Why Moody's Makes Me Moody

By Brady Willett
If last months weakness in auto sales are any indication of broader consumer demand this weeks retail sales numbers could be soft.  In fact, economists expect a mere 0.1% gain in May retail sales -- this after a strong showing in April (+1.2%).

Other reports of interest due out this week include the Fed's Beige Book (Wednesday), producer prices (Thursday), industrial production, and Mich consumer sentiment (Friday).  The Mich. Sentiment data, which is the preliminary report for June, could be worth watching considering that last months conference board numbers suggested the consumer was growing impatient. Moreover, as terrorism, war, and stock market (price) fears appear to be on the rise Mich. Sentiment could be headed lower (last month Mich confidence registered 96.8).

The Tyco Saga
We have been led to believe that the countless investigations following Enron will help add clarity to financial statements and disallow conflicts of interests from developing at accounting and Wall Street firms. However, what is becoming painstakingly clear is that change will come slowly, if at all, and that conflicts of interest may be growing rather than subsiding.

With this in mind, consider last week's debt downgrade of Tyco (by both by Moody's & S&P).  These downgrades may have arrived weeks late -- perhaps also they were delayed for dubious reasons.

To begin with, ask yourself a couple of questions: did Moody's and S&P downgrade Tyco in reaction to bond investor selling (follow the leader)?  Did Moody's delay downgrading Tyco because knocking the company's debt lower than investment grade would trigger payments and/or was Moody's pressured by Tyco debt holders to give the company an opportunity to dig itself out of a looming credit crunch?  If the answer to either of these questions is yes than Moody's (S&P) are no different than many accounting and Wall Street firms (corrupt).

The reason why I am harping on this issue is simple -- when Lehman's pulled its $5 billion offer for CIT on May 24, 2002 Moody's and S&P should have acted mercilessly.  They did not.  Rather, they waited until the SEC delayed approval of the CIT prospectus late last Thursday to swing the ratings axe.  The problem with this timetable is that the corporate bond market had already sent Tyco debt lower (last week).  Thus, Moody's, like Wall Street analysts clinging to buy ratings, was behind the curve.

Magical Asset Sales
 Remember a company named 'ENRON'?

Moody's and S&P delayed downgrading Enron because of information of a pending Dynergy takeover.  Accordingly, when takeover talks vanished the rating houses waited a couple days (for what reason no one knows) and finally downgraded Enron.  The downgrades triggered huge payments for Enron and sealed the company's fate (meaning loans that could have been paid later had to be paid immediately because Enron's debt slipped below investment grade). 

Keeping the Enron debacle in mind, when considering that corporations often lie to investors is it that far fetched that companies are lying to Moody's???  "Don't worry Moody's, we will sell off some assets shortly. Please don't downgrade us" says Mr. CEO...
-- Once the phone hangs up all the insiders sell…

Side note: how about a new rule that states no insiders can sell any shares if their company have debt that is rated less than investment grade?  Why reward management for doing a poor job - why not make them tough it out by holding the stock rather than spinning lies (both to investors and Moody's) as they sell?

Point being, Moody's, who supposedly knows corporate debt better than anyone, would appear to be rating stocks with cash problems based upon magical future asset sales.

A Simpleton Solution
 The SEC needs to force companies to do a simple acid test (current assets minus inventories divided by liabilities), and if this number is below 1 (implying lack of liquidity to meet upcoming obligations) companies should be forced to include the following statement at the top of all PR and financial statement releases:

"IF WE CLOSED OUR DOORS TODAY AND DID NOTHING OVER THE NEXT 12 MONTHS WE WOULD NEVER BE ABLE TO OPEN OUR DOORS AGAIN. YES, CASH IS EXTREMELY TIGHT AND YOU MAY WANT TO CONSIDER BUYING ANOTHER COMPANY. "

Quite frankly, a blunt statement like this is required reading for the average investor – it should be used to brand managers as failures well before a crash crunch develops and/or before Moody's gets around to hacking its ratings lower.  Consider the warning investor's would have had with Tyco:

Tyco – TYC

31-Mar-01

30-Jun-01

30-Sep-01

31-Dec-01
         

Acid Test

0.81*

1.24

0.28*

0.33*

Acid Test (inventories incl.)

1.24

1.43

0.42*

0.51*
         

Tangible Book ($Bil.)

-4.36

-1.09

-0.96

-3.65

* All Tyco propaganda is released with the above bolded statement.  

The above exaggeration aside, balance sheets and acid tests are not the gospel when it comes to predicting cash crunches.  For instance, take Moody's (the company), which Warren Buffett has a stake in: its balance sheet looks terrifically horrible (negative book value).  However, after realizing that Moody's is a perennial 'cash cow' these worries quickly slip away

Cash Cow: a company that generates consistently strong cash flows (free) from its assets.  The higher the cash flow/assets ratio is the louder the mooo.

In sum, unless a company is a 'cash cow' a poor acid test could be bad news.

Conclusions
It may or may not be the case that Tyco follows Enron into the abyss.  To be sure, while it was relatively easy to figure out that Enron was finished back in November 2001 (even before Moody's figured it out), with Tyco the situation may not be as dire, at least not yet.

That said, if Tyco was warning investors of a crash crunch a year ago (a la the bolded statement) when the company purchased CIT for $10 billion investors would have probably known that something was amiss. 

By contrast, Moody's should have known what to do when acid test failing Tyco began to lose its mooo.  Instead, for some strange reason Moody's held on to their investment grade rating for as long as possible. In sum, Moody's should stop excepting phone calls from Robert Rubin's buddies and start realizing that future asset sales are NOT CASH.  Moreover, Moody's, and every investor for that matter, should understand that when asset sales are undertaken in today's market out of necessity such sales are unlikely to reap the companies expected price.

Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com

June 17, 2002