Disney debt gets 'cheaper'

Late last week the Walt Disney Company got a nice little boost from Fitch Ratings with an upgrade in the company's overall debt rating.  According to the the Associated Press article at Forbes.com, Fitch boosted Disney's long term debt ratings from 'A-' to 'A' and their short term debt from 'F2' to 'F1'.

Why does that matter to a Disney fan you ask?  So, a quick bit of finance 101 if you need it for why this matters, if you don't, skip the next few paragraphs to the last couple.

Fitch is the smallest of the three credit ratings agencies that are 'sanctioned' by the Securities and Exchange Commission to rate debt instruments.  The other two are Standard & Poor's and Moody's.  Fitch and S&P use essentially the same rating scale from AAA to D for long term debt and F1+ to D for short term debt, Moody's version is slightly different but very close. 

These rating scores are based on proprietary models built by each debt rating service that basically rate the company's STATISTICAL chance of default.  It is similar to how a life insurance company uses a mortality table to figure out the probability of you reaching a certain age without dying and setting your premiums based on that information.

So an 'A' rating puts Disney, according to Fitch, solidly in the 'economic situation can affect finance' category.  Which of course makes pretty good sense to me if you think about where Disney is in relation to the market.  Fitch is basically saying as long as the economy is good, Disney most likely is good.  If the economy is bad, Disney COULD do bad, but they probably won't. 

Banks usually use a so called 'risk free' investment such as a US Treasury Bond as the basis for making long term loans, since these debts are always considered AAA rated (you and I are such good interest payers.  Pat yourself on the back.).  Very, very, very few companies have AAA ratings on their debt (think like less than 10).

They then use a spread over the T-Bill rate for new borrowings to price new bond issuances in the case of long term deb (they use some other published rate typically such as the Fed Funds rate, Prime Rate, or the LIBOR rate for short term debt).  The lower your rating, the higher the spread and the more you pay in interest.  The more interest you pay, the less that you get to keep out of all those nice pieces of plush you sell in the park for profits.  Lower profits make investors, boards and the market grumpy, and as we discussed in depth the other day, they also put the cabosh on Bob Iger's performance pay (among others), limit cash flow, and often can lead to lower capital expenditures or inventory that might further improve the business.

How much does this affect Disney's debt service?  One example site I found here shows that for a move from A- to A can save a company like Disney as much as 30 basis points on 5 year debt.  30 basis points is .30%, so about a third of a percent different for the new rating over the old.  On every $1,000,000 in borrowings that accounts for about $15,000 less in interest paid using simple annual compounding over that 5 years. 

That may not sound like a lot, but TWDC closed out 2007 with almost $12 billion in borrowings and paid $593 million in interest.  Somewhere in the neighborhood of $7 billion of that are medium term notes like the 5 year note example above.  So you can see that adds up to a LARGE amount of money if they were to suddenly re-finance all those notes at a rate even .3% lower.  They won't do that of course, because it's too impractical and too costly, but it sure helps going forward.

Possibly more importantly of course is the psychological effect ratings increases have.  The fact that it has the potential to give the market a sometimes needed boost in confidence that a company is moving in the right direction can really be good for the long term prospects of the stock. 

Somebody thinks the folks at TWDC have it together, which is good news!