Realogy Corp.’s chief financial officer has responded to a "negative" outlook issued by Standard & Poor’s Ratings Services with a statement about the company’s financial footing.
The company has also been called out by the Wall Street Journal for using financial instruments known as payment-in-kind (PIK) toggle notes, which the newspaper’s "Deal Journal" blog refers to as "a much-maligned financing structure that allows (the company) to pay debt with debt," and Realogy’s chief financial officer has said the decision to use the PIK toggle notes is intended to spare the company from dipping into its cash reserves.
Standard & Poor’s on March 27 affirmed Realogy’s corporate rating of "B," but revised its ratings outlook from "stable" to "negative," citing lower earnings expectations, the company’s "highly leveraged capital structure," and reduced ability to generate cash flow because of the housing market downturn and the close of the $9 billion leveraged buyout in April 2007 by an affiliate of Apollo Management L.P., a private equity firm.
"The negative outlook reflects our concern that in the event a recovery in the U.S. residential real estate market is not achieved before early 2009," the company may face earnings decline that could reduce the company’s cushion in meeting its debt covenant, according to the ratings report by Standard & Poor’s. "In the event the industry is not tracking toward recovery by the beginning of the September 2008 quarter, the rating could be lowered."
Realogy had about $6.2 billion in funded debt and $7.7 billion in lease-adjusted debt at the close of 2007, and the company’s earnings before interest, taxes, depreciation and amortization must improve in the second half of this year "to maintain an adequate covenant cushion," according to the Standard & Poor’s report.
Also, the report suggests that the company may see a return to growth in transaction volume and home prices in early 2009, and the company could "benefit meaningfully" in earnings growth and the generation of cash flow when the real estate cycle turns around.
In its annual report, Realogy reported that its transaction volume declined by 19 percent for its franchising business and by 17 percent in its company-owned brokerage business, compared with an overall industry decline in transaction sides of 13 percent.
In the near term, S&P expects Realogy to have negative discretionary cash flow and that there will be "significant reductions in capital expenditure and acquisition spending." That means that remaining in compliance with the company’s debt covenant is key to the company’s liquidity, according to the report.
Realogy had cash balances of $153 million at December 2007, with excess cash balances not otherwise committed of about $100 million, S&P noted.
Tony Hull, Realogy’s chief financial officer, said in response to the report that S&P’s negative outlook "does not explicitly mention three key factors" about the company’s financial position.
The company’s interest cost in 2008 "will be significantly less than previously expected," the company has engaged in some cost-cutting plans such as an exit from a category of relocation business, and the fact that the first quarter of any year "is historically our slowest quarter" because of the seasonality of the real estate market, Hull said in a statement.
The S&P report notes that the March 2008 quarter "is seasonally weak," and that the pace of decline in transaction sides was steeper than expected for the company in that quarter.
The company reported a $797 million net loss in 2007 for the period beginning after its April 10 acquisition through the end of the year. The company had a non-cash impairment charge of $667 million last year that reduced intangible assets by $550 million and reduced goodwill by $117 million, and officials blamed the results on a "continued downturn in the residential real estate market in 2007 as well as reduced short-term financial projections."
In an article last month, the Wall Street Journal reported that Realogy issued $550 million worth of pay-in-kind toggle notes, or PIK toggles, as a part of the financing to fund Apollo’s leveraged buyout. The article refers to this plan to pay interest due with additional bonds as "a particularly risky type of debt that became popular during the credit boom."
Hull said in a statement that the PIK toggle feature "simply permits Realogy, at our option, to exchange some of our interest payments for additional debt which saves us cash. We negotiated this flexible credit option when we originally structured our deal with our bondholders, and now we’re electing to use it.
"We made this decision because we feel it is in the company’s best interests to be conservative in our use of cash until we have better visibility into the remainder of 2008," he added.
Realogy has announced continuing plans to cut costs through office consolidations, and expects to benefit from an altered formula for splitting commissions between brokers and agents. The company consolidated about 67 company-owned brokerage offices in 2007 and has plans to consolidate or down-size an additional 70 company-owned office locations in the first half of this year. In the past two years, the company has consolidated about 20 percent of its company-owned offices.
Realogy company-owned and franchise brands include Coldwell Banker, Century 21, ERA and Sotheby’s International Realty, among others. There are an estimated 308,000 sales associates working with Realogy company-owned and affiliated brands, and Realogy has 13,400 employees internationally.
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