Wednesday, October 21, 2015

Corporate Debt: Elephant in the Room

How much is too much debt?  In its announced acquisition of EMC, Dell will borrow over $40 billion to complete the deal

Financial analysts, including equity-research analysts, asset managers, and investment bankers, spend gobs of time assessing the equity of a company.  They value the stock, they assess market and book values, and they project performance and tie that to the company's overall value.  

MBA students in finance take courses in analyzing stock values of companies. They learn theories of valuation, portfolio analysis, and the factors that influence market values.  In business school, however, they seldom immerse themselves in subject matter that addresses the intricacies and complexities of companies taking on debt. 

Unless they are credit analysts and risk managers at banks, even experienced analysts sometimes overlook the burden of debt. Or they don't address it properly. Or they take it for granted (take for granted that companies can borrow when they need financing to support growth and take for granted that companies can make payments in timely fashion).  Some analysts prefer companies avoid debt altogether or dismiss how debt can be a vehicle that leads to higher returns on equity.

(Corporate debt includes an array of funding sources:  bank loans, corporate bonds, private-placement notes, structured notes, subordinated debt, convertible debt, etc.)

Debt:  A Burden or a Spark?

Debt can be a burden; it be can be hurdle, a conundrum, or the elephant in the room. This month, Dell announced it will acquire EMC, the cloud-computing and data-storage company, in a major deal that will acquire that it assume over $40 billion in new debt to consummate it.  Will that debt load eventually haunt the combined companies? Or will it be the spark to promote revenue growth and surging earnings?

If shrewdly deployed, debt can lead to higher stock prices or company valuations.  Some companies could be better off if they borrowed more.  Other companies have no more room to borrow another dime.  

It's up to financial analysts (including bankers, fixed-income researchers, and arguably equity analysts) to determine what's the right amount--what's too much and what might be too little. How is the analyst assured that the company under review can generate cash flow to meet all debt requirements due in the next quarter?

Apple avoided debt by all means during the Steve Jobs era, but now embraces it (if only to pay dividends, buy back stock, and get accustomed to the discipline required to run a company with higher leverage).  Other companies (Dell and Verizon, e.g.) resort to debt to finance large acquisitions.

Others use a combination of new debt and new equity to spearhead growth and expansion.  Financial institutions, with blessing from regulators, pile on long-term debt to avert the possibility of an occasional "run on the bank." 

All companies (and the analysts who follow them), nonetheless, wrestle with the right amount.  When does debt become too much of a burden?  When do once-manageable debt loads evolve into a mad scramble by companies to find cash in its operations to make interest and principal payments?

Financial analysts have tools, models, and ratios--even for debt--to help them draw conclusions.  Yet analysts also use intuition and experience to determine how much is too much.

Debt-to-equity ratios are often analyzed. Cash-flow coverage models are deployed.  Analysts sample many capital structures to determine the right debt load.  Past experience and history (previous defaults, bankruptcies, and companies that deteriorated in the past, e.g.) and current statistics (probabilities of defaults, e.g.) are useful, as well.

Grappling with "Ebitda"

To determine what might be too much of a burden, a favorite, traditional ratio for analysts is a Debt-to-Ebitda (“E-bit-dah”). Earnings, of course, are an obvious source to manage the burden and pay down debt when it's due. Debt/Ebitda is a useful tool to measure what's too much, but the ratio alone is a flawed approach.

First things first. Let’s agree on what “Ebitda” is, why it is a popular reference to a company’s performance, and why it might lead to a flawed approach.

Credit and equity analysts like to use this common pre-tax earnings line item as a proxy for operating cash flow, a “back-of-the-napkin” estimate of actual cash generated from operations before they derive it more precisely.

Picture two bankers in a discussion of a client’s performance. They want to size up operating cash flow without the benefit of spreadsheets, calculators or detailed financial information. Ebitda is a start.

Ebitda is the first glance at whether operating cash flow is positive, negative or trending one way or the other. It is what it can be—a cash-flow proxy. Analysts, nonetheless, must be mindful it disregards working-capital adjustments, capital expenditures, and a list of other required pay-outs (e.g., lease and tax payments).

Sometimes Ebitda is a fairly close approximation to actual derivations; often, it over-states actual cash flow or disregards how a company may generate cash from non-operating activities (e.g., the sale of an investment or manufacturing facility). (Last year, Pepsico reported Ebitda of about $14 billion. An analyst might compute gross operating cash flow at about $12 billion.)

But all analysis must start from somewhere.

Debt-to-Ebitda as a Debt-Burden Tool

Now Debt-to-Ebitda. This ratio is used frequently to measure debt burden. To assess whether debt is too high or has become a financial challenge, analysts look at an array of debt ratios (Debt/Equity, Debt/Tangible Equity, LT Debt/Equity, Cash/ST Debt, e.g.).

Or they examine Debt/Ebitda. 

The ratio is popular among bankers, credit analysts, and deal-doers. It is widely used in loan agreements as a financial covenant (borrower requirement) or in comparing debt levels for peer companies in an industry. Ebitda is much easier to confirm than actual cash flow, which may require bankers from different institutions to agree on the derivation.

Analysts interpret the ratio in many ways. For example, it can be an approximation for how long (in years) it might take for a company’s business operations to pay down a set level of debt. 

For any analysis to be complete, analysts will still eventually go through the painstaking exercise to compute and project actual cash flows, but Debt/Ebitda gets the analysis off the starting blocks. 

Debt/Ebitda < 3, for example, as a financing benchmark, implies debt on the current balance sheet will likely take about three years to amortize, three years to expunge if the company opted to do so.

Indeed many strong companies with stable, predictable cash flows will exhibit Debt/Ebitda < 3. However, in the realm of “leveraged finance” (financing structures for less creditworthy, but established borrowers), those negotiating big debt deals will argue analysts should find a way to get comfortable with Debt/Ebitda > 5, based on an argument Ebitda (or actual cash flows) for the borrower is stable, sustainable, and predictable. 

Some analysts use the ratio as another way to put leverage in perspective. A borrower might have a high Debt/Equity ratio (> 3?), but with relatively strong earnings, could have a low Debt/Ebitda ratio (< 2?). Debt, therefore, may appear high on the balance sheet, but earnings are strong enough to amortize it quickly. 

Take a look at recent calculations of the ratio: Microsoft 1.6, Yahoo 5.5, Pepsico 1.6, Goodyear 8.8, and Merck 1.0. 

The ratios imply Microsoft, Pepsico and Merck have earnings that result in healthy cash flows that can amortize debt in less than 2-3 years. They suggest that Goodyear and Yahoo might have earnings and cash-flow woes, where debt will take years to amortize and could be a burden, especially if earnings prove to be volatile in the future.

In leveraged-finance transactions, analysts determine the maximum amount of debt that creditors will tolerate for an earnings stream (maximum Debt/Ebitda). The more confident they are that the borrower can achieve a stream of earnings, the more comfortable they are with debt, which will be amortized by the same, predictable flow of earnings. That explains the possibility of getting a debt deal done at Debt/Ebitda ratios < 5. 

When Verizon acquired all of Verizon Wireless from Vodafone in 2013 and took on $49 billion in new debt to do so, Debt/Ebitda calculations pushed toward eye-popping 9.0--very little room for error in operating performance to pay this all down.)

No matter how much the ratio is discussed or used, analysts should recognize its flaws, because 
  1. Ebitda, as mentioned, is still an approximation of cash flows,
  2. The ratio assumes cash from operations is available only for debt-related payments,
  3. The ratio disregards interest rates and related fluctuations,
  4. The ratio neglects that tax obligations are real, required, and must be tended to, and
  5. The ratio presumes earnings are not necessarily available for dividends, new investments and capital expenditures—an unrealistic scenario for many companies.
A thorough analysis, of course, requires the analyst to use Ebitda to derive actual cash flow from operations and to consider a variety of factors, including investment requirements, working-capital requirements and adjustments, and perhaps other cash sources. 

But all deals, discussions of new financings and negotiations must have a starting point, and why not Debt/Ebitda?

Debt Capacity: 
What's the Most a Company Can Tolerate?

For any company under review by an analyst, what about the approach of computing the maximum amount of debt the company's operating cash flows can handle?

When they project operating cash flows in the periods to come, whether 5- or 7-years out, analysts measure whether a company can pay down existing debt and interest expense and any new debt that’s necessary to generate those projected cash flows. 

Analysts, too, if they wish, can compute an imprecise, but useful number: a maximum “debt capacity,” the highest amount of debt the operations can tolerate over a certain time frame. (Five-year debt capacity would be the sum of discounted projected cash flows over five years, discounted at the interest cost of debt and assuming all cash flow is used for debt-service only.)

“Debt capacity” can be a marketing tool for bankers in discussions with clients who contemplate new debt to finance growth, new investments or planned expansion. Knowing what might be maximum debt capacity, bankers can respond immediately to a client to confirm whether new debt is worth considering. 

Pepsico, for example, has about $23 billion in debt. A rough debt-capacity exercise might show its extremely reliable cash flows will tolerate as much as $20 billion more in debt (or $45 billion in total capacity). It won’t need this much in new debt, but it proves what its operating cash flows can handle despite debt-equity ratios that continue to rise.

Debt-capacity calculations come with red flags. Does the calculation reflect all the capital expenditures necessary to keep the company growing? Does it allow for cash to be set aside for unplanned or emergency purposes? 

Does it permit companies to pay dividends to shareholders who expect predictable quarterly payouts (as a company like Pepsico would surely want to do)? Does it capture no-growth and worst-case scenarios? 

Just like the Debt/Ebitda, “debt capacity” is merely one tool among many. Analysts must probe and still take steps beyond. 

At least companies (and the analysts who assess them) have ways to get more comfortable with that elephant in the room, tame it and use it to gain advantages to shareholders. 

Tracy Williams

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