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December 31, 2001
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Heard
on the Street
Some Early Warning Signs
For Exiting Distressed Firms
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
On Friday, Nov. 30, two days before Enron filed for
bankruptcy-court protection, its shares were trading at 26 cents -- down from a
high of $90 and a little late for investors to decide to ditch the stock. Ditto
for investors in any number of other big corporate casualties this fall,
including Bethlehem Steel, Federal-Mogul and Polaroid.
But astute investors realize there are some early-warning signals
that work better than plunging stock prices to tell them to head for the exits.
And as more companies seek protection from U.S. Bankruptcy Court, predicting
whether a company may file becomes an ever-more-relevant skill.
The stakes are higher than they used to be in reading the market
equivalent of tea leaves. First, the number of bankruptcy filings is up sharply
this year, and many experts believe more are to come in the current unsettled
economic climate. Chapter-11 bankruptcy filings by publicly traded companies
hit a record 143 this year, affecting $76 billion of debt, compared with 119
the previous year on $30 billion of debt, according to David Hamilton, a
specialist on defaults for Moody's Investors Service in New York.
Moreover, many companies that file for bankruptcy protection
nowadays are more likely to end up in liquidation than in the past, analysts
say, making the stock of a distressed company less likely to be worth much. It
isn't only New Age telecommunications companies -- becoming famous for the
plummeting values of their fiber-optic networks and other assets -- that may be
valued less in bankruptcy court than their shareholders hoped. The same may
prove true for retailers now in Chapter 11 proceedings, restructuring advisers
warn.
Here is a guide to a half-dozen barometers of financial health
watched by sophisticated investors for signs of potential bankruptcy, some are
easier than others for average investors to follow on their own:
SWAPS THAT SWEAT IT OUT: The derivatives markets can be
especially valuable as an early-warning signal -- particularly the
credit-default swap market, where institutional investors seek financial
protection against corporate bankruptcies. The default swap market is probably
the most sensitive measure of how market participants view corporate prospects.
For example, the credit-derivatives market was far ahead of the
rating agencies in suggesting that once-mighty energy trader Enron was a weak
credit. Weeks before the Houston company sought bankruptcy-court protection,
pricing on Enron protection was far more expensive than it should have been,
given Enron's then investment-grade rating. Essentially, these credit swaps are
a form of insurance on Enron debt; if Enron defaults, the buyer of such a swap
goes to the seller of the swap and receives 100 cents on the dollar, regardless
of how worthless the debt may have become.
See
full coverage of the rise and fall of Enron
Increase
in Corporate Debt Could Hurt U.S. Recovery
Stock
Gurus Disregard Most Big Write-Offs, but They Often Hold Vital Clues to Outlook
In September, shortly after Enron Chief Executive Jeffrey Skilling
stepped down, there was a drastic increase in Enron credit-default swap
volumes, and spreads doubled on Enron risk to a steep 2.75 percentage points
over the London Interbank Offered Rate, the short-term rate off which banks
price some loans.
By October, with the announcement that the Securities and Exchange
Commission was investigating Enron's financial statements for accounting
irregularities, spreads doubled again, to more than five percentage points.
Then, after Enron lost access to the commercial-paper market, spreads rose to
an almost prohibitively expensive 15 percentage points, according to data from
KMV LLC, a credit-risk-management service in San Francisco. Meanwhile, the
shares edged down to $13 from $37 during the course of the month, levels that
didn't hint at the fate that would overtake Enron just a few weeks later.
Indeed, the shares didn't drop below $1 until Nov. 28, from above $4 on Nov.
27.
(Unfortunately, there isn't a market for many corporate names
below investment grade, unless, like Enron, they plunge rapidly into junk
territory.)
DEBT THAT DIVES IN VALUE: Often the secondary bond
market can provide valuable clues about a troubled company's fate, as bond
analysts are much more focused on a company's ability to repay its debts. They
scour information pertinent to the sort of distress that leads to a filing.
Henry Miller, vice chairman of Dresdner Kleinwort Wasserstein, an
investment-banking and advisory boutique, has worked out a formula as follows.
"When the bonds start trading between 90 cents and 80 cents on the dollar,
a light bulb goes on," he says. "When the bonds then fall to between
60 cents and 80 cents, that tells you that somebody is nervous. And when they
start trading between 40 cents and 60 cents, it is a question of when, not
whether. And when they go below 40 cents, a filing is -- to varying degrees --
imminent."
BANKING ON TROUBLE: Another indication that a company
may be about to seek bankruptcy-court protection is when it draws down all its
credit or standby credit lines from its bankers, according to Brad Eric
Scheler, head of the restructuring practice for law firm Fried Frank Harris
Shriver & Jacobson in New York. Such drawdowns are also an early-warning
symptom that a company anticipates a turn for the worse in its fortunes.
CONSCIOUSNESS OF RATIOS: Financial distress quickly
translates into a company violating its lending agreements with its bankers.
Such violations allow the banks to pull their lending lines or even declare a
company in default. While information about the relationship between bank and
client usually isn't public, there are certain relevant financial ratios that
can provide clues. For example, lending agreements oblige most companies across
a wide range of industries to keep the debt level at no more than about seven
or eight times earnings before interest payments, taxes and depreciation. If
the amount of the debt is far greater, investors can assume the banks aren't
happy. Unhappy bankers can even petition the courts to push their client into
involuntary bankruptcy.
A DATE WITH DEBTHOLDERS: Figuring out the timing of a filing
can be tricky, of course. One indicator watched by many hedge funds: whether a
potential Chapter 11 candidate has an onerous interest payment coming up.
Managers of these sophisticated investment pools assume that a troubled company
would prefer to file before, rather than after, paying out large sums of
precious cash.
But that may not be a sure thing. For example, in advance of a
scheduled payment on Global Crossing bonds in November, many hedge funds
made bearish bets on the telecommunications company, which already had drawn
down bank lines, anticipating it soon would be in violation of its bank
covenants and would seek bankruptcy protection. The company, though, met the
cash call, and the hedge funds closed out their losing positions. On Friday,
Global Crossing announced it had come to agreement with its bankers on loan
covenants.
FLASHING RED LIGHT: Some signals couldn't be more
glaring. If a company retains bankruptcy counsel or calls in
restructuring-advisory boutiques, such as Greenhill & Co. or Blackstone
Group or Lazard Freres & Co., it is reasonably certain a company is at
least considering bankruptcy. (Another reason for some hedge funds' bearishness
on Global Crossing: It has hired a restructuring adviser, according to people
familiar with the matter; it won't comment on the matter, saying its
relationships with any advisers are confidential.)
One of the messages that restructuring advisers tell their clients
is to file early. That means investors can be caught off guard more easily
since some recent bankruptcy-court filers, such as Covad
Communications Group, have had significant amounts of cash on their balance
sheets.
Write to Henny Sender at henny.sender@wsj.com