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Managing The Red Ink

Aburdensome debt load can restrict companies from making acquisitions; undertaking needed capital expenditures; borrowing cheaply; and, in the long run, …

Aburdensome debt load can restrict companies from making acquisitions; undertaking needed capital expenditures; borrowing cheaply; and, in the long run, satisfying shareholders. How can a company best decrease debt? There are three basic approaches: divestiture, issue new equity and/or refinance debt, or spend out of cash flow. Within the three approaches, there is a lot of leeway. Sometimes companies can catch the right cycle, while others struggle against an economic tide. It often takes a combination of operational changes and good timing in the economic cycle to reduce debt smoothly.

Consider Asarco, a $3.2 billion New York-based mining company, and Los Angeles-based Kaufman & Broad Home Corp., a $1.4 billion homebuilder. Both are attempting to reduce debt. Both have made a major acquisition in the midst of their debt-reduction programs. But only one so far has successfully reduced debt. Since 1985, Asarco has been transforming itself from a custom smelting and refining company to an integrated mining company. The change required a significant capital expenditure of about $425 million, mostly financed through debt. Early in 1994, Asarco’s debt-to-capital ratio reached 40 percent, a level at which the company wasn’t comfortable-and nor were the rating agencies. With a credit rating of BBB, Asarco was still investment grade, but a further decline in rating could be expensive in the financial markets. So Asarco devised a long-term target of a 25-percent debt-to-capital ratio. “The most obvious way to do that was to generate cash from operations, and, of course, we had good metal prices during that period,” notes Kevin Morano, Asarco’s CFO. “But to further reduce debt we had to undertake special programs.” Asarco concentrated on improving cash flow to pay down debt, and divestiture. Asarco changed operations by better managing inventory and reducing stocks. In 1995, however, the company increased its interest in Southern Peru Copper, paying $116.4 million for an additional 10.7 percent interest in the company. Offsetting the purchase, Asarco from 1993 through 1995 disposed of nine separate businesses and operating units, realizing a gain of $185 million in cash. The company’s biggest divestiture came this spring, when it sold its 15 percent stake in Australian mining concern M.I.M. Holdings for $331.2 million. Most of the proceeds from the M.I.M. sale are being used to trim debt, taking it down from $1.2 billion to $833 million, adding 20 cents a share from interest savings to its annual results. Money allotted for interest and debt repayment now can be used elsewhere.

At the end of the first quarter, Asarco’s debt-to-capital ratio was 34.8 percent, and with the recent divestiture, that ratio has fallen to 28.3 percent.

Wandering away from its long-term goal of restoring its debt-to-capital ratio of 50 percent to 60 percent is Kaufman & Broad. Unlike the mining industry, homebuilding has been at the bottom of the cycle. But K&B is transforming itself from a California home-builder to a regional builder with operations throughout the West. K&B last March paid $104 million to buy San Antonio-based homebuilder Rayco Ltd. At the end of the first quarter, K&B’s debt inched up to 63 percent and probably will be higher by the end of the second quarter. Debt at the end of the first quarter for K&B totaled $692 million. And while the company is shooting to reduce debt by $100 million (the amount paid for Rayco), K&B’s internal goals are more ambitious. “Fundamental K&B strategies include maximizing our return on investment and reducing our risk profile,” says Bruce Karatz, chairman and chief executive. “Lowering interest expense helps maximize return, and we can redeploy resources to strong markets that will reduce our reliance on California.” K&B will try to attain its goals through divestiture and improved cash flow by selling larger tracts of raw land, and significantly changing its operations. It will be moving from a “spec” homebuilder to a “presold” developer. At the beginning of the year, 70 percent of its houses were spec. The company will attempt to bring that percentage down to 30 percent.

“It is kind of a neat trick,” says Michael Henn, K&B’s CFO. “But at the end of the day, we should wind up with lower total investment, because for the most part, the investment we have is selling houses and that will wash off the balance sheet as soon as the homes are finished.” Fortunately, the housing industry is expected to rebound in California, and K&B should catch the upward movement in the cycle.

There are no magic numbers when it comes to debt, says David Eisinger, a senior vice president with Duff & Phelps, although his firm sees many companies that like to keep the leverage ratio in the 40 percent to 50 percent range. “In the 1990s, we are seeing more focus on maintaining a strong capital structure, refocusing on core businesses, and strengthening credit.”

Steve Bergsman is a Mesa, AZ-based freelance business writer who has written about corporate finance for Reuters, Barron’s, Global Finance, and Corporate Finance.

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