David Wright Cea: An Analyst With River Investment Is Consid

David Wright Cea An Analyst With River Investment Is Considering Bu

An analyst with River Investment is evaluating whether to buy a Montrose Cable Company corporate bond. The analysis involves assessing the company's financial statements, ratios, and off-balance-sheet items to determine if the bond's current credit rating and yield premium adequately reflect the company's credit risk. Specifically, the analyst seeks to understand how off-balance-sheet obligations impact key financial ratios and whether the current credit premium aligns with internal bond-rating criteria.

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Introduction

The evaluation of corporate bonds involves a detailed analysis of a company's financial health, risk factors, and external market conditions. In this context, River Investment's analyst, David Wright Cea, aims to determine whether the bond issued by Montrose Cable Company is correctly rated and whether its current yield premium over U.S. Treasuries sufficiently compensates for its credit risk. This analysis integrates a review of financial ratios, off-balance-sheet liabilities, and internal rating criteria to arrive at a comprehensive understanding of the company's creditworthiness.

Financial Analysis and Ratio Adjustments

Montrose Cable Company's financial statements as of March 31, 2011, reveal a stable financial position with total assets of approximately $48 million and equity of $33.46 million. The company's income statement indicates operating income of $4.45 million and net income of $1.192 million. The key ratios provided include EBITDA/interest expense at 4.72, long-term debt/equity at 0.30, and current assets/current liabilities at 1.05. According to internal bond-rating criteria, these ratios suggest an 'A' rating, which reflects moderate credit risk.

Impact of Off-Balance-Sheet Items on Financial Ratios

Wright considers three off-balance-sheet items: a guarantee of unconsolidated affiliate debt, sale of receivables with recourse, and a non-cancellable operating lease. These items affect financial ratios as follows:

1. EBITDA/interest expense: Off-balance-sheet guarantees and leasing commitments potentially lower the company's true EBITDA coverage, as the lease obligations and guarantee maturity might impose additional liabilities not reflected in current earnings.
2. Long-term debt/equity: Guarantee obligations and lease liabilities increase the company's leverage, effectively raising the debt base and altering the debt/equity ratio toward higher risk.
3. Current assets/current liabilities: Sale of receivables reduces current assets with recourse obligations, which may diminish liquidity ratios, though this depends on whether the receivables and guarantees are included or excluded in working capital calculations.

Calculating the combined effect involves adjusting the ratios to incorporate the present value of guarantee obligations ($995,000), lease liabilities ($6,144,000 discounted at 10%), and the recourse receivables ($500,000). The adjustments highlight a potential deterioration in the company's financial ratios, signaling higher leverage and lower coverage ratios when considering these contingent liabilities.

Implications for Bond Rating and Yield Premium

Based on calculations, the adjusted EBITDA/interest ratio could decrease from 4.72 to approximately 4.2-4.3, and the leverage ratio (debt/equity) could increase towards 0.35-0.40, reflecting higher risk levels. The current ratio might also decline slightly but remains close to 1.00, indicating marginal liquidity. Under the internal criteria specified by Blue River Investments, an 'A' rating requires interest coverage of 4.00-5.00, leverage ratios of 0.30-0.40, and current ratios of 1.00-1.15. The adjusted ratios suggest that, after considering off-balance-sheet liabilities, the company's credit standing might have shifted towards a lower rating, potentially into the 'BBB' category, which requires a higher yield premium.

Assessment of the Current Credit Yield Premium

The bond's current trading at a 55 basis point premium over U.S. Treasuries initially aligns with an 'A' rating based on the unadjusted ratios. However, once the off-balance-sheet items are incorporated, and the company's risk profile is adjusted downward, the premium might be insufficient to compensate for the increased risk. According to internal criteria, the 'A' rating correlates with a premium of 50 basis points, but the adjusted ratios indicate that the bond might warrant a premium of 75-100 basis points to adequately reflect the heightened leverage and liquidity concerns. This suggests that the prevailing yield premium may not fully compensate investors for the true credit risk after accounting for off-balance-sheet liabilities.

Conclusion

In conclusion, the analysis demonstrates that off-balance-sheet obligations materially impact Montrose Cable Company's financial ratios and overall credit risk profile. When these contingent liabilities are duly considered, the company's adjusted ratios point toward a potential downgrade in internal ratings, which could justify a higher yield premium. Therefore, the current credit yield premium of 25 basis points over U.S. Treasuries appears insufficient to compensate for the increased risk associated with the company's off-balance-sheet commitments. Investors and analysts should incorporate these liabilities into their risk assessment to avoid underestimating the company's true credit exposure.

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