IBM Trying to Steer Clear of Bond Market's Triple-B Bogeyman
(Bloomberg) -- International Business Machines Corp. is trying to avoid the fate of other companies that loaded up on debt to fund acquisitions, saying it will use some of its cash hoard and suspend share buybacks in an effort to prevent downgrades to the cusp of junk.
The transaction will take IBM’s debt load close to $80 billion as it pursues the second-largest technology deal of all time in buying Red Hat Inc., according to Bloomberg Intelligence analysts Robert Schiffman and Mike Campellone. JPMorgan Chase & Co. and Goldman Sachs Group Inc. are providing a $20 billion bridge loan to back the deal, and IBM will also use some of its more than $14 billion cash pile, according to a filing.
That could help IBM steer clear of the route taken by other companies that sacrificed strong credit ratings to pursue large scale mergers and acquisitions. The M&A boom has fueled a 52 percent surge in the amount of bonds rated in the lowest investment-grade tier of triple-B the past five years, Bloomberg Barclays index data show. S&P Global Ratings cut IBM’s rating by just one level Monday to A (five notches above junk) and Moody’s Investors Service said it may do the same.
“The ratings are very important to them -- their competitors in IT services are all rated A or higher,” S&P Global Ratings analyst David Tsui said in an interview. Debt issuance will be “substantial” but with more than $6 billion in projected free cash flow, the company won’t have to go close to funding the whole deal with debt, according to Tsui.
At $33 billion, the Red Hat acquisition will be the world’s second-largest technology deal ever, and boosts IBM’s credentials in the fast-growing and lucrative cloud market. Red Hat gives IBM much-needed potential for real revenue growth, as it has been slow to adopt cloud-related technologies and lagged market leaders Amazon.com Inc. and Microsoft Corp. IBM has seen revenue decline by almost a quarter since Chief Executive Officer Ginni Rometty took the role in 2012, mostly from declining sales in existing hardware, software and services as it lost out to the internet.
Still, concerns the deal would rack up debt seeped into its existing bond prices. IBM’s securities fell Monday morning, with its $650 million of 4.7 percent bonds due 2046 sliding the most since February as investors demanded more yield. The cost to insure IBM’s debt against default for five years jumped almost 9 basis points to 54.5 basis points, the highest since December 2016, according to data provider CMA.
S&P cut IBM’s rating one notch to A and Moody’s Investors Service put it on review for a downgrade, saying it was likely to also lower the company by one level. Its bonds still trade at a premium to similarly-rated companies, Bloomberg Barclays index data show.
A spokesman for IBM pointed to the firm’s strong free clash flow and said the deal is accretive from the first year. He acknowledged the ratings agency moves, adding that IBM remains in “solid investment-grade territory.”
IBM also said it would suspend share buybacks in 2020 and 2021 in its commitment to maintaining strong ratings. That should give the company another $6 billion annually to repay debt, according to Moody’s analyst Richard Lane. Moody’s will likely downgrade IBM by one level to A2 upon the close of the acquisition, he said.
Instead of waiting until nearer the deal’s finalization to fund the deal, IBM may look to sell bonds sooner, especially if interest rates are expected to move higher, said Travis King, head of investment-grade credit at Voya Investment Management.
“Avoiding BBB ratings at this point is something that should give most investors comfort to plan a new deal for when it comes,” King said in an interview. “We haven’t had much tech issuance since the tax reform was announced, so there could be a reasonable amount of appetite for a single A tech name.”
JPMorgan is covering about 70 percent of the $20 billion bridge loan, according to people familiar with the matter, who asked not to be identified discussing private details. The deal comes with a $975 million breakup fee if Red Hat were to accept a higher offer or the transaction were terminated for certain other reasons, IBM said in the filing Monday.
In addition to issuing at least $20 billion of debt in public markets, Bloomberg Intelligence analysts said in a report Monday that IBM may also refinance outstanding debt. The expected new debt issuance was already pressuring prices on IBM’s existing bonds.
“The purchase of Red Hat for an enterprise value of about $34 billion, brings credit default swap and bondholder fears to fruition,” the BI analysts said. “We have consistently highlighted enhanced event risk as IBM’s revenue growth remains stymied and its stock continues to fall.”
S&P cited a debt load that will more than double to about 2.4 times a measure of earnings after the acquisition, in its ratings cut. Still, that leverage ratio should come down by 2021 to around two times debt to earnings before interest, tax, depreciation and amortization once the suspension of share buybacks takes effect, S&P said. Moody’s placed IBM’s A1 rating on review for downgrade, projecting that gross debt to Ebitda, or earnings before interest, tax, depreciation and amortization, will exceed three times upon the transaction closing in the second half of next year.
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