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Downgraded: Triple-A Credit Ratings

You would think that almost all self-respecting blue-chip companies would need and want a top-of-the-line AAA credit rating, right? Not necessarily. Today, only seven businesses in the nonfinancial industries -- Johnson & Johnson (JNJ), Pfizer (PFE), General Electric (GE), Merck (MRK), United Parcel Service (UPS), Exxon Mobil (XOM), and Automatic Data Processing (ADP) -- hold the coveted triple-A rating from rating agency Standard & Poor's (which, like BusinessWeek Online, is a unit of The McGraw-Hill Companies).

That's down by a third from 20 years ago, when Procter & Gamble (PG), 3M (MMM), Coca-Cola (KO), and IBM (IBM) enjoyed the top rating. And it's half the number from the 14 outfits, including Mobil, BellSouth (BLS) and Bristol-Myers Squibb (BMY), with triple-A ratings at the end of 1994.

The list continues to dwindle. On Nov. 2, Standard & Poor's Rating Services placed Merck's triple-A corporate credit rating on watch with negative implications after the pharmaceutical concern revealed more on its probe into what it knew and when about problems with arthritis drug Vioxx.

What happened? Credit ratings are a gauge of a company's ability to repay debt on time. The higher the rating, the lower interest rate the company has to pay. Have all these businesses fallen from grace? Since cash flows determine the ability to repay debt, do these outfits have cash issues?

Well, the answers aren't that simple. BusinessWeek Online's Pallavi Gogoi, spoke with Nicholas Riccio, S&P's managing director for corporate ratings, about the rationale behind the changes on the corporate-debt front. Here are edited excerpts of their conversation:

Q: How important is the triple-A rating?

A: In days past, the symbol of that rating was important for a good number of corporate issuers. Twenty five years ago, most companies aspired to that level of rating. And a single-A would have been unacceptable to them.

Q: So, why is anything lower acceptable today? What happened?

A: The business environment is a lot more complex today. The CEO or senior finance manager has a broader-based constituency to deal with. Creditors may have been given certain preferences and higher priority in the scheme of things. But the shareholder revolution of the 1980s changed the way executives at companies think about their finances. Today companies are much more shareholder-oriented. And the number of triple-As is not even a percentage of our total rated universe.

Q: What has changed in the outlook of companies?

A: In 1980 there might have been about 30 triple-A-rated corporations in America. But many of them embarked on higher-risk business strategies, which weren't consistent with a triple-A rating. Others were caught in a rapidly changing business environment. And still others acquired companies to step up growth.

Previously, their constituency was banks and bondholders. Look at who was triple-A back then -- P&G, Coca-Cola, AT&T (T), Campbell Soup (CPB). It was part of their cultural milieu that being at the top of their game, a triple-A rating was a reflection of that. It's not like they had much to benefit from that rating [because] they didn't need to borrow as much. But in their dealing with bankers it represented their station in life.

Some companies managed to have ample financial resources even as they grew. Look at GE, which managed to grow year after year and satisfy everybody -- and also maintain a triple-A rating.

Q: GE needs the triple-A rating because it borrows more, no?

A: GE would agree with that. GE probably borrows more than some of the other former triple-As. P&G or Campbell, for instance, might not have had similar borrowing needs. But later they borrowed to acquire other companies. For instance, General Foods acquired Oscar Meyer and lost its triple-A. Other companies, like Kellogg (K) borrowed more to achieve other goals. Around 1984, Kellogg borrowed to buy back a huge amount of stock and lost its triple-A rating.

Q: Did globalization affect this process?

A: If you look at history, General Motors (GM), Ford (F), and Eastman Kodak (EK) all lost their ratings because the business environment changed, and their business models no longer worked. The competitive dynamics in the global market changed, and their previous rate of success didn't translate in the new world.

Q: You mentioned that some companies didn't necessarily need the rating anymore?

A: Yes, companies like Coca-Cola and P&G became very aggressive financially. And Federated Department Stores (FD) acquired other stores. These were strategic business decisions which matched their priorities, such as growth.

Q: How much do borrowing costs go up typically when a company's credit rating is downgraded?

A: On average, a one-notch downgrade would add about 10 to 15 basis points to a company's financing costs.

Q: So, companies are willing to bear that slightly higher cost of capital for other gains.

A: Yes, sometimes you have to take on new risk to achieve your full potential growth. Companies weigh their options and the cost for those options, and a lower rating when measured against other inputs makes sense for them.

Q: What was the last big downgrade?

A: Royal Dutch Shell lost its triple-A in January, 2004. Bristol-Meyers lost its rating in July, 2002, and now we have Merck on watch.

Q: Do any companies regain the badge of honor?

A: Kellogg is the only company in recent memory that made it back. After losing it in 1984, the company had three years of tremendous growth and gained back the triple-A, only to lose it later on. And AT&T was a former triple-A-rated company that's not even investment-grade at this point.

Keep in mind that the overall attitude in Corporate America has changed. The symbolic value of triple-As has changed. There has been a fundamental shift in attitude toward credit quality in the last couple of decades. The most pervasive ratings are in the universe of single-As to triple-Bs.

Q: So, money managers have companies with worse credit profiles to choose from for their portfolios.

A: Much of Corporate America is below investment-grade today. It's easy for middle-market companies to access capital markets. And how people view credit quality has also changed. There's a lot of money to invest in low-rated, high-yield debt.

I would say that in the 1980s, when investment-grade companies were doing leveraged buyouts and were downgraded, there was a lot of resistance from unhappy investors. Now it's less of an issue because most of these companies doing leveraged buyouts are already below investment-grade.

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