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How We Assess a Company’s Credit Quality
We’re rolling out credit ratings on hundreds of companies. Once we’re done, we’ll cover the vast majority of significant corporate-bond issuers in the United States, along with a good number of European and Asian issuers. The credit ratings are flowing into Morningstar’s products, including Morningstar Principia, Workstation, and Office. To assign a credit rating to a company, we calculate four separate, forward-looking scores. This allows us to monitor changes in the credit quality of each company in four independent ways, some of which may flash red before others. Once we have four scores, a committee of five senior Morningstar analysts reviews the proposed rating. The committee will either vote to accept the proposed rating or vote to adjust it up or down. Companies earn scores in each of the following categories. Business Risk is our assessment of a firm’s inherent business characteristics. A differentiating factor among firms is how long they can earn high returns on capital and hold competitors at bay. Only firms with economic moats—something structural in their business models that rivals cannot easily replicate—can stave off competitive forces for a prolonged period. Other components of Business Risk include size (the larger the company, the less likely it is to succumb during difficult times), customer and product diversity (the more diversified a company’s revenues streams, the safer its bonds), and cyclicality (the less cyclical, the less likely is bankruptcy). We also take a company’s dependence on capital markets into account. As we saw during the financial crisis, if a company’s business depends on its ability to access capital markets, it will be in trouble when capital markets freeze. The Cash-Flow Cushion compares our projections of future cash flows on the one hand, with debt maturities, interest payments, pension contributions, and other financial commitments on the other. It takes into account our projections of free cash flow under various scenarios over the next five years. The greater the Cash-Flow Cushion, the less likely a firm will be forced to tap into the debt and equity markets at dilutive prices. The Solvency Score is a ratio-based scoring system that we developed through careful analysis of historical corporate bankruptcies. We consider the ratios that are the most predictive of bankruptcy in order to assess a firm’s financial strength, including the size of a company’s obligations relative to its assets and the firm’s debt load relative to its cash flow. In addition to examining these ratios in past years, our analysts forecast the cash flows we think a company is likely to generate in the current year. Distance to Default uses option-pricing theory to appraise the risk that a firm’s assets will turn out to be worth less than its liabilities. It’s an academically tested measure and a proven early indicator of financial distress. (Distance to Default also drives Morningstar’s Financial Health Grade for stocks.) We incorporate a market-based measure into the our credit ratings because markets are often a leading indicator of financial distress. In many cases, the stock price will reflect deterioration in a company’s credit strength well before it shows up in financial statements or in analyst forecasts.

million acquisition in 2012, creating another financial strain in our worst-case scenario.
Investment Rationale

50%-plus share of the process diagnostic and control market. Chipmakers rely on KLA’s tools to accelerate manufacturing to full production of new chip designs and factory startups.
Credit Rating Rationale

Valeant’s senior notes trade firmly in junk territory, at spreads significantly wider than our BBB2 credit rating implies. Just considering ongoing operations, we think credit spreads could tighten considerably. If the firm’s pipeline succeeds, spreads could tighten even further. Valeant’s major rating catalyst, retigabine, could receive word from the FDA in late 2010.

Morningstar’s A1 rating of KLA is a much more favorable view of the company’s creditworthiness than that held by the major rating firms. The firm is small and concentrated in the niche it serves, but we believe that its entrenched position with its customers and the feedback loop this creates reduces technology risk relative to other firms in the industry.
Investment Rationale

points greater yield than Treasuries, a solid return for a BBB credit, let alone an A rated issuer. The notes are callable, but only with a make-whole provision at the prevailing Treasury rate plus 50 basis points. In the event of a change of control that causes a rating downgrade, KLA is required to offer to repurchase the notes at 101% of par.

Actuant ATU BBB2
Business Risk Cash-Flow Cushion Solvency Score Distance to Default

KLA-Tencor KLAC A1
Business Risk Cash-Flow Cushion Solvency Score Distance to Default

Fair

Good

Fair

Background

Good

Background

KLA-Tencor KLAC occupies a sweet spot in the chip-equipment industry because of its

We think demand in the semiconductorequipment industry will rebound this year and into 2011. KLA-Tencor is among our favorites in the group. Its 2018 notes offer a very attractive relative yield, in our opinion. The firm’s 2018 notes offer more than 200 basis

Actuant is composed of seemingly unrelated businesses—hydraulic tools, actuation systems, and joint integrity services—glued together with deep distribution networks and a strong Asian sourcing group. These assets allow Actuant to develop and deliver products

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Morningstar Advisor - June/July 2010

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