Complicated times

The credit ratings agencies rained on Gary Pruitt's parade last week. The chairman, CEO and president of McClatchy Co. had likened his company's post-makeover transformation to that of an athlete -- "fit and trim yet muscular where we need to be" -- at the annual shareholders meeting barely a month ago. And then Moody's Investors Service and Standard & Poor's Ratings Services not only dropped McClatchy's corporate credit rating several notches deeper into junk, but started acting as if Pruitt's athletic newspaper company might never warrant a victory lap.

Last week's downgrades were in response to a monthlong exchange offer for $1.15 billion of McClatchy notes and debentures that, after an extension, expired on June 25. Only 9% of all five tranches participating in the offer were swapped for "new notes," with significantly sweeter terms than the "old notes." And only 2.2% of the tranche with the nearest maturity -- 7.125% notes due 2011, with a face amount of $170 million -- were exchanged.

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One source considers the 2.2% participation of the 2011 notes nothing short of "an insult." His indignation takes into account that the same notes were trading at between 20 cents and 25 cents on the dollar right before the exchange offer began. Yet when McClatchy proposed to cash out all $170 million of the 2011s for 33 cents on the dollar, holders of only $3.8 million aggregate principal amount embraced the opportunity.

"They basically said, 'Thanks, but no thanks. I'd rather sit tight,' " the source offers as a straightforward interpretation. "And they said this when many believe these noteholders may be lucky to get one more coupon."

The meager participation reinforces the belief that many of the notes are in the hands of hedged investors -- investors who have protected themselves against a default by purchasing protection in the form of credit default swaps. After all, for those hedged with so-called CDSs, McClatchy's wherewithal suddenly becomes moot.

If the company stays solvent, explains CreditSights Inc. analyst Jake Newman, it will "repay the bonds at 100 cents." If it doesn't, hedged investors will still recover an amount equal to the par value of the bonds that their CDSs reference.

"Either way, the return is better than the 33 cents [that McClatchy was offering in cash to take out the notes]," Newman writes of the 97.8% in the 2011 tranche that elected not to tender.

McClatchy's underwhelming results also seem an eerie replay of those leading newspaper publisher Gannett Co. elicited after winding down its own monthlong exchange offer in May. For Gannett's next maturity in June 2011, only 13% of nearly $500 million 5.75% notes tendered (for more see "The default option").

For the credit ratings agencies, it's as though McClatchy has already defaulted. Standard & Poor's even lowered its corporate credit rating for the country's third-largest newspaper company to SD, selective default, on grounds the tendered notes were exchanged at such a discount to their par value that it's "tantamount to a default given the distressed financial condition of the company." Moody's also cited discounts to par on labeling McClatchy's debt-retirement exercise "a distressed exchange, which is an event of default under Moody's definition of default."

Both agencies expressed concerns about covenant trips as well, with S&P singling out McClatchy's total leverage covenant of 7 times Ebitda as ripe for violation "by the end of 2009 or in early 2010." Its elaboration on this contingency even cast doubt on Pruitt's long-term standing as a favored bank borrower. "In this scenario," S&P stated in its release about the ratings cut, "we are uncertain that lenders would grant temporary relief -- and even if they did, we believe that potential leverage of 7x or more would not be manageable over the long term given secular trends in the newspaper industry."

Back-of-the-envelope calculations suggest McClatchy's bankers will be making hard choices sooner rather than later. With consensus 2009 Ebitda for McClatchy at $218 million, total in-compliance leverage would be limited to $1.53 billion. But in its most recent Form 10-Q, filed May 7, McClatchy puts its total long-term debt at $2.05 billion. This total, moreover, is almost evenly split: 47% from banks, 53% from bonds.

Given McClatchy's interest expense last year of $157 million, coupled with a bank leverage ratio (as opposed to a total leverage ratio) already at a high 4.4 times consensus 2009 Ebitda, banks have reason to worry about every coupon payment McClatchy continues to make. "Banks don't say yes forever," a source says. "They get very nervous seeing millions go out the door" on which they would have had first claim in the event of a bankruptcy.

McClatchy's precariousness must frustrate Pruitt, who at the recent annual meeting said last year's operating cash flow margin came in at "a healthy 21.5%." But that margin wasn't discounted for interest payments, which expanded considerably on McClatchy's buying Knight Ridder Inc. for $6.5 billion in 2006. And it doesn't address the brief window the company had to stretch out the combined company's maturities before the credit crunch.

However, even if McClatchy management had swallowed its pride and allowed borrowing costs to double -- which a source snidely dismisses as "unthinkable, at the time, for a great newspaper company" -- shareholders might have called foul. Yet with McClatchy stock 92% off its 52-week high, how much worse off could these shareholders be? It's unlikely many still care about McClatchy's transformation into the "trim yet muscular" jock Pruitt envisions when, as a metaphor for these complicated times, a financial nerd is what the company needs.

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