Capital structure should never be a constraint for profitable investments

For international technology company Kongsberg, having a strong balance sheet is in the company’s DNA, says CFO Gyrid Skalleberg Ingerø (GSI). She tells Nordea Thematics’ Johan Trocmé (JT) about the company’s overarching goal of always having access to funding and how its capital structure journey was influenced by a major acquisition of a business in free fall in the midst of an offshore industry downturn.

JT: Kongsberg has had quite a capital structure journey over the years, raising new equity, buying and selling companies, and buying back shares. How would you briefly describe that journey and the capital structure phases you have gone through?

GSI: I think the development of our capital structure has to be seen in the context of what happened to our business; our Maritime business area saw a 25% drop in revenues from the offshore industry demand peak in 2015. With 60% of the group’s revenue derived from Maritime, the resulting negative impact on profitability was so substantial that it had potential implications for our capital structure. Maritime’s profits fell from a 10% EBITDA margin to just above breakeven in 2016. During the same period, our Defence & Aerospace business area saw steady revenue growth of some 5%, and was positioned to potentially win some major orders, which represented a major growth opportunity. Historically, the group has benefited from this diversification, with different timings for cyclical ups and downs for the main business areas. Kongsberg has managed to avoid reporting a loss at the group level, which is something that particularly bond investors appreciate.

The downturn in Maritime prompted heavy restructuring, and we got to the point where we had taken cost cutting as far as it could go. Part of our success has come from our deep market penetration: we have a presence in 125 locations in 40 countries, close to our customers everywhere. Also, 90% of our revenues are derived from outside our Norwegian home market. Starting to close some locations would put our revenues at risk. The only alternative option was to position ourselves for growth, to leverage our market presence. And in a depressed market, the only way to grow is through acquisitions. We therefore started looking into a number of potential acquisition opportunities, and I think you could describe this as the start of our capital structure journey.

In 2018, an opportunity came up to buy the Commercial Marine business of Rolls Royce, which we considered a perfect fit for Kongsberg Maritime. It had peaked in 2013 with revenues of GBP 1.7bn and collapsed to GBP 700m in 2018, a decline more than twice as bad as ours. Its EBITDA had plunged from GBP 173m to a loss. It had always been on our wish list but acquiring it represented a significant risk owing to its weak performance and the fact that it was actually bigger than our own Maritime business. Our bargaining position was helped by the loss-making status of the business, making it non-bankable for potential private equity players. But for us, too, it meant the acquisition could have been a hard sell to our banks and bond investors. In addition, a number of major defence contract wins meant that we needed to have the financial strength to enter into contracts with major FX exposures, and for customers to see us as a sufficiently strong counterparty before making big contractual prepayments. We did not want to risk losing these big prepayments, which keep our net working capital very low in our Defence business.

It was evident that we needed a clearer capital structure strategy, to consider and optimise all these variables. We had always aimed to have an investment grade credit profile, and our internal interpretation of this was that we should always have access to funding when we need it. We did not have a credit rating at the time. We carefully analysed the business to be confident that we could turn it around, and we concluded that we would need a new treasury management system to manage the greatly increased FX flows from the new business, and indeed the increased business flows from adding an entity bigger than our own Maritime business. Having reviewed all this, we presented four different options for how to proceed to our board:

1. Increase our borrowing
2. Raise new equity through a rights issue
3. Find a partner to make the acquisition through a joint venture
4. Sell assets to raise funds

More borrowing would have required our banks to buy into the case. We believed we would have room to fund some, but not all, of the NOK 5bn acquisition with additional bank loans. Advantages included no dilution of earnings per share, and a higher return on equity from increasing our share of debt funding in the company. On other hand, elevated indebtedness would to some extent reduce our operational flexibility and burden our earnings with additional interest costs.

Raising new equity would be a first for Kongsberg. We were confident that we had a strong base of committed long-term shareholders but recognised the need to have a compelling investment case for an acquisition in Maritime. A big benefit was that equity is perpetual funding, available once raised even if the acquisition took longer than expected to turn around. And it would be seen favourably by our existing bond holders, and also offer existing shareholders an opportunity to literally buy into our proposed investment case. The downside was, of course, a dilution of our earnings per share, and a reduced return on equity. It could also be argued that equity funding puts less immediate pressure on management to deliver and make everything work, since there is no specific mission-critical milestone such as paying interest due or repaying a loan upon maturity.

We did approach a number of potential partners, but all considered the risk of a joint acquisition too high, owing to the heavy losses and the steep decline in the market, which had not yet bottomed. The main benefit of partnering would have been sharing the risk. The downside would mainly have come from giving up some control, having to agree on the strategic and operational agenda with an industrial partner, and perhaps not having control over the acquired entity’s cash flow.

Regarding disposals, we carry out a detailed annual review of the businesses in all three of our business areas to determine which of them we believe have the potential to be number one in their market segments. Those without that potential can be considered for divestment. We did sell Hydroid in March 2020. We saw a good opportunity, as it was in an attractive market segment in the US. But in the end, we decided that running a major acquisition and multiple potential disposal projects simultaneously would use up too much management capacity.

Ultimately, we opted to raise NOK 5bn of new equity and NOK 1bn through a new bond to fund the acquisition of Rolls Royce Commercial Marine. We considered a split with more debt and less equity but decided to play it safe, as the business at that time was getting worse and worse. We preferred to err on the side of caution. And after closing the acquisition in 2019, we tried to be very transparent and communicate our view on our capital structure at our capital markets day, emphasising strongly that:

• We will maintain a solid balance sheet
• We should always have funds to invest organically in our business
• Investors should get a good return from Kongsberg shares

JT: What is management’s high-level view on Kongsberg’s capital structure? How do you weigh factors such as the level of business risk, working capital requirements including pre-payments, the business cycle, growth ambitions including potential M&A and your dividend policy?

GSI: I would argue that having a solid balance sheet is in our DNA. As justification for our view that we merit an investment grade rating we should always have access to capital when we need it. We should be robust enough to be able to cope with big swings in net working capital caused by the timing of defence contracts with big prepayments. Our business could probably tolerate having leverage of 2x net debt to EBITDA, but we have set our target at 1x plus/minus one. This is to allow for working capital swings and our significant FX exposures. We see this as a middle ground appealing to both equity and bond investors.

We also need to consider our size and access to different funding sources. We have historically only issued NOK bonds, without a credit rating. NOK will still be the primary funding market going forward, but now that we have grown in size, we may at some stage also consider tapping into the eurobond market. We are aiming for an official credit rating this year, which will facilitate our NOK funding needs and potentially also other markets.

JT: Are you aiming for an optimal WACC for the group? Are you thinking in WACC terms for big investments decisions, such as big capex projects becoming less value-accretive if the group has an overly strong balance sheet with a higher WACC?

GSI: We have definitely considered our WACC when deciding on leverage targets, dividend policy, and business priorities, although we have not focused much on external communication about our thinking on WACC. We do estimate the WACC for each business area, which can be found in our annual report.

With the dramatic changes in our maritime end-markets and to our company, we have remained on a journey for an optimal capital structure. We are building competences and learning from our experiences. An important part of this has involved our operational management – anchoring with them and ensuring they are on board with our priorities, our view on risks, and that capital is a scarce resource that should be used in a way that is best for our shareholders. This has become even more relevant now that we have 4-5,000 employees who are also shareholders in the company.

We believe we have an optimal capital structure and WACC at present, but we see the potential of a higher share of debt, as we continue to evolve and benefit from our acquisitions.

JT: Does the Norwegian State being your biggest shareholder with 50% of the company influence your view on what is an appropriate capital structure?

GSI: The State’s ownership stake does not affect our choice of capital structure for the company. But as a shareholder, it expects us to take a stance on a capital structure, communicate it, and argue for it. It is as demanding as any institutional shareholder.

The speed of decision-making can be an issue, as the State answers to the Norwegian parliament. When we proposed our rights issue in conjunction with the acquisition of Rolls Royce Commercial Marine, the State was expected to contribute NOK 2.5bn in new equity. This decision was subject to parliamentary approval, which was not given until October 2020, after the parliamentary summer break. It was also very apparent that the perceived uncertainty regarding the State’s participation in the rights issue was a wet blanket over the share price for several months.

As a shareholder, the State also pays extra attention and needs additional information on specific areas such as sustainability. One specific example is management remuneration, for which the State wants more detailed information than is mandatory under Norwegian corporate law and stock exchange regulations.

The State’s ownership stake does benefit the view of our credit risk profile among banks and Norwegian bond investors. This perception has probably strengthened among other investors as well, after the State committed to its full NOK 2.5bn share of our NOK 5bn rights issue in 2020.

JT: Is capital structure a theme in your ongoing dialogue with investors and shareholders? Are there big differences in views between equity and bond investors? Or between different equity investors?

GSI: In short, yes! Capital structure is a theme brought up in virtually all of our investor meetings, typically towards the end of the conversation. This applies to all types of investors – equity, bond, domestic, and international. It is also a topic discussed at most of our board meetings.

Bond investors focus on changes to risks. Among equity investors, international investors are typically keen on replacing dividends with share buybacks, particularly to avoid withholding tax.

Investors all seem to agree that they prefer we put money in the company to use, rather than sit on idle, low-yielding cash. We will accordingly pay out some NOK 4bn to shareholders in the coming 12 months, which should be seen in relation to our annual profits of NOK 500-700m in 2018-19. We want to send a strong signal that we listen to and agree with our shareholders, will pay out funds that we do not need, and use buybacks as a complementary tool in a way that is attractive for investors.

If we had known everything we do today, we might not have needed to raise NOK 5bn in 2018 to acquire Rolls Royce Commercial Marine. The key reason at the time was the performance of the acquired business, which was in a tailspin with accelerating losses. Our priority was to secure the financial strength to integrate it and turn it around, irrespective of how many quarters it would take before demand stabilised. We are very aware that there are transaction costs associated with raising new capital and paying out excess capital, but these are very minor compared to the cost of financial distress.