As the Federal Reserve debates on tightening the money supply even further, many corporate treasurers are scrambling to manage the impact of over a year of central bank rate hikes. One measure companies are taking is to cut costs and pay down debt. According to a recent survey conducted by data provider Calcbench Inc., interest costs at US companies skyrocketed by 22% in Q1 2022 compared to the same period in the previous year, right after the Federal Reserve began raising rates.
Large corporations like Apple and Verizon are some of the companies affected by the surge in interest costs, with Verizon’s interest expenses jumping from $786m to $1.21bn within a year. In response to these increasing costs and others like wages, materials, and energy, companies are forced to seek savings. Apple, for instance, is scaling back hiring and delaying bonuses for some divisions to keep costs in check. Higher interest costs set a higher standard for how much companies must earn from projects to cover financing costs, possibly resulting in less investment.
Continued rate increases by the Fed could lead to even higher interest spending. While the US central bank is expected to keep rates unchanged at its upcoming meeting, interest-rate futures markets think rates will peak in September, compared to previous estimates of July. A move by the Federal Reserve to maintain high rates for longer periods will likely put more pressure on companies with weaker credit ratings. For larger businesses with higher ratings, persistently high borrowing costs will likely result in a gradual reduction in interest coverage ratios and a focus on trimming outstanding debt and balance sheets as articulated by Carnival Corp., the Miami-based cruise ship operator.
Carnival is working to reduce its debt and interest costs after raising $24 billion in additional funds throughout the pandemic. Its CFO David Bernstein explained in an email: “We predict significant increases in adjusted free cash flow in 2024 and beyond, and we plan to leverage this free cash flow to decrease our debt balances, reducing interest expenses over time.” The company aims to pay off $1.8bn in maturities in 2022 and close the year out with approximately $33.5 billion in total debt. Carnival's Q1 interest expense jumped from $368m to $539m YoY.
Carvana, a debt-laden auto retailer, saw its first-quarter interest expense rise to $159 million compared to the same period last year when the cost was significantly lower. Meanwhile, American Airlines, a Fort Worth-based airline operator, has reduced its floating-rate debt holdings in recent quarters, paying down two floating-rate term loans worth around $2.3bn, according to its treasurer.
Regarding profitability improvement and savings searches across businesses, Bain & Co.'s Michael Mankins revealed that "Until March 2022, below 6% was the weighted average cost of capital for companies in the S&P 500. Now, that cost is higher than 9%. In that world, choices are very different." Interest expenses of $540m were recorded by American Airlines in the Q1 of 2022, up from $463m YoY.
Companies are making other changes to address higher financing costs, in addition to tweaking their debt structures, such as reviewing spending decisions and dividend payment timings. "The cost of cash is a catalyst for change," says Wes Bricker, co-leader of the trust solutions business at PwC. "It is an opportunity for companies to get their house in order."
Higher interest rates have also resulted in companies earning more interest income from cash and short-term investments, including money market funds. Corporate cash holdings in the US increased by $47bn during the Q1 of 2022, up $10bn YoY, according to the Carfang Group's analysis of Federal Reserve data.
I asked Fraser Woodford, treasurer at Warner Bros. Discovery, for his opinion, and he said, "Higher rates can also create opportunities. We are earning more on cash holdings and can also take advantage of bonds trading at a discount, which makes them attractive candidates for retirement." WBD is purchasing $460 million worth of floating-rate notes that expire in March 2024. The company recorded interest expenses of $571m for the quarter, down from $598m in pro-forma interest expenses during Q1 of 2022, before the Warner Bros.-Discovery merger.
According to Barak Ravid, Americas Leader at EY-Parthenon, the strategy consulting arm of the professional services firm, while higher interest income can benefit some companies, most businesses hold significantly more debt than cash, and increased interest income is usually insufficient to offset the hike in interest rates.