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Appeal of Shared National Credit (Third Quarter 2014)

Background

A participant bank appealed the special mention rating assigned to a revolving credit during the 2014 Shared National Credit (SNC) examination.

Discussion

The appeal asserted that the facility should be rated pass because of the company’s market position, improved earnings before interest, tax, depreciation, and amortization expense (EBITDA) margin, repayment capacity, and fixed charge coverage (FCC) ratio.

The bank stated that the borrowing company is a market leader benefiting from vertical integration and scale. The company is one of the largest integrated producers with diversification by both geography and product, providing it flexibility to weather poor economic conditions and maintain margins. The company also enjoys high barriers to entry.

The appeal also asserted that financial performance improvements are expected to continue despite revenue declines over the past few years due to challenging market conditions. EBITDA margins have sequentially improved via cost cutting initiatives, and cash flow remains robust relative to peers.

The appeal noted that the company has an investment grade credit rating supported by peer group leading solvency and liquidity. First quarter 2014 leverage was modest at 3.0 times compared to 4.2 times in 2012. In addition, the company has a combined $4.4 billion in liquidity sources from cash and full availability under the cash flow revolver with sources of liquidity covering uses approximately 3.8 times in 2014.

The appeal stated that the company shows a strong repayment capacity under base-case projections. Under the appealing bank’s base case, projections indicate 91 percent of total debt repayment using cash flow over the next seven years. Utilizing a zero growth scenario, debt repayment capacity remains reasonable at 54 percent over the same period.

The appeal stated that the company has a solid FCC ratio of 1.71 times versus the SNC examination team’s calculation of 1.01 times. The difference in the FCC ratio calculation is attributed to the use of book versus cash interest and tax expenses, inclusion of the convertible note as debt when it was converted to equity in the first quarter 2014, and inclusion of both maintenance and growth capital expenditures.

Conclusion

An interagency appeals panel of three senior credit examiners concurred with the bank’s pass rating due to the company’s ability to execute its strategic plan and its financial flexibility and ability to reduce debt over a reasonable period should the company forego planned growth initiatives.

The appeals panel acknowledged that the company is a market leader in an industry with high barriers to entry. The company, however, has faced challenges in its industry, such as overcapacity and relatively low prices in the primary market.

The appeals panel noted that loan ratings are based on regulatory rating definitions and are not required to be aligned with ratings from third parties, such as rating agencies. The risk ratings should consider all relevant financial information, including company leverage and liquidity, to make an informed risk rating decision. The panel agreed with the appeal that the company’s $4.4 billion liquidity is adequate based on cash and full availability under its cash flow revolver. In addition, due to the modest leverage level, the company has financial flexibility allowing it to enter the capital markets, if necessary.

The appeals panel also recognized the success of the company’s cost cutting measures reflected in EBITDA margins maintained in the low double digits. The proactive measures have positively affected the gross margin and are expected to improve cash flow. Gross margin increased by 16 percent from 2012 to 2013, and projected FCC ratios are 1.4 times in 2015 and 1.5 times in 2016.

Base-case projections reflect weak cash flow performance in 2014 with improvement in 2015 through 2017 due to expected increases in product prices each year, improving EBITDA margins. The operating plan calls for substantial capital expenditures and working capital investment to realize performance objectives. The plan also projects sufficient free cash flow generation to reduce debt over a reasonable period. In the first quarter 2014, holders of convertible notes exercised the option to convert the notes into shares of common stock reducing total leverage to 2.98 times and annual interest expense by $30 million.

The appeals panel acknowledged that the FCC ratio should be adjusted upward based on the cash interest and taxes paid, resulting in a revised ratio of 1.12 times rather than 1.01 times calculated by the SNC examination team and 1.71 times noted in the appeal. The company’s conversion of the convertible note to equity does not affect the fiscal year 2013 ratio, which uses fiscal year 2012 current maturities of long-term debt. Both maintenance and growth capital expenditures were deemed fixed charges because the company’s expansion plans are an integral part of its plan to improve financial performance to reduce leverage.