Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com. Morningstar recently launched corporate credit ratings as an extension to our existing equity research services.
I'm here today with the credit analyst Rick Tauber to discuss a bond issue that he's found that seems like it's attractively priced right now. Rick thanks so much for joining me.
Rick Tauber: I appreciate it.
Jeremy Glaser: So the company that we're talking about today is Actuant which is an industrial manufacturer. Right now, we have the credit rated BBB-. Can you talk a little bit about what went into that rating?
Rick Tauber: The credit ratings are derived directly from our forward-looking equity model. Once we put the model together, we basically determine four different pillars which calculate to the credit rating.
Those pillars are business risk, solvency score, cash flow cushion, and distance to default. Basically, the inputs to the model end up basically calculating the rating which came out as BBB-. This rating was then taken to the Credit Committee which approved that rating.
Jeremy Glaser: How does this rating differ from maybe some of the other rating agencies that are also looking at this debt?
Rick Tauber: The interesting thing about Actuant is we've got our BBB- rating, which is the lowest investment-grade rating. But the other two rating agencies rate it at mid-BB which is a high junk rating. So we're two notches higher than the rating agencies.
Jeremy Glaser: So we're right on that border between what's considered a junk bond and what's considered investment-grade. What gives you the confidence to say that this is definitely investment-grade versus some of the competitors?
Rick Tauber: There's I guess a couple of things I'd highlight. One, we think this company is very well positioned. It's built itself up over the last several years via both internal growth and with acquisitions to establish a competitive advantage in its niche businesses. We think this gives it a narrow economic moat which will allow it to generate some economic profits that are sustainable over time.
Secondly, as I mentioned before, we are using forward-looking data and modeling. Right now, the company is in the trough of its recessionary cycle and going forward. We would expect operating earnings to improve substantially and credit metrics to follow along in the same direction.
Jeremy Glaser: So what are some of the things that could go wrong here?
Rick Tauber: Well, a couple key risks I guess. One, it's still a cyclical company, even though they've diversified over the last few years. Obviously, they're tied to primarily an industrial economic cycle.
Secondly, as I mentioned, they have grown via acquisitions. They've done this with good discipline and they've used both debt and equity. But the risk here would be that they would potentially do a big debt-financed acquisition and which would leverage the company up.
Jeremy Glaser: For bond investors, what does the fact that we think its investment- grade and think that the spread should maybe be a little bit tighter than they are now? What does that mean for them in terms of actually going out and investing in this idea?
Rick Tauber: There are two approaches here. One is the spread on this bond is about 400 off on the six and seven-eighths bond I'm referring to which is right in line with double-Bs. A weak triple-B might be in the 275 spread area.
You're getting paid an additional—say 100-plus basis points, relative to the amount of risk you're taking, as we rate it as a BBB- rating. So you can just buy the bond, sit on it and basically be overcompensated for your risk.
Secondly, we look at what are potential catalysts that could drive those spreads to tighten up towards investment-grade and that would then lead to appreciation of the bond price. Those are both situations to consider which we think makes this bond cheap.
Jeremy Glaser: Now, some of their outstanding debts are convertible, so you would have an option to convert it to equity. Do you think that that converts option could be exercised?
Rick Tauber: Sure. That's definitely something that we're factoring in and is one of the catalysts that I was talking about. We have a constructive view of the equity here. The interesting thing, again about this company is the strike price on their converts is right around $20.00 and the equity is trading right around $21.00, so they're very close which means these bonds are callable in November. They're also potable.
So if the stock continues to move up, it's quite possible that the company will call them and the debt will convert to equity which will basically take debt out of the capital structure and improve the credit overall.
Jeremy Glaser: So for bond investors who maybe are looking for a little bit more yield, but maybe don't want to take on a ton more risk, this could be an interesting opportunity.
Rick Tauber: Yeah, absolutely.
Jeremy Glaser: All right, great. Rick thanks so much for speaking with me today.
Rick Tauber: I appreciate it.
Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser.