Wachovia analyst: Cendant needs to focus on improving credit metrics

By Ronda Fears

Nashville, Tenn., Oct. 1 - Cendant Corp.'s write-down of mortgage servicing rights should not be treated as a special charge and moreover the company should focus on bettering its credit metrics, according to a report Tuesday by convertible analyst Sri Nadesan at Wachovia Securities, Inc.

Cendant can probably preserve its BBB/Baa1 credit ratings if it is cautious on acquisitions, the analyst added, noting both Standard & Poor's and Moody's have the ratings on negative review.

"The company has to be careful about acquisitions over the next couple of years. We would like to see the company use free cash flow to reduce debt and shore up its credit metrics, rather than focus on acquisitions," Nadesan said in a report Tuesday.

"The company also has $2.15 billion of debt coming due in 2003 including $1 billion of liability that is coming due related to a 0% convertible that may be paid in cash and/or stock."

Fundamentally, the analyst said Cendant's treatment of mortgage servicing rights should be a normal business risk rather than a special event as ongoing write-downs in that area skews performance.

Las week, Cendant said it would take a non-cash charge of about $280 million before taxes, or about $175 million after taxes, to write-down the value of its mortgage servicing rights owing to mortgage prepayments as a result of the decline in interest rates.

At June 30, Cendant's mortgage servicing rights portfolio was $2.2 billion. So, the write-down will cost Cendant $0.17 in terms of earnings per share for the third quarter.

This, coupled with a somewhat offsetting strength in Cendant's other businesses, will lower EPS for the quarter ended Sept. 30 to $0.28, from the company's prior guidance of $0.42. Thus for fiscal 2002, the company is guiding for EPS of $1.26, whereas the Street's consensus estimate after the write-down is $1.28.

"Under the interest rate scenario that has unfolded thus far in 2002, it is understandable that Cendant would be forced to take a write-down of its MSR portfolio. However, we question the treatment of this charge as a 'one-time' charge," Nadesan said.

"In fiscal 2001, Cendant took a $94 million charge in the third quarter to write down the MSR portfolio due to declining interest rates. Then, too, Cendant treated the write-down as an 'other charge' and separated it from operating expenses.

"For a company that owns a substantial MSR portfolio, changes in portfolio values due to interest rate changes should be treated as a normal business risk rather than as a special event."

In addition to charges relating to its mortgage servicing rights portfolio, the analyst added, Cendant has consistently had substantial other charges and costs it has attempted to treat as one-time or special charges.

As a result, over the past three and a half years Cendant's reported EBITDA including the "other or special charges" has differed from its own publicized "adjusted EBITDA." At times, the analyst said, EBITDA after these special charges has been substantially lower than before the special charges.

Currently, Cendant has total long-term debt, including current portions, of $5.5 billion.

The last 12 months EBITDA at June 30, after special charges, was $1.59 billion, leading to a leverage ratio of 3.4x, which the analyst said is somewhat high for the current senior unsecured rating of BBB/Baa1.

Interest coverage is comfortable at 6.3x, he said.

"Over the past three and a half years, if we take into account substantial restructuring charges and so-called one-time charges, 'an average' leverage ratio was 3.0x and the interest coverage ratio was 7.1x," Nadesan said.

"We view the debt levels at Cendant to be a bit high - about one-half to a full turn too high, depending on how we adjust for the periodic special charges."

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