How does Moody's Assign Corporate Ratings?

DAVID STAPLES, MANAGING DIRECTOR, EMEA CORPORATES SOUMMO MUKHERJEE, VP SENIOR ANALYST EMEA CORPORATES

Overview of Corporate Finance Analysis

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Key rating drivers

Business Risk Profile
Product diversification Geographic diversification Customer base and supplier exposure Control on costs and revenues drivers Exposure to volatile markets

Industry analysis
Key trend in the industry Macroeconomic scenarios Competitive position and market share trend Political and regulatory environment Cyclical vs. stable demand

Rating
Strategy and Management
Growth prospective and assumptions Financial policy and targets Shareholders returns Management team experience

Financial Risk and Liquidity

Historic and forecasted ratios analysis Peer group comparison Liquidity profile and debt maturities Structural consideration

Corporate governance

Off-balance sheet liabilities and adjustments

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Meaning of rating
Rating Expected loss

Issuer rating
For Investment Grade Normally in line with debt instruments ratings

Corporate Family Rating (CFR)

Baseline Credit Assessment (BCA)

Used for Government Related issuers One of the 4 core inputs along with Support, Dependence and rating of supporting entity

For Sub-IG
Normally in line with Probability of Default Ratings (PDR) Used as a base for notching of different classes of debt

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Aiding tools
Industry rating methodology

Overall assessment
Analyst expertise Industry outlook Adjusted Financial ratios (MFM) Liquidity Risk Assessment Peer group Loss Given Default Track record and ability to execute Corporate Governance assessment

Industry analysis

Financials

Notching of debt instruments Assessment of Management quality

Government Related Issuer Methodology

Mix of qualitative and quantitative skills to judge soft and hard data
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Moodys global rating scale

long term short term
Aaa

Independent opinion

Aa1 Aa2 Aa3

A1 A2 A3 Baa1 Baa2 Baa3

Prime-1

Probability of default and severity of loss

Prime-2 Prime-3

Global consistency

Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca C

Issuer and Issuance ratings

Not Prime

A globally comparable rating

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Moodys South Africa national scale mapping

Global Scale National Scale- Long Term Rating Aaa Aaa.za Aaa.za Aa1.za Aa1.za/Aa2.za Aa2.za/Aa3.za Aa3.za/A1.za A1.za/A2.za National Scale- Short Term Rating P-1.za P-1.za P-1.za P-1.za P-1.za P-1.za/P-2.za P-1.za/P-2.za Aa2 Aa3 A1 A3

Independent opinion

National comparability

Baa1 Baa2

Baa3

A2.za/A3.za
A3.za/Baa1.za Baa1.za/Baa2.za Baa2.za/Baa3.za Ba1.za/Ba2.za Ba2.za/Ba3.za Ba3.za/B1.za B2.za/B3.za/Caa1.za Caa1.za/Caa2.za

P-1.za/P-2.za
P-1.za/P-2.za P-2.za/P-3.za P-2.za/P-3.za NP.za NP.za NP.za NP.za NP.za

Issuer and Issuance ratings

Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2

Not globally comparable

Caa3
Ca

Caa3.za
Ca.za

NP.za
NP.za

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Financial Ratios and Key Adjustments

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Reasons for adjusting accounts

Improve comparability US GAAP accounts IFRS accounts Convergence programme still has some way to go Also, different treatments are permitted under IFRS for the same transactions in certain areas Accountants couldnt agree on a single method Better reflect underlying economic reality We need a full and accurate picture of financial performance and position Implies accounts are deficient in certain respects Three biggest problem areas:

Lease accounting
Pensions accounting No global standard for the same transactions in certain areas (i.e. Treatment of R&D costs)

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Summary of adjustments typically made by Moodys

Off balance sheet leases are capitalised Pension deficit is added to the debt Product development costs are written off Securitization proceeds are treated as financing when risk not fully transferred Hybrid securities are reclassified according to a basket to reflect Moodys view of their debt-like vs equity-like characteristics

Interest capitalised is reversed

One-off items are stripped out

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What is Debt?
On Balance Sheet Debt, i.e. Borrowings We tend to focus on gross debt (i.e. excluding cash) but give some credit for cash balances in excess of working cash BUT ALSO Leases Pension obligations Different rules for different GAAPs Some other off-balance sheet obligations Environmental Legal Put Options Guarantees

Not as simple as it may seem, so we make Adjustments!

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Which ratios do we focus on and why?

Operating Performance and Profitability Business model sustainability Margins earnings divided by sales Returns earnings divided by something

Leverage Financial structure sustainability

Debt to EBITDA (largely used but with some limitations) Cash flow divided by debt Interest Coverage Capability to sustain ongoing payments

Cash flow or earnings divided by Interest

Capitalisation Debt divided by Capital (Debt plus Equity) Debt divided by Equity

All ratios are adjusted according to our methodology

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Leverage - Which Ratios do we Look at?

Debt to EBITDA EBITDA is not a good proxy for Cash Largely used in financial documentation

Cash Flows to Debt Cash Flow from Operations (CFO) = Funds From operation +/- Working Capital Changes Retained Cash Flow (RCF) = FFO (before working capital) Dividends Free Cash Flow (FCF) = CFO Dividends Capex

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How We Assess a Companys Liquidity Profile

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Liquidity A critical factor in recent crisis

Liquidity is crucial in todays environment Difference between life and death Liquidity crisis can emerge very quickly Market liquidity

2001/2003 and 2007/2008 crisis

Re-pricing of risk may be costly even fatal for most leveraged issuers Consequences on mostly cyclical issuers Default increases lead to lack of confidence in the markets Issuers performance Covenant breach Issuer specific rather than sector

Moodys uses LRA as a gauge for liquidity strength

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What is important to survive a liquidity crisis

Degree of preparation by management Robust Contingency Plan Degree of nimbleness in crisis management

Conviction by lenders that entity is viable

Proven business model Soundness of operations Capacity to control cash-burn Manageable level of leverage And ability to raise cash Committed bank facilities that can be drawn Cushion under covenants Valuable assets that can be pledged/sold

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The LRA - Liquidity Risk Assessment

Sources
Internal
Liquid assets Cash, marketable securities, accounts receivable Repatriation Tax implications Convertibility Cash From Operations

External
Committed bank facilities Availability Quality (facility attributes: MAC, covenants, maturity date, triggers) Quantity Trade credit

Assets / Back Door

Unencumbered assets Divestitures Product lines Divisions

Uses
Operations, Working capital, Capital expenditures, Debt payments (P&I), Dividends, Share repurchases, Contingencies

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Example of a Methodology: Global Packaged Goods Industry

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Global Packaged Goods Industry Methodology Grid

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1. Scale and Diversification

Size matters as a driver of scale, lower fixed costs, marketing strength, diversification

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2. Franchise Strength and Growth Potential

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3. Distribution Environment and Pricing Flexibility

- For packaged goods companies exposure to private labels is a negative in particular on some European markets where private labels represent significant market shares

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4. Cost Efficiency and Profitability

Operating margin is an indicator of efficiency, profitability, competitive position

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4. Financial Strategy and Credit Metrics

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4. Financial Strategy and Credit Metrics (Contd)

Credit metrics measure the capacity of operations to generate sufficient cash to repay debt. Our packaged goods methodology suggests a 40% weighting for Credit metrics in the rating (45% including assessment of financial policy) Weak factors are often overweighted in the methodologies or by rating committees Ratings based on prospective credit metrics more than historical ones

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Grid-Indicated Ratings as of July 2009

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Grid-Indicated Ratings as of July 2009 (contd)

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Grid summarizes main factors but is not the rating

Grid outcome is the weighted average of the various qualitative and quantitative factors determined by the methodology Rating committees may determine that some measures are mitigated by qualitative factors Other factors are not captured by the grid: liquidity, management quality, corporate strategy, corporate governance, legal environment in particular ratings may be shaded due to local operating conditions: ratings in emerging markets are generally lower than calculated weighted average of the grid The grid is published as a reflection of historical performance but ratings are primarily forward-looking Ratings aims at stability through the cycle

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Notching Framework:

Notching Framework:
How do we arrive at our guidelines for notching?

How do we arrive at our guidelines for notching?

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What is Notching?
Notching refers to the relative ratings assigned to different obligations of an economic unit. Relative seniority and security of corporate obligations

We refer to two Moodys Special Comments:

Notching for Differences in Priority of Claims and Integration of the Preferred Stock Rating Scale, November 2000 Summary Guidance for Notching Secured Bonds, Subordinated Bonds, and Preferred Stocks of Corporate Issuers, September 2001

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Notching Guidelines
Senior Secured debt should be rated one-notch higher than unsecured debt. Secured bank loans may merit a rating two or more notches above senior unsecured debt. Subordinated debt should be rated one-notch lower than senior unsecured debt. No distinction between Senior and Junior Sub Debt.

Wider notching differentials for issuers that carry corporate family rating (CFR) or senior unsecured ratings of Ba3 or lower.

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CFG Notching Framework:

LGD Ratings

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Goal of LGD Framework & Model

Studies show that Family LGD rates are extremely difficult to forecast (Carey & Gordy 2004) Standard fundamental analysis provides little guidance for separating PD from E[LGD]
A leverage ratio might offer information about both However, some factors may help explain Family LGD

Industry, credit cycle/macroeconomic conditions, covenant considerations, and capital structure

LGD Framework is designed to provide robust estimates of family-wide and obligation-specific recovery rates LGD Model blends the expected liability structure at default with a model of uncertainty to produce LGD estimates

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Using the Model: Estimate Liabilities at Default Resolution

Make adjustments to reported liabilities
Assume bank loans will be fully drawn Evaluate adequacy of expected collateral coverage

Incorporate expected issuance and retirement of debt

Analyze non-debt obligations (trade credit, tort claims, pension obligations, etc.)

Establish priority of claim

Senior obligations will be paid in full before junior obligations receive anything
(absolute priority)

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Introduce Uncertainty An Example

Suppose a firm has $50 million in secured debt, $50 million in unsecured debt, and $50 million in anticipated enterprise value at resolution
The expected family recovery rate (as well as the Family LGD Rate) is 50% Without uncertainty, the recovery rate on secured debt would be 100% (LGD = 0%) and that for unsecured debt would be 0% (LGD = 100%) With uncertainty (using a distribution with a mean of 50% and a standard deviation of 20%), the expected recovery for secured debt will be 86% (LGD = 14%) and for unsecured debt, 14% (LGD = 86%)

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Behind the Scenes (1)

A Family Recovery Rate of 15% implies:

The secured debt recovers 30% ($15 mill./$50 mill.)

The unsecured debt recovers 0% ($0/$50 mill.)

14% 12% Probability 10% 8% 6% 4% 2% 0%

This state will occur with a probability of 2.93%

2.93%

35%

45%

55%

65%

15%

25%

75%

85%

Family Recovery Rate

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95%

5%

Behind the Scenes (2)

A Family Recovery Rate of 50% implies:

The secured debt recovers 100% ($50 mill./$50 mill.)

The unsecured debt recovers 0% ($0/$50 mill.)

14% 12% Probability 10% 8% 6% 4% 2% 0%

This state will occur with a probability of 9.57%

9.57%

35%

45%

55%

65%

15%

25%

75%

85%

Family Recovery Rate

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95%

5%

Behind the Scenes (3)

A Family Recovery Rate of 75% implies:

The secured debt recovers 100% ($50 mill./$50 mill.)

The unsecured debt recovers 50% ($25 mill./$50 mill.)

14% 12% Probability 10% 8% 6% 4% 2% 0%

This state will occur with a probability of 5.45%

5.45%

35%

45%

55%

65%

15%

25%

75%

85%

Family Recovery Rate

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95%

5%

Behind the Scenes (4)

We multiply the payout for every debt class (using absolute priority) under each state (family recovery = 0%, 1%, 2%, etc.) by the probability that the state will occur We then sum across all possible states The result is an Expected Recovery Rate and therefore Expected LGD for each debt class

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Assigning LGD Ratings

Obligation-level LGD estimates will be used to assign LGD ratings using 6 buckets

Rating
LGD1 LGD2 LGD3 LGD4

LGD Range
0% - <10% 10% - <30% 30% - <50% 50% - <70%

LGD5
LGD6

70% - <90%
90% - 100%

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Assigning Obligation Ratings

Obligation-level Expected LGDs are combined with the Corporate Family Rating (CFR) to determine obligation ratings
A Rating Committee decides the CFR, which implies a Family EL using idealized loss tables The Family EL, combined with the expected Family LGD, determines the Family PD The obligation EL (= PD*E[LGD]) will be derived from the Family PD and obligation E[LGD], and will imply an obligation bond rating using an idealized loss table

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Rating Timetable and Process

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Rating Timetable
New ratings have been delivered in as little as a few days or weeks following appointment; however the norm for investment grade issuers is around 6-10 weeks from appointment, assuming high quality information flow Issuer and advisers often prepare rating information packs with background and important information Moodys analysts meet management following receipt of background pack for formal presentation Moodys reviews information and interacts with issuer/adviser to request further information or clarify points Moodys holds rating committee meeting Rating disclosed to management on confidential basis Rating outcome can be appealed if new information is available If rating is accepted for publication, rating is publicly disseminated though press release and accompanying research, always with issuers ability to review

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Dissemination of the Rating Decision

Issuer is informed immediately following the rating committee. This information is confidential and privileged until Moodys makes a public statement

Public statement can be in the form of a press release, new issue or new issuer report or other broad-based electronic media transmission
Public statement is sent to the issuer in advance of public dissemination to ensure accuracy and that no confidential information has inadvertently been included

Following publication of the rating, the analyst is available to investors and other users of the rating to comment on Moodys rating decision
Issuer always has right not to accept a new rating and in such cases it is not made public by Moodys, but it is not able to be used by the issuer

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Monitoring Moodys Ratings: Meeting Schedule and Rating Review, Outlook and Action
After the initial rating decision, ratings are monitored continuously Issuers determine whether, and how often, they want to meet with the analyst, but meeting schedules do not determine the timing of rating reviews. Normally, issuer meetings are conducted on an annual basis. Events in the market place may put positive or negative pressure on an issuers rating, ultimately resulting in a rating action for: Upgrade Downgrade Confirmation Rating Review and/or a Rating Outlook may precede a Rating Action

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Typical timescale for a rating assignment

Weeks Date
M 2 9 16 23 30 T 3 10 17 24 Month 1 2010 W T F 4 11 18 25 5 12 19 26 6 13 20 27 S 7 14 21 28 S 1 8 15 22 29

1 3rd

2 10th

3 17th

4 24th

5 1st

6 8th

7 15th

8 22nd

9 29th

10 5th

Initial discussion with Moodys Sign & return to Moodys a Rating Application Form Schedule date for Rating Meeting

M 7 14 21 28

T 1 8 15 22 29

Month W 2 9 16 23 30

2 2010 T F 3 4 10 11 17 18 24 25 31

S 5 12 19 26

S 6 13 20 27

Submission of background information

Moodys forwards Agenda for Rating Meeting Rating Meeting

M 4 11 18 25

T 5 12 19 26

Month 3 2010 W T F 1 6 7 8 13 14 15 20 21 22 27 28 29

S 2 9 16 23 30

S 3 10 17 24

Subsequent analysis and questions Rating Committee & assignment of Rating

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David Staples Managing Director EMEA Corporates +971 (4) 237-9562 David.Staples@moodys.com Soummo Mukherjee Vice-President Senior Analyst EMEA Corporates +27 11 217 5477 Soummo.Mukherjee@moodys.com

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