So, the next domino falls in the Pan-European Sovereign Debt Crisis. As has been the casse for much of the Asset Securitization Crisis and the Pan-European Sovereign Debt Crisis, the ratings agencies have arrived to smoldering pile of ashes littered with charred bones and remnants of the putrid smell of burnt flesh with a fire hose and a megaphone yelling "Get out! We have word there may be a fire here!"

From Bloomberg: Ireland Debt Rating Cut to Junk, Adding Pressure for EU to Contain Crisis:

Ireland joined Portugal and Greece as the third euro-area nation to have its credit rating reduced to below investment grade as European Union finance ministers struggle to contain the region’s sovereign-debt crisis.

Moody’s Investors Service cut Ireland to Ba1 from Baa3, citing the probability that the country, which received a bailout last year, will need additional official financing and for investors to share in losses before it can return to the private market to borrow. The outlook remains “negative,” Moody’s said in a statement late yesterday.

Irish bonds dropped for a sixth day today after the downgrade, which came after European finance ministers failed to present a solution to the contagion that’s threatening to spread to Italy from the so-called peripheral euro-area states. Ireland’s debt agency said the downgrade will make it “more difficult” for Ireland to return to the market next year.

While Ireland “has shown a strong commitment to fiscal consolidation and has, to date, delivered on” the terms of its bailout, “implementation risks remain significant,” Moody’s said in the statement.

Irish 10-year bonds fell, pushing the yield on the debt up 31 basis points to 13.65 percent. The premium over German bunds widened 32 basis points to almost 11 percent. Italian yields were at 5.47 percent after surging above 6 percent earlier this week. The euro, which dropped to a four-month low against the dollar yesterday, rose 0.5 percent to $1.4049 as of 9:06 a.m. in London.

Debt Markets

Irish Finance Minister Michael Noonan had said he hoped to be able to sell debt again next year. That may now be less likely, according to the country’s debt agency.

“The action by Moody’s will make it more difficult for Ireland to access the market next year, that is certainly the case,” Oliver Whelan, head of funding at the National Treasury Management Agency in Dublin, said on RTE radio today. “Ireland does deserve a higher than junk status from the agencies.”

Ireland, which had a top Aaa rating just over two years ago, has suffered after a real-estate boom collapsed, fueling bank bailouts and a surge in the country’s debt.

As he tries to regain the confidence of investors, Noonan said this month that he may seek a bigger budget correction than the 3.6 billion euros ($5.1 billion) planned for 2012 to ensure deficit targets are met. In Spain, Finance Minister Elena Salgado said yesterday the nation might need to endure even deeper spending cuts next year than currently planned.

‘Evolving Approach’

The NTMA said in a statement that “the situation in the euro area is evolving rapidly” and noted that Moody’s cited the decision was “primarily driven by their concern about the prospect of private investor participation in future financial support programs in the euro area.”

European finance ministers have discussed a plan to roll over Greek debt with the participation of private bondholders. Ratings companies had said that could be a “selective default,” something that the European Central Bank opposes.

“In the end, these kind of discussions and the evolving approach just reflect uncertainties that weigh on the creditworthiness of countries that are dependent currently on support,” Dietmar Hornung, a senior credit officer with Moody’s in Frankfurt, said in a telephone interview yesterday. “We also decided to keep the negative outlook just to reflect the implementation risk, but also to reflect the shifting tone among EU governments toward the conditions under which support to a distressed euro-area sovereign will be made.”

Irish Bailout

Ireland was forced to seek an 85 billion-euro rescue from the European Union and the International Monetary Fund in November as a banking crisis overwhelmed the government.

The European Commission in Brussels said the downgrade “contrasts very much” with recent economic data and the “determined implementation of the program by the Irish government.” The Irish program is “fully on track,” it said.

Moody’s rationale for cutting Ireland echoed its review of Portugal, which was lowered to junk on July 5. European leaders may hold an extraordinary summit in two days in another attempt to stem the debt crisis, Greek Finance Minister Evangelos Venizelos and Irish Prime Minister Enda Kenny said separately yesterday.

Standard & Poor’s cut Ireland’s rating one level to BBB+ with a “stable” outlook on April 1. Fitch Ratings affirmed Ireland’s BBB+ rating on April 14 and removed it from “rating watch negative.” It said the outlook is negative. Both firms’ ratings are three levels above junk.

Ireland’s debt will rise to 118 percent of GDP in 2012 from 25 percent at the end of 2007, the European Commission has forecast. Taxpayers have pledged as much as 70 billion euros to shore up the country’s debt-laden financial system.

“Things need to get worse before they get better,” said Steven Lear, deputy chief investment officer at J.P. Morgan Asset Management’s Global Fixed Income Group in New York, who helps oversee $130 billion in assets. “There has to be a lot of pain before the alternative of pain seems palatable.” 

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This is a free addendum to the post: On Shorting Stocks, Double Dips and the UAL/CAL Merger.

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Free and Retail subscribers should strongly consider upgrading to access our Premium Pro and Institutional Content (much more dense and informative). The subscription addendum to this is the product of exhaustive research (about a 1 and 1/2 man/months) to whittle this list of over 1,400 companies down to 7 who will make the most profitable short candidates. The professional and institutional level subscriptions will include full forensic analysis of those companies as well as the results from our financial short list as well.

The professional and institutional level subscriptions will include full forensic analysis of those companies as well as the results from our financial short list as well as an upgraded version of the shortlist that contains 33 companies and computed metrics for:

• Valuation
• Solvency
• Growth
• and other ratios.

Professional subscribers can access an expanded list of 33 companies here and institutional subscribers can access the expanded list here.

This is the Pro and Institutional subscription addendum to the post: Non-Financial Companies to Short in 2010.

Following are the key weak points of the six analyzed companies (for subscribers only):

• GET US equity – The Company is in hotel business and is witnessing sharp declines in sales. The sales declined 5.6% in 2009 and the analysts are expecting a further y-o-y decline of 17.3% in 2010. The interest coverage is extremely low at 1.11x based on the annualized interest expense in 2010 and TTM EBITDA. Looking at the  debt maturity schedule, there are no maturities till July 2012. The valuation is also stretched with the company trading at EV/EBITDA (2010e) of 19.9x.The stock has increased nearly 103% in the last one year
• USG US equity – We covered this company earlier and we have again shortlisted this company owing to extremely weak fundamentals. The company continues to record sharp decline in sales with y-o-y decline of 29.8% and 17.1% in 2009 and 1Q10 respectively. The TTM EBITDA margin has been declining and became negative in 1Q10. While the company has no major debt maturity till 2014, the negative operating cash flows require financing which might become a concern amid the weak fundamentals. The weak fundamentals also undermine the valuations. The company is trading at EV/EBITDA (2010e) of 42.2x. The stock has increased nearly 51.5% in the last one year.
• GGC US Equity – The Company is a chemical manufacturer and has recorded sharp decline in sales and EBITDA in 2009. While the sales have picked up in 1Q10, the margin continues to decline. In 1Q10. While the sales grew nearly 55% (y-o-y), EBITDA grew just 3.0% (y-o-y). On TTM basis, the EBITDA margin has come down to 6.6% in 1Q10 against peak of 8.0% in 3Q09. The interest coverage on TTM basis has improved to 2.05x against 1.11x in 2009 largely owing to decline in interest expense resulting from conversion of large chunk of debt into equity. While the company’s interest coverage is stable at these levels and the company has no major maturities till 2013, the debt ratios are extremely high. Net Debt to market cap is 129% and Net debt to common equity is 198%. Another noteworthy weakness of this company is the lack of cash generation from operating activities owing to increasing working capital needs over the last one year. Receivables and inventories amounted to nearly 33.1% of the total assets against 22.9%, year ago. Total working capital has increased to 43% over the last three quarters.  The company is trading at EV/EBITDA (2010e) of 8.4x. The stock has increased remained flat over the last one year.
• SFD US Equity – We covered this company earlier and we have again shortlisted this company. While the sales have picked up and margins are improving, the interest coverage continues to remain depressed. Base on annualized interest expense of 1Q10 and consensus estimates for EBITDA in 2010, the interest coverage is 1.5x. The company is trading at EV/EBITDA (2010e) of 13.7x. The stock has increased nearly 64.7% in the last one year.

The other last comp – STON is a small company with float of less than 15 million shares and is involved in cemetery business. The primary concern for STON is very low interest coverage which hovers around 1.0x in 2009 and 2010.

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Retail subscribers should strongly consider upgrading to access our Premium Pro and Institutional Content (much more dense and informative). The subscription addendum to this is the product of exhaustive research (about a 1 and 1/2 man/months) to whittle this list of over 1,400 companies down to 7 who will make the most profitable short candidates. The professional and institutional level subscriptions will include full forensic analysis of those companies as well as the results from our financial short list as well.

The professional and institutional level subscriptions will include full forensic analysis of those companies as well as the results from our financial short list as well as an upgraded version of the shortlist that contains 33 companies and computed metrics for:

• Valuation
• Solvency
• Growth
• and other ratios.

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Complete smartphone component vendor list, shortlist, and selection criteria for professionals and institutions.

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The free preview of the Mobile OS Market Share Model

Other relevant links of interest:

Subscription Content (click here to subscribe):

• Google Valuation Model (pro and institutional)
• Google Final Report
• An Analysis and Valuation of Google’s Android and AdMob.
• Smartphone Market Model – Blog Download Version – all paying subscribers
• Mobile Operating System Market Share Model – all paying subscribers – This model is key to showing the trends across operating systems, and not just handset manufacturers.
• Google Q3 2010 review for all paying subscribers
  

• Apple business model note (1.7 MB 2010-08-02 12:09:55)

Free Content:

1. Google’s 3rd Quarter Operating Results: The Foregone Conclusion That Was Amazingly Unanticipated by the Street!!! Monday, November 8th, 2010 and 
2. A Glimpse of the BoomBustBlog Internal Discussion Concerning the Fate of Apple
3. There Is Another Paradigm Shift Coming in Technology and Media: Apple, Microsoft and Google Know its Winner Takes All
   
4. The Mobile Computing and Content Wars: Part 2, the Google Response to the Paradigm Shift
   
5. An Introduction to How Apple Apple Will Compete With the Google/Android Onslaught
   
6. A First in the Mainstream Media: Apple’s Flagship Product Loses In a Comparison Review to HTC’s Google-Powered Phone
   
7. Android is gaining preference as the long-term choice of application developers
   
8. A Glimpse of the BoomBustBlog Internal Discussion Concerning the Fate of Apple
   
9. Math and the Pace of Smart Phone Innovation May Take a Byte Out of Apple’s (Short-lived?) Dominance
   
10. Apple on the Margin
    
11. RIM Smart Phone Market Share, RIP?
    
12. Android Now Outselling iOS? Explaining the Game of Chess That Google Plays in the Smart Phone Space
    
13. How Google is Looking to Cut Apple’s Margin and How the Sell Side of Wall Street Will Enable This Without Sheeple Investor’s Having a Clue
    
14. Empirical Evidence of Android Eating Apple!
    
15. More of the Android Onslaught: Increasing Handset Revenues and Growth
    
16. Many More Black Eyes for the Blackberry? A Complete Forensic Analysis of Research in Motion
    
17. The BoomBustBlog Multivariate Research in Motion Valuation Model: Ready for Download
    
18. The Complete, 63 pg Google Forensic Valuation is Available for Download
    
19. iSuppli Continues to Validate BoomBustBlog’s Original Thesis: Android as the Viral Game Changer!
    
20. BoomBustBlog Research Hits Another One Out the Park! Google up nearly 10% after hours, true blowout earnings unlike JPM
    
21. As I Warned in June, DO NOT DISCOUNT Microsoft in This Mobile Computing War! Their Marketing Campaign is PURE GENIUS! and it Appears as if the Phone Ain’t Bad Either
    
22. Reggie Middleton Wasn’t the ONLY Openly Apple Bear in the Blogoshpere, Was He?
    
23. A Quick Peek Into the REAL WORLD Logic That Went Into Building the BoomBustBlog Apple Model: It’s Called Compression!!!
    
24. Goldman’s $430 Target, Screaming Buy On Apple At Its All Time High Is In Direct Contravention To Reggie Middleton’s Logic – Who’s Right? Well, Who Has Been More Right In The Past?
    

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In "With the Euro Disintegrating, You Can Calculate Your Haircuts Here",  I explicitly illustrated the likely loss to principal of sovereign debt investors who would be forced to take haircuts "for the cause". While we fully stand behind the calculations and the logic, chances are several sovereigns may attempt to undergo sleight of hand in order to placate investors as best they can. We suspect we will soon be hearing of significant restructuring plans in the Eurozone, starting with Greece. The piece below expands on these thoughts and offers subscribers live spreadsheets that illustrate the potential repercussions. It is recommended that these scenarios be taken into consideration in light of the info offered in the post "Introducing The BoomBustBlog Sovereign Contagion Model: Thus far, it has been right on the money for 5 months straight!" and compared to the haircut analysis as well. All paying subscribers are welcome to review our analytical overview of Greece's public finances (Greece Public Finances Projections) as well as the full Pan European Sovereign Debt Crisis analysis which is freely available to everyone.

Greek Restructuring Scenarios

There are several precedents of sovereign debt restructuring through maturity extension without taking an explicit  haircut on the principal amount, and many analysts are predicting something of a similar order for Greece. This form of restructuring is usually followed as a preemptive step in order to avoid a country from technically defaulting on its debt obligation due to lack of funds available from the market. It primarily aims to ease the liquidity pressures by deferring the immediate funding requirements to later periods and by spreading the debt obligations over a longer period of time. It also helps in moderating the increase in interest expenditure due to refinancing if the rates are expected to remain high in the near-to medium term but decline over the long term.

However, the two major negative limitations of this form of restructuring if applied to Greek sovereign debt restructuring are –

• It solves only the liquidity side of the problem which means that the refinancing of the huge debt (expected to reach 133% of GDP by the end of 2010) will be spread over a longer time period while the debt itself will continue to remain at such high levels. The sustainability of such high debt level, which is growing continuously owing to the snowball effect and the primary deficit, is and will continue to be highly questionable. Greek public finances are burdened by a very large interest expense which is approaching 7% of GDP. The government’s revenues are sagging and the drastic austerity measures need to first bridge the huge primary deficit (which was 8.6% of GDP in 2009), before generating funds to cover the interest expenditure and reduce debt.

Thus, even though the amount of funds required each year to refinance the maturing debt will be reduced by extending maturities, the solvency and sustainability issues surrounding Greece’s public finances, which were the primary reasons for it’s being ostracized from the market in the first place, will remain unanswered.

• It will lead to a very material decline in present value of cash flows for the creditors since the average coupon rate is lower than the cost of capital (reflected by the yields on the Greek bonds). The average coupon rate for bonds maturing between 2010 and 2020 is about 4.4% while the average benchmark yield for bonds with maturities from 1-10 years is nearly 7.5%. Also, as the maturity of the debt is extended, the risk increases and so does the cost of capital.

In order to assess the effectiveness of this form of restructuring for Greek sovereign debt, we have built three scenarios in which the maturities of the Greek debt is extended. These scenarios weren’t designed to be exact predictions of the future but to represent what may happen under a variety of highly likely scenarios (a pessimistic, base and optimistic case, so to say):

• Restructuring 1 – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having same coupon rate but double the maturity.
• Restructuring 2 – Under this scenario, we assumed that the creditors with debt maturing between 2010 and 2020 will exchange their existing debt securities with new debt securities having half the coupon rate but double the maturity.
• Restructuring 3 – Under this scenario, the debt maturing between 2010 and 2020 will be rolled up into one bundle and exchanged against a single, self-amortizing 20-year bond with coupon equal to average coupon rate of the converted bonds.

In all the three scenarios, we computed the total funding requirements and compared the same with funding requirements prior to restructuring. It is observed that restructuring will help in easing the immediate pressure of procuring funds to meet the huge funding requirements lined up in the next 5 years. However, it will also lead to substantial loss to creditors in the form of erosion of present value of cash flows. (Discount rate was the benchmark yields of Greek government bonds for similar maturity period).

• Under restructuring scenario 1, the decline in present value of cash flows is 9.3% and the cumulative funding requirements between 2010 and 2025 reduces to 155.2% of GDP from cumulative funding requirements of 177.7% of GDP if there is no restructuring. The cumulative new debt raised will decline to 78.6% of GDP from 80.7% of GDP if there is no restructuring
• Under restructuring 2, where the doubling of maturity is also accompanied by halving the coupon rate, the decline in present value of cash flows is 26.3% and the cumulative funding requirements between 2010 and 2025 reduces to 116.9% of GDP. The cumulative new debt raised will decline to 40.3% of GDP
• Under restructuring 3, the decline in present value of cash flows is 18.0% and the cumulative funding requirements between 2010 and 2025 reduce to 131.5% of GDP. The cumulative new debt raised will decline to 69.0% of GDP.

We have also built in the impact of EU/IMF assistance to demonstrate the impact on funding requirements over the period 2010-2025. We assume that IMF/EU will disburse the entire assistance of EUR 110 billion by 2013. The IMF loans will have to be repaid after 3 years from the disbursement date and the payment will be distributed over the next two years. The EU loans will have to be repaid after 3 years from the disbursement date and the payment will be distributed over the next five years. It is observed that IMF – EU assistance will be just a short term relief and Greece will face the pressure when it will be forced to turn to the market to not only fund its maturing debt but also repay EU-IMF loans.

Conclusion – It is seen that the restructuring by maturity extension will marginally moderate liquidity concerns. But the primary and the more fundamental concerns about the high level of debt and the related refinancing and interest rate risks, the huge interest burden, the poor primary balance will be left unresolved by this form of restructuring. The revenues are weak and expenditures are high resulting in huge primary deficit and the government need to first fill this huge gap before it earns a primary surplus to cover the interest expense and reduce debt levels.

The government debt currently stands at 124.5% of GDP and is expected to balloon to 156.1% of GDP owing to lack of funds from primary balance to cover the interest expenditure which continues to add to the government debt levels. The three scenarios built for maturity extension show that maturity extension will not substantially help this issue to contain the ballooning government debt. Under restructuring 1, 2 and 3, the government debt is expected to stand at 154.4%, 123.7% and 147.0% of GDP at the end of 2025.

Disclaimer

Reggie Middleton, LLC's Boom Bust Blog analysis and conclusions in this presentation are based on publicly available information. Reggie Middleton, LLC recognizes that there may be confidential information in the possession of the Companies discussed in the presentation that could lead these Companies to disagree with Reggie Middleton LLC's conclusions. The analyses provided may include certain statements, estimates and projections prepared with respect to, among other things, the historical and anticipated operating performance of the Companies. Such statements, estimates, and projections reflect various assumptions by Reggie Middleton, LLC concerning anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. No representations express or implied, are made as to the accuracy or completeness of such statements, estimates or projections or with respect to any other materials herein. The content herein is not, and should not be considered, investment advice of any form or fashion. Users of this content agree to hold harmless and indemnify BoomBustBlog, Reggie Middleton, LLC and its agents, contractors, members, employees and associates against any action that may occur out of the use of this material.

Actual results may vary materially from the estimates and projected results contained herein. Reggie Middleton, LLC and its affiliates may own investments that are bullish or bearish on the subject entity in this material. These investments may include credit-default swaps, equity put or call options, warrants and short sales of common stock. Reggie Middleton, LLC is in the business of trading - buying and selling - public and private securities. It is possible that there will be developments in the future that cause Reggie Middleton, LLC to change its position regarding the Companies and possibly increase, reduce, dispose of, or change the form of its investment in the Companies.

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