In my recent blog “Gauging Credit Risk Drivers Using Absolute Contribution and Sensitivity Analysis”, I discussed how Contribution Analysis and Sensitivity are powerful analytic tools for seeking to identify main drivers of a company’s credit risk. Detailing how absolute contribution shows which input has moved furthest from the best condition, whilst sensitivity analysis tells us what happens at the very next “little step”.
These analytic tools can also be used to identify a potential path to recovery of the credit strength of a distressed company.
So, how do we do this in practice? Let us look at a case study.
Lundin Petroleum AB (OM:LUPE), an independent oil and gas company founded in 2001 and headquartered in Stockholm, Sweden.1 , engages in the exploration, development, and production of oil and gas properties. It focuses on exploration and production (E&P) of assets located in Norway and South East Asia. The company also has assets in France, the Netherlands, the Russian Federation, Malaysia, and Indonesia.
Through S&P Global Market Intelligence’s PD Model Fundamentals, LUPE’s probability of default (PD) is 11.3%, using 2016Q2 financials.2 This PD maps to a lowercase letter score of "b-".3
Source: S&P Global Market Intelligence, as of October 12th 2016
Looking at the colour codes within the Contribution Analysis pie chart, the three main drivers of the current PD can be visually identified: Total Equity, EBIT/Revenues, and Retained Earnings/Total Assets.
By acting upon these three inputs, the company could potentially improve its credit strength. In this sense, the sensitivity analysis score helps provide an idea of how much something needs to be improved in order to have a meaningful impact. Combining the information provided by the absolute contribution and the sensitivity analysis, a potential path to improve the creditworthiness may include the following “waterfall” steps:4
- Increasing Total Equity six-fold (to 1.2 Bn EUR): the PD drops from 11.3% to 6.4%;
- Further adjustment of Debt/(Debt+Equity) ratio to account for increased total equity: the interesting thing is that there is no real improvement of the PD, if we change also this ratio; we will discuss below why this happens.
- Additional improvement of EBIT/Revenues to 29%: the PD will drop to 1.8%;
- Final improvement of Retained Earnings/Total Assets to 17%: the PD will fall to 1.3%. This PD maps to a letter score of "bb", representing an improvement of 4 notches, towards the top range of the non-investment grade.
Something may have also attracted your attention in the image above: Debt/(Debt+Equity), has top sensitivity and no contribution, so why does it have no impact at all on the final result? The case of Debt/(Debt+Equity) is special, because this ratio penalizes (i.e. increases) the PD of a company only when the ratio value is above a fixed threshold (100%).
Any improvement of the ratio, below the 100% threshold, will have no (beneficial) impact to the PD. This is the reason why, when we adjust the ratio in the waterfall process above, the PD does not improve. This is also the reason why the absolute contribution of this ratio is null.
Ok, so why is the absolute contribution null and the sensitivity so high?
Do you remember how we calculate the sensitivity? We look at the change of the PD when we increase the input by a “little step”.5 In this case, the “little step” is actually large enough to make Debt/(Debt+Equity) cross the threshold, where the PD gets penalized/increased. Thus the sensitivity is not null and, in this specific example, highest among other input sensitivities.6
At S&P Global Market Intelligence, we offer a whole set of statistical models that help clients scaling the credit risk analysis of multiple counterparties. Our models come equipped with analytic tools that help users identifying a potential path to recovery of credit strength of companies in distress, thus allowing to do more business, and better.
1 Source: S&P Capital IQ platform, as of 28th September 2016.
2 Source: S&P Global Market Intelligence, as of 1/9/2016.
3 S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence PD credit model scores from the credit ratings issued by S&P Global Ratings.
4 We understand that company financials are reflective of the way a company operates; changing company operations by improving efficiency and processes will usually affect all the items reported in the financial statement of a company; nevertheless, this is an example to show how sensitivity and absolute contribution may be used.
5 In PD Model Fundamentals, we calculate the sensitivity by looking at how much the output changes by, when the input value is increased by 10%.
6 PD outputs may sometimes be floored due to the presence of the Sovereign capping mechanism; this simply means that despite the company may have “amazing” financials, its creditworthiness cannot be better than the Sovereign score of the country where the company is headquartered. So an input may have very small contribution simply because the PD improvement is “cut-off” by the floor, that does not allow the PD to improve, when the input is “switched off”. This becomes relevant especially for the emerging market countries, where the sovereign capping mechanism may play an important role.