(The Toronto Star posted the following column by Rasha Mourtada on its website on April 11.)
TORONTO — Paul Tellier must have known what he was getting into when he decided to take over as navigator of Bombardier Inc. After all, the beleaguered maker of planes, trains and snowmobiles has had its woes splashed across headlines ever since Sept. 11, 2001. And Tellier was no stranger to Montreal-based Bombardier (TSX: BBD.B)–he’d served on its board for more than five years. But when the unexpected management shuffle occurred last December, replacing president and CEO Robert Brown, a flashing red signal went off for analysts and investors. If Bombardier’s board was parachuting Paul Tellier, of Canadian National Railway Co. fame, into the company’s hot seat, things must be pretty ugly.
That notion was confirmed on March 4, when Tellier was faced with the grim task of announcing that Bombardier would not meet its previous guidance for year-end results, due April 3. In fact, the company would suffer its first quarterly loss in 10 years. Instead of meeting its earnings guidance (before special items) of 81¢ a share for fiscal 2003, Bombardier slashed its estimates to between 40¢ and 45¢ and reduced its cash flow forecast from $1.3 billion to $800 million. That translates into a loss of between 2¢ and 7¢ per share for the fourth quarter of fiscal 2003. But it was only the start. Tellier warned of unspecified writedowns that could “materially lower” the numbers even more.
The day after the announcement was made, the stock fell 10%, to $3.79. It’s now trading at its new 52-week low of $2.90, not even within shooting distance of its 52-week high of $15.67. But more significant than the tumbling stock price, what emerged from the announcement was a renewed sense of urgency for the transportation giant that was founded in 1942. While it’s in no danger of becoming bankrupt, and has so far avoided a liquidity crisis, the company has other serious credit concerns and internal problems that cannot be ignored. Now, all eyes are on Tellier to see what sorts of changes he’s going to make at Bombardier–and everyone agrees changes will come soon. While no one really knows what Tellier’s got planned, there are some steps that informed observers say he can take now to begin turning the troubled company around.
ACCOUNTING CHANGES
In his March 4 announcement, Tellier gave the first sign that he’s going to make good on his promise to change Bombardier’s accounting to make it more transparent. The company has always been notorious for not disclosing many details in its financials. “You can play around with it so much,” says Mark Rosen of Toronto forensic accounting firm Rosen & Associates Ltd., about the program accounting Bombardier uses. “And then there’s so much information they don’t even give you. It’s one of those black boxes.”
With its program accounting, which other aerospace companies like Boeing use, Bombardier relies on assumptions it makes at the time a new aircraft is developed. The company estimates costs based on the expected number of aircraft of a certain model it plans to deliver over the life of the program (typically, about 15 to 20 years). When a new aircraft is designed, the costs of manufacturing the first few planes are extremely high. As Bombardier gets past the steep learning curve, the costs go down and subsequent productions are cheaper. Currently, Bombardier smooths out those early development and manufacturing costs over the life of the program. The problem is, the company never tells investors what it’s estimating. So when the unexpected–like the Sept. 11 terrorist attacks–happens, investors are surprised with a writedown. For instance, in its past fiscal year, Bombardier lowered its estimate for sales of the Dash 8 Q400 turboprop, and as a result took a $264-million writedown of non-recurring costs.
Tellier announced that Bombardier is considering moving to a more conservative accounting approach to avoid that kind of situation. If it does, then expect a writedown to come with the change as the company plays catch-up and attempts to start with a clean slate under the new accounting system. It could also mean the company will restate earnings. For wary investors these days, that phrase–“restate earnings”–might set off alarm bells. But Linda Scott, a senior financial analyst with Toronto-based Dominion Bond Rating Service (DBRS), says that while the accounting is “aggressive,” it’s entirely aboveboard. “If it falls in the realm of GAAP, which it does, it’s acceptable,” she says. Toronto-based Canaccord Capital analyst Robert Fay says that the purpose of restating earnings would simply be to help investors and analysts find their bearings. “If you go through a significant change like this, people will want to know, based on these numbers, what is the apples-to-apples comparison,” he says. “We don’t want an apples-to-oranges comparison.”
While changing accounting methods might appease investors, it won’t necessarily address the problems of transparency. What Bombardier really needs to do, some observers say, is fill in the blanks and disclose the numbers behind its assumptions; simply repackaging the current information isn’t enough. “If we knew what the assumptions were, we could assess whether we believe them or not,” says Anthony Scilipoti, an executive vice-president at Veritas Investment Research in Toronto. “The fact that they’re not disclosed means that we’re left guessing. We don’t have enough details to assess whether it makes sense or not.”
RAISING CAPITAL
If anything’s clear right now, it’s that Bombardier needs to raise money–and it needs to do it fast. As of April 30, Bombardier’s banks will change the company’s key debt covenant, meaning its debt-to-capital ratio will go down. The company is currently allowed to have a ratio of up to 60%, but that number is being reduced to 50%. In other words, Bombardier has to ensure that it has an equal amount of debt and capital. But with hints of a writedown to come soon, the company’s equity base could take a hit, causing its debt to outweigh its capital and possibly result in a breach of its covenant. (According to the numbers Bombardier has released to date, it can afford to writedown $1 billion and still be within its covenant.)
The danger is, no one knows how big the potential writedown would be. And even if it stays within its covenant, Bombardier needs to strengthen its balance sheet. Otherwise, it’s likely that debt rating agencies will even further reduce Bombardier’s ratings, which are already hovering above junk status. (In late March, Moody’s Investors Service cut Bombardier’s credit ratings for the second time this year, to just above junk. Standard & Poor’s also cut its ratings to one level above junk status, with DBRS following suit and lowering its ratings to three levels above.)
Before Bombardier can roll up its sleeves and get its hands on some cash, it needs to find a permanent CFO. For the time being, Tellier has installed an interim number cruncher to replace Louis Morin, who left in February. And while Tellier is revered as the man who made a success of CN Rail, the question is, Does he have enough time to weave his magic at Bombardier?
“The problem is that this is a very complicated task right now in front of him,” says Fay. “When Tellier was running CN, that was a 10-year story, and it was at a very measured, steady pace that we saw improvement, and he delivered on it.” Not so with Bombardier. “Between now and first-quarter results, we’ve got to see some changes,” adds Fay. “This is a sprint, not a marathon.”
One thing the company will probably do is try to renegotiate with its banks. But if that doesn’t cut it, an obvious choice would be to turn to the equity market. Most analysts agree that Bombardier won’t go to the market for less than $1 billion, and that would result in about 15% dilution to current shareholders. There’s also concern that investors would not be willing to buy the stock at its current trading price, considering its volatility and the general uncertainty surrounding Bombardier. “I hate to see a company raising equity when its stock price is at a historic low,” says Cameron Doerksen, an analyst at Montreal-based Dlouhy Merchant. “But if they don’t do something to shore up their balance sheet, it could lead to a downgrade again, and that would probably have very negative consequences for the company. It’s almost that they really have no choice.”
Also on the table is the possibility of selling non-core assets, such as the Belfast City Airport, though that would take time. As for selling off divisions, Bombardier Capital, the financing arm of the company, seems a likely candidate. “Bombardier Capital has left a bad taste in investors’ mouths,” says Doerksen. In a move virtually all analysts viewed as a mistake, Bombardier Capital went into the business of financing manufactured housing and consumer products purchases. After taking a writedown of $663 million in October 2001, Bombardier said it would exit those portfolios. A year later, it announced that it had targeted further portfolios to sell or wind down, and began to reduce the division’s assets under management from $11 billion to $5 billion, with the difference going to reduce Bombardier Capital’s debt. Investors have yet to hear any word on how the sale or winding-down of those targeted portfolios is proceeding. However, the division’s business aircraft portfolio could be an ideal part to sell, because of the credit risks associated with customers buying business jets. “When you’re lending money to an airline, you have a pretty good sense of their credit quality and what their business is,” says Doerksen. “But when you’re lending money to somebody who’s buying a business jet, you don’t know the status of those customers.”
A third possibility is selling the recreational products division, or spinning it off into an initial public offering. Bombardier has become synonymous with the world-famous Ski-Doo, but the truth is that the division is not core to Bombardier’s main businesses–rail and aerospace. And some analysts say the company could fetch about $2 billion for it. But as with Bombardier Capital, a sale wouldn’t happen overnight. And, of course, Bombardier needs a buyer. “The market is not going to be bidding up for anything significant at this stage,” says Fay. “With financial and geopolitical uncertainty, there are a lot of issues about people being too aggressive on large acquisitions.”
COST-CUTTING
The flip side of raising capital is getting costs under control, a measure Bombardier needs to tackle aggressively in light of the challenges its aerospace division faces. With airlines plunging into bankruptcy protection–US Airways last August, followed by United Airlines in December–the forecast is cloudy. To date, Bombardier has yet to get any significant deferrals or cancellations for regional jets, and the future of the regional jet business remains an unknown. But, as aviation analyst Richard Aboulafia at Virginia-based Teal Group says, the airline sector is likely on the verge of a massive restructuring: “The aviation industry is witnessing a roll of dice of almost cosmic proportions. We just don’t know what’s going to happen.”
Taking a more upbeat approach, Scott of DBRS says that although the airline business may currently be hurting, things will turn around in the long run. “As long as people are still flying, there are still going to be planes,” she says. The imminent danger is that 29% of Bombardier’s backlog orders lie with United’s feeder airlines. If the troubled carrier doesn’t recover, Bombardier could be left short 123 of the 423 orders backlogged as of Dec. 31, 2002.
Things are even worse on the business-jet front, a market that ebbs and flows with the state of the economy and the stock market. With an unrelenting bear market and corporate scandals fresh on investors’ minds, boards are understandably loath to dish out millions for a new company jet. Furthermore, Fay says, so-called fractional ownership is hurting Bombardier. Companies such as Warren Buffett’s NetJets buy business jets in bulk and then sell shares of them to corporations, so a company can enjoy the perks of a private plane without having it on its books and dealing with maintenance. On the one hand, such time-sharing wears out planes a lot faster. But the downside, says Fay, is that it creates a wholesale market and puts margins under pressure. Bombardier’s delivery of business jets declined from 203 in fiscal 2001 to 162 in fiscal 2002, and those numbers are expected to be down even more dramatically this fiscal year.
Analysts agree that Bombardier has excess capacity in both its rail and aerospace operations, and the job axe has already begun to fall. Tellier started the ball rolling on March 5, when the company announced it was laying off 3,000 (10%) of its aerospace workforce. That came after 3,800 employees lost their jobs following the events of 9/11, with another 1,980 let go a year later. The latest cuts will bring the aerospace workforce to 27,000, down from almost 36,000 two years ago. Another step Bombardier can take is renegotiating labor contracts, as it did recently at its Downsview plant outside Toronto. Consolidating plants and reducing production are also key, not only across the aerospace division, but also throughout its rail operations.
The rail business, while not in the crisis aerospace is in, isn’t without its own problems. The company bought German rail manufacturer Adtranz from DaimlerChrysler in May 2001 and recorded just less than $3 billion of goodwill as a result of the purchase. Most analysts say the steep price was worth the gain because it puts Bombardier at the forefront of the European rail business. But Fay suspects that consolidation is a distinct possibility at the company’s European plants, because it simply has too much capacity for the current demand. “How they do that is going to be tricky,” he says, “because, of course, you have to have some indigenous manufacturing operations in order to bid on certain contracts in certain countries.”
Outsourcing equipment is another im-portant part of cost-cutting, says Doerksen, and he’d like to see Bombardier do more of it. “They can’t suddenly say we’re outsourcing all of these parts at the same time, because they simply can’t do that without disrupting production,” he says. “We’re going to see more and more of the basic production and minor sub-assembly activities given to suppliers, and Bombardier left with the marketing, design and final assembly of aircraft. They’re not going to be so involved in machining individual parts.”
CREDIBILITY
Canada has already seen one of its national icons, Nortel Networks Corp., turned into a national disaster. To keep Bombardier from going down that same bumpy road, the most important thing it can do is restore investor confidence. And one way it can start is by acknowledging its mistakes.
Some observers say Bombardier is hurting to the extent it is now because company execs thought its good fortune would never run out. “They should have prepared for a rainy day,” says Aboulafia. “There are strong indications that they thought the market would keep going up and up–a classic mistake to make. You can see that through their extended financing position and lack of transparency.” Fay also thinks Bombardier has made mistakes. “There’s no question that there were some aggressive decisions made to show growth in this company,” he says. “And I think the problem is, when you have a down cycle, those things can come back and haunt you.”
Another point of contention is Bombardier’s relationship with the Canadian government, a coziness that investors have come to distrust. The question always lingers: how much of Bombardier’s business is done with taxpayers’ dollars? This is a tricky issue, because the government doesn’t directly put money into Bombardier’s coffers. Instead, through Export Development Canada (EDC), Ottawa loans customers the coin to buy Bombardier goods. According to EDC’s Web site, since January 2002 it loaned between $115 million and $725 million in nine such transactions. The concern: what happens if the government stops handing money out to Bombardier customers?
Because the buyers might have been able to get financing elsewhere for Bombardier aircraft, it is impossible to say what impact the lack of EDC loans or guarantees might have on Bombardier’s sales. Given the spotty level of disclosure in its financials, investors are left to conclude this is yet another detail Bombardier won’t share. What it boils down to is that Bombardier needs to become more transparent, and a change in accounting is a step in the right direction.
It might also help if the Bombardier family invested more money in the company. Four family members sit on the board, and chairman Laurent Beaudoin, who is married to the founder’s daughter, was also chief executive until 1999. With its multiple voting share structure, the family has the final word on all the company’s decisions. And it knows the way the Bombardier machine works best. However, while the clan collectively owns 83% of voting shares, it holds less than 1% of common stock. If Bombardier does indeed turn to the markets and issues more stock, what could give investors more confidence than seeing the principal owners at the front of the line?