Credit ratings agency Standard & Poor's recently placed both Reynolds American (NYSE:RAI) and Lorillard (UNKNOWN:LO.DL) on negative credit watch. Essentially, this means that it could downgrade their credit ratings within the next few months.
However, both companies already have ratings of BBB- so the next level for them is 'junk' status. This would mean that both companies would essentially become speculative picks, suitable for only the most fool-hardy of investors .
In Wall Street terms, a move like this, where debt moves from investment grade to junk status, would brand these companies as 'fallen angels'.
On a more serious note, junk credit ratings would mean that Reynolds and Lorillard would be forced to pay more in order to borrow (higher interest rates). What's more, some funds would have to sell the debt and stock of Reynolds and Lorillard as they cannot hold companies with junk status within their portfolios.
Additionally, many investors would be forced to stay away from the two companies because most investors prefer to invest in companies with solid, investment-grade credit ratings. In other words, anything above the junk rating of BBB-.
But are Lorillard and Reynolds really junk companies?
What's the real deal?
According to market data services company Morningstar, on a trailing-twelve-month basis, TTM for short, Reynolds has 10.5 times coverage on its debt interest, in other words, the company earnings before interest and tax, cover interest costs 10.5 times, which does not signal much to be worried about.
However, over the past five years Reynolds' debt-to-equity ratio has jumped from 0.5 times to 1 times on a TTM basis; that's 25% growth per annum.
Lorillard, on the other hand, has seen its debt pile grow much faster. In fact it has doubled during the past four years and shareholder equity is now negative, so it is not possible to calculate a debt-to-equity ratio for Lorillard. Lorillard has been borrowing heavily during the past few years to finance its stock buyback program. Now, this is a good idea right now as the company is able to borrow the cash at low rates of interest, however, when interest rates rise, the company could have a problem on its hands.
Additionally, negative shareholder equity is usually considered to be a red flag when investing. As a measure, shareholder equity reveals what shareholders would be left with if all assets were sold and all debts were paid. In the case of negative equity, in theory, shareholders would own cash to the company's creditors, although as Lorillard is a limited company, this is not the case.
The company's debt-to-asset ratio has doubled from 50% at the end of 2010 to 100% at the end of 2013. More worryingly, Lorillard's interest coverage has eroded from 18 times at the end of 2010 to 11 times on a TTM basis.
Still, none of these figures suggest that either company is heading for the rocks. Indeed, the company is able to cover its debt interest and if worst comes to worst, the Lorillard can sell all of its assets to pay off its debts. This is unlikely to happen unless the company defaults, or cannot afford the interest on its debt, which is can.
Piling on the debt
It would appear that Standard and Poor's is worried about the acquisition of Lorillard by Reynolds. Lorillard's current market cap is $22.5 billion and unless a deal between the two companies is structured as a merger, Reynolds is going to struggle to find the cash.
However, it's unlikely that a deal will be structured as a merger. You see, Reynolds' largest shareholder is British American Tobacco, and a merger, where shares are issued instead of cash, would dilute British American's ownership.
On the other hand, if Reynolds were to borrow the $22.5 billion needed, the company's debt-to-asset ratio would explode to 160%, including acquired debt and assets. Moreover, interest of say 5% on $22.5 billion would cost Reynolds around $1.1 billion per annum, or 65% of net income. If Reynolds were forced to pay out 65% of its net income just to sustain its debt pile, it's likely that the company would have to slash its dividend payout.
Reynolds and Lorillard have been piling on the debt during the past few years but the companies cannot be considered junk at present. Indeed, both Reynolds and Lorillard can cover their interest costs and debt at the moment.
Nevertheless, if Reynolds were to swoop on Lorillard, acquiring its smaller peer with debt, the company could be headed for trouble.
Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.