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Receivables 0.258 0.264 0.259 0.270 0.263
Inventory 0.080 0.100 0.089 0.098 0.095
Other current assets 0.054 0.047 0.063 0.026 0.024
Total current assets 0.452 0.460 0.533 0.488 0.711
Plant, property, equip 0.331 0.341 0.276 0.317 0.261
Other long-term assets 0.218 0.199 0.190 0.194 0.028
Total assets 1.000 1.000 1.000 1.000 1.000

Notes payable 0.022 0.016 0.024 0.007 0.002
Other current liabilities 0.243 0.248 0.249 0.270 0.197
Total current liabilities 0.265 0.263 0.273 0.277 0.198
Long term debt 0.048 0.051 0.066 0.044 0.009
Other liabilities 0.041 0.045 0.050 0.029 0.047
Total liabilities 0.354 0.359 0.389 0.350 0.255
Shareholders™ equity 0.646 0.641 0.611 0.650 0.745
Total liabilities and equity 1.000 1.000 1.000 1.000 1.000

Total assets (millions) $1,932 $1,877 $1,619 $1,318 $967

Sales 1.000 1.000 1.000 1.000 1.000
Cost of sales 0.328 0.294 0.306 0.309 0.298
SGA expense 0.575 0.541 0.516 0.517 0.489
Operating income before depreciation 0.097 0.165 0.178 0.174 0.213
Depreciation 0.066 0.064 0.065 0.062 0.048
Interest expense 0.011 0.010 0.007 0.007 0.002
Nonoperating gain/loss 0.010 0.010 0.008 0.013 0.015
Special gain/loss 0.000 0.000 0.000 “0.007 0.000
Income before tax 0.030 0.100 0.114 0.111 0.179
Income tax provision 0.011 0.035 0.042 0.039 0.077
Income before extraordinary items 0.018 0.065 0.072 0.072 0.102
Net income 0.018 0.065 0.072 0.072 0.102

Sales (millions) $1,922 $1,866 $1,633 $1,315 $1,035

EBI/Sales 0.023 0.069 0.075 0.075 0.102
Earnings/EBI 0.812 0.940 0.964 0.961 0.993
Sales turnover = sales/average assets 1.009 1.067 1.112 1.150
Leverage = assets/equity (average) 1.554 1.595 1.591 1.449
ROE = product of above 0.029 0.111 0.128 0.120
..................................................................................................................................................
EBI = earnings before interest, net of tax. Tax effect of interest is assumed to be 40 percent.
899
Case: The Computer Industry in 1992




169
Part 4 Additional Cases




EXHIBIT 4
Stratus Computer “ Common-Size Financial Statements and Selected Ratios

1991 1990 1989 1988 1987
..................................................................................................................................................




The Computer Industry in 1992
Cash 0.256 0.133 0.117 0.142 0.223
Receivables 0.348 0.379 0.417 0.375 0.356
Inventory 0.169 0.217 0.166 0.228 0.190
Other current assets 0.023 0.026 0.019 0.016 0.016
Total current assets 0.796 0.755 0.719 0.760 0.786
Plant, property, equip 0.171 0.199 0.245 0.209 0.196
Other long-term assets 0.033 0.046 0.036 0.030 0.018
Total assets 1.000 1.000 1.000 1.000 1.000

Notes payable 0.010 0.014 0.015 0.014 0.013
Other current liabilities 0.157 0.210 0.207 0.240 0.240
Total current liabilities 0.167 0.224 0.222 0.253 0.254
Long term debt 0.007 0.044 0.107 0.051 0.042
Other liabilities 0.010 0.014 0.000 0.000 0.000
Total liabilities 0.184 0.283 0.329 0.304 0.296
Shareholders™ equity 0.816 0.717 0.671 0.696 0.704
Total liabilities and equity 1.000 1.000 1.000 1.000 1.000

Total assets (millions) $385 $321 $274 $200 $145

Sales 1.000 1.000 1.000 1.000 1.000
Cost of sales 0.340 0.361 0.342 0.354 0.319
SGA expense 0.457 0.463 0.451 0.436 0.470
Operating income before depreciation 0.203 0.176 0.207 0.210 0.211
Depreciation 0.064 0.049 0.049 0.040 0.044
Interest expense 0.004 0.007 0.005 0.000 0.000
Nonoperating gain/loss 0.010 0.008 0.009 0.003 0.005
Special gain/loss 0.002 0.000 0.000 0.000 0.000
Income before tax 0.146 0.127 0.162 0.173 0.172
Income tax provision 0.035 0.036 0.058 0.062 0.066
Income before extraordinary items 0.111 0.092 0.104 0.111 0.105
Net income 0.111 0.092 0.104 0.111 0.105

Sales (millions) $449 $404 $341 $265 $184

EBI/Sales 0.112 0.094 0.106 0.111 0.105
Earnings/EBI 0.985 0.970 0.982 1.000 1.000
Sales turnover = sales/average assets 1.271 1.357 1.441 1.537
Leverage = assets/equity (average) 1.297 1.437 1.467 1.430
ROE= product of above 0.183 0.179 0.219 0.243
..................................................................................................................................................
EBI = earnings before interest, net of tax. Tax effect of interest is assumed to be 40 percent.
Debt Ratings in the Chemical Industry




R ichard Mandrell is a newly hired credit analyst, employed by a small
but quickly growing insurance company that is becoming increasingly active in the mar-
ket for private placements. In reviewing possible investments, the company considers
what rating would have been assigned to similar bonds in the public markets. Such rat-
ings play a signi¬cant role in determining the issues™ yields and marketability. At this
date, early 1991, AAA-rated corporate bonds are yielding, on average, about 9.4 percent,
whereas BBB-rated corporates are yielding an average 10.2 percent. Some junk bonds
are, of course, yielding much higher rates.
Analysis of prospective investments inevitably involves a degree of subjective busi-
ness judgment. However, Mandrell is aware that, in the view of some, determination of
an appropriate debt rating category for a particular issue is sometimes based largely on
a few key ¬nancial ratios. In fact, several of Mandrell™s competitors in the private place-
ment market use purely quantitative debt scoring models as an important input to their
credit analysis. Such an approach suggests that one could explain much of the variation
in bond ratings based on a handful of ¬nancial ratios. Intrigued by that observation,
Mandrell has decided to review a few recent public debt issues to see how well he can
“predict” their current ratings based solely on a cursory review of the ¬nancial state-
ments of the issuers.
The ¬rms selected by Mandrell for analysis are all in the chemical industry: Fargo
Chemical Company, Texas Gulf Corporation, MST Company, Boland Corporation, and
Quotron Chemical Corporation. Despite their common industry membership, the ¬ve
¬rms have widely varying capital structures and pro¬tability.
The wide variation across the ¬ve ¬rms™ performance re¬‚ects the differences within
the chemical industry. The prices of both inputs and outputs are volatile, and often they
do not move in tandem. Thus, pro¬tability critically depends on which prices are most
important to a given ¬rm. Some ¬rms focus on basic chemicals”essentially, commod-
ities that are similar across producers”and have little control over prices on either the
input or output side of their market. Other ¬rms focus on specialty chemicals. These
¬rms tend to have highly differentiated products, specialized knowledge and processes,
and close customer relations. In some cases, they are the sole supplier of a particular
chemical. These ¬rms are better insulated from changes in the prices of their inputs,

.........................................................................................................................
Prepared by Professor Victor L. Bernard, with the assistance of Mike Finn, Elise Kartchmar, and Hans Littooy. The
¬rms on which the base is based are real, but the names have been disguised. The case was prepared as a basis
for class discussion and is not intended to illustrate either an effective or ineffective management of a business
situation.




901
902 Case: Debt Ratings in the Chemical Industry




172 Part 4 Additional Cases




because they have some ability to pass on such changes to their customers. Many chem-
ical companies diversify across basic and speciality chemicals, sometimes achieving
some manufacturing synergies in the process.
Debt Ratings in the Chemical Industry




Pro¬ts in the chemical industry reached an all-time high in 1988 and 1989, due to fa-
vorable trends in prices. Sales grew by 10 percent, while net pro¬t margins reached a
healthy 8 percent and ROE moved to 17 percent. In 1990, however, the industry was not
as fortunate. The prices in many input markets, including those for petroleum products,
rose during the Gulf War. Simultaneously, a worldwide recession dampened demand for
the outputs of chemical ¬rms, including demand from the key sectors of construction
and transportation. Sales growth in chemicals slowed signi¬cantly, and net pro¬t mar-
gins fell below 7 percent. Several specialty chemical manufacturers maintained strong
pro¬ts, but producers of basic chemicals struggled. With the world still in a recession in
1991, and the industry now facing some excess capacity due to the plant expansions that
commenced during the highly pro¬table late 1980s, the near-term pro¬tability picture
for many chemical companies is only mediocre.


FARGO CHEMICAL COMPANY
Fargo Chemical is a leading international manufacturer and marketer of intermediate
chemicals and specialty products. The company produces three principal chemicals:
propylene oxide and derivatives, used in urethane foams and in solvents for furniture,
auto, and construction industries; tertiary butyl alcohol and derivatives, used as an oc-
tane enhancer; and styrene, used in plastic and rubber components.
Fargo resulted from a spinoff of a major petroleum company in 1987; the majority of
its shares remain in the control of that company. Earnings grew steadily in 1987 and
1988, but then fell in both 1989 and 1990, re¬‚ecting the generally dif¬cult conditions in
the chemical industry and the heightened price competition.
Fargo™s long-term debt includes a half-dozen public and privately placed issues. The
one for which Mandrell will attempt to “predict” a rating is a $100 million debenture,
issued in 1990 and due in 2005. Like nearly all other long-term debt issued by Fargo, the
debentures are unsecured, subordinated, and issued “for general corporate purposes.”
They are not callable.
Fargo™s ¬nancial statements are presented in Exhibit 1.


TEXAS GULF CORPORATION
Texas Gulf Corporation is the smallest of the ¬ve chemical companies reviewed by
Mandrell. It produces several highly integrated lines of commodity and specialty chem-
icals, and is a leading producer of chlorine, caustic soda, sodium chlorate, vinyl chloride
monomer, and other chlorine-based and alcohol products. End uses for the products are
diverse: housing and construction markets, solvents, plastics and ¬bers, consumer prod-
ucts, pulp and paper, and other uses.
903
Case: Debt Ratings in the Chemical Industry




173
Part 4 Additional Cases




Texas Gulf enjoyed extraordinary margins in 1988 and 1989. The pro¬tability re-
¬‚ected not only the favorable relation of output to input prices, but also the ef¬ciencies
of Texas Gulf™s highly integrated manufacturing process. Texas Gulf considers itself a




Debt Ratings in the Chemical Industry
low-cost producer of commodity and specialty chemicals, and claims that its productiv-
ity rates are among the highest in the industry. Nevertheless, Texas Gulf was not invul-
nerable to the downturn of 1990, with operating pro¬ts falling by nearly 25 percent.
In an effort to insulate itself from potential takeover, Texas Gulf undertook a recapi-
talization in April 1990, and followed that action with the adoption of a poison pill
agreement. The recapitalization involved the distribution of a $30 dividend to sharehold-
ers, ¬nanced with a combination of $191 million of subordinated notes (issued to the
shareholders), a $507 million term loan, and a smaller ($44 million) revolving credit
agreement. The term loan and revolver were arranged with a group of ¬nancial institu-
tions. The term loan is payable in quarterly installments through 1998.
The debt considered by Mandrell is the subordinated note issue. The notes are call-
able at par beginning 1995, and are due in 2000. Prepayment of the subordinated notes
is prohibited while the bank debt remains outstanding. The notes are unsecured, but re-
quire that certain ¬nancial ratios be maintained.
Texas Gulf™s ¬nancial statements are presented in Exhibit 2.


MST COMPANY
MST Company is the largest of the ¬ve ¬rms considered here, and one of the largest
chemical producers in the U.S. Its lines of business include agriculture, personal care
products, food products, construction materials, plastics, resin products, rubber and pro-
cess chemicals, and pharmaceuticals. In several of its lines of business, it holds major
brand names.
MST is more widely diversi¬ed than others in the chemical industry, and therefore
may be better insulated from the current industry conditions. Nevertheless, it experi-
enced a decline in margins and a resulting dropoff in pro¬ts in 1990.
Among MST™s many debt issues are $100 million of callable sinking fund deben-
tures, issued for general corporate purposes. The debentures rank on a parity with nearly
all of MST™s other debt, and are unsecured and unsubordinated.
MST™s ¬nancial statements appear in Exhibit 3.


BOLAND CORPORATION
Boland Corporation is a diversi¬ed manufacturer of chemicals, metals and materials,
and defense-related products. Within its chemical operations, Boland produces industri-
al chemicals (including caustic soda, urethanes, and chlorines), performance chemicals,
water sanitizing chemicals, and image-forming chemicals. Its metals products include a
variety of copper and steel materials. The most important defense-related product is am-
munition.
904 Case: Debt Ratings in the Chemical Industry

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