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Keep an Eye on Captive Finance Entities

Jeremy Glaser

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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Glaser: So for people who might be interested in investing in the parent, obviously can't invest directly into captive finance company yet for the most part. So, let's say Ford is a 5-star call right now. If you are looking to buy Ford, how closely should you be following the captive finance credit ratings? Should you be worried about something like that blowing up? Should we be worried about how it's going to affect cash flows from an equity perspective?

Hilgert: Well, for investors in the stock of the parent, it would affect them if, let's say, for example, the portfolio of the captive was of a poor credit quality. Let's assume a parent says, "We want to be able to manufacture as much as we can manufacture and sell as much as we can sell, and we want our lending company to support us in that endeavor. We're going to lax the credit policies of the lending company, and that way we'll be able to sell more product,"

If a parent says that, then you wind up having a poor credit portfolio. If you have a poor credit portfolio, you have more charge-offs, more bad loans, and more losses. If you have more losses, that's bad for the parent and bad for the parent's stock. But investors can also invest in the bonds of the corporate finance entity, which is a reason why we are also taking a hard look at the credit ratings of the captive finance company.

Glaser: So it sounds like those credit ratings can be helpful on a few different levels.

Hilgert: Exactly.

Glaser: Can you walk us through a little bit of the credit ratings that we recently initiated on and where you are seeing maybe more value on the bond side and where there might be some less value?

Hilgert: Well, as I mentioned, Ford Motor Credit was one of the companies on which we've initiated a credit rating. There we saw a strong linkage between the parent company and the finance company, simply because the finance company has 100% of its portfolio in support of the parent.

We also did Textron. Textron was a more unique situation. The finance company there has been selling off assets. Textron wants to get out of the finance business and really outsource it. The firm no longer wants to have a finance company in support of the parent's business.

The firm does have some minor amount of business that it will continue to do, but that was a situation where the finance company actually had a significant portion of business outside of the parent's operations. And there was some disparate linkage there. That's no longer the case. We now see a strong linkage between the two and the credit worthiness of the two are more tied together.

That's also the same case for Deere, as well as Caterpillar, that we also rated as part of this initiation of the rating methodology.

Glaser: And looking at the individual bonds, do any look like they are particularly a good value right now, or do they all look like they are about fairly valued?

Hilgert: For the most part fairly valued at this point.

Glaser: Richard, thanks so much for talking with me today.

Hilgert: Thanks for having me.

Glaser: For Morningstar, I am Jeremy Glaser.