Corporate Finance – FNCE201 For Professor Fu Fangjian
Group Case Study 2
HBS Case Study: Williams 2002
Class/Section: G4
Submitted by: Bo Macken Kyle Patrick Pingco Gonzales Helena Margareth Holst Krogtorp Liu Ju Hui Tang Lei
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1. How does Williams get into financial distress? Answer: a) Write-off of investment in WCG During the Tech Bubble, the whole telecom market that WCG was involved in suffered a lot of problems due mainly to a large oversupply, as indicated by an estimated 2% to 5% of the fiber- optic lines which were only carrying traffic. The revenue of WCG eventually plummeted, wherein prices of the lines decreased by more than 90% from 1998 and 2002. When WorldCom filed for bankruptcy protection in July 2002, it became apparent that the telecommunications sector was experiencing a lot of problems. WCG itself also began to experience a lot of financial stress, and in hopes of supporting it, Williams converted notes to shares, providing “credit support” of $1.4 billion of WCG’s debt (which Williams listed as an off-balance sheet item). Despite attempts to lessen WCG’s debt burden through raising new funds, WCG still had problems paying off its debts. While it managed to at least pay the required interest payments, it was not able to meet certain “covenants” and a breach was created with its secured creditors. This has caused WCG’s debt rating to fall due to “weakness in financial performance, lack of forward visibility, and exposure to customers whose risks are increasing.” In the end, Williams took a one-time accounting charge of $1.3 billion of guarantees and payment obligations. The problems with WCG ended up affecting Williams as well, causing Williams’ net income after extraordinary items to plummet, making it less desirable for creditors and investors. b) Unforeseeable market conditions for energy trading The Energy Trading market also experienced its own share of problems and issues. For one, because of the collapse of Enron, the market condition for energy trading became very unclear. This led to most competitors in the industry choosing to switch focus or scale back. In addition, Williams Energy Marketing and Trading also experienced its first loss in 3 years. Williams was suffering from deteriorating credit ratings and increasing yields, and it provided a huge risk on the company’s ability to participate in the market. Due to the nature of the business, where “Obtaining credit was especially important when trading long-dated positions, such as ‘prepays’,” this issue became a huge problem. c) Ongoing inquiries from regulators about reporting and energy trading Williams was also facing an Investigation by the SEC concerning the collapse of WCG and its financial reporting. This could lead to a few more problems for the company. In the end, the final indication of Williams’s financial distress can be reflected in the decrease in William’s stock price by more than 90% in the past year; with $2.95 per share in July 2002. 2
2.1 What are the some specific/potential costs of financial distress for Williams? Answer: Direct Costs: Legal, accounting and professional consulting fee. WCG seeked to reorganize under the U.S. bankruptcy code in 2001, producing huge costs on legal and professional services related to reorganization. For example, Williams took a onetime accounting charge of $1.3 billion related to guarantees and payment obligations due to lingering ties to WCG. Indirect Cost: 1) Loss of Suppliers: Because it is an assets-based business, Williams spent about $2 billion a year on capital expenditures. With the onset of financial distress, suppliers may now be unwilling to provide the firm with machines or they may begin requesting for payment by cash rather than credit, further limiting the company’s transactions. 2) Loss of Employees: Since the firm is facing financial difficulties, it will not have enough resources to offer job security to all of its employees. For example, in the case, Williams’ rival, Aquila Inc., dismissed its entire staff of 1,290 people. Because Williams is in the same situation, it may have difficulty hiring new employees and existing employees may even quit or be hired away. Without the right incentives, it may become impossible to retain key employees. 3) Loss of Receivables: A firm in financial distress tends to have difficulty to collect money from debtors. Therefore, Williams may suffer a huge loss from bad debts. 4) Fire Sales of Assets: One of Williams’ strategy was an aggressive program of assets sales. However, because the goods will have to be heavily discounted, Williams has no choice but to accept a loss from lower priced sales in order to quickly raise cash. 5) Costs of financing: Given Williams’ financial health and financial stress, Moody’s and Standard & Poor’s downgraded the credit rating on Williams bonds three times, from Baa2 to B1. In late July 2002, the yields on some of Williams’ publicly traded bonds also skyrocketed. As extracted from Exhibit 4, Williams’ 10 year bond yields increased as high as 25%. All of these events in addition to the high bond yield will certainly boost up the firm’s financing costs.
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2.2 Are there signs of under-investment at Williams? Answer: Under-investment is when the shareholders choose not to invest in low-risk assets, even though it will give the firm a positive NPV. This can be seen as a conflict of interest - shareholders do not want to invest because the debt holders will get most or all of the benefits from the positive NPV. In this case, the total liabilities are $ 31.9 billion for Williams by June 2002, which gives a leverage ratio of (31,947/37,566 =) 0.85. With the high leverage ratio, if there is investment opportunities for Williams, debt holders will be getting the major shares of the profit generated as they may charge a higher rate of return. This proves that there are signs of under-investment for Williams. 3. In the class, we argue that outside investors are reluctant in funding a firm with debt overhang. Why is BHLB willing to offer a large financial package to Williams? Answer: BHLB is willing to offer a financial package because Williams’ asset-based business continued to meet the performance expectations. Even with bad economic condition, Williams’ revenue increased by $1.4 billion in 2001. The fundamentals of the business remained strong despite the difficulties currently being faced. Furthermore, Warren Buffett, the CEO of BH, regards Williams as an investment-worthy project. Buffett’s philosophy is to invest in companies which he can forecast the balance sheet in 10 or 20 years. Therefore, Williams can be seen as a company with a longterm perspective. In addition, the financial package offered also gives a high return of the loan due to the limited financing options of Williams in the open market. Even under the most extreme conditions of default, with Williams’s large amount of assets as guarantees, BHLB would be still able to ensure their return of the debt. 4.1 Why does the financing agreement impose certain levels of financial ratios and liquidity? Answer: Financial ratios and liquidity show the company’s ability to fulfill its commitments. The interest coverage ratio tells us how easily the company can actually pay the interest of outstanding debt. Here, a ratio greater than 1 is preferred. The fixedcharge coverage ratio shows us how well the company is able to pay its fixed financing expenses, such as the leases and fixed payment in the BHBL’s agreement. In general, the agreement imposes these ratios and the maintenance of Williams liquidity to ensure the repayment of the loan. In case of default, RMT will be liquidated to make sure that the short-term debt agreement will be fulfilled. 4
4.2 Why does the financing agreement limit certain payments and intercompany indebtedness? Answer: The limitations of certain payments are implemented to prevent excess dividend payment and redemption of capital stock. These are meant to restrict the transfer of Williams’s assets by the shareholders and to ensure the benefit of BHLB. Limitation on inter-company indebtedness is to prevent bad loans within the corporation and cap Williams’s leverage ratio. 4.3 Why does financing agreement restrict the capital expenditure? Why not on the expenditure of RMT? Answer: The agreement limited capital expenditures in excess of $300 million. The reason for this is to force Williams to focus on maintaining efficient operations and achieving progress, rather than expanding their company and investing in new projects. RMT on the other hand, operates in a rather different market and have less risk of financial distress. 4.4 Why does BHLB want to attend board meeting? Answer: By attending to the board meeting, BHLB will have full knowledge of the company and its development. This gives the debt holders greater insight and disclosed information concerning both operations and strategies. An insight in the company is important for BHBL so that they can take action before the market reacts.
5. “Tough times demand tough decision.” As the CEO of Williams, would you recommend accepting the proposed $900 million financing offer? If not, what alternative would you pursue? Answer: Despite the fact that Williams was a company with strong fundamental in its core business, the unexpected cash flow issue/low liquidity problem had caused the firm to experience severe financial distress. The four-pronged plan that involved selling assets, reaching a resolution for its energy and trading, emphasis on liquidity, and re-sizing, will help Williams to deal with the current problem in the long run and 5
prevent the issue from happening again. However, the firm was in urgent need to tackle the problem of liquidity in the coming year due to amount of debt payment that was required. Under such a situation, our group thinks that with Williams’s current financial position, the firm should accept BHLB’s credit agreement in order for it to get through the debt and cash flow burden in the near term. It is indeed true that the terms of the agreement are passive to Williams and it may put the firm in an unfavorable position, with the cost of the financing agreement being high. However, it could effectively prevent Williams from defaulting on its debt and being forced to sell its high value assets with an undervalued price. Compared to the possible costs of defaulting, we believe that it is still valid and plausible for Williams to accept the agreement.
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