Sunday, May 14, 2006

The Corporate Debt Shell Game

American companies have spent the last few years of boom building up a huge increase in profits. But at the same time companies have spent the last two years building up a truly massive amount of debt, despite solid cash flow and surging profits. Whenever I see conflicting numbers like that I start to look for the “trick”.

I have found the trick and am here to tell you about it.

The trick here is tax related. Cash paid out to repay debt is a deductible expense for the payer and income for the receiver. Together with today’s low interest rates this tax detail leads to an interesting form of financial engineering.

Let’s go through how it works.

Imagine a company, XYZ corp, with 100 shares trading at $10 each and no debt. XYZ makes a profit before taxes of $100 each year by providing whatever service it is that XYZ does, which amounts to a net profit of $65 after taxes. The market values XYZ at a Price-to-Earnings (PE) ratio of 15, which means that $65 of profit equals a market value of $975 and each of those hundred shares is trading at $9.75.

Now along comes a hedge fund who has bought a chunk of XYZ stock. They want management to raise the stock price and they have consultants to show XYZ exactly how to do it. Using their currently solid balance sheet XYZ borrows $500 at a 6% carry cost (meaning they will pay $30 per year; assume for the example that’s all interest because the loan is non-amortizing), then XYZ uses the $500 loan to buy back shares, taking 51 shares off the market.

XYZ is still making $100 per year from its business, but now they pay $30 of that as deductible interest before taxes which leaves $45.50 after taxes. They earn less cash but the $45.50 profit is only matched against 49 shares still on the market so at the same PE of 15 each share is worth $13.92, and the hedge fund just made a 43% return by inducing the healthy XYZ corporation to dirty up its finances. All perfectly legal.

Last year I noted an article about a coal mining company called Massey Energy [MEE]. A hedge fund called Jana Partners demanded Massey buy back $1.5 billion in stock. Massey announced a $500 million buyback and told Jana Partners it didn’t have the money for a larger buyback. Jana demanded that the company borrow the money – essentially demanding they execute the strategy above. The drama is still unfolding with another hedge fund piling on and more demands on the company than ever.

Time Warner [TWX], similarly, had plans to buy back $5 billion in stock. Financier Carl Icahn wanted the company to buy back more shares and threatened to make trouble for the board. This time the board caved in. Time Warner, already holding $20 billion in debt, now plans to buy back $20 billion in shares, approximately 25% of its market value.

A final example is copper mining company Phelps Dodge [PD]. Five percent owner Atticus Capital demanded a stock buyback last year. That October Phelps Dodge announced $1.5 billion in buybacks and dividends. In a now familiar refrain the hedge fund pushed the matter further a few months later and demanded even more debt financed buybacks, driving Phelps CEO Whisler to publicly announce in February that he considered such a path a “reckless bet that could threaten our company's future". Despite this tough talk it’s hard for a CEO to fight such large shareholders (the stock dipped on his nasty letter), in April Phelps Dodge grudgingly arranged for an additional $500 million in buybacks.

All told the buyback wagon carried $349 billion out of company coffers in 2005, a 77% increase over 2004. For another view of this trend we can look at Federal Reserve numbers on equity issuance rates. Companies frequently issue debt so the number has wandered around zero, creeping from -$120 billion (meaning companies retired $120 billion more in equity than they issued) in the late 1980s to the high $40 billion range during the tech boom as lots of companies were issuing shares and going public. But recently the nature of the data has changed altogether and in 2005 almost $400 billion more equity was retired during buyouts than was issued – and this during a year that saw a resurgence in IPOs.

So what does all this mean to us? Well it means different things for stocks and bonds…
Stock buying

If you have enough money and want to become a buyout king this technique means you don’t need to know much business. Just buy up a company and borrow a pile of money at low rates to retire equity, then use the altered balance sheet to show Wall Street nice numbers and sell shares again. A fair number of titans of finance have made money using this very method.

On a more quantitative level it is helpful to know that A. Eberhart of Georgetown’s McDonough School of Business and A. Siddique of the office of the Comptroller of the Currency have done a study of over 7,000 buybacks announced from 1981 to 1995. They found no significant long term improvement in performance of the stocks or the companies, although they do acknowledge a stock price bump after the initial buyback announcements. Apparently the weakening of the balance sheet is noticed by Wall Street after a little while and offsets any gains. In fact, the average firm engaging in a buyback actually winds up needing cash after not very long and winds up increasing shares outstanding by 23.7% within 5 years after announcing a buyback. This, of course, is exactly the strategy from the preceding paragraph.

The short version of this analysis is that it might be a good idea to be like a hedge fund and sell your position not too long after a buyback announcement (which in this context could mean up to a year) because a company loaded with debt is carrying a very real business burden. The example XYZ corporation above was almost magical, seeming to increase the value of the shares while the underlying business stayed the same, but in reality the resulting business is far more brittle and unable to react to changes in the industry or needs for capital spending. The market is full of debt-saddled companies who need capital (consider Quest [Q] and Sprint [S] – both still recovering from massive borrowing to support capital buildout) and they often are not good investments. Think like an owner and buy good businesses that you want to own, and head for the door if someone else tries to wring the blood from the company for short term gains.

The Bond Market

The huge spate of debt financed buyouts (to the tune of well over half a trillion dollars in the last 24 months) has added a huge amount of debt to the bond market. This trend is in competition with the delta hedging and carry trade factors I have written about in the past.

The buyouy strategy only makes sense if the cost of borrowing is low (6-7% is probably getting to be the limit) so as soon as rates rise past this point the rate of debt issuance will drop, lowering supply and raising prices a bit. This will probably moderate the rate of interest rate increases a bit, although I am still comfortable with my bet against bonds on Profunds Rising Rate Opportunity Fund [RRPIX] and I hope you took advantage of it as well. Here at the Finance Wonk I always own every position I call a BUY on and this position has been gaining nicely while the rest of the market has been dropping on inflation fears. It’s only been a few weeks since I put a buy on it and I reiterate my call now.

In Conclusion

When buying a stock we should be thoroughly reviewing the business looking for strength and growth in a solid business with as little possibility of disaster as possible. The large amounts of debt some companies have been taking on limit their ability to build the business while making the company very sensitive to a downturn. I would consider any debt-ridden company to be questionable for investing.
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Anonymous Jo said...

So, are you saying that they're carrying a lot of debt to have the interest write-off? Thanks again..

2:25 PM  

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