Debt Issues: Interpublic fights to dig its credit rating out of junk

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At an investor conference last December, Interpublic Group of Cos. Chief Financial Officer Sean Orr vowed Interpublic had "a sacred commitment" to retain its investment-grade credit rating. Interpublic failed to keep that commitment, becoming the first major agency holding company to slump to junk.

Yet Interpublic's debt woes are fixable, and analysts say there is a good chance ratings will return to investment grade in the next year. Interpublic "more than likely" will rise above junk before its next debt issue comes due in September 2004, said Rao Aisola, managing director and head of convertibles research at Bear, Stearns & Co.

Such optimism assumes that Interpublic continues to pay down debt, new Chairman-CEO David Bell delivers on a corporate restructuring and the ad market and economy head north rather than south.

Lots of ifs. But despite the unwelcome image that comes from being cast off to the junk yard, the reality of Interpublic's debt situation isn't so bad. Using proceeds from the pending $425 million sale of NFO WorldGroup-due to be completed this summer-Interpublic expects to reduce debt to about $2.3 billion, putting borrowings below the most recent reported total debt of rivals Omnicom Group and WPP Group.

big three troubles

The big three credit agencies have all cut ratings of the big three ad agency companies. Early this decade, Interpublic and Omnicom shared a strong A rating at debt risk arbiter Standard & Poor's, with WPP two notches below. Today, McGraw-Hill Cos.' S&P and rivals Moody's Investors Service and Fitch Ratings rank Omnicom highest, followed by WPP and Interpublic.

The ranking is no surprise. In recent years, Omnicom has been the strongest and most consistent and Interpublic the weakest and least consistent performer. Ratings agencies-paid by debt issuers to grade credit worthiness so companies can borrow money-judge the relative risks as to which is mostly likely to repay debts.

In March, one day after Mr. Bell vowed to focus on the balance sheet and get credit and liquidity concerns "off the table," S&P downgraded its debt to speculative or junk status. S&P cited "operating performance challenges" and expectations of longer than anticipated turnaround.

On May 9, after Interpublic posted dismal first-quarter results, Moody's put Interpublic on review for possible downgrade to junk. Fitch moved its debt to junk May 14, citing weak performance and expectations that balance-sheet improvement this year "will be more limited than previously anticipated." Both S&P and Fitch have a longer-term "negative" outlook on Interpublic.

The grade assigned to Interpublic indicates the "possibility of credit risk developing" (Fitch) and "major ongoing uncertainties" (S&P). One serious unknown: Outcome of a Securities and Exchange Commission investigation that began after Interpublic last year disclosed improper bookkeeping and overstated revenue.

Interpublic became the first big agency holding company to be tarnished as junk by big ratings houses. (Debt-saddled Cordiant Communications Group is not rated by S&P, Moody's or Fitch.)

Interpublic has moved to resolve debt concerns by refinancing a long-term debt issue, renewing a short-term credit line and preparing to pay down debt with NFO proceeds. "We have made such great progress in addressing our balance sheet and liquidity issues that these concerns are substantially behind us," Mr. Bell said in a staetment. "I believe our credit ratings reflect the company's past problems more than they do the positive actions we've taken or our future prospects."

downplay

Mr. Bell downplayed downgrades in memos to employees, saying S&P was being "overly cautious." CIBC World Markets analyst David Doft said credit agencies were "overly reactive" following credit blowups at companies such as Enron and WorldCom.

Ratings houses have reason to be cautious. A record 16.4% of junk bonds defaulted last year, according to Fitch; junk defaults reached $188 billion in 2001 and 2002, exceeding all defaults from 1980-2000.

But factor out a corporate scandal (WorldCom, one-fourth of last year's default volume) and junk issues in two capital-intensive sectors (telecoms, 43.5% default rate; cable systems, 34.4% default rate), and the market doesn't look as bad. Last year, Fitch's default rate for broadcasting/media was a comparatively low 7.9%, including defaults at Sirius Satellite Radio and Ziff Davis Media.

Downgrades still exceed upgrades. But default rates started to fall last summer, and investors, searching for yield when interest rates and stock returns are low, decided the reward of higher interest rates was worth the risk of default.

"The worst of the defaults appear to be behind the market," said Mariarosa Verde, Fitch managing director-credit market research. "That's very attractive to investors." The result has been a boom in battered bonds; Bear Stearns' high-yield index is up 14% year to date while the Dow Jones Industrial Average is up 3%.

Investors this year have dumped twice as much money into junk mutual funds as into stock funds, according to funds tracker AMG Data Services. Junk investments carry both the risks of default and of price declines if interest rates rise. Many savvy investors say junk is now too pricey and argue the pool is getting junkier as riskier ventures find easy financing; Warren Buffett, one of last year's big junk-bond investors, stopped buying after prices shot up.

The junk market is far bigger today than when Michael Milken pitched low-grade bonds in the `80s. Junk ratings now are common; just 48.4% of corporate debt issuers were investment grade in 2000-02 vs. 68.2% in 1981-83, according to Forbes/Lehmann Income Securities Investor. In dollar terms, Fitch's Ms. Verde said 19% of U.S. corporate bonds are junk. On Ad Age's 100 leading national advertisers list, eight companies are below investment grade: Dillard's; Gap Inc.; Hyundai's Kia Motors Corp.; Kmart Corp.; Saks Inc; Vivendi Universal; WorldCom; and Yum Brands.

In broadcasting/media, Fitch shows 21.6% of bond holdings are junk; the sector includes Primedia, Sinclair Broadcasting and Interpublic. Interpublic is at the top of the junk heap, with ratings one notch below investment grade. It barely qualifies as "high yield"; one of its long-term bonds yields less than 7%.

Like rivals, Interpublic loaded on debt in the `90s as it piled on acquisitions. Interpublic in 1992 had $1.9 billion in revenue and $300 million in debt; 10 years later, it had $6.2 billion in revenue and $2.6 billion in debt.

bad buys

Interpublic made some bad buys, such as money-losing race tracks now on the block, and it will continue to pay for other deals. Interpublic will keep NFO's debt-$180 million when it bought NFO three years ago-after it sells the research firm.

Yet Interpublic's most pressing financial problem is weak revenue and profits. If Mr. Bell's restructuring can reduce costs without damaging the product and if Interpublic agencies generate more business, that could take care of debt concerns.

"The fundamental market position for the company is still good, and if they can get their operating performance in order, [Interpublic] can recover," said Albert Turner, a Fitch director who follows media and advertising. Mr. Turner is still cautious, noting Interpublic must re-establish credibility following multiple accounting restatements last year.

Merrill Lynch & Co. analyst Lauren Rich Fine, a long-time bear on Interpublic, said in a late May report that "the balance sheet is vastly improved" but continued to voice concerns about Interpublic's performance.

Even if Interpublic and the economy remain in a slump, the balance sheet should get stronger. First, the NFO sale will generate cash (albeit, less than hoped for). Second, it's unlikely Interpublic will try major acquisitions any time soon. Third, deferred payments on past acquisitions are winding down, freeing up cash.

coming due

Interpublic resolved much near-term uncertainty in March when it refinanced a debt issue, replacing it with $800 million in convertible notes due in 2023. Interpublic's next borrowings-$250 million-come due in September 2004. If Interpublic can improve its balance sheet and performance before then, it's conceivable the credit rating will be upgraded before Interpublic issues new debt.

In general, a junk bond rating raises the cost of borrowing as a company pays higher interest to reflect higher risk. For Interpublic, direct costs should be limited. Interpublic must pay an extra 1/4% interest on a credit line it renewed in May and will see that increase slightly if Moody's downgrades credit-but that may be moot since Interpublic hasn't drawn on that credit over the past year. Interpublic said there are no junk-related penalties or repayment triggers in other debt, though holders of the March note offering could convert notes into stock-diluting existing shares-if it suffers deeper junk downgrades.

Interpublic has plenty of liquidity, with untapped credit of $1.65 billion, so there's no question about its current ability to transact business. While advertisers should always be careful when passing media money through an agency, there's nothing inherent in the junk downgrade that should make clients or media concerned about doing business with Interpublic, said advertising attorney Doug Wood. "From a client standpoint, it's business as usual," said Mr. Wood, who represents Interpublic and the Association of National Advertisers but was offering his own opinion on how advertisers should view the downgrade.

To be clear, Interpublic has plenty of problems. It's likely this quarter to post the third loss in four quarters. It's betting on restructuring to improve margins and performance-two years after taking a $646 million charge for a restructuring that failed to improve overall margins and performance. And it faces the SEC investigation, an Internal Revenue Service audit and shareholder lawsuits.

The question is not whether Interpublic can get back to investment grade, but whether Mr. Bell can resolve the SEC matter and retain and gain clients while cutting costs. He insists Interpublic's financials will start looking up in the third quarter. "We are clearly a work in progress," he told analysts last month. "Understand that fully."

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