collcct rcvcnucs
from rcmil customers on bchalf of the supplicrs. Thcrcforc, IVC imputc dcbt only to Ncw
Jcrscy utilitid qualifying facility and cxmpt
whoIcsalc gcncntor contncts-rid not for
othcr clcctricity supply contracts wlicrc thc
utilitics mcrcIy act as conduits bctwccn thc
76
www.corporatccritsria.standardnndponrs.Eom
rvinncrs of thc regulator's supply auction and
thc cnd-uscr, rcmil customen.
\Vc also cxcludc PPAs with durations of
lcss than onc ycar whcrc thcy S C ~ Y CmcrcIy
as gap BItcrs, pcnding eithcr thc construction of new capacity or thc cxccurion of
Iong-tcrm PPA contracrs. Thcsc contracts are
tcmporary-and W E focus on thc morc pcrmnnent situation, which is factorcd into tbc
forcmst ratios.
Givcn thc long-tcrm mandatc of clcctric
utititics to mcct thcir customcrs’ dcmand for
clcctricity, and aIso to cnatlc comparison of
cornpanis with diffcrcnt contract Icngths, w c
usc an crcrgrccning mcthodology. hcrgrccn
tratmcnt mends thc duration of shortsnd
intcrmcdiatc-tcmi contmcts to a common
Icngtli of around 12 ycm. To quantify thc
cost of thc mtcnded apacity, w c usc cmpiria1data regarding the cost of dcvcloping ncw
pcaking mpacity, incorponting rcgional diffCrCRCCS. The cost of ncw mpncity is tmnslnrcd inro a doltars-pcr-kilo~v;ltt-y~r
figrc
using a proxy wcightcd avcragc cost of mpital and a proxy capital rccovcry pcriod.
Sornc PPAs arc trcatcd as opcrating Icascs
for accounting purposcs-bnscd on tlv tcnor
of thc PPA or thc rcsidud vduc of thc a s c t
upon the PPA’s cxpimtion. Wc accord PPA
trutmcnt to thosc obligtions, in Iicu of lcnsc
trrutment, if cornpanics idcntify thcm to us.
That way, such PPAs will not bc subjcct to a
100% risk baor for analytid purposcs I S
though tlicy wcrc ordinary Icascs;rathcr, thc
PV of tIv strcam of capacity payments associntcd with thcsc PMs is rcduccd to rcffcct thc
applimblc risk [Actor. (PPAs trcatcd as mpitn1
Imscs lor accounting purposcs do not fall
undcr our PPI\ adjuarncnt.)
Long-tcrm transmission contracts an aIso
scrvc in Iicu of building gcncration, and,
accordingIy, fall undcr our PPA mcthodoIogy.
In some u s c s , thcsc transmission contracts
providc acccss to spccific p o w r plants, whilc
otlicr transmission srmngcmcnts providc
acccss to compctitivc wholcsalc clcctrieity
markcts. Wc vicw thcsc typcs of transmission
amngcmcnts as cxtcnsions of thc porvcr
plants to which thcy arc conncctcd or tlic
markcts that they scfvc. Accordingly, wc
imputc dcbt for tlic lixcd costs sssocintcd
with such transmission contmcts.
EXHIBIT RVH-2
Page 108 of 139
A djiutrrwrit pro ccdrircs
Data rcquircmcnts
Future apacity paymcnts obtaincd from
thc financial smtcmcnt footnotes or from
managcmcn t.
= Discount rate thc company's cost of nonsc.
curitizcd dcbt.
AnalyticaIIy dctcrmined risk factor.
~lmlationr
Bakncc-shcct dcbt is incrcucd by thc PV
of thc strcarn of mpacit). paymcnts muftiplicd by the risk factor.
Equity is not adjustcri, bceausc thc rccharactcrimtion of thc PPA implies the crcirion
of an asset, which offsets thc dcbr.
PP8E and tord m c t s arc incrcascd for thc
impticd crcation of an iissct quivdcnt ro
the dcbt.
= An implicd intcrcst c q c n s c for tlic imputcd debt i s aIculatcd by multipIying the
utiIity's avcngc cost of noncccuririzcd dcbt
by tIic amount of imputcd dcbr (or, avcmgc
PPA imputed dcbt, if thtrc is fluctuation of
thc Icvcl), and is addcd to intcmt cxpcnsc.
Thc cost amount attributed to depreciation
is rcclassilicd as mpcx, tIicrcby incrmsing
opcrating a s h flow and FFO.
\Vc imputc a dcpm'ation componcnt to
P P h . Thc dcprcciation cornponcnt is
dcrivcd by mdtiplying thc rclcwnt ym?s
capcity paymcnt by the risk factor and thcn
subtracting thc implid PPA-rcIatcd interest
for that ymr, Accordingly, thc impact of
PPtk on a s h flow mcisuccs is tcmpcrcd.
= Somc !?PA contracts rcfcr only to a single,
alI-in cncrgy pricc. \Vc identify an implicd
mpacity pricc within such an all-in energy
price, to mlcalatc an implicd capacity paymcnt nssociatcd with thc PPA. This
implicd apacity paymcnt is cxprcsscd in
do1Im-s pcr kilowntt-pr, multiplicd by thc
numbcr of kiIowvata undcr contract. (In
mscs that cxhibit markcdly diffcrcnt
capacity factors, such as wind powcr, thc
rchion of capacity payiiicnt to tlic 311-in
chsrgc is adjusted accordingly.)
Opcmting incomc bcforc DSEA and
EBITDA arc incrcascd for rhc imputcd
intcrcst cspcnsc and imputcd dcprcciation componcnt, thc total of which
cquab rhc cntirc amount paid for PPA
(subjcct to thc risk factor).
-
.
.
Stumhrd & Poor's
3
Opcmting incomc aftcr D&A and EBlT arc
incrcascd for intcrcst cxpcnsc.
prcase SEC "Starrdnrd 6 Poor's
Mcfhodology For Itlipirfitig D c k /or U.S.
utilities' Porucr pirichuse ~grecmcttts,
Rtblislwd May 7,2007, atid "Crcdit FAQ:
hptttcd Dcht Calczilufiott For U.S. Utiliiics'
Power Pirrchse c\greenicnls, pitblished
March 30, 2007, OII RalitisDircct.]
Share-based compensation expense
Wc view thc value of cquity instrumcnts (for
mairiplc, n o d options aid rcsfrictcd shares
aruard5) grantcd to cmployccs andlor othcr
servicc providcrs as nn outlay that sliould bc
mkcn into account in cvaluating issucrs' pcrformancc and profitability. Whcn w c asscss a
company's ability to gcncratc il rcnl, all-in
return on capital cmpIoycd, IVC sliould not
vicrv diffcrcntly companics granting cquity
frompccrs using cash 3s a form of compcnsation. Although o h not rcprcscnting P dircct
or an irnmediatc call on a company's cash
rcsourcccs, thcsc grants arc made in cxchangc
for, or in anticipation of, scrvim to bc providcd: Thcy havc a rcal cconomic vd~rcand
so shouId bc considcrcd.
In analyzing thc financia1 aspccts of cquity
awards gnntcd by an isucr, wc considcr
adjustmcnts tD:
Normalize thc value of thcsc grants in ulculating mrnings and pcrfonnancc-hscd
mctrics. That is, ccrtain accounting rcgimcs
mandatc cxpcnsing of stock-bascd grants
wbilc orhcrs do not. In addition, ccrnin
practices cmploycd by manngcmcnt, such as
vcsting aceclcmtion and otlur award modifiatiotls, could mcaninghtly affcct rcportcd
results. Accordingly, ccrtain adjustmcnts
m3y bc rwrmntcd for morc rncaningful
pccr and period-ovcr-pcriod comparisons.
Highlight thc cffcct that thcsc arrangemcnts might havc ovcc timc on cash flows.
That is, although most mvirds do not
rcsult in a s h bcing exchangcd upon grant,
futurc cash flows arc clcarly affcctcd. This
occurs as a rcsult of paymcnts rcccivcd by
thc company upon c?icrcisc or issiiancc of
diarcs; paymcnts niadc by thc coriipmy for
sham rcpurchascs (to mitigntc HPS dilutionk a company's pnciicc to scttlc tlic
wtuc of cquity grants in ash in Iicit nf
Corporate Ratings Cdteda 2008
n
EXHIBIT RVH-2
Page 109 of 139
Ratios And Adjustments
sharcs; and my savings gcnctrted by tlic
favorable tax trcarmciit gcncnlly affordcd
to options and o;hcr gmnts.
= Scpantcly, wc try to asccnain tbc cffectivcnus of a company’s grants in aligning
cmploycc inccntiva with sharcholdcrs’ and
crcditors’ obicctivcs.
Until rcccntly, thc major accounting
rcgimcs (q.,
IFRS, U.S. GMP, Canadian
GAAP, and Australian GAAP) did not mandate cxpcnsing of thcsc costs. Now most
rcquirc thc fair valuc of cquity-bascd grants
(or an approximation of that wluc) to bc
inchdcd 3s an cxpcnsc in thc incomc statemcnr. T h i s amount is g c n c d y cxpcnscd OVCF
thc bcncfiting pcriod, Lc., the pcriod thc
cmploycc is assumed to providc scrviccs in
cxchnngc for thc award. Oftcn thc vcsting
pcriod is uscd as il proxy. Prior to thc advcnt
of ERS and thc rcccnt mandating of cxpensing undcr US. GAAP for all stock-bascd
grants, tlic accounting was grmdy fmgmcntcd and inconsistcnt among cornpanics and
jurisdictions, and abo varicd according to thc
form of thc atyard. For cxamplc, aLhough
rcstrictcd s h a m or stock apprcciation rights
may be cconomidIy equivdcnt to stock
option grants, thc accounting diffcrcd.
FurtIicr, disclosurcs of stock-bmd compcnsation arnngcmcnts, which IVCZC Iacking in thc
past, ~ Z Y Cvastly improvcd as a rcsult of govcrnancc and tnnsparcncy rcquircmcnts by
accounting-standard scttcrs, sccuritics rcjylators, and mzhzngcs, providing morc pcrtincnt data on thcsc armngcments.
Profitabilityatrdysis
Our objcctivc is to capturc cornpcnsation
cost in our profitability mcasurcs-regardlcss of the mcms of paymcnt (it.,whcthcr
paid in cash, sharcs, options or othcr inkind paymcnt)-s
fully and as consistcntly
3s possiblc.
With thc rcccnt accounting changcs, most
mtcd cornpanics now cxpcnsc t I v cost of cquity-bascd grants, so thc consistency of rcponcd
mrnings is signifinntIy cnhanccd, obviating in
many mscs thc nccd to dcfinc il diffcrcnt common basis for analysis. Howcvcr, rvlicrc information cnnbling quantifimtion is not
availabIc, wc cmploy 3 qmlimtirc asscssmcnt,
to bc corisuow of thc diflcrcncc among pccrs.
78
wwwxorpora tecriteria.standardandpoors.com
Cornpanics ma); at timcs, modify thcir
sham-bascd mwrds, gmnt 3 onc-time m v a d
(c.s., upon an acquisition), or acccbntc vcsting (cg., upon a change in control or downsizing). Thcsc actions could mcaninglulIy
iltcr rcportcd iiicomc and introducc discrctc
volatility to caming. Howvcvcr, idjustmcnts
for thcse variants gcncmlly arc not Icasiblc 1 s
a practical mattcr, and arc attcmptcd only
whcrc matcria1 and tlic rcIcvant information
is available.
Cash-flow nnalysis
Whcn a company gnnts sharc-bascd nvards,
gcncrally no cash is paid or rcccivcd. f i s h flow conscqucnccs, if any, only arisc whcn
thc options arc cxcrciscd (c.g., as il rcsult of
paymcnt of thc cxctcisc prim and from associatcd tax bcncfits). For somc otlicr gnnts,
such as stock apprccintion rights (SARs)
payablc in s h a m and rcstrictcd slim grants,
no cash chnngcs hands at all. Just as with all
issuancc of cquity, thc company’s financinl
position is cnhanccd, or at lmst is not diminishcd, ns a rcsult of the grant (assuming scttlcmcnt is cffcctcd with sharcs, and thc
grantlcxcrcisc is not ticd to commcmuratc
rcpurchascs]. From a cash-flow snndpoint,
cornpanics would gain ffcuibility to thc cxtcnt
that stock-bnscd grants providc an nltcmativc
to a s h compcnsation and thcir crcditors
shouId be bcttcr off, whilc thcir sharcholdcrs
wit[ bc diIutcd.
Our cash-flow rncasurcs, such as FFO
and OCF,arc not affcctcd by sharc-lascd
grants. Being a non-cash itcm, shnrc-bascd
rclatcd cxpcnsc \vi11 continuc 10 bc backcd
out on tlic cash flow statcmcnt. Bcciusc
options and rcstrictcd stiarc grants rcprcscnt non-cash cwnts, our kcy cash flow
ratios-FFO to total debt, EBlTDA to
intercst, and dcbt to EBITDA+xcludc
stock option cxpcnsc. Accordingly, for companics whost stock-bascdcornpcnsation
cxpcnsc (payablc in sharcs) has bccn
dcductcd, wc adjust EBITDA mcasurcs by
adding back the cxpcnsc.
Unlikc options or rcstriacd sharc awards,
ccrtnin otlicr sliarc-bascd armngcmcnts arc
papblc soldy in cash (c.s., stock apprcciation ridas rcquircd to bc scttIcd in cash), and
rcprcscnt P future nll on a company’s a s h
EXHIBIT RVH-2
Page 110 of 139
flow. TLc obligations undcr thcsc arnngcmcnts arc trcatcd as dcbt.
For tax-rcporting purposcs, thc cxcrcisc or
thc point of vcsting (not granting) of ccrtain
stock-based awards oftcn gcncntcs a t u dcductiblc cxpcnsc, rqardlcss of whcthcr thc
company has bccn cxpcnsing stock-option
grants for financiaf rcporting purposcs. Tax
crcdirs arc shown 3s an apcrating itcrn on thc
a s h flow statcmcnt undcr U.S. GAAP o d y to
thc cxrcnt thcy rclatc to thc accounting
cxpcnsc; if the tax dcduction rvcccrls tht
amomt attribuutb to thc accounting
cxpcnse, such exccss is a financing itcm.
Rnalyticdly, ivc vicw tax tencfits morc
approprimly as a financing jtcm on thc u s h
flow statcmcnt, since thcy arc triggcrcd only
upon cquiry issuancc.
To rnitigatc diIution atiscd by options
and 0 t h sharc-rclatcd grants, cornpanics
oftcn cngagc in sharc rcpurchascs. Arguably,
if 3 company rcgulady rcvccscs thc dilution
rcsulting from thc cxcwisc of sliarc-tascd
awards through sharc rcpurcliascs, the rcIatcd cash outlays (nct of cash proeccds from
thc cxcrcise) could bc trcatcd as P cash
opcmting cxpcnsc. I-Iowcvcr, \vc vicw a
company’s decision to rcpurchnsc its shares
as a scparatc mmtcr-and part of tbc coinpany’s overdl corporate financc strategy.
Accordingly, wc dctcrminc thc Icvcl of
cxpcctcd sharc rcpurchascs in the contcxt of
a broadcr asscssmcnt of Iiquidity, mpitali7~tion, and financial policy.
In contrast, whcn an issucr c n t m into
dcrivativc or similar conrracts to rcpurcliasc
sharcs at il fumrc datc, w c vicrv thcsc contracts ns prccursors to such purchases-nd
incorporate thc rcpurdusc immcdiarcly in tlic
analysis, Still, C V C in
~ thc abscncc of such
contractual ilcmngcmcn&, thc andysis incorpomtcs thc cvcntud sham rcpurchascs if thcy
arc anticipated. Wc adjust dcbt by adding
amounts tllat arc anticipatcd as ncccssary to
fund thcsc transactions.
cldditiorial corrsidcratioiis
For US. tax purposcs, gcncmlIy tlic cxcicicisc
(not granting) of ccrtain stock options rcsults
in a tax-dcducriblc cxpcim to thc cmploycr.
Mowcvcr, for GARP purposcs, thc coiiipany
cspenscs thc fair vduc of stock options,
Stam?nrJ & Paw‘s
*
which is dctcrmincd at thc grant daw, ratably
ovcc thc rclarcd scrvicc pcriod. As ;Ircsult of
thc usc of thc gmnr datc fair vduc to dctcr-
mine thc accounting e~pcnsc,rathcr than an
cxcrciscdatc intrinsic or othcr wluc for tax
dcduction purposcs, thc book and thc tax
expcnscs \vi11 diffcr. Furthcrmorc, U.S. GAAP
docs not ollow cornpanics to rccord a rcduction to incomc tax cxpcnsc on thcir incomc
statcmcnts for thcsc CXECSS fax bcncfits.
Instcad, thc tax bcncfit is rccordcd dircctIy as
an incrcrncntnl incrmsc to cqiiity (morc
spccifidly, additional paid-in wpital) and a
rcduction of taws papblc (Le., ncvcr rccordcd in ils a bcncfit in thc incomc smrcmcnt).
Consisrcnt with our vicw that thc rax bcncfits
arc morc financing in naturc, bmusc thcy
rclatc to cquity issuance, this will not givc
risc to an adjustnicnr.
If tlic options uItimarcly cxpirc uncxcrcised, any prcviousIy rccorded accounting
cxpcnsc (rccordcd bascd on tlic award’s initiaI fair valuc) is not rcvcrscd undcr U.S.
GAAP. Although in this circumstance no tax
dcduction would bc gcncratcd a t all, it
would rcsult in 3 dclcrrcd tax assct bcing
rccordcd on thc company’s balancc shcct
ovcr tlic cxpcnsc rccognitioii pcriod (bcmusc
tbc took cxpcnsc and rcsuIting dcfcrrcd tax
asscts arc calcularcd bascJ on thc initial fair
value). T h i s tax assct is rcvcrscd through
carnings only upon cxpiration of tIic cxcrcisc pcriod. This rcquircmcnt can MUSC Inrgc
dcferrcd tax asscts, unlikcly to bc rcalizcd,
to rcmain on il company’s balancc shcct,
causing artificialIy inflitcd cquity b3lancc in
circurnsranccs in wliidi a company’s forruncs
are advcrscly changing, and its options arc
moving substantially out of tlic moticy (rcndcring both cxcrcisc and USC of thc MX bcncfit improbable). i\nalytimlly, it would bc
morc appropriatc to rcvcrsc rhc ilssct
amount against cquity whcn it bccomcs
apparcnt that usc of thc bcncfits is unlikcly.
Adjustmcnts for thcsc situations arc considcrcd only in rmc circumstanccs.
Both IFRSand U.S. GAAP now rcquirc tlic
cxpcnsing of stock oprions and othcr durchscd cmploycc compcnsation. Howcrwr, to
hcilintc thc transidon from tlic prior npproacli
of not qxnsing, ilic tnnsiiion provision
nllows c o r n p a i i i ~to~appIy this approach onIy
Corporate Ratlngs Criteria 2008
79
EXHIBIT RVH-2
Page111 01139
Rotios And Adjustments
to grants that \vex msdc a
h a spccific datc
(c.g., Nov. 7,2002, undcr Fa).As a mlt,
costs for an incrasing pmporrion of outstanding grants rvill bc cxpcnscd over timc. Wc hnvc
pncnlIy not ancmpted to adjust mrnings
mcasura to indudc the missing
in thc
~~~
Mrly y a r s af the m i t i o n .
Adjirsttrrctrt procedures
Data rcquircmcnts
Total pcriod sharc-bascd compcnsation
cxpcnsc rcffcctedin thc financial mtcmcnts. (Amounts may bc available in thc
stitcrncnts or in the notcs.)
In jurisdictions that. do not rcquirc cxpcnsing of such compcmtion, a n estimatc of
what rvould bc cxpcnscd.
= Amount of dcfcrrcd t a m unlikcly to bc
rcalizcd.
= E x a s h flows includcd in opcmting that
wc vicw ils financing.
ktimatc of amounrs to bc uscd for
sharc tcpurdiascs.
Cdculations
EBITDA: Whcrc iionmsh stock compcnsation costs have becn cxpcnscJ, w c rcvccsc
thc cxpcruc arnounr.
SG&A, Opcrating incornc bcforc and
aftcr D&A, and EDIT: In jurjsdictions
whctc rharc-bawd compcnsation i s not
rcquircd to t c cxpcnscd, thc cstimatcd
amount is dcductcd from thcsc
profitability rncasurcs.
Tax m c t s that arc unlikcIy to bc rtzilizcd
arc. subtmacd from itsscfs and cquity.
1 Twcs that zrc financing in namrc arc
a d d d to operating a s h flow arid FFODcbt is incrmscd-and cquity dccrascdlor d a t e d sharc rcpurchasscs that arc contnctually committcd or othcnvisc imminent.
(Plcasc see “Atralyfic Itliplicafions Of
Stock-Based Corrtpc~rsatiotrAccoiattiirg,
prrblishd March 24, ZOOS, nrrd
“CamortflagcdSltarc Rcprirchascs: Tlic
Rating Iirtplicutiotrs of Total-R E I Z I ~ J ISwaps
atid Sitnilar Eqirity Deriwfltiucs,” priblishcd
Dcc. 7, 2U00, OII RatiqsDircct.)
Stranded costs securitizations
of
regulated utilities
For mtc-rcguIatcd utilitics, wc remove thc
cffccts of dctt rcIatcd to smiritimdon of
80
wwrv.corporatccriteria.etandardandpoors.com
stmndcd costs, to thc cxtcnt that dcbt is SCWiced scparatdy by rlic utilitics’ customcrs
through dircct incIusion in ram, Bcmusc tlic
customcrs, not rhc utiliry, arc rcsponsiblc, by
statute, for principal and intcrcst payrncnts,
rvc rcmovc thc Jcbt from rlic balnncc shcct
for analytiul purposes. Wc also rcmovc rclatcd amounts from rcvcnuc, dcprcciation,
and intercst.
A djwf ntctit pmccdrwcs
Dam rcquiremcnts
Amount of sccuritizcd dcbt rclatcd to
stmndcd costs on tlic utility’s balancc shcct
at pcriod cnd;
= Intcrcst c?cpcnsc rclntcd to sccuritizcd
stmndcd-cost dcbc for thc pcriod; and
1 Principal rcpaymcnts on stnndcd-cost
sccuritizcd dcbt during thc pcriod.
a Notc: Wc obtain thc data from thc financial smtcmcnts and foomotcs of thc utility;
or scpantc spccinl purpose \#chick (SPV)
cratcd for thc dctt sccuritiwrion; or information rcccivcd dircctly from the utility
Calculations
Adjusrmcnt to dcbt: W c subtnct thc stnndcd-cost sccuritimd dcbt from total: dcbt.
Adjustmcnt 10 revcnucs: We removc thc
mvccnuc mrncd from customcrs that is
comrnittcd to paying sccuritizcd dcbt principal and intcrcst from toal rcvcnucs. Wc
assumc that rcvcnuc cquals thc sum of
interest and principal payrncnts madc during thc ymr.
Adjustment to operating incomc bcforc
dcprcciation and amortization and EDITDA: Wc rcmovt thc rcvcnuc mrncd from
mstomcrs comrnittcd IO paying principal
and intcrcst on sccuritizcd dcbr.
Adjustmcnt to opcrating incomc a h
dcprcciation and arnortimtion and EIIIT:
1% rcmow thc rcvcnuc carncd from mstomcrs committcd to paying principal and
intcrest. Wc also rcniovc dcprcciation and
arnortimtion rclatcd to thc rcgulatory
asscr, which w c assurnc cquals thc sum on
principal payrncnts during thc pcriod. As il
mutt, thc rcduction to optrating incomc
afrcr D&A is only for thc intcrcst portion.
= Adjustmcnt to intercst cxpcnsc: Wc rcducc
intcrcst mpciisc by intcrcst cxpcnsc of tlic
sccuritircd dcbt,
3
.
EXH18lJ RVH-2
Page 112 of 139
Opcrating cash flows: W c rcdiicc opcmting
msh flow for rcvenucs and incrasc for
the assumcd intcrcst amount rclatcd to thc
sccuritizcd dcbr. TIus rcsults in P ncc
dccrcasc to opcnting cash flows cqud to
thc principal rcpaymcnt amount.
( P h c scc “Scctiritizing Straitdcd Costs,”
pxrblisbcd Jarr. 18. 2001, on RatiirgsDircct.)
3
Surplus cash
Thc crcdit profilc of cornpanics that haw
accumulatcd cash is, of COIITSC, cnhanccd by
thc availablc liquidity. But our analytical
mcrhodology rcplarly gocs a stcp hrthcr,
by adjusting both financial and operating
ratios to rcflcct II company’s surplos cash
(that is, unless thc surp1tis is dccmcd to bc
only tcmpomry).
Industrial crcdit ratios arc intcndcd to u p turn thc dcgrce to which a company has
Icvcngcd i t s risk nsscts, and highly liquid
linancinl assets oftcn involvc virtually no risk.
Morcovcr, ratios arc dcsigncd to indicate a
company’s abilicy to scrvicc and rcpay dcbt
obligations from operating as11flow, and
surplus cash and/or highly-liquid PSSCIS arc,
in a scnsc, amilablc to rcpay dcbr apart from
ongoing ash flow gcncmtion. Accordingly,
IYC o h ncr surplus u s h against debt and
dcbt-likc obligations--so that nct dcbt is
what Iigurcs in ratio calculations.
In somc situations--only whcrc thc surphs
cash is stmcturaIly linkcd to dctt that rvouId
not bc nccdcd, \vcrc it not for thc cash holding-wc also use P nct intctcst cspcnsc whcn
a k u k t i n g thc dcnominator of covcmgc
mtios, such as FFOlintcmt, EBlTlintcrcst
and EBlTDMntcrcst. (Abscnt such linhgc,
wc USC gross intcrmt in thc dcnominator.
Also, sincc intcmt incornc is diffcrcntiitcd
from opcmting incomc, it is gencrally not
includrd in thc numcmtoc)
Furthcr, maintcnancc of surplus cash distom
operational bcnchrnarks and ruturn on m c w
(ROA) m m u m that arc imponant for pccr
comparisons in some scctors, such 3s pliarm~cutimls.Giwn thc rclatircly low rcturns on
lowrisk fmancinl ssscts, maintaining such
;zsscw dcprcsscs asscr-rclatcd margins ( w n
without taking into account intcmt mpcnsc
rcquircd if tbc company is financing t f v msh
with dcbt that orhcnvisc would not tc nccdcd).
Slaidurd & Poor‘s
T h c kcy anafyticd considccltions rcgarding
nct dcbt adjustmcnts arc thc quality of the
financial asscw thcrnsctvcs, and thc company’s
purposc and stmtcgics for mainmining thcmdthough doing so involves commcnsumtcly
highcr lcvcls of drbt. Somc of thc possiblc
stmtcgi-nd
what thcy impIy for thc pcrrnnncncc of thc surplus--ilrc discusscd bclow.
Virtually all companics rcquirc somc cash
to faditarc thcir opmtions. Rctailcrs, rcstaurants, and supcmarkcts, for cmrnplc, nccd
a s h to makc c h q c . Mom broadly, companies rcquirc a ccrtain Icvcl of u s h for v c q ncar-tcrm liquidity. Wc do not givc any
spccial crcdit or makc m y adjustmcnts for
cash that is mcrcly adcquatc to support ongoing opcmtions, cvcn though thc amount can
somctimcs bc quitc subs~ntial-~spccidly
for
cornpanics that opcratc numcrous bciIitics,
and thosc that transact in divcrsc currcncics.
Companies cngagc in dialoguc with us to
help us gaugc thcsc ncm-tcrm opcrating liquidity nccds, and our scctor comparisons
and rcvicws 3150 rargct pccr consistcncy
regarding maintcnancc of suflicicnt liquidity. Apart from potcntiai nctting for surpluscs, maintaining adcquatc liquidity is always
an important racing consideration. A company with a dcficicnt Icvcl of cash for working capital nccds would bc pcnalizcd in ia
rating arrignmcnt.
However, many cornpanics posscss still
grcatcr cub, andlor liquid, lowrisk, finnncia1 rcsourccs. Scvcrd differcnt possiblc purposes and stratcgics could apply. This is
important to our analytical tmtnicnt: %crc
arc many situations in which \vc usc nct calculations and, many otlicrs whcrc w c do nor,
‘usually dcrcrmincd by thc company’s stratcgia. Thc stmtcgics cxplaincd tcloiv arc in
dcsccnding ordcr, starting with tlic most supportivc of a nct approach and concluding
with a numbcr of stmtcgics that do not lcad
to il nct approach.
Strutcgics that support ncl-dcbt trcdttrtctit
= Dcfcasancc {both lcgd and cconomic).
Bcwuc dic company phccs wry highquality asscrs in a trust to covcr thc intcrcst
and principal of a spccilic dcbr issue, this is
thc most obvious application of thc tict
dcbt adjustnicnt. (SL‘L.UDc{casmcc Of
Corporate Ratings Criteria 2008
81
EXHIBtT RVH-2
Paga113of139
Ratios And Adjustments
Corpomtc Boizds May Bc Gairiirig
Fopdarir): " prchlishedJiify ZS, ZOUG,
011
Ratilrg5DirccrJ.
TLXarbitragc. Somc companics manubcturc in various tax havens; retain rclatcd
profits in thosc low-tax IOLIICS and avoid
tollgatc t a x a by hofding financial invcstmcnts thcrc; while financing and incurring
tax-dcductiblc intcrcsr cxpcnsc in highertax rate jurisdictions. Such structud basis
for maintaining a s h is anothcr solid reason for applying thc nct dcbr adjustmcnrs.
(Hoivvevcr, for analytial purposcs, any
Utollgatcnt a x a payablc upon rcpstriation
arc subtracted from the ash.) T h e lagc,
ash-rich U.S. pharmaccutical cornpanics
o h a good cmmplc of thi5 tax nrbitngc
stmtcgy. And, givcn thc rnqpitudc of this
aspcct of thcsc cornpanics' finances, profitability rncasurcs could bc quire disrortcd
without also adjusting return on assct
&os to a nct basis. (Scc 'Credit FAQ:
Tar RcIief Otr Foreign Cash Artd Its
Spcciai Bcircfit To U.S.Dncg Arid Mcdicd
Dcvicc Finits," pttblishcrl Scpt. 14,2004,
atid "Ralirtgs lmplicahiis Of hnrittgs
RepufricrfiotisWider The Atiiericait Jobs
Crcatiori Act,"
prttlished J z I m 215,2006,
ing outstanding dcbt bafanca), IioIding thc
procccds in usli or mar-msli invcstmcnts,
drawing down t l u cash as thc ymr progresscs, and thcn repIcnishing it at pcriod
cnd. T h c company should not bc pcnalizcd
rdativc to a company that instwd rcIics on
borrowing onIy as thc nccd actually matcrializcs, rhus avoiding thc dcbt showing up
on its ycircnd financial statcrncnts. (In
both citscs, thcre may bc cqual prudcncc,
sincc thc Imcr company woutd t y p i d y bc
ablc to rciy on a revolving crcdit ngrccmcnt.) To avoid such a distortion and promote comparability, wc wouId usc P
nct-dcbt approach. Howcvcr, it would bc
tricky to cstimatc thc impact on intcrest
cxpcnsc irivolvcd for this pnttcrn, rvliicli is
onc rcnsun w c arc rcluctant IO focus on nct
intcrcst cxpcnsc.
= Mainrain ~ C C C S Sto financial markcts. Vcry
simifar to thc 3bow smtcgy, sornc companics bclicvc it is in thcir bcst intcrcsts to
kccp a hirly stablc prcscncc in thc finnncia
markcts, cspccially in eommcrcial paper
markcts. Thcy maintain niarkct prcscnec
on a rcgular basis, and avoid going in and
out of thc markcts as thcir msh flow patterns would dictate.
on R atitjgsD irect.)
= Funding futurc paymcnt of obhgationscspccially rctircc obligtions. Somc com-
1
82
panics m a y carmark financial ilsscts on
thcir balancc shcct to providc for thcir
rctircc bcncfit obligations. In particular,
some large Gcrman corporations assert
that this is thcir financial poIicy. Iiidccd,
ahilc thcsc isscts arc not IcgalIy scgrcgatcd, IVC would vicw tlicin as offsctting thc
Iiability. Application of thc nct dcbt
approach in such ciscs prcsumcs that the
IiabiIity itsclf is sufficiently dcbt-likc IO bc
includcd in our dclinition of ndjustcd
Jcbt. [U.S.,U.K., and Dutch companics,
among othcrs, arc forccd by law to fund
thcir pcnsion obIigations in 3 trust. Our
pcnsion ndjustmcnt 3dds back only any
unfundcd portion, which is cquivalcnt to
nctting thcse financia1 nsscts against thc
dctt-Iikc pcnsion IhLiIity.)
hlcct smsonal rcquircmcnts. A company
may choosc to prc-fund its intraycar borrowing nccds, by borrowing (or not repay-
wwrv.corporntecritcrla.slandardandpoors,com
Strategies that do not sttpport
ttcr-dc6t treattitext
Cyclial safcty nct. Somc cornpanics tcnd
to accurnulatc cash during good tirncs, and
hold onto it for sdf-prcscmtion during
cxpcctcd lmn ymrs. For cornpanics that
liavc I q c ongoing spiral rcquircmcnts,
this can bc critical. Thc largc U.S.auro
cornpanics offcr il dramatic cxamplc.
Similarly, high-tcchnologycornpanics tcnd
to opcntc with a l a q c ash cushion, gi:ir.cn
thc vicissitudcs of thc tcchnoIogy product
lifc cyclcs. Such cash is not rcalIy an offsct
to dcbt, and nct debt is nor uscd as rlic
basis for analysis in thcsc insmnccs.
(Noncthclcss, it is hard to formst how
much cash is appropriatcly dcdimtcd to
spending in futurc downturns. So thc analyst might calculate suppfcmcnmry ntios
bascd on nCKing, just to gain pcrspcaivc
and for pccr comparison purposcs.)
Racrvc for invcstmcnt opportunitics. Cish
cmnarkcd for invcstmcnt it1 opcmtions-
EXHI8TT RW-2
Page l14of139
expansion or capital projects-or acquisitions docs not qualify for nctting against
dcbt. The a s h position is tcmponry,
although some cornpanics may take thcir
timc until thc opportunity thcy scck
arrivcs. Ofcoursc, having such a s h to
invcst is a grmt posirivc that must not Ilc
ovcrlookcd; it figures in othcr aspccts of
thc anaIysis: Thc potcntid zdditiond n s l i
flow that can bc anticipatcd from enlargcd
operations is considcrcd in financial projcctions, and thc currcnt availability of a s h
cnhanccs liquidity.
Awaiting return ro sharcholdcrs. In thc current financial cnvironmcnt, this sitriation
may bc thc most common, at Imst in thc
U.S. Many cornpanics that liavc bccn succcssful at gcncmting surplus a s h arc motiwtcd to repurcliasc stock or pay out spccial
dividends. While shrehoIder enrichment
progmms may strctch out ovcr s c r ~ n l
quancrs or cvcn a fcw yurs, tht cash position of such companics is cphcmcnl, and
should not bc nettcd against dcbt.
Thcrc arc many imwnccs wlicrc tlic purpose may l
x mixcd or tlic strrtcgy undwr.
Local busincss pmcticc can thcn form tlic
basis for dcciding wvhcther the a s h position
is likcly to bc long-fasting. Accordingly, companics with surplus n s h that opcmtc in the
Europcan contcst are rcguIarIy afforded nct
dcbt trmtmcnt, given thc acccpranc-vcn
tradition--of cornpanics opcratiq pcrman c d y with surpIus cash. (Whatcvcr portion
is dccmcd to be nccdcd for operations is
cxdudcd from thc adjusmenr.)
In contrast, North Amcricm companics
opcmrc in an cnvironmcnt that looks askancc
at cash accumulation. Sharcholdcrs cxpcct
thcsc h d s to bc invcstcd, or rcturncd to
thcm for rcinwstment. W e thcrcforcpresume
that, in most m a ,surplus ash will bc distributcd to sharcholdcrs sooncr or later.
Accordingly, fcw cornpanics in North
Rmcrim arc a n a l p d on il net-debt basis.
Somc cornpanics participate in global
industries, and may bc influcnccd, ;o sornc
extent, by thc bchavior of cross-tordcr pccrs.
This couId providc additiona1 insight into
what to cxpcct in thosc instanccs.
A company’s cxcc55 cash may bc invcstcd
in ilsscts of varying quality or liquidity. WC
Sraedard & Pwr’s
tcnd to bc fairIy conscrvativc about wIiicli
asscts can be used to fuIIy offsct dcbt.
Horvcvcr, 3 divcrsificd portfolio of assetssuch ns tradcd cquitics, for cxarnplc-an
conrtitutc a msonably high quality invcstmcnt, and is ccrtainly vcry Iiquid. W c Iiaw
somctimcs mkcn a nct approach cvcn with
rcspcct to nonfinancial m c w . whcn thcy
cxhibit similar critica1 aspccts of low risk and
liquidity. For cxarnplp, agriculcuml commodity and cncgy trading cornpanics hold invcntory against cornmittcd ordcrs. Nctting thc
vahc of thcsc commoditics against dcbt
alIows a bcttcr picturc of tlic truc crcdit risks.
To thc cxtcnt that assct d u c s may bc subjm to dccline, \vc wvouId haircut thc invcstmcnt prior to thc nctting adjustrncnt. Tiicrc
arc situations whcrc wc would not adjust for
csccss cash on rlic baIancc slvct b m u s c tlic
company has only limitcd icccss to thc funds.
Such cxccptions indudc:
a Funds Iicld a t partially owncd subsidiarics.
Joint-venture partncrs or minority shareholders may insist on maintaining signifimnt liquidity at thc subsidiary levcl, or
may othcnvisc limit thc rcpatriation of
cash to thc group’s ccntml tmsury OPCMtions. Rcstrictivc bank loan covcitanw at
thcsc units crcatc similar rcstrictions.
= Opcmting subsidiarics that arc rcgulntcd.
Thcsc busincss units may bc prcvcntcd
from ugstmming cash to thcir pmcnts, or
may havc to maintain substantia1 cash bala n m for rcgulatory rasons.
= CTptivc insumncc subsidiarics. Whilc cash
appmrs uncncumtcrcd, it usually Ius to t c
invcstcd in linc with thc subsidiary’s insurmcc status and regulations.
a Rnsion funding vchiclcs. Ewn pension surpIuscs arc generally rqardcd as inacccssib b for dl pmctim1 purposcs.
Adjtrstrrteirt proccdirrcs
Data rcquircmcnts
= Thc amount of surpIus cash is judgmcntalty
dctcrmincd, bascd on our asscssmcnt of liquidity avdablc to rcpay dcbr.
htimmcd ~ x c that
s would bc subjcct IO
collcction upon rcpatriation, if appliablc.
Gfcularions
= Dcbt and a s h and invcstmcnts arc rcduccd
by thc surplus msli amourit, nct of rclarcd
Corporate RatIngs Criteria 2008
83
EXHtSrr RVH-2
Page I15 of 139
Ratios And Adjustments
tascs. Howcvcr. thc rcsulring dcbt amount
may ncvcr bc ncgtivc.
= If thc cash and dcbt arc structurally
linkcd, intcrcst cxpcnsc is rcdiiccd by an
amount that corrcsponds to carnings on
thc surplus cash.
[Please scc "Nct D E ~Adjrrstnzerrts
Z
Rcjlcct
Asset Qrralic):Strategic Ititerit," pid~lishd
h b . 22, 2007, oit RahgsDircct.)
Trade receivables securitizetions
Sccuririmtion is nn important financing vchiclc for many companics, oftcn providing
lowcr+ost, mom divcrsc sourccs of funding
and liquidity than othcnvisc available to thc
company. Howcvcr, sccuritimtions do not
ordinarily transform thc risks or thc undcrIyins cconomie rmlity of tiic busincss activity,
and do not ncccswrily providc cquity rclicf
(i.c., that having accomptishcd a securitization, thc issuer can m a i n lcss cquity, or incur
morc dcbt, thnn othcnvisc would bc thc a s c ,
without any changc in ils crcdit quality).
To thc went thc saritimtim ammplishcs
tmc risk mdcr (Le., all r i s h n m c t u a l ,
lgal, and rcpumtional), dic tmnmction is intcrprctcd as an assct mlc. Yct, in d s much mort
common m c , thc company rcnins thc bulk of
risks rclated to thc a c t s trrmfcrml, and thc
tmwction is akin, in our vimv, to a srmrcd
financing.Morc imporrantly, pcrhaps, IW do
not givc any bcncfit for mritiz-ttionof ilsscts
that will bc mgcnemtcd in thc ordinary course
of busincss (and linanccd on an ongoing basis).
Kcy considcntions in assessing thc cxtcnt
of cquiry rclicf include:
Riskincss of thc smritizcd nsscrs. Thc only
risk tlmt can be tnnsfcrrcd is that which
cxistcd in thc first place. If, 3s is oftcn tlic
msc, an issucr sccuritizcs i t s highatquality
or most Iiquid ilsscts, that limits thc cxtcnf
of any mcaningtul cquity rchf.
First-loss mposurc. Thc issucr commonly
rctaim the first-Ioss cxposurc, to cnhancc
thc crcdit protcctioa a f f o d d for thc sccuritized dcbr. For thc sccuririzd dcbt to bc
IiighIy mtcd, thc cstcnr of cnlianccmcnr
must t c 3 multiplc of the cvpcctcd IOSPCS
associatcd with thc ;1sscts. Tlic first-loss
laycr thus cncampasscs thc prcpondcnncc
of risk associated with dic sccuritizcd ~ S S C E ,
and the issucr's total rwlimtions horn the
84
www.corpom tccriterla,standardandpoors.com
securitization will vary dcpcnding on tlic
pcrformancc of thc assct~.O h ,o d y thc
risk of mta~tropliicloss is transfcrml 10
third-party inw.stors--nsk gcnmlly of littlc
rclcvancc in thc corpomrc rating andysis.
m Moral rccoursc. How the compny would
bchavc if Iosscs did mdi unstrophic Ic~~cls.
Empirial cvidcncc sugpts cornpanics oftcn
hlicvc they mwt bail out rroublcd financing (for cmmplc, by rcpurchasiq probkmatic asscis or rcplaciq rhcm with othcr
ilsscts) to prcscrvc ~ M C S Sto this funding
MUCCC and, morc broadIy, to prcscrvc thcir
good namc in tl:c m p i ~ markcts,
1
cvcn
though thcy linvc no lcgl rcquircmcnt to do
so. Monl rccoursc is magnified whcn sccuritimrions arc a sigifimnr part of a company's financing activiry, or whcn a company
rcmains linkcd to tlic smritizcd 35scts by
continuing in thc rolc of scrviccr or opcmtor.
Ongoing funding nccds. R c n if i t wcrc
cont~ctuallyand Icgally ccrtnin that tlic
risks rcIatcJ to a givcn pool of assets had
bcen fully tmnsfcrrcd and thc issucr would
not support failing srmritimtions, cquity
rclicf [oran anatytid dcconsolidation) still
would not nccessariIy liavc bccn achicvcd.
If, for whatcvcr ccason, Iosscs rclatcd to
thc sccuritizcd assets rosc dnmatirrlly
h i g h than initidy anticipatcd, and if thc
issucr has a rccurring nccd to financc similar asscts, futurc acccss to tlic smritimtion
Imst ccornarkct would bc dubio-at
nomially. Futurc funding nccds would
thcn havc IO t c mct by oihcr mcms, with
thc rcquisitc cquity {rind thc cquivdcnt
Icvel of borrowings)to support tlicm.
Thus, cven if a company scpamtcIy sclls
thc first-loss cxposurcs, or sclIs thc cntirc
assct without rctnining any first-loss cxposurc, it wouId not achicvc cquity rclicf.
The accounting trcatmcnt of sccuritimtions
may not bc congrucnt with our nndytical
pcrspcctivc, and, accordingly, adjustments to
thc rcponcd financials o h arc ncccssmy
(cspccially for cornpanics rcporting undcr
US. GtUP, sincc many sccuritimtions rcmain
on-balancc shcct undcr IPRS).
For transactions in which ;1 company
retains thc prcpondcrancc of risks (including
thosc rclatcd ro ongoing funding iiccds), we
crrlculatc ratios whcrc thc outstnnding
EXHIBIT RW-2
Page 116 of 139
amount of smritizcd asscts arc consolidatcd,
dong With thc rclatcd sccuritid dcbtregardless of thc accounting tmtmcnt. If
smritimtion is uscd csscntially to tmnsfcr
risk in full and thcrc arc no contingcnt or
indircct liabilitics, w c vicw thc transaction as
thc cquivnJcnt of an assct saIc. \%cn ncccssay, thcn, wc recast the ~SSCKS,dcbt, carnings
and mshffow, and sharcholdcrs’ equity
accordingly, including adjusting for dcfcrrcd
tax cftccts and imputcd intcrut.
Issiieslliniitatiorrr of adjijllsirricrrtr
thc sccuritimtion is consotidatcd, thc rchtcd
borrowings arc trcatcd 3s P financing activity. If thc securitization is not consolidatcd, it
is as if thc asscts sclf-liquidatcd on nil accclcmicd basis: No dcbt incurrcncc is idcniificd
scparatdy, citlicr 3s an opcmting or financing source of cash. Whcn our anaIytic vicw
is that sccuriti.mtions should bc consoIidatcd
(or, in tarc situations, whcn thosc that arc
consolidatcd should not bc}, it would bc
dcsirabJc to m a s t the stmmcnt of cash
flow accordingly-to smooth out thc variations in opctaring cash flow that can rcsult
from thc sale trmtmcnt of thc sccuritization,
which can givc a distorted picture of recurring a s h flow. Again, as a practical. mattcr,
this oftcn a n bc diflicuIt to accomplish.
Whcn sccuritimtions arc accountcd for as
s=h,
thcy commonly givc rise to upfront
gaidoss-on-saIc CC~CCIS, which rcprcscnt thc
prcsent n l u c of the cstimarcd diffcrcncc
bcnvccn thc ilssct yicld and thc sccuritimion
tcrd
funding mtc and othcr sccnriti~~ti~n.rclatcd ~ d j ~ r s f ~ ~proccdirres
Data rcquircmcnts
costs. For sccuritimtions that w c arc putting
back on thc balancc shcct, it is appmpriatc to
Idcntify thc pcriod-cnd amount and mcrback out such gains and s p m d thcm out
agc outstanding aniount of t n d c rcccivovcr thc lifc of thc sccuritimtions, givcn rlic
ablcs sotd or sccuritizcd, for wliich nn
unccrminty about whcthcr thc crrrnings will
adjustmcnt is wamntcd, that nrc not on
ultimatcly bc rmlizcd as cxpccrd and thcir
thc balancc shcct.
csscntinlly non-recurring chnrmcr. Losscs
thar rcflcct thc discount on salc arc also
backcd out, to avoid doublc-counting the
intcrcst componcnt of the transactions.
To imputc intcrtrt, IYC gcncmIly have to
approximate il mtc, givcn thc lack of pmisc
information that is availablc. Since sccuritimtions tcnd to h rclntivcIy wcll-srmrcd and
risk-frcc for rhc invator, wc assume a mtc that
approximaw thc risk-frcc nrc, currently 5%.
In theory, it midit bc dcsirilblc to h t I y
rcast thc incomc statcmcnt, and consolidm
off-balancc-shect sccuritimtions, bur as a
practical rnnttcr, this is difficuIt to accomplish. Still, some companics haw voluntarily
indudcd pro forma schcdulcs in thcir public
discJosurcs to cnablc sudi niialysis.
Cash inflows or outflows rclatcd to working capital assets or hbititics, or linancc
rcccimblcs, arc classilicd as opcrating in
natttrc on tlic statemcnt of cas11 flows undcr
U.S. GAAP and IFRS. Hcncc, sccuritimtions
affcct opcrating cash flow, with particulady
significant cffccrs possiblc in rcporting pcriods whcn sccuritizations arc initiatcd or
mitiirc. The rcporting convcntion varics in
linc mirh tlic balnncc shcct classification. If
Stairdnrd Sr Poar3 a Corporate
GIculations
= Dcbt and rcccivables arc incrcfiscd by
thc amount of tradc rcccivablcs sold
.
or sceuritizcd.
Intcrest c~pcnscis incrcascd by an amount
of intcrcst imputcd at thc risk-frcc discount ratc.
= Operating cash flows arc adjustcd to
rcmovc the procccds from rhc sccuritizntion whcn tticrc is an incrcascd lcvcl of
sccuritimtion-upon initiadon of smritimion or subscqucnt fluctuation in
amounts sccuritizcd. Mcrcly rolling ovct
cxisting sccudtimtion rcquircs no a s h
flow adjustmcnt.
{Plcasc scc “Searritim~ioi~’~
Effect On
Corporate Crcdit Qiinlitx” prrblishif Nov.
28, 2005, atid ”Fi~iarrccCowparry Ratitis
Mctlmiology: Credit Ratios To Bc Arrdyrcd
Oit A Marragcd Basis,” ptrldishcd FL& 2.3,
2001, oii RathgsDircct.)
Volumetric production payments
A voltrmctric productitin paynicnt (VI’P) is an
armngcmcnt in rvliiuti an cxpIoratioii and
production (EM‘)company agrccs to dclivcr
a spccificd quantity of hydrocarbons lroin
RatIngs Criteria 2008
85
EXHIBIT RVH-2
Page 1’17 of 139
Ratios And Adjustments
spccific propcrtics to a countcrpatty (oftcn a
financial institution) in return for a Iixcd
amount of cash rcccivcd a t tIic tcginning of
thc transaction. Thc scllcr oftcn bcars all of
thc production and dcvclopmcnt costs associatcd with dclivcring the agrccd-upon volurns. T h c buycr rcccivcs a nonopcrating
intercst in oil and ps propcrtics that producc
thc rcquircd volumcs. T h c sccurity is a rcaI
intcrcst in thc producing propcrtics that is
cxpectcd to survivc bankruptcy of thc E&P
company that sold thc VPP, Whcn thc total
rcquisitc units of production arc dclivcrcd,
thc produaion payment arrangcmcnt tcrmin a t a and thc convcycd intcrcst rcvcrts back
to thc sellcr.
WCvicw production piymcnts structurcd
with a high lcvcl of sccurity to production
covcmgc a5 dcbt-likc obligations, and adjust
financial and opcrating andysis accordingly.
Thc rctcntion of risk in WPs is ccntml to our
trmtmcnt of such dcals 3s largcly dcbt-iikc.
T h c accounting for VPPs a I f m thc scllcr’s
financial stitcmtnts and also opcrating smtistics in scveral ways. Thc W P volumcs [i.c., thc
amount of oil and gas rcquircd to be ddivcrcd
undcr tlic agrccmcnt) arc rcmovcd from thc
scllcr’s racrvcs. Procccds rcccivcd for thc W P
i n m s c thc scllcr’s a s h balances, and thc scllcr boob il dcfcrrcd rcvcnuc liability-r
dcbr--to rcflcct thc obligation undcr thc agrccmcnt. Rcvenucs and cats incurrcd to produce
thc VPP volumcs an‘ incIudcd in the scllcr’s
income smtcment as and when thc ail and ps
is produced. Opcmting smtistia c;llcutatcd on
a pcr-barrcl basis will bc ovcaatcd becilusc
thcy includc both thc amortization of dcfcrrcd
rcvcnum and costs, but do not fixtor in thc
voIurnes rclarcd to thc VPP. In thc u s c of lifting costs, for mmplc, barrcls produccd in the
numcraror arc Iowcr, whilc thc c~pcnscin tlic
dcnorninator continua IO indudc thc cost of
producing thc VPP volurncs.
Whcn thc ncccssary data arc au;lilablc, w c
adjusr thc rcportcd rcsutts to minimizu thc distortion wuscd by accounting for a production
paymcnr. Thc rcquird volui~icsare rcturncd
to mcncs and dcfcrrcd rcvcnuc is trcatcd as
dctt. Similarly, Lhc oil arid gas volumcs produccd to mcct thc VPP rcquircmcrirs arc addcd
to thc E W company’s production whcn c;lIctilating per-bxrcl salcs and lilting costs. T h i s
86
trmtmcnt rcflccts tlic vicw that VPPs arc concepruilly similar to sccurcd dcbt, mhcr than
asct saics. Thc similari~ypcmins in typiclf
d a h , in which tlic mcwcs indudcd in dic
production ngrccrncnt arc signifi~intlygrmtcr
than thc rcquircd volumcs. TIic sdlcr bcars thc
obligtion to dclivcr thc ngrccd-upon volumes,
and rcnins thc production and a significant
amount of mcrvc risk, whitc rccciving thc
bcncfit of fixing commodity prim. A WP
strucmrcd with minimal covcragc would bc
vicwcd 3s closcr to an assct d c , sincc tht
tmnsfcr of risk woiild bc mom subsmntial.
A djirsrrrrcitrt proccdirrcs
Data rcquircrncnts
Amount of VPP-rclatcd dcfcrrcd rcvcnuc
rcponcd on thc balincc shcct at pcriod cnd;
= Oil and gas mcmc dam (rdmd to VPPs that
liavc k n rcmovcd from rcponcd amounts);
Remaining quantity o€ oil and gas mccvcs
rcmovcd from rcporrcd rcscrycs at cnd of
pcriod [yct IO bc dcIirwcd); and
= Oil and gas volumcs produccd during thc
ycar from thc VPPs.
T h c amount of dcfcrrcd rcvcnuc rcIatcd to
WPs a t pcriod cnd is obtained from tIic
financial statcmcnts. Rcscrvc quantitics may
comc from the financial statcmcnts or from
d ~ company.
c
ChlcuIations
Adjustmcnt to dcbr: 1% add thc amoiint
of dcfcrrcd WP rcvcnuc a t pcriod cnd
to dcbt.
= Adjusmcnt to intcrcst cxpcnsc: 1%
impute inrcrcst cxpcnsc on thc adjustmcnt
to dcbr. Thc ratc is that inhcrcnt in tlic
contract, or n mtc estimatcd by tlic anaIyst based on thc company’s sccurcd t o r rowing ratcs. In citlicr msc, it i s applicd
to thc avcrage of thc currcnt pcriod cnd,
and thc prcvioiis pcriod cnd dcfcrrcd VPP
rcvcnuc balancc.
a IVt add pcriod-cnd rcscrvc volumcs rclatcd
to VPPs back to rcportcd rcscwcs.
SimiIarly, IVC add rhc oil nnd gas volumcs
produccd to meet tbc VPP rcquircmcnts to
thc company’s production and salcs statistics uscd to mlculatc pcr-tarrcl sclling
prim and lifting costs.
Adjustmcnt to opcratingcnsh flow: \Vc
rcclassily a s h procccJs from VPPs as
EXHIBIT RVN-2
Page $18of 139
financing a s h flows. Futurc cash flows
\vi11 bc adjustcd (if pracrimbt and dam arc
available) upon dclivery, to rcfIcct the a s h
flows associatcd with thc propcrtics.
(Plcarc sce “Credit FAQ: Volrrtrreiric
Productioir PqwcIits For US.Oil And Cas
Conipariics. prtbtished April 14,2005, and
“Oil Arid Cas V o h e t r i c Produdon
h y ~ i i c / ~ lThe
s : Corpordtc h l i t l g f krspcclive, ”
piiLdishcd Dec. 4, 2003, an RatitrgsDirect.]
Workers compensationlself insurance
Workcrs cornpcnsation systems providc cornpcmtion for cmployccs injured in rlic course
of employmcnr. Whilc sdicrncs diffcr bcrwccn
jurisdictions, provisions may bc madc for
pagmcnts in licu of wages, cornpcnsation for
economic losscs [past and future], rcimburscmmt for or paymcnt of mcdiml and Iikc
cxpcnscs, gencml darnagcs for pain and suffcring, and bcncfits payablc to rhc dependents
of workers killcd during employmcnr. {For
cxamplc, U.S. c o d mining eompanics, undcr
thc Fc’cdetrl Coal Mine Health and Safcty Act,
arc rcsponsiblc for mcdinl and disability
bcncfirs to existing and former cmployccs and
their familics who arc iffccrcd by pncumoconiosis, better known 3s black lung dismsc.)
Workcrs compensation covcragc may bc
provided through insiirnnce companies, and
thus is not a financial concern for thc cornpany. But, in ccrtain instanccs andlor industn’cs,
Standard & I’our’s
=
cmploycrs issumc dircct rcsponsibiIity for
medial rrcatmcnt, Iost wagcs, ctc.
In these cases, undcr U.S. G M P or IFRS,
thc incurrcd Iiabilitics usually arc rccordcd on
the company’s balancc shccr as othcr liabilitis,
tasd on an actuarially dctcnnincd prcscnt
value of known and utirnatcd claims.
Accordingly, thcsc obligtiom rcprcscnt a mII
on fururc cash flow, distinguishing them from
many orhcr, less-certain continEcncia. TIICY
arc nndogous to postretircmcntobligations,
which IVC also add ro debt.
Trating tlic workcrs-conipciuationliability
as dcbt affects many linc itcms on tlic financial
statcrncnts. IdmIIy, if tlicrc is suffjcicntdisclasum amilablc, wc wouId adjust fully (in a
msnncr akin to our port-rcdrcment adjustments). In pmc~icc,tlm Jan arc not awilablc.
so wc reclassify t h m obligations, adjustcd for
MX, as dcbr. Similarly, wc may aIso t r m othcr
analogow self-insumncc-type liabilitia
3s dcbt.
Arijirstntent proccdtrres
-
Data requircmcnts
Nct amount recagnizcd as n liability for
workcrs compensation obligations and for
self-insurance claims.
CaImlations
Add amount rccognizcd for workcrs compcnmtion obligations (rict of tax) and nct
amount rccognizcd for sclf msurnncc
*
cIaims (nct of tnx] to dcbt.
Corporate Ratings Ctitetta 2008
87
EXHIBIT RVH-2
Pago119of139
Rating Each Issue
vv
e assign two types of credit ratings-one to corporate
issuers and the other to individual corporate debt issues
(or other financial obligations).The first is called a Standard &
Poor‘s corporate credit rating. It is our current opinion on an
issuer‘s overall capacity to pay its financial obligations, Le., its
fundamental creditworthiness.This opinion focuses on the
issuer‘s ability and willingness to meet its financial commitments
on a timely basis. It generally indicates the likelihood of default
regarding all financial obligations of the company, because, in
most countries, companies that default on one debt type-or file
for bankruptcy-virtually always stop payment on all debt types.
Thc corpontc racing docs not rcflcct any priority or prcfcrencc among obIigations. In thc
pasr, \vc publisticd the “implied scnior-most
rating” of corpontc obligors- diifcrcnt
t c m for precisdy thc silmc conccpt. “Dchult
risk raringRand ‘nnrural rating” arc additional ways o€rcfcrring to this issucr rating.
(Gcncmlly,il corpomtc crcdit mting is pubIishcd for all cornpanics tIiat have issue rating-in addition to thosc cornpallies that
haw no mrablc issucs, but rcqucst just an
issucr nting. Wherc it is gctmanc, both 3
loclll currcncy and forcign currcncy issucr
’
88
raring arc nssigncd.)
Wc abo assign crcdit ratings to spccific
issircs. In fact, thc v.ist majority of crcdit
ratings pcrtairi to rpccific dcbt issucs. long-
www.corporatscriterIa.standardandpoors.com
rcrm issuc ratings arc il bIcnd of dcfault
risk (somctimcs rcfcrrcd to as ‘timcIincss”)
and thc rccovcry prospccts (Iossgivcn
d c f d t , or LGD) associatcd with thc spccific dcbt bcing ratcd. Dcbt with rclativcly
good rccovcry prospccts-cspccially wcllsccurcd debt-is ratcd i b o v c rhc corporatc
crcdit rating; dcbt with rclativcIy poor
prospccts for such Ioss-~~vcn.dcf~ult--cspccially junior dcbt-is ratcd bclow tlic corp o r m crcdit rating. Notching docs
not appIy to short-tcrm ratings (see
Cotin~rcrcialPapnr clmptcr of this Irook].
Rccowry ratings mcm addcd in 2003.
Thcsc rating addrcss only rccovcry
prospects, using a smlc of onc to six, mthcr
than thc lcttcr n t i n g .
EXHIBIT RVH-2
Page 120 of f3P
Notching Down; Notching Up
Thc pmaicc of diffcrcntiating issucs in rcIation to thc issucr's fundamcnral crcdinvorthincSS is known 3s "notching." Issues are
notchcd up or down from die corpomtc crcdit nting Icvel. Payment on time as prorniscd
obviomIy is cridal with rcspcct to 311 dcbt
issucs. Thc potcntial for rccovcry in thc cvcnt
of a dcfautt-Le., ultimatc rccovcry, albcit
d c l a y c d ~ l s ois irnpormnt, but timclincss i s
thc primary considcration. That cxplains why
issuc ntings arc stilI anchored to the corpomtc crcdit rating, They arc notchcd-up or
down-from thc corpomtc crcdit rating in
accordancc with atd~lishcdguidclincs
mplaincd hcrc.
As dcfaulr risk incrmscs, tlic conccrn ovcr
what a n bc rccovcrcd tnkcs on prmtcr rclcvancc and, thercforc, grcatcr nring signifiancc. kcordingly, thc loss-givcn&bu~t
aspcct of ratings is givcn morc ivcighht 3s onc
mows down thc nting spcctrurn. For cxamplc, subordinatcd dcbt mn bc mtcd up to nvo
notchcs bclow a non-invcstmcnt gmdc corpomtc crcdit rating, but onc notch at most if thc
corpomtc crcdit rating is invcstmcnt gmdc. (In
thc samc vcin, issucs of cornpanics with a
'AAA' rating nccd not be notchcd n t all.)
For invcstmcnt-gndc conipanics, \vc scck
to differcntiatc thosc financial obligations
judgcd to h a w matctialIy infcrior rccovcry
prospccrs by virtuc of bcing unsccurcd or
subordinatcd--eithcr contmctually or strucrunlly. Priority in bankruptcy is considcrcd
in broad terms; thcrc is no attcmpt to spccify
il dcfault sccnario.
In the spcculativcgr;ldc atcgorics, wc do
scck to predict spccific rccovcry levcls bascd
on full-blown dcfault-scenario modcling.
Ilcuusc any d c f d t would p r a m a b l y bc Icss
disrant in timc than far invfsrmcnrgnde
cornpanics, it is morc rmsonable to analpx a
spccific inticipntcd dcbult sccnario, with
s o c i a t c d nssct mix and mlimblc vnlucs.
Whcn such il rigorous rccorcry analysis is pcrformcd, wc assign P rccovcry rating and basc
the notching on thc spceilic outcomc. W c
focus on n ccntml tcndcncy of approximatcIy
50%. Thcrcforc, issucs with rccovcry f i t &
significantly abovc 50% arc ratcd nbovc thc
corpomtc nting; convcady, issucs rccovcting
signilinntly lcss than 50% arc ntcd bclow
Stu~durd& Poor's
a
thc corpomtc rating. Wc go into grcatcr dctail
in 'Speculativcgmdc"}.
Notching rclationships undcdying issuc ratings arc subject to rcvicrv and changc whcn
m u d dcvcloprncnrs vary from cxpcctations.
Changcs in notching do not ncccssarily havc
to bc accompnnicd by changcs in dcfauft risk.
Notching guidclincs arc a function of thc
bankruptcy law and pmcticc in thc lcgal
jurisdiction that governs il spccific instrumcnt. For mmplc, distinguishing bcnvccn
scnior and subordinatcd dcbt a n bc mmninglcsr in India, whcrc cornpanics may bc
nllowcd to continuc paying cvcn common
dividcnk at tlic samc rimc they arc in dcfault
on dcbt otligatiom; accordingly, notching is
not applicd in India, Thc maiority of Icgd
systcms broadIy follow thc practice undcrlying our critcria for notching-but it always is
important to bc ilwarc of numccs of the Iarv
as thcy pcrnin to a spccific issuc.
Preferred stock
Prcfcrred stock carrics grcatcr crcdic risk
than dcbt in two important ways: Thc dividcnd is at thc discrction of thc issucr, and
thc prcfcrrcd reprcscnts 3 JccpIy subordinatcd cIaim in thc cvcnt of bankruptcy.
Prior to 1999, Standard st Poor's uscd a
scparatc prcfcrrcd stock scdc. In Fcbruary
1999, thc dcbt and prcfcrrcd stock SLIICS
wcrc intcgratcd.
Accordingly, now, prcfctrcd sock gcncmlly
is ntcd below subordinatcd dcbt. Whcn our
crcdit rating on a company is invcstmcnt
gradc, its prcfcrrcd stock is r a t 4 nvo notclics
bclow thc corpomtc crcdit raring. For a m PIC, if tlic corpomtc crcdit nting is 'A+', thc
prcfcrrcd stock would bc rntcd 'ii-'. (In cnsc
of a ' A M corpomtc crcdit nting, thc prcfcrrcd stock rvouId bc ratcd 'M+'.)Wicn tlic
corpontc mdir rating is non-inwstmcnt
gradc, thc prcfcrrcd stock is r a d at Imst
thrcc notchcs (onc rating cmgory) bclorv thc
corpomtc crcdit nting. DcfcmbIc paymcnt
dcbt is trcatcd idcnticnlIy to prcfcrrcd stock,
j$vcn subordination and tlic right to dckr
paymcnts of intcrcsr.
Thcrc arc situations in \~liichthc dividcnd
is cspccially jcopardizcd, so norching would
cscced tlic guidclincs abovc. For cx~mplc,
statc chartcrs rcstrict payrucnt whcn tlwc is a
Corpamtc RatIngs Cdtei-ia 2008
89
EXHIBIT RVHQ
Page 121 of 139
Rating Each Issue
deficit in thc cquity account. T h i s mn occur
following P writc-off, cvcn while thc company is hmlthy and posscssrs ampb cash to
continuc paying. Siniilarly, covcnants in dcbt
instrumcnts can cndangcr payrncnt of dividends, tven whilc thcrc is 3 capacity to pay.
In all CIS=,
thc risk of dcfcml of paymcnts
is analyzcd from il pragmatic, nthcr than a
Icgal, pcrspcctivc, If a company d c h a paym a t or passx on a prcfcrrcd diuidcnd, it is
tannmount to default on thc prcfcrred issucs.
Thc rating is changcd to 'D'oncc thc payrncnt
dare has p a s d . T h c rating usually would bc
Iow~rcdto 'Cin the interim, to thc c\zcnt nonpayment a n bc mtiapat&.g.,
if thc comp7ny wcrc to announcc d m its d i m s hilcd to
dcclarc thc prcfcrred dividcnd. Whmcvcr a
company rcsumcs paying prctcmd dividcnds
but rcmins in a m r s with mpm to paymcno
it skipped, thc mung is, by definition, 'C.
Convertible preferredequity units
Somc sccuritics providc for mandatory conwr
sian into common stock of 3 company. Such
saritics vary with r q x c t to rhc formula lor
sharing potcntia1 apprcu'ation in sharc nluc.
In the interim, that sccuritics rcprcscnt il subordinatcd dcbt or prcfcrrcd stock claim. Othcr
offcrings pachgc a short-Iifc dcbt or prcfcrrcd
stock with a dcfcrrcd common stock purchasc
contract KOachievc similar cconomics.
Ratings on thc issuc addrcss primarily thc
IikcIihood of inrcrim paymcnts and thc solvency of thc company at thc time of convcrsion to cnablc it to honor its obIigation to
dclivcr thc sharcs. Tlicsc ratings do not
addrcss thc amount or vduc of thc common
stock invcstors ultimately will rcccivc. Thc
cquiry risk that pcrtains is rcflcctcd rncrcly
by Iirniting thc rating to thc cquivalcnt of
thc company's prcfcrrcd cquity sccuritics.
(Wc oncc highlightcd this risk by appending
an "rn to tbc ratings of thcsc hybrid sccuritics, but now rcly on thc markct's familiarity
with such instrumcnts and thcir tcrrns.)
Reflecting Recovery
In Issue Ratings
If w c u n confidcntly project rccormy prospects
cxcmling 70% for an iiidividual security, that
issuc is typiully n t c d highcr than thc corpontc
90
wwrv.corporatccriteria.standardondpoors.com
rating; convcrscfy, if \vc projcct rccovcry for P
givcn sccurity to bc undcr 30%, thc issuc is typi d l y mtcd lorvcr than thc corpontc rating.
When \vc unnot confidently model absolutc
rccovcry k u s c of jurisdictional issucs or
k u s c thc corpomtc c d i t raring is invlrtmcnt-gmdc and thc i s m is unsmrcd, ivc
notch dotrn wlicn il dcbt issuc's junior smnding, rclativc to othcr dcbt imcs of tIic cornpany, indiatcs rcbtivcly poor rccavcry prospects.
?hc wcighting of rccorwy aspccts in i w c *
ratings also v ~ r i c sas the potcntid for dcfadt
bccomcs mort mcmingful, 3s cxplaincd below.
investment grade
For invcstmcntgmdc companics, notching
rclationships arc bascd on t r o d guidclincs
that combinc coieidcntim of asset protcctbn
and nnking. Tlv guidclincs arc dmigncd to
idcntify matcria1 disadvmngc for P givcn
issuc by virtuc of thc cvistcncc of bcrtcr-positioncd obligations. Tlic analyst docs nor scck
to prcdict spccific rccovcry Icvcls, which
would involvc knowing rlic cxact assrt mix
and valucs a t a point welt into t b fururc.
Thcrcforc w c do not gcncrally pcrlorm P
fundamcntd rccovcry andysis, givcn thc difficulty of doing mmningful dcfault sccnario
anaIysis whilc thc company is still so srrong.
{For cmmplc, IVC would not p m m c that
dcfault m r s whilc thc company's =pita1
stmcturc rcmains roughly thc samc--as wc gcnc n l y do in thc rcravcry analysis of spcculativc
gndc compania. Wth mpcct to currcntly
strong crcdits-with rclativcly unturdcncd Idmcc s h c c w c h an approach would bc i n n p
propriatc. Indccd, currcntIy, wc typic;lIly do not
assign m c l i ~ c r yn t i n p for dcbt issucs of invcstmcnt-gnde c a r p o m r k t h the cvccprion of
uulity first rnonpgc bonds.)
Rather, w c USC il rut-of-rhumbapproach
to idcntify dcbt issucs with infcrior rccovcry
pmspccts-r, for considcntion of adding
notchcs, wc usc discrcrc s s c t valuations if
thcrc is collateral [modified sommvhit in thc
msc of rplarcd utilitics).
Rating below the corporate
credit rating: "Notching down"
Whcn a dcbt issuc is judgcd to be junior to
otlicr dcbt issucs of thc company, and thcrcby
to have rcIativcIy poor rccovcry prospMts,
EXHIBIT RW-2
Page 122 of139
that issue is notchcd down from thc corpomtc crcdit rating. As 3 rnattcr of raring policy, rlic diffcrcntial is limitcd to onc rating
dcsignation in thc invcstmcnt-gmdc atcgorics
givcn thc critica1 rolc of tirncIincss for inrcstmcnt gmdc dcbt. Loss-givcn-default is just
Icss signifimnt in thc schcmc of things for
investment gndc-leading to Ius wcight
givcn to mover)'; invcsrors arc locuscd on
getting paid in thc first place.
Whcnevcr P thmhold pcxcnnge of thc
company's asscts would first bc uscd to satisfy odicr claims, this translates into a mwningfu1 disadvantap for the ujunior" crcdirors.
Thc rhrcshold for norcliing ir rcachcd whcn
marc-scnior claims covcr o w 20% of thc
;ZSSCLS (unIcss Icss-vi~luablc
asscts makc up thc
collarcml or tlicrc wisr mitigating factors,
such as upstmm guuamntccs).
WIiiIc wc do not makc spccific judgments
rcgarding thc lcvcl of absolutc rccovcty for
invcstment-gndc dcbt, thc material disadvant a p of junior issues is dcsigncd to roughly
correspond to thc 30% absolute-rccooery
bcndirnark that applics for spcculativc-gmdc
notching. hlorc oftcn than not, junior dcbt
moverS Icss than 30% (aIthough this figurc
may vary by jurisdiction).
T h c thrcshold IcvcI taka into accouiir that
it normdIy nkcs more than $1 of book
asscts-as valucd today-to satisfy $1 of
priority debr. In thc case of sccuml dcbtwliich h i t s thc priority to thc cotlatcmI
plcdgcd-thc remaining asscts arc still Icss
likcly to be sufficient to rcpay thc unsccurcd
dcbt, inasmuch as tlic collatcrd ordinarily
consists of thc company's bctter assets and
oftcn substantially cxcccds the amount of
thc dcbt.
Morcovcr, in all Iikclihood, thcrc wil1 t c
additional dcbt by thc timc of dchult, 3s
pointcd out abo\,c. Sincc such dcbt-as ivclt
,as thc rcfinandng of misting dcbt-will be
incurtcd as thc company a p p r o d m dcbult,
it is mort Iikcly ro bc on a securcd basis {or
dircctfy to thc cnriry [hat holds thc opcnting
assets, in thc a s c of an opcmting
companyholding company structurc).
To the cxtcnt t h t ccrtnin obligations k v c
a priority daim on thc company's nsscts,
lorvcr-ranking obligations arc at a diridvmmgc bcausc a sniallcr pool of assets will bc
Srandard& Poor's
available to satisfy thc rcmaining claims. As
rncntioncd abovc, dcbt can bc junior by
virruc of tcing mntnctually subordinmdh a t is, tlic t c m s of thc issuc spccifimlIy provide that dcbt holders will rcccivc rccovcry in
a bankruprcy ody after thc claims of othcr
crcdimn haw bccn satisficd.
Anothcr u
s
c i s whcn thc issuc is unxcurcd,
rvhilc asscts rcprcscntinga signifimnt portion of
thc company's vaIuc cctlatcnlirr sccurcd borrowings. (If thc collntcmI that sccum a particular dcbt issuc is of dubious valuc, whilc thc
morc vaIu3bfc collatcd is plcdgcd to anothcr
loan, cvcn sccurcd dct t may Ix notchcd down
from thc corpontc crcdit rating.)
A third form of diszdvnntagc a n arisc if a
company conducts i t s opcmtions through nn
opcmting subsidiarylholdirig-cornpany strucmcc. In this msc, if tlic wholc group is bankrupt, crcdirors of tlic subsidiarics-including
holders of cvcn contractually subordinated
dcbt-would havc thc first claim to thc subsidiarics' asscts, whilc crcditors of tlic parcnt
would havc only it junior claim, limitcd t a the
rcsidual vduc of thc subsidiarics' nsscts
rcmaining a h rhc subsidiarics' dircct liabilitics have bccn satisficd. Thc disadvmtagc of
parcnt-compaiiy crcdirors owing to tlic parcndsubsidiary Icgal structurc is known as
"structural subordinadon." Evcn if rlic
group's opcmtions arc splintcrcd among
many sma11 sutsidiarics, tlic individual d c t t
obligations of which havc only dubious
rccovcry prospccrs, t hc pnrcnc-company crcditors may still bc disadvmtapd coniparcd
with il situation ill which all creditors would
haw an equd cIaim on thc ~SSCIS.
If a company has an atypia1 mix of xsscts,
thc 20% thmhold could bc highcr or Iowcr to
rcftcct thc rclativc amounts of bcttcr or ~ o r s c
asscts. Goodrvill cspcciaIIy is suspccr, considcring its Iikcly vaLc in 3 dcbult sccnario. In
applying thc notching guidcIincs, Standard &
Poor's gcncmlly cliniinatcs from total nsscis
goodwill in cxccss of a normal amount-10%
of tom1 adjusted 35scts. As distinct from goodwill, innngiblcs arc considcrcd parcnrially
wluablc-for cxampic, csnblishcd brands in
thc coiisumcr products scctor. iVc do iiot,
howcvcr, pcrforiii dctailcd nssct appraisals or
oitcmpt to postulatc spcciftwlIy about how
markct vducs might flucnintc in a hypotbcti-
Corporate Ratings Criteria 2008
91
EXHJBIT RVH-2
Page 123 of t39
Ratlng Each ISSUE-
a1strcss sccnario (mccpr in thc MSC of
s c c u d dcbtb
TIic conccpt behind thcsc thrcsholds is to
mwsurc matcrial disadmntqy with rapccr
to thc \rarious laycrs of dcbt. At czlch lcvcl, 3s
long 3s the next laycr of dcbt stilI cnjoys
pIcnty of asset covcrqc, \vc do not considcr
thc priority of tlic top layers as constituting a
rcal disadvmtagc for thc morc junior issucrs.
Accordingly, tlic naturc of rhc individual
company’s assct is impormnt: If a company
has an atypia1 mix of asscis, thc thresholds
could bc highcr or Iorvcr to rcflcct thc rclarivc
amounts of bcttcr or worse asscts.
Thc rclativc sizc of thc ncxt laycr of dcbr
also is important. I€ thc ncxt hycr is cspccialIy largc-in rclation to thc asscts assumcd to
rcmiin iftcr satisfying tlu morc scnior laycts-thtn covcngc is impaircd. Thcrc arc
numccous LDOs financcd with outsizcd issucs
just bclow thc scnior laycrs. Although thc priority dcbt may be small (bclorv thc thrcshord
Icvcfs), it poses a rml disadvantage for junior
issum givcn thc paucity of covcmgc rcmaining, thc junior dcbt should bc notclicd down.
One othct now to kccp in mind is that
“absolute trumps rclativc.” If far stmctunI
or othcr issuc-spccific (or jurisdiction specific)
rcasow wc a n eonEidcntIy anticipatc rccovcry abovc 30% (and bclow 70%), IVC would
cquatc thc issuc raring with thc corpomtc
crcdit rating, rqardlcss of the rcsult of thc
priority dcbt calculation. Similarly, if rhcrc
werc structural, issuc-spccific, or jurisdictionspecific rcasons to anticipatc rccovery bclow
30%, m c would mrc thc issuc onc norch
bclow tlic corpomtc credit rating. Thcsr
absolutc rccovcry nngrs arc similar to thosc
uscd for spcculativc-pdc issuc rating g u i d e
Iincs whcrc \vc assign rccovcry ratings.
Appticntiori of grrideliir~s
In applying the guidclincs abavc, Imsc obligations-whcthcr capitdizcd in thc company’s
financial rcporting or kcpt off balaricc shcct
3s opcrating Imscs as priority dcbt-and thc
rclarcd ~ S S C ~are
S includcd on rhc 3ssct sidc.
SimitarIy, sold trade rcccivablcs and sccuritizcd assets arc iddcd back, along with an
cqud amount of priority dcbt. Otlicr crcditors arc just 3s disadvantaged by such linancing arrmpmcnts as by sccurcd dcbr. In
92
wwrv.corporatccri teria.standnrdandpoors.com
considcring thc surplus ash and markctablc
sccuritics of cornpanifs tbar prcscntly arc
financially hcalttiy, wc m u m c ncithcr that
thc cash will rcrnain available in thc dcfault
sccnario, nor that it will bc totally dissipated,
but mthcr that, o w timc, this cash will be
rcinvcstcd in opcnting nsscts that mirror tlic
company’s currcnt ilssct base, stibjcct to crosion in vduc of tlic s m c mngnitudc.
Local- arid forcipt-ctrrrencyissric raiitip.
In dctcnnining Iocal-cutrcnq issuc ratings,
thc point of rcfcrcncc is thc Iocalcurrcncy
corpomtc crcdit raring: Ioml-currcncy ism
ratings may bc norclicd down onc notch from
thc lod-currcncy corponre crcdit rating in
thc a s c of invcstmcnt-gmdc issucrs, or onc
or two notchcs in thc MSC of spccuJntivcgradc issucrs. A forcign-currcncy corpomtc
credit rating on n company is somctirncs
Iowcr than thc IocaI-currcncy carpontc crcdit
rating, rcflcctiq the risk that 3 sovcrcign
govcrnmcnt could rakc actions that would
impingc an thc company’s ability to mcct forcign-currcncy obligations. But junior farcigncurrcncy issucs arc not notchcd down from
thc forcign-currcncy corpomtc crcdit rating,
bcmusc tlic govcrnmcnr action wouId apply
rcgardlcss of rlic scnior4unior ctianctcr of
the dcbt. Of coursc, thc issuc wouId ncvcr bc
mtcd higher than if it had bccn dcnominatcd
in Ion1 currcncy. For cxamplc, if rhc localcurrcncy corpomrc crcdit rating on a company wvcrc ‘BB+’and tlic forcigncurrcncy
corpomtc ucdir nting wcrc “3-’,sutordinatcd forcign currcncy-dcnominatcd issucs
could bc ntcd ‘BD-’.But, if rhc loal-currcncy
corpomtc crcdit rating ivcrc ‘BE+’atid thc
forcigti curtcncy corpomtc crcrlit rating \vas
‘Bo’, tlic subordinated foreign-currcncy
dcnominatcd issucs would bc ntcd ‘BD-’,as
wouId thc subordinatcd lod-currcncy
dcnominatcd issurs.
Rating above the corporate
credit rating: “Notching up“
Sincc wc gencrally do not pcrform spccific
dcfault sccnario modcling for invcstiiicntgrade cornpanits, idcntifying issucs wirh
stipcrior iccovcry cliamctcristics usunily rctics
on sccurity provisions of il spccific issuc.
Candidatcs for notching up arc sccurcd dcbt
issucs, whcrc colJatcm1 coiisists of ~ S S C I Swith
EXHIBIT RVH-2
Pago 124 of 139
a wcll-esmblislicd track rccord with mpcet ro
rccovcry, such ns first mortgage bonds of reg-
ulntcd utilirics.
As cxplaincd abovc, thc wight givcn to
rccovcry in assigning issuc ratings diminishes
as onc m o w up thc rating spccttum. Wlicn
a company’s rating is in thc ‘BDB’catcgory,
its wcll-sccurcd dcbt is rated one or two
notchcs abovc thc corporatc mting, dcpcndi q on thc extcnt of the collatcml covcragc.
For thc ‘A’ catcgory, thc maximum addition
is limited to onc notch-and this applics
onIy when full rccovcry is anticipatcd. For
‘ M A ’ and ‘AA’ mtcgorics, notching up
is phiscd out cntircly.
Structural subordination
At timcs, a parcnt and its affiliitc group bavc
distinct dchult risks. Thc diffcrcncc in risk
may arise from covcnant rcstrictians, w l a tory ovcrsight, or othcr considcmtions. This is
the norm for holding compania of insurmcc
opcmting cornpanics and banks. In such situations,thcrc arc no furcd limits govcming thc
gaps bcnvccn corporatc crcdit ratings of thc
parcnt and its subsidiaries. Thc holdingcompany has Iiighcr dchutt risk, apart from postdchult recovcry distinctions. If such a holding
company issucd barh scnior and junior dcbr,
its junior obligtions would bc notchcd rclativc to the holding company’s corporate crcdit
rating by onc or two norchcs.
O h , horvcvcr, a parcnt hoJding company with onc or more opcrating cornpanics is
vicrvcd as a singIc cconomic cntiry. Whcn
tlic dcfault risk is considercd tIic samc for
thc parcnt and its principaI subsidiaries,
thcy arc sssigncd tlic snmc corporatc crcdit
rating. Yet, in P liquidation, holding-company crcditors arc cntitlcd only to thc rcsidual
nct worth of thc operating cornpanics
rcmaining aftcr all opcrating company obligations haw becn satisficd. Parcnt-Id
dcbt issucs arc notchcd down to rcflcct
srructunl subordination whcn tlic priority
Iiabilitirs c r c m a rnntcrid disadvantagc for
thc parcnt’s crcditors, aftcr taking into
account dl mitigating factors. In considcring thc appropriatc rating for a spccific
issuc of parcnt-Icvcl dcbt, priority IiabiIitics
cncompass all third-party Iiabilirics [not just
dcbt) of thc subsidiarics-including tndc
paynbIcs, pcnsion and rctircc mcdical liatilitics, and cnvironmcntal Iiabilitics-nd any
rclativcly bcttcr positioncd parcnt-Jcvcl liabilitics. {For cxnrnplc, parcnt-lcvcl borrowings coIlatcraIizcd by thc stock of thc
subsidiarics would be disndwntrigcd rclntivc
to subsidiary Iiabilitics, but would rank
ahead of unsccurcd parcnt-lcvcl dcbt.)
Potcntid mitigating factors includc:
Ctrararttcu
Guarantccs by thc subsidiarics of parcntIcvcI dcbt (i.c., upstrcam guatmtccs) may
ovcrcomc structural subordination by putting the daims of parcnt company crcditors
on a pari passu basis with thosc of opcmting
company crcditors. Such guamntccs hmc to
bc ciiforccablc undcr rlic rclcvant national
lcgal sysstcm(s),and thcrc most bc no unduc
concccn rcgarding potcntid akgatians of
fmudulcnt convcyancc. AJthough joint and
s c v c d guarantccs from 311 subsidiarics provide tlic most significant protection, scvcrd
guarirntccs by subsidiaries accounting for 3
major portion of total asscts wouId bc sufficicnt to avoid notching of parcnt debt issucs
in most mscs.
Thc Icgal analysis outcomc dcpcnds on thc
specific fact pattcm, not Icgal Joeumcnmtion-so onc cannot standardizc the dctcrrnination. But, if citticr tlic guarantor company
rcccivcd valuc or was solvcnt for a sufficicntIy long pcriod subscqucrit to issuing thc
guarantee, thc upstrcam gunrmtcc shoutd bc
valid. Accordingly, wc considcr upstrcam
puamntccs valid if any of thcsc. conditions
arc inct:
Tlic procecds of thc guarmtccd obligation
arc providcd (dorvnsrrcamcd) to guuanntor.
It docs not mattcr whcthcr tlic issuer
doivnstrcams thc moncy as an cquity infusion or 3s a loan. Either way, thc linaricing
bcncfits thc opcratbns of rhc subsidiary
wliidi justifits thc guuarantcc;
1 Thc IqaI risk pcriod--ordinariIy, onc or
two ymrs from cntcring into tlic guannt c o l i a s passed;
* Tlicrc is 3 spccific analytic31 conclusion that
thcrc is litth ddault risk during rhc pcriod
that thc guuamntcc validity is at risk; or
3 Thc rating of the guarantor is a t Icast ‘BB-’
in jurisdictions dint involvc a two-par risk,
93
EXHIBITRW-2
Page I25 of 139
Rating Each Issue
or at lcast ‘B+’in jurisdictions with
onc
ycar risk.
Operatiug assets at the parerit
If thc parcnt is not il purc holding company,
but rather 3150 dircctIy owns certain opcrating asscts, this givcs thc parcnt’s crcditors a
priority claim to thc parent-lcvcl asscts. This
offscts, at lcast partidy, ttic disadvantagc
that pcrrains ro bcing structumlly subordinatcd with rcspcct to thc asscts owncd by
thc subsidiarics.
Diversity
W c n thc parcnt owns multiplc optrating
companics, mort libcral notching guuidelincs
may bc applied to rcflect thc bcncfit thc
divcrsity of asscts might provide. The
threshold guidclincs arc rclaxcd (but not
climinatcd) to corrcspond with the cstcnt
of busincss andlor gcographic divcrsificittion of thc subsidiaries. For bankrupt companics that own rnuItipb, scparate busincss
units, thc prospccts for rcsidual valuc
rcmnining for holding company crcditors
impmvc ns individual units wind up with
shortfalls and sutpluscs tllso, holding companics with diverse businesses-in tcrms of
product or gcography-liavc grcatcr opportunities for dispositions, asset traiisfcrs, or
rccapitalization of subsidiarics, If, howcvcr,
thc subsidiarics arc opcrationally integratcd, cconomicdy corrclntcd, or rcgulatcd,
thc company’s flexibility to rcconfigurc is
morc limited.
Concetrtratiotz of dclt
if a parcnt has a number of subsidiarics, bur
thc prcpondcrancc of subsidiary Iiabilitics arc
concentratcd in onc or nvo of thcsc, q.,
indirstrial groups having financc or trading
units, this conccntmtbn of Iiabilitics u n
limit thc disadvantage €or parent-company
crcditors. RIthough tIic nct worth of thc
I C W M ~ C units
~
could wcII bc climinatcd in
thc bankruptcy sccnario, thc pircnt might
stiII obtain rccovcrics from its relatively
unlcvcmgcd subsidiarics. In applying thc
notching guuidcline in such C ~ S C S ,i t may bc
appropriitc to cliniinatc thc BSSCLS of the
lcvcngcd subsidiary from total asscts, and its
linbilirics from priority linbilitics. The analy-
www.wrporatecriterla.stsndardandpoors.com
sis thcn facuscs on tlic MCIS and Iiabilitics
that rcrnain, and the standard notching
guidclinc must bc subsritutcd by orlicr judgtncnts regarding rccovcry prospccts.
D 0 ru~rslrcatrrIoalls
If thc parcnt’s invcstmcnt in a subsidiary is
not just an cquity intcrcst, but also nkcs thc
form of domnstrcam scnior loans, this niay
cnhancc thc standing of parcnt-lcvcf crcditors
bccaurc rhcy would have not only P rcsidual
claim on thc subsidiary’s nct ~vortli,but also
a dcbt claim that couId bc pari passu with
othcr dcbt claims. Howcvcr, most intcrcompany claims arc subjcct to cquimblc subordination andlor othcr cIimination in thc
bankruptcy proccss. Such nsscssmcnt of
downstrmrn advanccs must takc into
account tlic applimbIc Icgd frarncwork.
(On rhc othct hand, if tIic parcnt has borrowed funds from its subsidiarics, thc raulting
intcrcompany parcnt-lcvcl liability could
furthcr dilurc thc rccovcrics of cxtcrnal
parcnrdcvcl crcditors.)
A djMstrtxcrifs
Wc clirninatc from thc notching mIculations
subsidiarics’ dcfcrrcd rawa s s c ~and liabilitics
and othcr accounting accruab and provisions
that arc not likcfy to havc clmr cconomic
mmning in a dcbiilt.
Spccdativc grade
For spmhtivc gndc issucrs, wc pcrfonn il
fundarncntd moi~cryanalysis, which is cornmunimcrl via our rccovcry ratings. Vic diffcrcnt levels of recovcry arc factorcd into our debt
i m c ratings by adding or subrnaing n o t c h
from thc corpontc credit rating (sce tuhlc 6).
Rccovcry ratings ssscss a dcbt instrumcnt’s uItimam prospccts for rccovcry of
cstimatcd principal and prc-petition intcrcst
(i.c., intcrcst accriicd but unpaid at thc timc
of defauIt} givcn il simulatcd paymcnt
dcfautt. Our rccowry mcthodolob? focuscs
on cstimating thc pcrccntngc of rccovcry
that dcbt invcstors would rcccivc at thc cnd
ofa formal bankruptcy procccding or an
informal our-of-court rcstrucruring. Lcndcr
rccovcrics could bc in thc form of msh, dcbt
or cquity sccuritics of a rcorganizcd cntity,
or sornc conitination tticrcof.
EXHIBIT RW-2
Page 126 of 139
1% focus on nominal rccowry (rather than
discountcd prcscnt valuc rccovcry) bcmusc IVC
bclicvc discountcd rccovcry is bcttcr idcntificd
indcpcndcntly by markct participants wlia a n
appIy thcir own prcfcrrcd discount rate to our
nominal rccovcry, (Howcvcr, in jurisdictions
with anticipatcdworkout pcriods of longer
than two to thrcc ymrs, w c factor thc Jclay
into both rccovcry n t i n g and issuc ratings to
account for thc timc valuc of nioncy and tlic
inhcrcnt inacmcntd unccminty.)
Whilc informcd by historied rccowry
dam, our rccovcry ratings incorpomtc fundarncntal dcd-specific, sccnario-drivcn, forward-looking niialysis. Thcy considcr thc
impact of kcy structural fcaturcs, intcr-crcditor dynamics, thc naturc of insotvcncy
rcgimcs, muhi-jurisdictiondissucs, in thc
contcxt of il sirnulatcd dcfault.
Wc acknowIcdgc that rccovcry analysis
(including dcfmlt modcIing, vduation, and
rcstructuring dynamics) is complex and docs
not Icnd itsclf to prccisc or certain prcdictions. Outcomcs inmriabIy involvc unforcsccn cvcnts and arc subject IOcxtcnsivc
ncgotiations that arc influcnccd by thc subjcctivc judgmcnts, n c p t i a t i q positions, and
agcndas of thc various srakcholdcrs. Even so,
w c bclicvc our methodology of focusing on a
company’s uniquc and fundamental crcdit
risks-togctlicr with thc composition and
stmcmrc of its dctt, Icpt organimtion, and
non-dcbt Iiabili~i~-providww l ~ i b l cinsight
into creditor rccovcry prospccts.
In this light, our rccovcry mting arc
intcndcd to providc cducatcd approximations
of post-dcfautt rccovcry mtcs, mthcr t h n
matt forcmts. Rccovcry ratings, whcn
vicwcd togcthcr with a company’s risk of
dcbult 3s cstirnatcd by our corpomtc crcdit
rating, can hclp invcstors cvatuatc a dcbt
instrumcnr’s risklrcwatd chanctcristics and
dcrcrminc tbcir cxpmcd return.
]irrisd~ctiort-speci~c
ndjirsti~ieirts/or
recoucry mid issiic rutirtgs
Full-blown, fundamcnnl rccovcry analysis i s
limitcd to jurisdictions rvIicrc insolvcncy
rcgimcs arc reasonably wcll cstabIishcd and
sufficicnt prcccdcnt and Jam arc available.
In athcr jurisdictions, w c do not assign ICCOVcry n t i n g - a n d thc basis for rating a spccilic
issuc diffcrcnt from than tlic corporate crcdit
rating is simiIar to that uscd in invtrtmcntgmdc situations. That is, wc cmploy 3 sirnplc
rule-of-thumb approach to idcntify issues that
arc junior-nd thcrcby mntcrinlly disadvanngcd with rcspcct to rccovcry prospcets. If
c1aims that cornc ahcad of P givcn dcbt issuc
cqual 15% of ilsscts, wc subrract onc notch
from the mrpontc crcdit mting IcvcI; if such
priority claims rmch thc 30% Icvcl, wc sub
tract two notchcs. We do not mtc issucs
mom than nvo notchcs bclow rhe corpontc
[For issuers with a spsculntive-grado corporate cradit fating)
Raeovery
rating
RRCPWry
2
Racovory doscription
IIighesi expectation. full remq
Vew hioh remew
Substantial r m r y
3
4
Meaninnhut tE#)uDry
Aimsnr
m
tt
I
Sfurdurd & Poor’s
corporate Ratings Criteria 2008
expectations (%Y
I00
ISSUR
raling nofehas
rotative to corporalo
crodit rating
+3
9Q-100
+2
70-90
+I
50-70
0
0
30-50
95
EXHIBIT RVH-2
Page127of139
Ratlng Each lssuo
crcdit rating on thc b s i s of infcrior movcry
considcmions.
Wc arc in the proms of rcvicwitig a11 signifimnt jurisdictions around the world to
asscss how insolvcncy procccding in pmcticc
affca post-default rccovcry prospccs and to
consistcntly incorpomc jurisdiction-spccific
ndjusmrcnts. With thc hclp of loca1 insolvcncy pnctitioncrs, ivc asms c3ch jurisdiction’s
crcdiror fricndlincss-in thcory as wvcll as in
pmcticc (about 30 jurisdictions havc bccn
asscsscd to datc).
Thc four main factors that skqx our analysis of thc jurisdictions’ crcditor fricndlincss arc:
” Sccurity,
= Efficiency and control,
Adhercncc to prioritics, and
8 T m c to rcsolution.
Bascd on thcsc hetors, wc classify thc
rcvicwcd counuics into ttircc mtcgoriw,
according to thcir crcdiror-fricndhcss. This
classifiation cnablcs us to makc jurisdictionspccific adjutmcnts to our rccovcry analysis.
W c a p both rccoccry n t i n g and thc diffcrcntial bcnvccn rhc isrucr crcdit and dcbt issuc
ratings in countries with Jcbtor-fricndlyinso1vcncy q i m c s . (See J~~risd~ctiat~~pcci~c
Adjwtntctits To Recoue~yAnd Issw Raiittgs.”
p1161ishedj d y S, 2007, 011 RatitrgsDirect.)
Recovery Methodology
For Industrials
Rctovery amlytics for industrid~SSUCK has
thm basic componmts: dctcrmining thc most
likcly path to dcfautt for a company; valuing
thc company following dchult; and Jistribucing
that value M claimants that \vc idcntily, b m d
upon thc rcIitivc priority of mch claimant.
Establishing a simulated path to default
This stcp is 3 fundamcnd; w c must first
undcrstand thc form most Iikcly to musc a
dclault bcforc w c a n cstimatc a lcvcl of cash
flow at dehuIt or vduc n company. This stcp
draw on thc company and scctor knoivlcdg
of our crcdit analysts to fomulntc and quanti+ thc fslcrors most Iikcly to muse a company to Jchult, givcn its uniquc tusincss risks
and financial risks.
At the outsct of this pcoccss, W E dcconstruct thc borrowcr’s cash flow projcctions
96
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undcrstand rnanagcmcnt’s gcncrd business, industry, and cconomic cxpcctations.
Oncc wc undcrstand rnanagcmcnt’s vicwv, w c
niakc appropriatc adjustmcnts to kcy rconomic, industry, and firm spccific factors to
simulatc 3 paymcnt dcfault. While IYC rccognize that rhcrc arc many possiblc factors-both forcsccn and ttnforrsccn-that
couId lead to a dchult, wc focus on tlic kcy
opcmting factors that would most Iikcly
contribute to dcfault.
to
Forecasting cash flow at default
Thc simulatcd dcfauIt scenario is our ilsscssmcnt of tlic borrowcr’s most likely path
IO
a
hypothctid paymcnt dcbutt. Thc “imofvcncy proxy” is thc point along that path that
tlic company wouId Jcfaulr. Tficinsohcticy
proxy is ordinarily dcfincd as thc point at
which funds avaihblr. plus frcc a s h flow is
cxcccdcd by Iixcd clinrgcs.
T h e terms in this cquation arc:
Fzuzds audable. Thc sum of baIancc
shcct cash and rcvohing crcdit faciIity
availability (in cxccss of thc minima1
amount a c o m p a n y nccds to opcratc its
busincss at its scisonal pcak).
Frcc msh flow. EIIlTDA in thc ycar of
dcfault, lcss a minimal lcvci of rcquircd maintcnancc spital cxpcnditurcs, Icss cash taxa,
plus or minus changcs in working mpitd. For
dchuIr modcIing and m o v c r y cstimatcs, our
EDlTDA and frcc a s h flow cstimatcs i p o r c
nonmsh cornpcnsation cqcnscs and do not
use our adjwtmcnts for opcnting Icascs.
Fkcd cl~argcs.TIiu sum, in tlic ycar of
default, of:
= ScIicdulcd principd amortization. Bullct or
ballooning maturitics arc not trcatcd 3s
fixcd c h q q bccnusc Icndcrs typialIy
would refinance thcsc amounts as Iong as 3
coriipany can otticnvirc comfortnbly scrvicc
its furcd chnrgcs.
= Rcquircd msh intcrcst paynicntS, including
assumcd incrmscs to LmOR r a t a on floatingmtc dcbt and to thc margin clinrgcd on
dcbt obligations that luw pricing grids or
miintcnancc financial cavcnants; and
= Odvr msh paymcnts tlic bnrrowcr is citliur
contmctually or pnctimlly obligatcd to
pay that arc not already capturd ns an
opcming cxpcnsc. (Lcisc payiiictits, for
EXHIBIT RVH-2
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wamplc, arc accounrcd for within frcc
cash flow and arc not considcrcd a
fixcd chargc.)
A projcctcd dcbult may occur cvcn if L~cd
c h a r p arc fully covcrcd in a fcw spceial circumstanccs:
= Stmtcgic bankruptcy filings, whcn a borrower may attcmpt to rakc advantagc of thc
insoIvcncy proccss primariIy to obtain rclicf
from Icpl claims or oncrow contracts;
Whcn a borrowcr in distrcss may rationally
bc cxpcctcd to rctain a large amounrs of
a s h (C.S., to prcparc for a eomplcx, protmctcd restructuring; if it is in i~
vcry mpitat-intcnsivc industry; if it is in a
jurisdiction that docs not allow for supcrpriority standing for nciv cccdit in n postpctitian financing); or
Whcn a borrowx’s financial co\*cnmts
havc dcrcrioratcd bcyond thc Icvcl at which
cvcn thc most paticnt Icndcr couJd tolcmtc
further amcndmcnrs or waivers.
Frcc cash flow is not ncccssarily cqual to
the lcvcl 3 t point of default, though. Cash
flow may dcclinc bcIow thc insolwncy
proxy if thc borrowcr’s opcratiq pcrformancc is cxpcetcd to continuc to dctcrioratc
duc to whatcvcr compctitivc and cconomic
conditiolis arc nssumcd in thc sirnulatcd
dcfauIt sccnario. In any cvcnt, ivc attcmpt to
identify 3 lcvcl of n s t i flow as onc basis for
our valuation.
Determining vaIuation
W c considcr a wricty of valuation mcthodologics, including markct multipla, discountcd a s h flow (DCF)modcling, and discrcre
m e t anaIysis. Thc markct multiplcs and DCF
mcrhods arc used to dcterminc a company’s
cnrcrprisc va1uc as a going conccrn. This is
generally the most appropristcapproach
whcn our siinutatcd dchult and rccovcry
andysis indimta that thc borrowcr’s m r g a nimtion (orthc outright sale of thc ongoing
busincss or ccrtain scgrncnrr) is thc most Iikc
Iy ourcornc of an insolvcncy procccding.
Wc usc discrctc assct valuation most o h
for indusrrics in which this whation
approach is typically uscd, or rvhcn rhc simulated dcfauIt sccnario indimrcs that thc torrowcr’s liquidation is the most likcly outcornc
of insoIvcncy.
Statrdnd hPaor’s
1
If il company is cxpccrcd IO rcorgmizc, bur
ccrtain crcditors hold collatcrd consisting of
only particular asscts, rlicn cntcrprisc valuc is
inappropriatc-and w c assus thc collatcrd
bascd in its discrctc vatucs.
Market multiples
Thc kcy to vduing a company using o mnrkct-muItiplcs approach is to sctcct appropriate comparablc cornpanics, ot comps. T h c
anaIysis shoufd includc scvcml comps sirniIar
to thc company bcing d u c d with rcspcct to
busincss lincs, gcographic markcts, margins,
rcvcnuc, capital rcquircmcnts, and compcritivc position. Of coursc, an idwl sct of
comps docs not always cxist, so analytinl
judgrncnt oftcn is rcquircd to adjust for diffcrenccs in size, business profilcs, and othcr
attributcs. In addition, in thc conicxt of P
rccovcry analysis, thc multiplEs must considcr thc compctitiw and cconomic cnvironrncnts assumed in our simulntcd dcfault
sccnario, which arc oftcn vcry diffcrcnt than
prcsent conditions. As a rcsult, out andysis
strivcs to considcr a sclcction of multiplcs
and rypcs of rnultipla.
IdcalIy, wc arc inrcrcstcd in muItipIcs for
simiIar companics that liavc rcorganizcd
bccnuse of circumsranccs consistcnt with
our sirnulatcd d c f d t sccnario. In practicc,
howcvcr, thc cxistcncc of such ucmcrgcncc’’ multiplc comps arc ram. t\s 3
rcsult, our arialysis oftcn turns to tmnsnction or purchasc muItipIcs lor cornpirddc
cornpanics, bccausc thcsc gcncrally arc
more numcrous. With transaction multiplcs,
wc try to usc forward multiplcs (purchasc
prim dividcd by projcctcd EBlTDA], ratlicr
than traiIing muIriplcs [purchase pricc
dividcd by historical EBlTDA), bccausc \vc
bclicvc fonvard multiplcs, wliicti incorporaw thc bcncfit of pcrccivcd cash flow syncrgics uscd to justify thc purchasc pricc,
providc a morc appropriatc rcfcrcncc point.
In addirion, trading multiplcs for putlicIy
t ~ d c companics
d
can bc uscfuI bcmusc
thcy allow us to track how niultiplcs
eliangc ovcr cconomic and busincss cyctcs.
This is cspcciaIly rclcvnnt for cyclicd industries and for scctots cntcring il diffcrcnt
stagc of dcvclopmcnt, or cxptricncing
changing compcritivc conditions.
Corporate RatInss Criteria 2008
97
EXHIBIT RVH-2
Page 129 of 139
Rating Each Issue
A sclcction of multipIcs helps match our
valuation with thc conditions assumcd in
our simdatcd dchulr sccnario. Far cxamplc, a company projcctcd to dcfault in a
cyclical trough may ivarmnt a Iiighcr multiPIC than onc cxpcctcd to dcfaulr at a cyclia1 midpoint. Furrhcr, two companics in thc
samc industry map mcrit mcaningfully differcnt multiplcs if onc is highly lcvcrcd and
at risk of dcfault from reIativcly norma1
compctitivc strcsscs, whiic thc othcr is
unIikdy to dcfnult unless thcrc is il largc
uncxpcctcd fuundamcntal dctcrioration in
tlic c a d flow potential of thc busincss
modcl (which could makc liistorical scctor
multipks jrrclcvant).
Our muItipIcs andysis may also considcr
dtcrnativc industry-specific muItiplcs~ucIi
as subscribcrs, hospital. beds, w a r r i n g rcvcnuc, ctc.-where appropriatc.
Altcmarivcly, such mctrics may scrvc as a
chcck on the soundncss of a valuation that
rciicd on an EBllDA muItiple, DCF, or discrctc assct approach.
Discounted cash flow (DCFI
Our valuation is bascd 011 thc Iong-tcrm
opcrating pcrformance of thc tcorgmi7~d
company. Wc usc 3 pcrpctuity growth formula, which contcmpIatcs a Ionptcrm
stcady-smtc growth rare dccmcd appropriate for tlic borrowx’s busincss. Howevcr,
whcn applicable, wc Start with spceifie
annul1 cash flow forccasts for a pcriod of
timc lolIowing reorganization, wliitc rclying
on thc pcrpctuity growth formula for
subscqucnt pcriods.
Discrete asset vaJuau’on
W c vduc dic rclcvant asscts by applying
industry-and assct-specific advancc ratcs or
third-party appraisals.
Identifying and estimating the value
of debt and nondcbt claims
tiftcr valuing a company, wc idcntify and
quantify thc d c t t obliptions and othcr matc-
ria1 liabilitics that would bc cspectcd to hmc
P claim against rhc company. Potcntial claims
fall into thrcc broad mtcgorics:
a Principal and ,~ccrucdintcrcst on 111 dcbr
outstandiag at thc point of dchult,
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crrww.carporatecriferia.standardandpoors.com
whethcr issucd at thc opcmtiiig company,
subsidiary, or holding company Icvcl;
* Bankruptcy-rclntcd claims, such as dchtorfinancing and adminisin-possession (DIP)
trative cxpcnscs for professional fccs and
othcr bankruptcy costs;
1 Othcr riondcbt claims, such as taxes
payable, ccmin srmriti7i1tion programs,
tndc payablcs, dcficitncy claims on rcjcctcd lmscs, litigation liabiliticr, and unlundcd post-rctircmcnt obligations.
Our analysis of thcsc cIairns and tIicir
potcntial: vaIucs rakcs into considcration cach
borrowcr’s particular facts and circumstnnccs, as wcll as thc cxpcctcd impact on
t l v claims as a r m l t of our simulatcd
dcfaulr sccnario.
Wc cstimatc debt outstanding at tlic point
of dcfault by rcducing tcrm loans by schcdulcd amortimtion up to rlic point of our sirnularcd dcbult. Wc w u m c that all commincd
dcbt hcilitics, such as rcvohing crcdit h i l i tics and dclaycd draw ~ c loans,
m
arc hIIy
dmw. For assct-bascd Icnding (ABL) bcilitics, wc considcr whcthcr rhc borrowing base
Iomula would aI1oiv tlic company to fuHy
d n w thc facility in a simuhtcd dcfault sccnario. For lctters of crcdit, cspccially thosc
issucd undcr dcdicatcd syntbctic Icttcr of
crcdit tmnchcs, IVC ilsscss whcthcr tIicsc contingcnt obligations arc Iikcly to bc dnwn.
Our wimatc of dcbt outstanding at dcfauIt
also includes an cstimatc of prcpctition intcrcst, which is mlculatcd by adding six montlls
of intercst (based on historim1 data from
Standard Pr Poor’s LossStntP databasc) to
our csrimatcd principal amount at dcfault.
T h c inclusion of prc-pctition intcrcst makcs
our recovcry analysis morc consistcnt with
banks’ crcdit risk capital rcquircrncnts undcr
thc Bascl Il Framework.
Our anaIysis focuscs on thc rccovcry
prospccrs for tlic dcbt instrumtnts in il
company’s currcnt or pro forma d c t t structurc, and gcncmlly docs not make estimates for othcr dcbt that may bc issucd
prior to a dcfault. \Vc fccl that this
approach is prudcnt and mom rclcvant to
invcstors bccausc thc amount aiid composition of any additional dcbi (scwrcd, unsccurd, andlor subordineid) may nintcrially
impncr lciidcr rccovcry ritcs, and it is not
EXHIBIT RW-2
Page 130 of 139
possiblc to know thcsc parricufnrs in
advance. Furthcr, incrcmcntal dcbt addcd
to a company’s capital structurc may marcrially affcct its probability oE dchult,
which couId in turn affcct all: aspccts of
our rccovcry analysis (k,
thc most likcly
path to d c f d t , valuation givcn dcfauh,
and loss givcn dcfault). Conscqucntly,
changes to a company’s dcbt structurc arc
trcatcd 3s cvcnts that rcquirc t rcevaIuation of our dcfmlt and rccovcry analysis.
Still, w c take into account thc potcntid
for additional dcbt by limiting thc rccovcry
ratings ossigncd to unsccurcd dcbt-and, in
turn, thc ootclics sbovc thc corporate rating
that might bc addcd. For campanics with a
‘B’catcgory rating, ttic rccovery rating
would ordinarily be limitcd to ‘2’. For companics in thc ‘BB’ cmgory we would limit
thc rccovcry ratings assigned to unsccurcd
issucs to ‘3’. (Bccausc tlicy arc furthcr from
potcntial default, thcrc is a grcatcr likclihood that iritcrim cbangc of thcir capita1
structurc would occur.)
Also w e add morc dcbt to thc cxtcnt that
this is consistcnt with our spccific cxpcctations for a givcn issucr. SimiJarly, we may
assumc tiic repayment of mar-term dcbt
mamriti-without
rcfinancing-if thc company is expcctcd to mire tbcsc obligations
and has the liquidity to do so. Funhcrmorc.
revolving crcdit facilitia with ncar-term
manuitics arc gcncmlly assumcd to roll ovcr
with similar tcrms.
Determining distribution of value
Distributions arc asurncd to follow n watcrhlI approach that reffccrs thc dativc scniority
of thc claimants, rcffccting thc spccific laws,
customs, and insolvency rcgimc pmcticcs for
the rclcvnnt jurisdictions for a company. In
thc W.S., our gcncra1 assumption oftlic rclativc priority of cIaimants is:
a Super-priority cJaims, such as DIP financing;
Administmtivc cxpcnscs;
Fcdcral and statc tax cJaims;
= Scnior sccurcd claims:
= Junior sccurcd claims;
Scnior unsccurcd dcbt and nondcbt claims;
Sutordinatcrl cJairns;
Prcfcrrcd stock; i i i d
Cnninon stock.
Startdad & Ponr‘s
Howcvcr, this prioriry of claims is siibicct
to nvo critiml mVmtS:
a Tfv bcncficial position of sccurcd crcditor
claims, whcthcr first-priority or otticnvisc,
is only vaIid to thc cxrcnt that thc collatcn1
supporting such claims is cqud to, or
grcatcr rhan, tlic amount of tlic claim. If thc
collatcra1 valuc is insufficicnt to futly covcr
P securcd cJaim, thcn thc uncovcrcd amount
or dcficicncy balancc will bc pari passu
with all other scnior unsrmrcd claims.
StructunI issucs may altcr thc priority of ccrtain claims against spccific 3sscts or cntitics
in an orpnimtion b e d on thc company’s
J p I cntity srructurc and thc rclcvant tcms
and conditions of rhc dcbt instnuncnts.
Thc rccovcry prospccts for dilfcrcnt dcbt
instrumcnts of tbc same typc (scnior sccurcd,
scnior unswurcd, scnior subordinatcd, ctc.)
might bc wry differcnt, dcpcnding on thc
strucmrc of t11ctnnmcrions. IVc rcvicw n
company’s debt and 1 ~ cntity
1 stmcturc, tlic
tcrms and conditions of thc various dcbt
insrrumcnts as thcy pcrtain to borrorvcr and
guarantor rclationiips, collatcnl plcdgcs
and cxcIusions, facility amounts, covcnants,
and dcbt maturitics. In addition, ivc must
undcrstand thc breakout of thc company’s
cash flow and asscts ns it pcrtnins to its lcgal
oganizationd stmcturc, and consider thc
cffcct of kcy jurisdictional and intcrcrcditar
issues. Kcy structural issues to cxplorc
indudc identifying:
= Highcr priority licns on spccific assets by
forms of sccurcd dcbt such as mortgages,
industrial rcvcnuc bonds, a i d ADL bcilitics;
Non-guarantor sutsidiarics (domcstic or
forcign) that do not guuamntcc a company’s primary dcbt obIigations or providc
assct plcdgcs to support thc company’s
sccurcd debt;
9 Claims at non-guarantor subsidiarics that
will havc P h i g h priority (ix., a strucrumlly supcrior) claim on thc valuc rclatcd
to such entitics;
Matcrial cxclusions to thc collntcnl plcdgcd
ro sccurcd Icndcrs, including thc Iack of assct
plcdgcs by forcisii subsidiarics or thc
nbscncc of licns on signifiant domcstic
psscfs, including tlic srock of forcign or
donicstic nongtiuanntor subsidiarics (whcthcr
duc to concessions dcmandcrl by .iiid gniit-
Corporate Aatlngs Critcn’a 2008
99
EXNlBrr RVN-2
Page 131 of 139
Ratlng Each Issue
cd to thc borrorvcr, poor tnmctioti structuring, regulatory restrinions, or limitations
imposcd by 0 t h dcbt indcnturtr);and
Whctlicr a company's forcig sutsidiarics
arc likcly to fitc for bankruptcy in thcir
IomI jurisdictions as part of the dcfnult and
rcstructuring proccss.
Whilc o m analysis typiuily reduccs the
cntcrprisc valuc by thc amount of sceurcd
claims in accordancc with its prioriry, thcrc
m a y bc mmningful CXECSS colIatcnl wIue that
is amilabIc to other crcditors, cspccially thosc
with 3 sccond Iicn. For cxampIc, this is oftcn
thc mse when sccurcd dcbt collatcr~tizcdby a
first licn on nlI noncurrent asscts also MkCs a
sccond-priority Iicn on working capita1 asscts
that arc alrcndy plccigetl to support an assctbascd rcvoIving crcdit faciliry.
Signiliunt dommstic or forcign nonguanntor cntitics must bc idcntilicd bcnusc tbcsc
m i t i = haw not cvplicitly prorniscd to rcpay
rhc dcbt. Thus, thc portion of cntcrprise wluc
dcrivcd from thcsc subsidiarics docs not d i m ly support thc ntcd dcbt. As n m I r , dcbt and
ccrrain nondctt claim n t thrrc subsidiarics
have a structudy highcr priority clsini
against the subsidiary vdue. Accordingly, rtic
portion of the company's cntcrprise value
stcmming from thcsc subsidiarics must h cstimarcd and tmtcd scpantcIy in thc distribution of value to crcdirors. This rcquircs an
undcrsnnding of tlic bmkout of 3 company's
u s h flow and assets. Bmusc thae subsidiarics arc still part of tlic cntcrprisc bcing
CvaIuatcd, any cquity valuc that rcmains aftcr
satisfying thc stnrctunIIy supcriorclaims
would bc avaiJnblc to satisfy orher ctcditors of
thc cntitics diat oivn thmc subsidiarim. Wcllstrucmrcd dcbt will oftcn includc cownznts to
rtrtrict thc mount of structunlly supcrior
dcbt that can bc placcd a t such subsidiaries.
Funhcr, \vcll-stnrcturcd sccurcd dcbt will nkc
ii Iicn on thc stock of such subsidinrics to
cnsure a priociry intcrcst in thc quit). vduc
awilablc to support othcr crcditors. In pmcticc, thc plcdgc of forcign subsidiary stock
owncd by US. ciititics is usually lirnitcd to
65% of voting stock for tax msons. Thc
rrridiral vnhc that is not cnpturcd by sccurcd
lcndcrs through stock plcdgcs would bc
cxpccrcd to bc awiI.ddc to 311 scniar iitisccurcd crcditors on a pro rata basis.
.
www.corporakcriteria.standardandpoors.com
Materia1 asscis (orhcr than rvtiolc sutsidiarics or subsidiary stock)not plcdgcd to
support sccurcd dcbt wouId bc sharcd by nlt
scnior unsccurcd crcditors on n pro m a basis.
An cvaluation of whcthcr forcign subsidiarics would also bc Iikcly IO fjlc for
bankruptcy is also rcquircd, b c ~ ~ u this
sc
would IikcIy incrcasc thc cost of thc tankruprcy proccss and crcatc potential multijurisdictional issucs that could impact
Iendcr rccovcry ram. T h c involvcrncnt of
forcign courts in a bankruptcy proccss prcsents il myriad of complcxitics and unccrtaintics. For tlicsc samc rcasons, horvcvcr,
US.-Jornicilcd borroivcrs that filc for bankruptcy scldom also file thcir forcign subsidiarics without a spccific bcnclit or rcason
for doing so. Conscqucntly, \vc gcncrally
a m m c that forcign subsidiaries of U.S. borro\vcrs do not lilc for bankruptcy unlcss
thcrc is il conipclling rcsson to assumc 0 t h
cnvisc, such as 3 Iargc amount of forcign
dcbr that nccJs to bc rcstructurcd to cnnbIc
thc company to cmcrgc from bankruptcy.
Whcn forcign subsidiarics arc cxpcctcd to
filc bankruprcy, our analysis will bc tnilorcd
to incorpotatc tlic particuhrs of tIic r d c -
vant bankruptcy rcginws.
Inrcrercditor issucs niny affcct tlic distribution of MIUC and rcsuIt in dcvintions from
absolutc priority (i.c., rnaintcnnncc of thc priority of thc clnims, including structural considcrations, so that a class of claims will not
rcccivc any distribution unci1 all classcs abovc
it are fully satisficd) In pmcticc, Cliaprcr f 1
bankruptcies arc nqotiatcd scttlcmcnts and
thc distribution of valuc may vary somcrvhat
from thc idcal iniplicd by absolutc priority
for 3 varicty of intcr-crcditor masons, including, in the U.S., "accommodations" and
"subsnntivc consolidation."
Accommodations rcfcr to concssioiis
gmntcd by scnior crcditors to junior claimants
in ncgotiations to g i n tlicir coopcmtioii in a
timcly restructuring. Wc gcncmlly do not
cxplicitIy modcl for accommodations bccnusc
it is unccrtairi wlicthcr any conccssionswill bc
gmntcd, if thosc p n r c d wit1 uIrimmly haw
vsluc (c.s., ivarmnts as ;1 contingcnt cquity
claim), or whcthct thc valuc will t c inarcrial
ciiougli to rncaniriglully dfcct o w projcctcd
rccovcry mtcs.
Substanrivc consolidation-in its purc
form-rcpracnts P porcntialIy drastic dcviation from thc ordcriq of prioritics and distribution of MIUC in bankruptcy pIans of
rcorganimtion. In a truc “Icgal” mbstmtivc
consolidation. thc assets and liabilitics of an
affiliated corpontc group are collapscd into a
single It@ cnrity. This cffcctivcly wouId
climinatc thc crcdit support providcd by
structural priority, by trcating crcditors of thc
parcnt pari passu with crcditors of opcrating
units. Horvevcr, tmc subsrantivc consolida[ion is 3 mrcly implcmcntcd, discrctionary
judicial doctrinc. Our analysis rcIics on thc
low Iikclihood of truc substantive consolidation, though wc acknowlcdgc dint this risk
could affcct rccovcrics in ccrtain casts.
Many morc rcorpniwtion bankruptcy
plans do involvc a consolidation of a morc
Iimitcd nmrc. Thcsc consolidations do not
radically affccr thc priority ofcxtcrnal crcdifor claims-but do climinatc many intcr-conipany cIairns, gumntics, and distributions
and simplify thc plan approval:proccss and
distributions to crcditors undcr thc plan.
Thcsc Udccmcd“consolidations typially promotc rhc rcsoIution of compIcx multi-party
negotiations and scttlcmcnts along thc lincs
ofthc rclativc lcgd prioritics and bargaining
strcqths of crcditors.
The bankruptcy proccss involvcs an inhercnt clcmcnt of unccnainty. Indced, thc impact
of dccmcd consolidation on rccovcty mn
vary, The esrcnt to which moresenior crcditors arc willing to rnakc conccssions to morc
junior ctcditors ta kccp thc proms moving
srnootfiIy and to arrive at a conscnsual plan
is impossiblc to prcdict.
Howcvcr, in pmcticc, the result of COUKordcrcd consoIidation is not sufficicntly matcrial cnough of rhc time to bc considcrcd in
our rccovcry rating assignments.
Surveillance of recovery ratings
Our rccovcry analysis ut origination is unlikcly to idcntify all of thc actual claims at bankruprq; or prccisc!~prcdiet thc saluc of the
company or thc coItarcnI givcn a dcfault.
Ratings arc subjcct to pcriodic and cvcnt-spccilic suwcitlancc. Rctom that could impact
our rccovcry analysis or ratings includc:
= Acquisitions and divcstitiircs;
Stardud & p4Dr‘S
8
Updatcd valtiation assumptions;
Shifts in thc profit and cash flow contributions of borrowcr, guarantor, or nonguarantor cntitics;
I
Chingcs in dcbt or rhc cxposurc to nondcbt IiabiIitics;
Intcrcrcditor dynamics; and
Changcs in bankruptcy law.
Features of US.-domiciled
corporate bankruptcies
Debtor in posscssiorr fitiaitciiig. DIP fncilitics
are usually supcrpriority claims that cnjoy
rcpaymcnt prcccdcncc ovcr unsecured dcbt
and, in ccrtain circumstanccs, scciircd dcbt.
Howcver, i t is not possiblc to accurately
qunntify thc sizc or likclihood of DIP financing or to forccast how DIP financing may
aflcct the recovcry prospccts for diffcrcnt
crcditors. This is t c n u s c thc sizc or cxistcncc of a thcorcricnl DIP commitmcnt is
unprcdictatlc, DIP borrowings at cmcrgcticc
may bc substmially lcss than thc IlP commitmcnt, and such facihics may bc uscd IO
fulIy repay ovcr-coll~tcralircdprc-pctition
sccurcd dcbt. Rrtbcr, thc prcscncc of DIP
financing might actually hclp crcditor rccovcry prospccts by allowing cornpanics to
rcstructurc thcir opcmtions and prcscrvc the
wluc of thcir busincss. As a rcsult of thcsc
unccrtaintics, cstimating the impact of a DIP
facility is beyond thc scope of our analysis,
cvcn though w c rccognizc that DIP facilities
may rnatcrially impact rccovcry prospccts in
ccrtain u s c s .
A dinhisfraiivc ~ p c ~ i s cAdmi
s . n istm t i vc
cxpcnscs rclarc to profcssional fcm and othcr
costs associatcd wirh bmkruprcy that arc
rcquired to prcscrvc thc valuc of thc cstatc
and complcrc thc tankruprcy proccss. Thcsc
costs must bc paid prior to cxiting bankruptcy, making thcm cffcctivcIy scnior to thosc of
all orlicr crcditors. T h c dolhr amount and
matcriality of administrntivc claitns usually
corrcspond to thc cornplcxity of a company’s
capital structure. Wc cxpcct that thcsc costs
will bc lcss lor simpIc capital stmcturcs that
can usually ngotiarc an cnd to a bankruptcy
quickly and may cvcn usc a prc-paclagccd
bankruptcy plan. Convcrsdy, tlicsc costs arc
cxpcctcd ro bc grcatcr for largc bormwcrs
with complux apiml strucmrcs wlvrc thc
Corporate RatIngs Criteria 2008
101
EXHIBIT RW-2
Page 133 of 139
RatInn Each Issue
insolvcncy proccss is oltcn chanacrizcd by
protnctcd mdtipIc party disputcs that drivc
up bankruptcy costs and diminish lcndcr
rccovcrics. Whcn using an cntcrprisc valuc
approach, our mcthodology cstimatcs thc
wluc of thcsc claims as a pcrccnngc of thc
borrowcr's cmcrgcncc cntcrprisc valuc thusly:
1 Thrcc pcrccnt for capital srructurcs with
onc primary class of dcbt;
1 Ihc pcrccnt for two primary classcs of
dcbt (first-and sccond-licn crcditors may
bc adversarics in a bankruptcy procccding and arc trcatcd as scparatc classcs for
this purposcl;
m Scvcn pcrccnt for thrcc primaty classcs of
dcbt; and
1 Tcn pcrccnt for cemin complcx capital
structures.
Wlicn using a discrctc assct whation
approach, thmc costs arc implicitly accountcd
for in thc ordcdy liquidation value discounts
uscd to value a company's asscw.
Other nondcbt claims
TRUC.Various U.S. govcrnrncnt authorities
tLy claims as cirhcr adniins u ~ f u l I assert
y
istntivc, priority, or sccurcd claims. Howevcr,
it is wry difficult to projcct tlic lcvcl and status of such claims at origination (c.g., rax disputcs cn routc to dcbult nrc cxtrcmcly h a d
ro prcdictl. Horvcvcr, their ovcn11 amount is
scldom matcrial enough to impact Icndcr
rccovccics, so wc gcncrdly do nor rcducc our
c x p m t i o n for Icndcrs' rccovcry by cstirnaring potcntid tax claims.
Swap fmnzimtiort costs.
Thc US.
Bankruptcy Code accords special rrcatmcnt
for countcrpartics to financial contracts, such
as swaps, rcpurchasc agrccmcnts, sccuritics
contmcts, and forward contracts, to cnsurc
continuity in thc financial markcrs and to
avoid systemic risk (so long as tlic typc of
conmct and the rypc of counrcrpany fa11
within ccrnin statutory provisions). Rccent
amcndmcnts to thc Binkruprcy Codc cxpmdcd this safe harbor by, among othcr things,
induding within thc definition of a "swapn a
mngc of tnnsxctions widcfy uscd in thc a p i tal markets (such as tom1 rcturn swaps and
crcdit swaps) and expanding thc dcfinitions
of counrcrpartics (whethcr to s w ~ p srcptw
,
cliasc ilgrccmcnts, sccttritiB contram. or for-
102
ward contracts) cligibb to cxcrcisc tlicsc
rights. In addition to not bcing subject to thc
automatic stay that gcncmlly prcdudcs crcditors from cxcrcising thcir rcmcdics against
thc dcbtor, thcsc financia1 contract countcrpartics haw tlic right to liquidate, rcrminatc,
or accclcratc thc contract in 3 bankruptcy.
Most currcncy and intcrtst mrc swvaps rclatcd
to sccurcd dcbt arc sccurcd on il pari passu
basis with thc rcspcctivc loans. Othcr s w p s
arc IikcIy to be unsccurcd. Quinrifying such
claims i s bcyond thc ~ o p of
c our analysis.
Scczirititatimrs. Standard accounts rcccivable s m r i t i m i o n programs invohc thc s d c
of ccrtain rccciv~~lcs
to a bankruptcy-rcmotc
spcciaI purposc cntity in an arms Icngth
transaction undcr coinmcrcially rcnsonablc
tcrms. Thc m c t s sold arc not Icgally part of
the debtor's cstatc (although in somc circutnstanca t h y may continuc to bc rcportcd on
thc company's balancc shcct for accounting
purposcs), and the smritimtion invcstors arc
completdy rdiant on tlic vduc of tlic asscts
they purchascd to gcncmtc tlicir rcturn. As a
result, thc sccuritization invcstors do not h a w
any rccoursc against thc c m t c and w c do not
considcr thcm ckirnants whcn w c usc an
cntcrprisc valuation approach in out dcbult
and rccovcry analysis. Howcvcr, tiic dcbror
cmcrging from bankruptcy will nccd to
financc its t d c rcccivablcs ancw, crcating an
incrcrncntal financing rquircment that must
bc considcrcd in thc rccovcry analysis.
Whcn a discrcrc assct valuation approach is
uscd, thc sold reccivablcs arc not avaihblc to
any crcditors. AdditionalIy, futurc-flow typcs
ofsccuritization, which sccuritizcs d l or a
portion of thc borrowcr's futurc rcvcnuc and
msh flow (typimlly rcIatcd to particuhr contracts, parcnts, trademarks, or othcr intangiblc asscts), wodd cffccrivcly rcducc all or a
part of thc cntcrprisc MIUC avaitabb to othcr
corporarc crcditors.
Tradc crditor cluirits. Typically, tradc crcd-
itor claims arc unsccurcd chimp that rank
pari passu with a borrower's otlicr unsccurcd
obligations. Howcvcr, bmusc 3 borrowcr's
viability as a going conccrn hingcs upon continucd ~ C C C S Sto goods and scwiccs, sonic
prcpctirion claims arc citticr paid in tbc ordinary coursc or trcntcd .ts priority admitiistntiw claims. This cmiccssion to criticd t n d c
EXHIBIT RVH-2
Page 134 of 139
vcndors cmurcs that thcy rcinain willing to
carry on thcir rclationships with the borrowcr
during thc insolvcncy procccdings, thcrcby
prcscrving rhc vduc of thc C S M ~ Cand cnhnncing thc tccovcry prospects for a11 crcditors.
Our andysis assumes that thcsc costs continuc to t c paid as part of thc company’s norilia1 working m p i d cyclc.
Accordingly, w c includc tmdc crcdit claims
as priority obligations only to thc cxtcnt that
w c bclicvc thcrc rvilI be valid claims at thc
time of c m c r g c n c i r that the company wilI
incur additional dcbt (including DIP facilitics)
to pay thosc claims.
Lcasm. U.S. bankruptcy law providcs companics thc opportunity to accept or rcjcct
Jcnscs during the bankruptcy proccss. (For
cornmcrcial rwl propcrty Icascs, thc rcvicw
pcriod is liinircd to 210 days, ir~cludinga
onc-timc 90-day cstcnsion, unlcss thc Icssor
agrccs to an cxtcnsion.) If a Icasc is tcccptcd,
the company is rcquircd to kcep rcnt paymcnts on thc Imsc currcnt, mcming that
thcrc will bc no daim against thc cstatc. This
also allow5 thc Icssce to continue to usc thc
Icascd asscr, with the cash flow (k,
vduc)
Jcrivcd from thc asset anilatlc to support
otlicr crcditors.
If 3 lmsc is rcjcctcd, thc company givcs up
the USC of thc assct. (Thc Icssor may filc il
gccncraf unsccurcd claim against thc cstate
for damages arising from thc brmch of contract.) \Vc cstimatc tlic impact o€ leasc rcicction, starting with il Icasc rcjcetiori mtc for
thc firni bawd on thc types of ilsscts Icascd,
thc industry, and our simulatcd dcfautt scenario. Lcascs 3rc typically rciectcd for o m of
thrcc rcasons:
= Thc Icasc is pticcci abovc markct ram;
Thc lcnscd m c t is gcncrating nqptivc or
insufficient rctutns; or
= Tlic lcascd nssct i s highly vulncrablc to
obsolcsccncc during the tcrm of thc Icasc.
Our cv;llu;ltion may ballpark thc rcjmion
mtc by assuming it mtchcs thc pcrccnngc
dcctinc in rcwnuc in out simulatcd dcfantt s m
nario or, if appliublc, by looking at common
industry l a c rcjmion mcs. Gsc-spccific considcntions might indudc, f o r mmplc, that
Imscd m c i s arc unusually old, undcrutitid,
or priccd aborc currcnt markct rata; a higlicr
rcjmtion mtc in such a s c s !nay bc rmmnrcd.
Patidnrd & Poor’s
.
In bankruptcy, thc amount of unsccirrcd
claims from rcjcctcd lcnscs is dctcrmincd by
taking tlic amount of lost rental inconic and
subtmcting tbc nct V ~ U Ca~ailabltto t h IC+
~
sor by sclling or rc-lcasing tlic nssct in irs
ncxt bcsr usc. Howcvcr, thc dclicicncy claims
of commercial rcsl atarc lcssors is furthcr
rcstrictcd to the grcatcr of ORE y c d s ccnt or
15% of thc remaining rcntd paymcnts, not
to cxcccd thrcc scars’ rcnt. Lcsssors of asscis
othcr than commcrciai rcal propcrty do not
havc tlicir potcntial dcricicncy ctairns cappcd,
but such Icam nrc gcncrally not materia1
and arc usually for rdativcIy short-pcriods of
timc. With tlicsc issucs in mind, w c quantify
Icasc dericicncy claims for most cornpanics
by mirltiplyinig thcir cstimatcd lcasc rcjcction
ratc by thrcc rim= thcir annual rcnt.
Nowcvcr, thcrc arc a fcw cxccptions to our
gcncraI approach. Dcficicncy claims for lmscs
of major transportation cquipmcnr (c.s., aircraft, nilcars, and ships) arc spccifi~llyanaIyzcd bccrusc thesc Icasc obligations do not
Iiavc tlicir claims cnppcd, may bc longcr
tcrm, and arc typially for substantia1
amounts. In addirion, wc usc a lowcr rcnt
multiplc for cascs in wIkh a company rctics
primarily on wry short-tcrm !casu (tlircc
)rars or Iess). Furthcr, IVC do not includc any
dclicicncy claim for Imscs hcld by individual
asset-spccific subsidiarics that do not haw
crcdit support from othcr cntitics (by vimc
of guamntccs or co-Icsscc rclationships)
bccllusc of thc lack of rccoursc against othcr
cntitics and thc likclihood that thcsc subsidiarics arc IikcIy to bc worthless if thc Icxcs
arc rcjcctcd. (This situation \vas rclcvant iri
many of thc rnovic whibitor bankruptcics in
thc mrly 2000 timc pcriod.)
~ i : ~ i o ~ i ~ ~ c ~clui~iis.
~ t - r Mat
c l ~crinl
t c tinsc~
curcd claims may nrisc when a dcttor rcjccts,
tcrminatcs, or modifics thc t c r i m of cmploymcnt or bcnclits for its currcnt or rctircd
cmployccs. To rcflcct rhis risk for unsccurcd
dcbthoIdcrs, wc arc likcly to iitcludc somu
ICITI of cmploymcnt-rclatcddairns for coinpanics-but only whcre uncompctitivc labor
or bcncfits costs arc a factor in our simulntcd
dcfzult sccnario.
Pc~isionp l m ~cr~rzii:atioir
claim. Tlic
ability to tcrminatc a dcfincd bcncfit pmsion plan i s providcd undcr thc U.S.
Corporate Ratlngs Criteria 2008
7 03
EXHIBIT RW-2
Page135af139
Ratlng Each Issue
Employee Retirement Incomc Security Act
(ERISA).Under ERISA, these plans may be
terminated voluntarily by the debtor as the
plan sponsor, or involuntarily by the
Pcnsion Benefit Guaranty Corporation
(PBGC)as the agency that insures plan benefits. TypicalIy, any termination during
bankruptcy wilt be a "distress termination," in which the plan assets would be
insufficient to pay benefits under the plan.
However, the bankruptcy of the plan sponsor does not automatically rcsuIr in the termination of its pension plans, and even
underfunded plans may not necessarily be
terminated; the debtor must demonstrate
www.corporatecriterla.standardandpoors.com
that it would not be abIe to succcssfuily
reorganize unIess thc plan is terminated.
In a distress remination, the PBGC
assumes the Iiabilitics of the pension plan
up to the limits prescribed undcr ERISA
and gets an unsecured claim in bankruptcy
against the debtor for the unfunded bene
fits. The calculation of this liability is based
on diffcrent assumptions than the borrower's reported Iiatility in its financial statements. This, in addition to thc difficulty of
predicting the funded status of a plan at
some point in the €urnre, complicates our
abiliry to accurately assess the vaIue of
these claims. rn
EXHI8IT RW-2
Pago 136 of 139
Commercial Paper
ornmercial paper (CP) consists of unsecured promissory
C
notes issued to raise short-term funds. CP ratings pertain to
the program established to sell such notes.There is no review of
individual notes.Typically, only companies of strong credit standing can sell their paper in the money market, although there periodically is some issuance of lesser quality, unrated paper
(notably, prior to the junk bond market collapse late in 1989).
Alternatively, companies sell commercial paper backed by letters
of credit (LOC) from banks. Credit quality of such LOC-backed
paper rests entirely on the transaction's legal structure and the
bank's creditworthiness. As long as the LOC is structured
correctly, credit quality of the direct obligor can be ignored.
Rating Criteria
Eduation of an issucr's commcrcid papcr
rctlccts our opinion af the issucr's fuundamcntal
crcdit quality. Thc analytiml approach is vimally idcntid to tlic onc follorvcd in assigning B
long-tcrm corpontc crcdit nting, and thcrc is
a strong link bctwccn thc short-tcmi and longtcrm rating systcms. Indccd, thc dmc horizon
for CP n t i n p is not il function of thc typical
30-day lifc of n mnimcrcial-papr notc, rhc
270-day mixvimiim nmturity for thc most comn1on typc of coritiiicranl papcr in thc US., or
cvcn thc O I I C - tcnor
~ ~ typimlIy uscd to dewniinc wliiuti insmumait gcts a short-tcrm rnting
in tlic first placc.
Slutidad fs Paor's
*
To aeliicvc an 'A-1+' CP m h g , tbc company's crcdit quality must bc at lmst thc cquivalcnt of a20'A+' long-tcrm corpomtc crcdit
raring. Simibrly, for commercial papcr to bc
mtcd 'A-l', thc long-rcrm corpontc crcdit
rating would nccd to bc at Imst 'A-'. In fact,
thc 'A+/A-I+' and 'A-/A-1' combinations arc
mrc. OrdinariIy, 'A-I' CP ratings arc associircd with 'A+' and 'A' long-~crmntings.
Convcrscty, knowing the Iongtcnn rating
will not futIy dctcrminc a CP miing, considcring thc ovcrlap in rating atcgorics. Howvcr,
thc rnngc of possibilitics is always narrow. 'Ib
rhc cxtciit tfmt onc of hvo CP ratings might
bc assigncd at il giwt lcvcl of longtcnn crcdit
Corporatc Ratings CtIteda 2008
'105
EXHlBIT RVH-2
Page 137 of 139
Commorctol Paper
quaIity (c-g., if thr. Iong-tcmi rating is ‘A’),
ovcr;lII strcnph of thc crcdit within thc rating
mtcgory is thc main considcmtion. For c.wmplc, ii marginal: ‘A’ crcdit IikcIy would liavc its
commcrciil papcr mtcd ‘A-2’, whcrcas il solid
‘A’ would aImost auromaticdly rcceivc an
‘A-1’- Lccptional short-tcrm crcdit quality
would bc anorlicr factor that dctcrmincs
which of two possiblc CP r a t i n g arc assigncd.
For mrnplc, a company may posscss substantial liquidiv-providing protmion in thc
nmr or intenilediatc tcrm-but suffcr from
Icss-than-stellar profitability, a longcr-tcmi
factor. Or, thcrc could bc a conccrn that, ovcr
tirnc, thc Iargc cash holding may be uscd to
fund acquisitions. {Havins differcnt timc Iiorizons as the basis for long- and short-tcrm ratings implics cithcr onc ot thc otlicr rating is
mpcctcd to cbangc.)
Backup Policies
Evcr sincc thc Pcnn Ccnrnl bankruptcy roilcd
thc commcrcid-papcr rnarkct and zotnc companics found tlicmsclvcs avcludcd from issuing ntw commcrciil papcr, wc h a w dccmcd i t
prudcnt for cornpanics that issuc commcrcial
papcr to makc armngcmcnts in advancc for
dtcrnativc sourccs of liquidity. This attcmativc, backup liquidity pmtccts cornpanics
from defaulting if thcy arc unable to roll ovcr
tlicir maturing paper with ncw n o m , bccausc
af a shrinkagc in the avemlt commcrcialpapcr rnarkct or somc cloud ovcr thc company that might make commcrciil papcr
invcstors ncrvous.
Many dcvclopmcnts sffccting n sbglc company or group of companics-including bad
busincss conditions, 3 lawsuir, manigcmcnt
changcs, a ratingchangc--could m k c commcrcia1-papcr invcstors flcc thc mdir. Givcn
thc rizc ofthc commcrciaI-papcr markct, backup facilitics could not bc relicd on wirh a high
degcc of confidcncc in tlic cwnt of widcspmd disruprion. A gcncnl disruption of
commercial-paprr markcts could bc 3 highly
volatiIc xcmrio. undcr which most bank lincs
would rcprcscnt unreIiabb claims on wliatcvcr
msh would bc midc availatb through thc
banking sptcm to support thc markct. \Vc ncithcr anticipntc that siich a scenario is likcly to
dcvcIop, nor itssurnc h a t it IICI’CP will.
106
www.corporatccri terla.standardandpoo~s.com
Having inadcquatc backup liquidity
affccts both thc short-and long-term ratings
of the issucr bccausc it couId Icad to d c b d t ,
which would uttimatcly pertain to a11 of thc
company’s dcbt. Morcovcr, thc nccd for
backup appIics 10 all confidcncc scnsitivc
obligations, not just ratcd comrncrcial papcr.
Backiip for 100% of ratcd commcrcial papcr
is mcminglcss if otlicr dcbt maturities-for
which thcrc is no backupcoincidc with
rliosc of thc comrncrcial papcr. Thus, thc
scopc of backup must cxtcnd to curodcnominatcd comrncrcial papcr, mastcr
notcs, and short-tcrm bank notcs.
Tfic standard for industrial and utility
issucrs has Iong bccn 100% covcmgc of conftdcncc-scnsitivcpapcr for all but thc
strongcst crcdits. Companics nrcd ‘A-1+’ a n
providc 50%-75% covcmgc. A highcr-mtcd
entity is Icss likcIy IO cncountcr busincss
rcvcrscs of significance and-in tlic cvcnt of il
gccncml contraction of tltc coniriicrcial-papcr
rnarkct-thc highcr-mtcd crcdit \vouIJ bc ICES
likcly to losc invcsrors. In fact, highcrntcd
compmia could actually bc nct tcncficiarics
of a flight to quality.
Whik tlic backup rcquircmcnt rclatcs onIy
to outstanding papcr-mhcr than thc cntirc
program a u t h o r i m t i o m compmy sliouId
anticipatc prospcctivc nccds. For cxamplc, i t
may haw upcoming maturitics of Ions-rcrni
dcbt that it may want ro rcfinancc with commcrtial papcr, which wouId thcn call for
backup of grcatcr amounts.
A~aifablecash or markcnbk sccuritics arc
idml to providc backup. (Of coucsc, it may
bc ncccssary to “haircut” tlicir apparrnt
vduc to account for potcntial fluctuation in
vduc or tollgatc tams surrounding a saIc.
And it is critical that thcy bc immcdiatcly
salcablc.) Yct the vast majority of commcrcid papcr issucrs r d y on bank f d i t i c s for
altcmativc liquidity.
Thc high standard for back-up liquidity
has provided a scnsc of sccurity to thc comincrcial paptr markct-vcn diough backup
facilitics arc far from a gunmntcc that Iiquidity will, in rlic cnd, bc nmilabIc. For cxartiplc,
a conipany could bc dcriicd funds if its banks
iiwokcd matcrial arlvcrsc clmgc clauscs.
i\Itcrnativcly, a cimpany in troiiblc might
dmrv down its crcdit linc to fund otlicr cash
EXHIBIT RVH-2
Pago 138 of139
nccds, Icaving Icss-than full covcmgc of papcr
outstanding, or issue papcr beyond thc cxpiration datc of its lines.
In 1939, ivc inrroduccd a ncw approach
that offcs cornpanics grcatcr flcxibiliry
regarding thc amount of backup t h y maintain, if tlicy arc prcparcd to iiiatcli thcir
maturitics arcfully with availablc liquidiry.
TIICalrcrnative approach diffcrcntiatcd
bcnvccn cornpanics that arc rolling ovct all
thcir commcrcial: pipcr in just a few days and
rhosc that liavc a cushion by virtue of having
placed longcr-datcd papcr. Thc basic idm \vas
that compnnics-if and whcn thcy Iosc access
to cornmcrcial paper-should Iiavc sufficient
liquidity to mvcr any paper coming duc during thc time &cy would rcquim to nrrange
additional funding. Howcvcr, cornpanics
cncountertd practical diflicultics in impIcmcnting thc ncw approach. LMorcovcr,
changes in tlic banking cnvironmcnt have
sincc rnadc UP morc lcery about a company
arranEing ncw faditits d i c n uuder strcss.
StiII, n o m that comc duc only 11-12
months from now do not rcquirc backup so
far in advmcc. Cornpanics should b g i n to
actiucly arrange liquidity backup approximatcly six months prior IO maturity.
Similarly, 12-month n o t a that auroniatimllg
cxtcnd tlicir maturity month by month do
not rcquirc back-up arrangcrncnts from day
onc. Thcy wilI bc ablc to armngc backup
when and if thc cxtcnsions stop, Icaving a full
12 months to do so.
Estcndiblc commcrcial n o m (ECNs)provide built-in backup by allowing thc issucr to
cvtcnd for scvcml months if t h r c is difficulty
in rolling o w thc nom; accordingly, thcrc is
no nccd to providc backup for tlicm-i.c.,
until thc cstcnsion is cffctcd. Howcvcr, thcrc
is no way to prcrcnt the issucr from tapping
backup hcilitics intcndcd for othcr dcbr and
USC thc funds to rcpay maturing ECNs,
instcad of cutcnding. This risk is known as
lcakagc. Accordingly, for issucrs that pro\.jde
100% backup, unbackcd EC" inust not
clrcccd 20% of cstant backup for outstanding
convciitional commcrcial papcr.
All issuers-cvcn if thcy providc 100%
backup-must always cn5urc tlint tlic first icrv
days ofupcoming maturities arc hckcd with
cxccss a s h u t funding hcilitiE that providc
Strlridnrd & Faor's
1
for immcdiatc availability. For cxamplc, a
bank backup faciliiy that rcquircs nvo-day
notification to draw down will bc of no w c in
rcpaying papcr maturing in thc intcrim. Thc
satnc would hold truc if forcigii cxchngc is
nccdcd, and thc facility rcqirircs a fcrv days to
providc it. Moreover, if a company issuing
mrnmcrcial paper in thc U.S. wcrc rclping on
P bank hciliry in Europc, diffcrcnccs in time
zona or bank holidays could prcvcnt awiIability whcn nccdcd. Obviously, a bank facility in the U.S. would bc cquilly lacking with
rcspcct to maturing curo-dcnominatcd commcrciaI papcr. S o - d c d w i n g lincs typically
cqud 15%-20% of thc prognm sizc to d c d
wirh thc maximum m ~ o u n that
t
will maturc
in any thrcc-to fourday pcflod.
Quality Of Backup Facilities
Banks offcr various types of crcdit fncilitics
that diffcr widely regarding tlic dgrcc of the
bank's commitmcnt to advancc cash undcr a11
circumstanccs. \Vmkcr forms of comniitrncnt,
while lcss C o d y to issucrs, providc banks
great flcvibitity to rcdircct crcdit at thcir O W I ~
discrction. Some lincs arc Iittlc morc than an
invitation to do busincss at sornc futurc datc.
Wc cxpm a11 backup lincs IO bc in placc
and eonfirmcd in writing. Prc-approvcd lincs
or omlly committcd l i d s arc vicwcd as insuflicicnt. SpcciGc dcsignnation for commcrcialpapcr backup is of Iittlc signifimncc.
ContnctuaIIy committcd facilitics arc dcsirablc. In thc US., fuIIy documcnfcd revolving
credits rcpmcnt such contractual cominitmcnts. Thc wmkcr thc crcdit tlic gmtcr thc
nccd for morc rcliablc forms of liquidity. As a
gcncnl guidclinc, if contractually committcd
facilitics cover 10-15 days' upcoming maturitics of outstanding papcr, that should suffm.
Evcn contractual caminitincntsoftcn
include "material idvcrsc changc" clauscs,
allowing thc bank to witlidraw undcr ccrnin
cimmsnnccs. Whilc inclusion of such an
csapc clausc rvcakcns tlic commitmcnt, wc
do not considcr it critiml-or rcnlistic-for
most borrorvcrs to ricgotiatc rcriiovd of
"matcrial adrcrsc changc" clauscs.
In thc abscncc of a contrficttia1 cornmithy
mcnt, paymcnt for thc fnciIity-~~~tutl~cr
fcc or balances-is important t m u s c ir gcn-
Corporata Ratlngs Critcdn 2008
7 07
EXHIBIT RVH-2
Page 139 01139
Comrncrclal Paper
crally c m t B somc dcgrcc of mom1 commitmcnt on thc part of thc bank. In fact, a solid
busincss relationship is kcy to wIictlicr a bank
will stand by ia clicnt. Sandardizcd ctitcria
unnot clpturc or assm the srrcngth of such
rclationships. We thcrcforc arc intcmtcd in
any cvidcnc-ubjccrive
as it may bc-that
might dcmonstratc thc strcngrh of an issuer's
banking relationships. In this rcspcct, thc anaIyst k aIso mindful of thc busin- culturcs in
differcnt parrs of the world and thcir impact
on banking rcktionships and commitments.
Dependcncc on just onc or a few banks also
is vicwcd 3s an unwamnrcd risk. Apart from
the porcntial that the bank will not havc adcquztc up~dtyto lend, thcrc is thc chancc it
will not bc willing to I d to this issucr. Having
scvml banking rcbtiotushipsdivcrsifics rhc risk
that any bank wiII Iosc confidenu. in this borrower and Iiesitatc to providc funds.
Conccntmtion of banking faciliria also
tcnds to increase the dollar amount of an individual bank's participation. As thc dollar
amount of thc mponrc hints large, tlic
bank may bc mom relttctant to stcp up IO its
cornrnitmcnt. In addition, thc potentia1
rcquircmcnt of higher-levcl audiorimions at
thc bank could cmic logistical problems with
respcct to mpcditious accm to funds for thc
issucr. On rhe othcr hand, a company will not
bcncfit if it sprcads its banking busincss so
thinly that it lacks a subsnntial relarionship
with any of its banks.
108
www.corporatccriteris.s!andardandpoors.com
Tticrc is no analytical. distinction to t c
madc bctwccii a 364-day and P 365-day bci1ity. Evcn muttiycar hcilitics will providc commitmcnt for only a short tinic as t h y
approach thc cnd of thcir terms. It obviously
is c r i t i d that thc company armngcs for the
continuation of its banking facilitics wcll in
advancc of thcir lapsing.
It is important to rcitcratc that cwn thc
strongest form of bzckuj+a rcvolvcr with
no "matcrial adrqersc changc" clausc4ocs
not cnhancc tbc undcrlying credit and docs
not lcad IO a highcr rating than indiearcd by
thc company's oivn crcditworthincrs. Crcdit
enhancemcnt can bc accomplished only
through an LOC or anorhcr instrumcnt that
unconditionally transfers thc debt obligation
to a higher-ntcd entity.
Banks providing issuers with faciIitics for
backup liquidity should thcmsclvcs be
sound. Posscssion of an iiivcstincnt-grade
rating indicatcs sufficicnt financial strcngth
for thc purposr of providing a commcrcial
papcr issucr with a rcliabIc sourcc
of funding.
Thcrc is no rcquirmcnt that thc bank's
credit rating cqual tlic CP issucr's rating;
nonctliclcsr, w e look askance at situations
whcrc most of a company's banks wcre only
marginally invcstmcnt gmdc. That would
indicate an impnidcnt rcliancc on banks that
might dctcriorate to weaker, noninvcstmcntgrade S
M ~ rn.