4.17 Corporate Debt Market:  Wal-Mart and Target Different Approaches

From the 10-K it is evident that Wal-Mart has more of a mix of short term debt and interest rate swaps as part of its financing strategy.  This is reflected in the comparison of the long term debt to total debt ratios for Wal-Mart and Target.  Observe that Wal-Mart is increasing its reliance on short term debt to take advantage of the very low interest rate environment in the US whereas Target is pursuing a more traditional approach of increasing its long term debt.  However, the subtle difference between Wal-Mart’s and Targets financing strategy is revealed in the following part of the 10-K report from Wal-Mart:

We enter into interest rate swaps to minimize the risks and costs associated with financing activities, as well as to maintain an appropriate mix of fixed and floating-rate debt. Our preference is to maintain between 40% and 60% of our debt portfolio, including interest rate swaps, in floating-rate debt. The swap agreements are contracts to exchange fixed- or variable-rates for variable- or fixed-interest rate payments periodically over the life of the instruments. The aggregate fair value of these swaps represented a gain of $240 million and $304 million at

January 31, 2010 and 2009, respectively. A hypothetical increase or decrease of 10% in interest rates from the level in effect at January 31, 2010, would have resulted in a loss or gain in value of the swaps of $25 million and $24 million, respectively. A hypothetical increase or decrease of 10% in interest rates from the level in effect at January 31, 2009, would have resulted in a loss or gain in value of the swaps of $17 million.

You can see that Wal-Mart uses swaps to manage the cost of financing as well as to manage interest rate risk, and they are aware of the risks of the contracts, and that this was profitable.

On the other hand, a close reading of the 2010 10-K reveals that Target’s use of swaps is for hedging interest rate risk as opposed to reducing borrowing costs.  A relevant excerpt from Target’s 10-K is:

Derivative financial instruments are reported at fair value on the Consolidated Statements of Financial Position. Our derivative instruments have been primarily interest rate swaps. We use these derivatives to mitigate our interest rate risk. We have counterparty credit risk resulting from our derivate instruments. This risk lies primarily with two global financial institutions. We monitor this concentration of counterparty credit risk on an ongoing basis.  

This implication is reinforced by comparing the borrowings and interest expense from the two firms.  For Target the debt that is not collateralized by credit card receivables is:

2009:  707+10643,

2010: 728+12000

Targets interest expense is:

2009:  707, 6.18%

2010:  728, 5.49%

This is higher than Wal-Marts debt:

2009:  37,804

2008: 38,703

and the interest expense is:

2009: 1787, 4.72%

2008: 1896, 4.90%.

From the above it appears that Target is paying more for its non-credit card collateralized debt than is Wal-Mart.

Qualification

While we see differences in the financing strategies, this does not necessarily mean that one firm has a better strategy.  For example, in the low interest rate environment of 2009 and 2010, a company with a good credit rating can lock in low rates for a long period rather than using other methods.  It also depends on the company’s debt portfolio; if it had issued high interest rate debt in the past, it can take advantage of interest rate swaps.  If it has very little debt, it may be better to issue new debt at fixed rates.

We next turn to the main theme underlying leverage analysis.  This is to relate the various activities performed by a firm to growth.