International Business Machines Corp. (IBM) 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 company's acquisition of Red Hat, for $33 billion, will be the world's second-largest technology deal ever and will boost IBM's credentials in the fast-growing and lucrative cloud market. The transaction will also take IBM's debt load close to $80 billion, according to Bloomberg Intelligence analysts Robert Schiffman and Mike Campellone. IBM will use cash from its more-than $14 billion pile, as well as debt sales, to fund the deal, it said in a statement announcing the deal Sunday.
Still, those measures didn't allay debtholder concerns about the company taking on more debt. IBM's bonds fell Monday morning, with its $650 million of 4.7 percent bonds due 2046 sliding the most since April as investors demanded more yield. The cost to insure IBM's debt against default for five years jumped 6.6 basis points to 52.125 basis points, the highest since December 2016, according to data provider CMA. S&P Global ratings cut IBM's rating one notch to A and Moody's Investors Service put it on review for a downgrade.
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IBM wants to eschew the route taken by many companies that sacrificed strong credit ratings to pursue large-scale mergers and acquisitions that left them with lower, triple-B rankings, according to S&P analyst David Tsui.
“The ratings are very important to them—their competitors in IT services are all rated A or higher,” Tsui said. Debt issuance will be “substantial,” but with more than $6 billion in projected free cash flow, the company won't have to go as close to funding the whole deal with debt, according to Tsui.
A spokesman for IBM pointed to the firm's strong free cash flow and that the deal is accretive from the first year. He acknowledged the ratings agency moves, adding that IBM remains in “solid investment-grade territory.”
Bloomberg Intelligence analysts said in a report Monday that IBM may issue at least $20 billion of debt to fund the acquisition. Other estimates went higher: Bond research firm CreditSights said it may sell about $25 billion of debt for the purchase. Whatever the amount, it's already pressuring ratings and prices on outstanding debt.
“The purchase of Red Hat for an enterprise value of about $34 billion, brings credit default swap and bondholder fears to fruition,” the Bloomberg Intelligence analysts said. “We have consistently highlighted enhanced event risk as IBM's revenue growth remains stymied and its stock continues to fall.”
In its ratings cut, S&P cited a debt load that will more than double, to about 2.4 times a measure of earnings, after the acquisition. Still, the ratio should come down by 2021 to debt of two times earnings before interest, tax, depreciation, and amortization (EBITDA), 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 will exceed three upon the transaction closing in the second half of next year.
From: Bloomberg
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