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By Jeremy Glaser | 07-01-2011 02:14 PM

Keep an Eye on Captive Finance Entities

Morningstar's Richard Hilgert discusses why equity investors should check the credit worthiness of captive finance entities before jumping into a parent's stock.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Richard Hilgert. He is a securities analyst at Morningstar, and he recently helped put together our new captive finance entity rating methodology.

Richard, thanks so much for joining me today.

Richard Hilgert: Thanks for having me, Jeremy.

Glaser: So, let's start off kind of looking at the big picture. What is a captive finance entity, and why should investors care about it?

Hilgert: Captive finance entities are organizations that are typically owned by a parent organization and support the parent's business through financing for its customers or for its distributors or both.

A good example of that would be Ford Motor Company, and its captive finance company called Ford Motor Credit. Ford Motor Credit supplier lending services for Ford Motors' consumers who buy the vehicles as well as the floor-planning loans for Ford's dealerships. So, Ford's supported by the lending company's activities.

Glaser: So, when you are taking a look at these lending companies, how do you analyze them? Is it similar to looking at a bank? Is it similar to looking at the parent? What factors are you taking a look at?

Hilgert: There are many different factors that we utilize to do a credit rating for the captive finance entity, but primarily what we're looking at is the credit quality of the entity similar to the way that Morningstar's banking analysts look at the credit quality of a bank. And we're also tying that back in with the parent's credit quality.

The basic methodology that we run through is, first of all, to look to see whether or not you can do pro forma financial statements on the captive finance entity. Those would be the financial statements such as the income statement, balance sheet, and cash flow statement.

We're also looking for the composition of the portfolio, such as how much of it is a part of the parent's business. There are some captive finance groups that are not necessarily lending just to the parent company, so the portfolio might differ in that way. After we look at those types of things, then we're looking to see whether or not the captive finance company has any kind of formal agreements with the parent company.

Sometimes parent companies will have formal agreements with the captive finance company to say that you have to maintain a certain level of equity in the captive finance company. Sometimes there will be a certain level of profitability that the parent company has to deliver on for the finance company to see.

After you take a look at formal agreements, you would take a look at some of the corporate fundamentals. Some of the corporate fundamentals might be the cash flows that are going back and forth between the parent and the financial sub. Sometimes the parent has cash contributions that they make to the finance sub, just so that the finance sub stays financially healthy. Most typically, you'll see dividends coming from the financial sub back up to the parent.

And with the financial sub, if its primary business or mode of operation is to solely support the parent's business, then you are going to see a strong linkage between the two in terms of the creditworthiness of both.

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