Standard & Poor’s rates the creditworthiness of roughly 1,300 publicly traded, U.S.-domiciled companies. And only three of these companies are rated “AAA” – the highest tier.
The first two probably won’t come as a surprise.
Microsoft Corp. (MSFT) and Johnson & Johnson (JNJ) have enormous streams of stable cash flows. And both of these companies have negative net debt (debt minus cash). In other words, they have more cash and cash equivalents than total debt.
It’s virtually impossible to imagine a disaster scenario that would cause these companies to default on their bonds. Come hell or high water, they’re going to meet their obligations.
On the other hand, the third company that’s rated triple-A seems to be out of place.
Unlike Microsoft and J&J, Exxon Mobil Corp. (XOM) has far more debt than cash… and its debt levels are rising at a fast clip.
Exxon’s net debt is $35 billion, up from just $2 billion in 2012. In fact, Exxon’s net debt-to-EBITDA, a measure of leverage, has never been higher.
Exxon, which has been triple-A rated by S&P since 1985, had its rating placed on negative credit watch on February 2, 2016.
I believe Exxon is about to lose its coveted AAA rating.
Of course, a rating downgrade to AA+, or even AA, won’t be the end of the world for the company. Nonetheless, the marginal cost of debt capital does matter for a capital-intensive business.
Over the past five years, capital expenditures (capex) have totaled a whopping $158 billion for the oil giant. The price of crude oil and natural gas may have collapsed, but Exxon will need to continue to spend gargantuan sums to extract these commodities from the earth.
Therefore, the debt issuance will continue unabated.
Sometimes it’s easy to lose sight of how a business operates. A company raises capital, invests it, and then earns a return. When the return winds up being less than the cost of capital, there’s a problem.
Exxon’s return on invested capital (ROIC) for 2015 was just 5.2%, the lowest it’s been since the big merger with Mobil in 1999. At the same time, the company’s weighted average cost of capital (WACC) was meaningfully above its ROIC for the first time ever.
When Exxon loses its AAA credit rating, its cost of debt will become incrementally more expensive. This will push the WACC up further. Considering that its cost of funds is already higher than its returns, even a small increase in Exxon’s cost of issuing debt is a big deal.
Furthermore, acquisitions will become more expensive to finance, albeit slightly at first.
One of the causes of Exxon’s long-term ROIC decline is its inexorable increase in its dividend payments. Dividends are subtracted from net income to calculate the “return” in the ROIC numerator.
In 2015, Exxon paid out $12 billion in cash dividend payments, up from $10 billion in 2012.
Meanwhile, operating cash flows have deteriorated from $56 billion in 2012 to $30 billion in 2015. Last year, free cash flow (operating cash flow minus capex) was only $3.9 billion, which is far lower than the total dividend distribution.
So let me get this straight… This company is supposed to have effectively zero risk of default, but its debt is soaring, it’s destroying capital, it doesn’t have a stable stream of cash flows, and it has dividend sustainability issues unless the price of oil recovers significantly.
Furthermore, I’d be remiss if I didn’t at least mention that Exxon’s price-to-sales ratio is at its highest level of the past 10 years, besides brief periods in 2007. Ironically, Exxon had $25 billion more cash than debt at that time and was worthy of its triple-A rating.
Currently, Exxon’s credit rating is unjustifiably perfect. With the commodity supercycle having ended, Exxon is going to face an increasingly difficult business environment. Yet, its debt levels will continue to mount.
Exxon’s loss of its AAA rating will be downplayed by many, but the downgrade will be emblematic of some very concerning underlying trends.
Safe (and high-yield) investing,
Alan Gula, CFA