Ratings put the squeeze on cash: downgrades for Arrow and Avnet boost cost of borrowing capital - Moody's Investor Services and Standard & Poor's Ratings Services

Electronic News, Oct 14, 2002 by Heidi Elliott

In almost back-to-back decisions, Moody's Investor Services and Standard & Poor's Ratings Services (S&P) lowered their corporate credit ratings for top distributors Avnet Inc. and Arrow Electronics Inc. But Avnet got an additional-and unexpected-hit.

While the two leading distributors expected Moody's would downgrade their credit ratings (which it did-down two notches to Baa3), Avnet did not expect to garner a negative outlook. Moody's outlook for Arrow is stable. "Was I surprised? Absolutely," said Avnet CEO Roy Vallee.

S&P last week downgraded the companies' ratings, each to BBB-, with a negative outlook. The ratings for both distributors remain at investment-grade level. However, this is as low as investment-grade goes.

Lowered credit ratings mean a company will pay higher interest rates when it goes to the public debt market. Moody's cited concern about Phoenix-based Avnet's liquidity as the reason for its outlook, pointing to debt that matures next year.

"The negative outlook reflects concerns regarding [Avnet's] weak level of performance relative to debt levels combined with its usage of credit facilities or receivables securitizations that have very tight covenants or ratings triggers, which could potentially add some stress to its liquidity in slightly more severe conditions," Moody's said in announcing the downgrade.

The companies anticipated credit downgrades because overall market conditions remain weak and recovery did not return in the second half. "Nobody likes to be downgraded ... but it makes sense," said Robert Klatell, executive VP at Melville, N.Y.-based Arrow.

Though sales are down, Klatell noted Arrow has managed to adapt costs and that the company's balance sheet is strong. As of June 30, Arrow had $650 million in cash and had not borrowed any money from banks. The company has generated close to $2 billion in cash and lowered long-term debt. And during a downturn, distributors are not likely to seek additional credit.

"The downgrade was not unexpected ... we knew that Moody's was concerned about the impact on operating expenses of this downcycle," Klatell said.

"I understand the downgrade . . . we have not made a meaningful profit for five consecutive quarters," Vallee said. "I was surprised at the negative outlook and going down two [ratings] notches. And that they differentiated us from Arrow."

That is surprising to others, as well. Among their peers, the two distributors are often talked about as a single entity because of their similarities. Both are broad-line, global distribution companies and have swapped the No. 1 industry position. They are individually and collectively several times larger than the next closest competitors.

Though surprised, analysts do not believe Avnet is in dire straits. "They're just going to have to pay a little more in interest," said Robert Damron, senior VP of Equity Research at SWS Securities Inc. in Milwaukee.

Vallee took issue with Moody's assessment on its debt. Conceding that Arrow has more cash on hand than Avnet, Vallee argued that Avnet has less overall debt and more equity than its chief rival. Plus, Avnet has made strides to contain the damage wrought by this unexpected and prolonged downturn.

"We have reduced our expenses by 30 percent from their peak (in 2000). We have reduced working capital by 45 percent, and we have reduced debt by almost 50 percent during a time when sales have fallen 40 percent," he said. "I am extremely proud of what our team has done relative to the balance sheet."

In separate decisions, S&P had virtually identical conclusions about Arrow and Avnet. It cited the same concerns over each company's future, primarily the uncertain economic environment in electronics. It expects financials to continue to be weak for both in the near term but does not believe earnings levels will deteriorate materially from their current levels.

And, S&P left the door open for future downgrades on both companies' credit ratings should the market go even further south.

"We expect that profitability will improve over the intermediate term as industry conditions improve. But a material decline in debt protection measures in the near term, or the lack of profitability improvement over the intermediate term, could lead to a downgrade," S&P Credit Analyst Martha Toll-Reed said of Arrow.

Of Avnet, she said, "We expect that Avnet will refinance its near-term debt maturities in a timely manner ... however, a material decline in debt protection measures in the near term or the lack of profitability improvement over the intermediate term could lead to a downgrade."