Managing Interest Rate and Currency Exposure

The Company

XYZ Company is a public company and is a leading global producer, designer and supplier of engineered aerospace components, systems and subsystems. The company has very high profit margins with EBITDA margins as high as 46.3%. It is also very acquisitive over the years and as such the company is highly leveraged with funded leverage (Total Debt/EBITDA) at 6.99X at the end of last year. The company has a competitor who has about 10% market share and is about 25% in asset size compared to XYZ. XYZ Companys main competitive advantage is its long history in the industry, stellar reputation, and the strong relationships it has cultivated with its customers, suppliers, and banking partners. It has a strong and highly respected management team that is gradually undergoing a transition as the reins are slowly being handed off to the next generation of managers and leaders. This is part of a long-term succession plan that was put in place ten years ago by the executive team to ensure as smooth a transition as possible to avoid any disruptions and to preserve the companys leadership position in the industry.

International Operations

XYZ Companys customer base is global with 52% of its sales coming from international clients. As such, a sizable portion of its revenues are non-US dollar denominated with about 75% of its international receipts denominated in Euros, 12% denominated in Chinese RMB and the rest in different currencies. As part of a strategy to balance out its exposure to the foreign exchange markets, XYZ Company acquired companies overseas. This shifted its expenses from USD sources to other currencies making its cash inflows versus outflows more in line. With these acquisitions, the companies operating expenses are now 80% in US dollars and 20% in other currencies. Of the 20% not denominated in US dollars, 77% are denominated in Euros.

Indebtedness

The acquisitions were largely financed through debt. XYZ explored the possibility of accessing the international debt markets but given their high leverage, it concluded that it would not be cost-efficient to do so. The company ended up borrowing money from its existing US-based banks. The credit facility was in the form of a Term Loan B for USD1.5 billion for a term of five years with amortization in quarterly increments as follows:

Period Annual Principal Payment

Year 1: 1.0%

Year 2: 1.5%

Year 3: 1.5%

Year 4: 2.0%

Year 5: 3.0%

The banks also gave the company the option of drawing down the funds in US dollars at a rate of LIBOR + 3.00% or in Euros at a rate of EURIBOR + 3.25%. The LIBOR index is subject to a floor/minimum level of 0.00% while the EURIBOR index is also subject to a floor/minimum level of 0.00%. If the company decides to draw down the funds in Euros, they will be converted at the current spot USD/EUR exchange rate. The principal paydown will be the same as how it is laid out above.

Including the new debt above, XYZ Company currently has $11.8 billion in existing debt. $8 billion of this debt is in the form of term loans with an average duration of four and a half years and an average variable rate of LIBOR + 2.85% while $750MM is in a line of credit facility on a variable rate basis of LIBOR + 2.75%. This facility is renewable annually. The rest of the companys debt is in Senior Secured notes with an average duration of six years and a weighted average fixed coupon of 4.75%.

The Companys Exposure

Because XYZ Company is a highly leveraged corporation, debt service is a major expense. Doing some analysis, it has been determined that XYZ Company can service its debt obligations as long as its effective interest rate stays below 6.5%. Once it approaches and exceeds 6.5%, its cash flow situation will become tight. The company does not have an economic research department so it does not have a good official forecast of where they expect interest rates to go for the next five years.

The credit facility was used to acquire companies with overseas operations. These companies revenues are mostly denominated in either Euros or Chinese RMB. Since the inflows are in currencies that are not USD, the company bears the foreign exchange exposure due to the mismatch between its cash inflows and its outflows due to its USD-denominated debt service and its non-US denominated revenues and receivables. Receivables aging are on average approximately 60 days.

Additionally, although XYZ Company has several customers, 65% of its revenues are tied to two large clients who are dominant players in the aerospace industry. Revenues are very dependent on the general health of the US economy. If the economy experiences a downturn, it will have significant detrimental effects on XYZ Companys revenue stream and cash flow situation. Customer 1 currently has a probability of default of 4% and a recovery rate of 55% while Customer 2 has a probability of default of 3.75% and a recovery rate of 62%. XYZ has contracts in place with both customers to supply parts at locked in prices. Although the contracts stipulate the XYZ Company will be the sole supplier for both customers, the volume is not predetermined and will be at the sole discretion of the customers. The contract with Customer 1 is for a three year time period while the contract with Customer 2 is for five years.

Market Information

Below are the current conditions in the financial markets:

USD/EUR Exchange Rate: 1.1106

Current 3 Month LIBOR: 1.96%

Current 3 Month EURIBOR: -0.398%

How sensitive is XYZ Company to interest rate fluctuations?