Daily briefing: Wednesday - Towergate playing a risky game

Towergate has received yet another piece of bad news about its financial position, with rating agency Fitch threatening to downgrade the firm’s already sub investment-grade issuer default rating (IDR) of B if it can’t reduce its debt-to-profit ratio over the next 18-24 months.
 
Issuer default ratings basically describe how likely a company is to default on payments to its bond investors. Receiving a B rating by no means suggests a default is imminent or inevitable, but neither is it particularly reassuring: Fitch describes a B rating as “highly speculative”, saying that there is a material risk of default, but that a limited safety margin remains.
 
A downgrade to B- would put Towergate dangerously close to the CCC category where, according to Fitch “default is a real possibility”.
 
Why the threat of a downgrade?

Simply put, the problem is that Fitch gave Towergate its B IDR on the understanding that its profits would grow faster, thus reducing level of debt relative to profits.

But that didn’t go according to plan. Tough market conditions and Towergate’s need to invest constantly to stay ahead of the game have conspired to erode its EBITDA in 2011, making the debt as a proportion of EBITDA bigger.
 
To recap, Towergate’s EBITDA for the first nine months of 2011 was £100.2m, 9% down on the £109.7m it made in the comparable period of 2010.

Fitch had expected Towergate’s debt to be 5.8 times EBITDA by now, but it is 6.6 times.
 
Defensive position

Towergate has, understandably, responded strongly, acknowledging Fitch’s assessment but insisting that the company is financially sound and that its rating is in line with other rated brokers.
 
It is important to remember, of course, that Towergate’s business model is deliberately debt-heavy. It is also a perfectly acceptable strategy to use debt, rather than internal funds, to finance activities. As long as you can continue making interest payments, and banks and others are still willing to lend, there is little to fear.
 
Towergate’s interest coverage ratio (how many times EBITDA exceeds interest payments – a measure of a company’s ability to meet interest payments) was a just-acceptable 1.5 times for the first nine months of 2011, although this has deteriorated from 1.7 times in the same period of 2010.
 
While Towergate may argue that Fitch’s announcement is to be expected in the current environment, and is nothing new, it serves to highlight the danger of having a highly leveraged (read: debt-laden) operating structure in times when revenue growth is hard to come by.