Adecco: called to account

The Swiss employment services firm has repeatedly delayed filing its 2003 accounts, giving analysts cause for concern. Some give their opinions

Said Saffari
CSFB

Outperform
For crossover investors with the ability to sustain high volatility, we see value at the very wide ranges of Adecco cash and CDS trading. Since the group’s original announcement that the audit of its full-year 2003 results would be delayed, we expect the spread volatility to continue until the conclusion of the independent investigation and the publication of accounts.

We base our continued outperform recommendation on the group’s statements that the board has yet to find any evidence demonstrating “any major misappropriations and irregularities”. Also, note that the company has about €1 billion of cash, with only about €400 million of maturities for 2004. As a result, we see the spread widening witnessed in the name since the original announcement as an opportunity for crossover investors based on what we know so far.

We also view the decision by Moody’s and S&P to downgrade the group to Baa3/review for downgrade and BBB-/ creditwatch negative as odd, considering that the agencies have no information beyond that contained in the company’s statements. However, the action is clearly a sign, in our view, that the rating agencies are keen to avoid any Parmalat-like embarrassment. The key reason given for the cuts was the inability of the agencies to cap the potential impact of the accounting concerns on the group’s credit quality, operating cashflow and debt repayment capacity.

We do not expect to have full visibility on the name until its full-year 2003 audited results are released, but the worst-case scenario still seems acceptable.

Carmen Hummel
HVB Group

Sell
Investing in Adecco (Ba1 watch neg/BB+ watch neg) based on current information is like buying a car without seeing it first. We recommend investors to refrain from buying into the name in spite of spread levels which might look tempting for a company that, if we believe its financial statements, still has a low triple-B financial profile.

News and speculation after the repeated delay in the publication of the 2003 accounts due to “material weaknesses in internal controls discovered at its North American operations” were the major driver for spread development of Adecco issues this year. While management stated already in early March that “based on information currently available to it, to date no evidence demonstrating major misappropriations or irregularities that would be financially significant to the Company as a whole has been found,” more than two months later, the publication of the accounts is still out of sight.

We are inclined to give the Swiss top management some leap of faith, because the irregularities took place in North America, far away from Adecco’s headquarters. However, our positive stance is eroded as the company might be wrong with its estimate that the investigation would not result in any material impact on its financials. Adecco was also mistaken when giving a time frame for the publication of the audited accounts (April 20, May 03 and currently June 18). And the examinations have not yet been completed.

Additionally, Adecco’s financials are deteriorating. Since full-year 2001, Adecco has reported decreasing revenues and depressed profitability margins and cashflows. Reported net debt reduction of CHF500 million to CHF2 billion in full-year 2002 was, to a major part, driven by off-balance sheet vehicles. Adjusted net debt (CHF3.9 billion) was double the size of the reported net debt. Consequently, its adjusted credit metrics were headed south long before the January 12 announcement. Adjusted net debt to Ebitda was 3.1x in full-year 2002 (full-year 2001: 2.7x) and adjusted Ebit net interest coverage weakened to 4.0x in full-year 2002 (full-year 2001: 4.8x). Adecco’s credit metrics were considered to be weak for its mid triple-B ratings, assigned prior to the January 12 announcement.

Subsequently, Moody’s and S&P downgraded Adecco’s ratings by two notches each, and both state that the best outcome for the company’s ratings would be a confirmation at current levels.

During the ongoing financial year, Adecco’s financials will additionally be affected by increased refinancing costs, higher expenses for IT and administrative and legal advisory (for the time-consuming audit as well as for class action lawsuits filed following Adecco’s January 12 announcement). Last but not least, Adecco will have hard work to regain confidence amongst investors, customers and employees.

Sonia van Dorp
SG CIB

Negative; sell the 2006 and 2008
Since it revealed accounting irregularities in January, Adecco (Ba1/BB+) has been downgraded twice, although problems have not been quantified yet. A further delay in releasing full-year 2003 results or larger-than-expected restatements may push bond spreads wider (Adecco 2006 at 287bp ASW). We downgraded our recommendation on January 12 and have remained negative since.

Similarities with the Ahold case are striking. The missed deadlines, management’s miscommunication and the resignation of both the CFO and head of staffing operations in North America all testify to the current disorganisation. Present investigations, focused on senior management emails, could lead to further management changes.

Like at Ahold, we believe that receivables are the key problem. This could prompt banks to review letters of comfort used to fund working capital. In May, banks finally granted the necessary waivers at a cost – higher interest rates – but without demanding additional security. It is crucial that Adecco meets the next deadline (June 18) or banks could become more demanding – a negative development for bondholders. Note that the US division, Olsten, was chiefly responsible for the irregularities, suggesting that the integration of this large acquisition ($1.55 billion in March 2000) was incomplete and controls insufficient.

Yet, unlike Ahold, Adecco has been steadily reducing debt over the past four years and in the last six months. Net debt at end March stood at only €850 million, €215 million lower than in September, putting leverage at no more than 2x. The only debt due this year is a €360 million convertible maturing in November, while cash stands at €800–900 million, easily covering repayment of the bond and short-term bank lines. This is fairly reassuring, as asset cover is not a strong point in this industry. Finally, Adecco has maintained that the restatements would have “no material impact” on results. This is probably the weakest point of the argument as it is not quantifiable at this stage, given new restrictions imposed on US auditors (Sarbanes-Oxley Act).

We believe the credit market is right to remain cautious. While default risk appears remote given reported liquidity, there is still some downside potential on the bonds as long as the scope of the restatements remains unknown or if the next deadline is missed. If these factors reduce Adecco’s Ebitda by €125 million maximum, credit ratios would not change materially (net debt/Ebitda of 2x, funds from operations/net debt of about 30%, and Ebitda/net interest at 5x).

But an upgrade to investment grade seems premature, given the impact on its reputation and profitability. More importantly, Adecco will need to restore margins at Olsten, the source of its problems. As corporate credit spreads are widening, other investment-grade sectors (autos and tobacco) and the high-yield market present better risk/reward opportunities.

Charles Mounts
UBS

Hold
Since early January, the world’s largest employment services group has maintained a situation where bondholders have had to make investment decisions in the absence of financing information and in the context of rapidly changing market sentiment. Should the accounting reporting problem be settled before the June 18 revised deadline, we would expect bond valuations to recover progressively as institutional investor purchases are likely to remain muted for some time.

We believe that a majority of forced sellers of the Adecco bonds left the market in mid-January, thus limiting major flows in both euro and Swiss franc issues. In this context, we maintain our hold recommendation.

The rating agencies’ downgrade of Adecco to sub-investment grade levels leave the impression that these pre-emptive revisions have been based on a worst-case scenario, allowing for the group’s mismanagement of accounting and controlling issues rather than an actual material decline in the group’s credit profile. While the company’s behaviour and communication policy would appear to bear the symptoms of a sub-investment grade credit, we believe that the agencies have ‘front-run’ the rating review process in the absence of tangible information to fully assess the credit. We therefore continue to consider the group as a low investment-grade credit (triple-B minus), based on the following:

• Net debt including one-off balance sheet items declined to below €850m at the end of March, in line with the company’s prior guidance of €900m. Based on comparable net debt figures (third quarter 2003), this would suggest a reduction of €240m or a 22% decline.

• The preliminary trading update showing sales for the first quarter at €3.8bn, a 5% increase on a yearly basis when expressed in local currency, suggests that the group is weathering the storm satisfactorily despite an expected weaker Ebitda for the same period.

• We understand from the group’s latest communication that only €180m is currently used for letter of credits under the €580m syndicated facility. In the meantime, the company can rely on cash and equivalents of around €1bn to address the forthcoming repayments in November 2004 of a €360m convertible bond and around €200m working capital requirements from ongoing business, thus relieving some pressure on short-term solvency.

• There has been no indication of criminal evidence or misappropriations so far.

Given the magnitude of the recent downgrades, we do not however believe that upward rating revisions will be promptly undertaken, even if Adecco’s 2003 and first-quarter 2004 credit metrics do not encompass sub-investment grade benchmarks. Issues to be closely monitored following the publication of the group accounts will include the amplitude of restatements relating to US activities, the potential build-up of provisions for pending US lawsuits and any management reshuffle at a group board level.

Angeli Mulchand
Barclays Capital

Reduce
Adecco dropped what would be considered by some to be a bombshell on the market on January 12. The announcement that it did not expect the audit of its consolidated financial statements for the 2003 fiscal year to be completed by its auditors by February 4 sent the markets into a spin. The reasons given for the delay were “the identification of material weaknesses in internal controls in the Company’s North American operations of Adecco Staffing” and “the resolution of possible accounting, control and compliance issues in the Company’s operations in certain countries” .

After the January 12 announcement, five-year credit default swap spreads for the then Baa3/BBB- credit jumped almost immediately from 50–60bp to trade as high as 550bp. Although spreads later reduced back to a range of 100–150bp in the February to late April period, they blew back out again to as high as 325bp at the start of May as the market was gripped by fresh concerns. These concerns centred on continued delays to publication of fiscal year 2003 financial statements, potential covenant breaches on the company’s €580 million multi-currency credit facility and downgrades below investment grade by both Standard & Poor’s and Moody’s (Ba1/BB+).

Five-year credit default swap spreads have recently settled back in around the 210–225bp level as the company’s bank creditors provided an extension until June 18 for delivery of its financial statements. Bond prices on the €400 million 6% due 2006 have followed a similar pattern and are now trading in cash terms at slightly above par (a Z-spread of 270bp) from a pre-January 12 cash price of around 106bp.

The market sees the June 18 date for delivery of the company’s consolidated financial statements to bank creditors as a pivotal point for the company. This view is predicated on the fear that if they are not produced, it could endanger the company’s €580 million multi-currency facility and lead to a potential liquidity crisis as the company’s sizeable cash and cash equivalents balance (€983 million as at September 30, 2003 and stated by the company to be over €1 billion as at April 30, 2004) is used to fund working capital and sizeable convertible bond and bond maturities in 2004, 2005 and 2006.

Although it is hard to come to a definitive view on the company’s current situation, we take comfort in the statements the company has made post-January 12 about the potential impact of the current issues as well as first-quarter operating performance, suggesting strongly that there has not been a material degradation in the company’s credit statistics from those reported in the third quarter 2003. Furthermore, continued encouraging economic statistics, particularly from the US, suggest that the company’s operating environment is continuing to improve.

On balance, and based on the information provided to date, we do not believe that the company’s current issues will endanger its survival. However, there remains a distinct possibility that we are wrong. For this reason we recommend a reduce on Adecco.

Chavan Bhogaita
Commerzbank Securities

Underweight
Let’s get straight to the point. Current spreads for Adecco bonds and CDS are being driven neither by operational performance, nor corporate strategy. In our view, the ongoing (but unspecified) ‘issues’, their financial impact, and delayed accounts are the real drivers behind spreads at the present time.

With the Parmalat situation still bubbling away, the investment community is understandably concerned: after all, what is the precise nature of the problems announced by Adecco? What are the financial consequences for the group? And when will the audited 2003 accounts actually be published? At present, we are none the wiser on any of these issues and frankly attempts thus far by Adecco’s management to calm investor concerns have, in our view, backfired and left people even more confused and frustrated.

So, what is actually going on at Adecco? Well, that’s the million-dollar question to which the answer is as yet unknown – to us outsiders anyway. In our opinion, this situation can go one of two ways: either it turns out that the problems discovered are indeed localised and controllable, and not financially significant to the group as a whole; or we are informed sometime in the future that in fact the problems discovered are major and do have a material impact upon the consolidated results.

If the former is true, then we believe that the company could certainly have dealt with this whole fiasco much better. Alternatively, if the latter is true, then the statements and assurances provided by senior management recently have been outright misrepresentations.

At this stage, we would err on the side of the former scenario. We believe it is possible that the company has discovered some localised fraud within the group, probably resulting from internal controls weaknesses, but the problems can be ring-fenced and rectified. In our view, this situation is more akin to that of Ahold than Parmalat.

The fact that the syndicate lenders have on two occasions extended the deadline for delivery of the audited 2003 accounts would suggest that they must surely have some degree of comfort about the nature and scale of Adecco’s problems as well as the ability of the company to deal with them and recover from such a situation. If the problems are indeed of a much more serious magnitude, one would think that the banks would have been less willing to extend the deadline, or that they would have demanded some security in return for the deadline extension.

For now, we remain in the dark. Until Adecco’s management spills the beans, spreads are likely to remain volatile (say in the 200–300bp range for five-year CDS). For choice, we remain underweight at this stage, and for those seeking to take a long position we believe there will be cheaper entry points ahead.