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Leverage and financial strength affect share value
Leverage is the relationship of borrowing to equity
and cash flow. Financial strength, on the other hand, is a company’s ability
to meet its financial obligations, under adverse earnings, cash flow, and
liquidity conditions. The overall profitability of a company, combined with
the degree to which it utilizes leverage, determines its financial strength
and credit rating. Normally, the higher the credit rating, the stronger the
company. Additionally, a strong company has more opportunities to grow its
business, thereby increasing its stock price.
Pros and cons of leverage:
Leverage is said to be a two-edged sword. If the
proceeds from the leverage are invested in projects that generate cash flow,
and are accretive to earnings, then equity and share value can rise rapidly.
Most of your larger companies grow through acquisitions. In effect, they are
leveraging their balance sheets. The down side to leverage: when cash flow
dries up, equity and control can be lost very quickly.
In financial downturns, management’s decisions can be
dictated or influenced by the lenders. Even the fiduciary duty of the board
can “flip-flop” and change in favor of the lenders. Tyco experienced the
negative effects of being over-leveraged. For example, in July of 2002 Tyco
was pressured by its lenders to sell The CIT Group, which it had purchased
just a year earlier.
This resulted in a $4.5 billion loss to the Tyco
shareholders, even though CIT was a quality franchise that transformed Tyco
into a miniature GE. In situations where the lenders pressure companies to
quickly sell assets to reduce leverage, the shareholders are usually the
losers.
While leverage provides growth opportunities, it
comes with the price tag of increased financial risk and potential equity
erosion.
Why do companies borrow?
Most companies use a balanced mix of debt and equity
to fund business opportunities. Many companies prefer debt over equity,
because interest paid on debt is tax deductible, while dividend payments to
shareholders are made with more costly “after-tax” dollars. Equity
investors, moreover, expect a higher rate of return than lenders, due to the
extra risk that equity participants take.
It is actually cheaper and easier for management to
meet its financial ROE objectives by using debt financing over equity. This
is one of the reasons that companies become over-leveraged. Debt dollars are
cheaper than equity dollars.
How can investors tell if a company is properly
leveraged?
Investors need to ensure themselves that their
interest and control will be protected, by reviewing the company’s long-term
and short-term leverage. The long term debt to equity ratio measures
a company’s leverage; it’s an indication of a company’s ability to meet its
long-term debt obligations. Acceptable numbers vary according to industry.
Following are several general guidelines:
·
1:2 for small private companies
·
1:1 to 2:1 for larger public companies
·
10:1 to 12:1 for banks
The higher the ratio, the harder it becomes to
weather a downturn.
Cash flow to bank debt is another method used
to look at a company’s financial strength.
A company, in good and bad times, should be able to:
pay its bills as they come due; comply with its bank covenants; have the
ability to satisfy its long-term obligations, as scheduled; have an
emergency fund available; and have the wherewithal to take advantage of
unexpected opportunities as they present themselves.
All other things held constant, a balance sheet is
healthier with less debt.
How do companies improve their credit?
When the relationship between management and lenders
starts to turn upside down, companies that are over-leveraged use various
techniques to strengthen their balance sheet by repaying their debt.
One of the techniques used to improve a company’s
financial strength is down/right-sizing. Companies sell assets to pay off
the lenders, while hopefully keeping equity intact. Often, however,
shareholders’ equity is the extra cushion that companies need to satisfy
creditors, if proceeds from asset sales fall short of book value. This can
ultimately reduce the future earnings potential and existing share value of
a company.
Some companies ask their existing shareholders to
help improve their leverage, by issuing common stock rights. Stock rights
allow existing shareholders to purchase additional shares at below-market
prices, in order to raise equity. While this practice does improve a
company’s financial strength, it also dilutes the current shareholders’
percentage of ownership. Those shareholders who elect not to participate in
increasing their investment in the company are left with a reduced
percentage of the re-capitalized equity. The dilemma for investors is: do
they have the wherewithal and interest to purchase the additional shares?
Equally important to investors, is the concern that they may be throwing
“good money after bad money.”
For example, in the spring of 2002, Imperial Chemical
Industries (“ICI”) successfully raised approximately $1.1 billion from its
existing shareholders in an unstable market. The company was able to avoid
having its credit rating downgraded. For those investors who never heard of
ICI, it is a world class chemical company, that in the late 1990’s
reshuffled its product mix out of low margin commodity chemicals into higher
margin specialty chemicals, fragrances, flavors, adhesives, starches, and
paints. Was its effort a success? Absolutely yes! The company’s stock price
is up over eightfold from its low price of $6 in March 2003.
In many cases, a company’s leverage ratio is matrixed
directly with the company’s interest rates on its bank debt.
Can companies have too much equity? Absolutely!
At the opposite end of the debt spectrum are
companies with excess equity. While it’s a nice position to be in, it can
also have uncertain consequences. Excess equity lowers a company’s ROE
percentage and indicates that management is not deploying its resources
properly. This seems to be one of Microsoft’s headaches. As a result,
Microsoft distributed, in 2004, a one time, $32 billion cash dividend to its
shareholders. That’s not a bad perk.
Motorola, additionally, is in the news because it is
being targeted by private equity investors trying to get their hands on
Motorola’s accumulated cash hoard. In situations like this, private equity
investors try to weasel profits (cash) and opportunities away from the
smaller shareholders, to themselves. Proper capitalization, therefore, is
important and the mix between debt and equity needs to be delicately
balanced.
What do you look at?
Young adults should review the composition of the
total capitalization structure of their investments: how much of a company
is financed by equity versus debt? In a difficult financial climate, the
key concerns always center on the following: (a) does the company have any
emergency borrowing capacity, (b) is the company’s cash flow sufficient to
pay its bills, (c) does the company have any non-core assets that are worth
anything, and (d) if the company needs to down/right size, which assets
should be sold first?
When the economy is strong and business is
profitable, most investors focus on the P&L. When business is down, or the
economy is in a recession, however, it’s the financial strength of the
balance sheet that distinguishes a good company from a distressed one. A
byproduct of the last recession in 2000 is that companies have reduced their
leverage and are holding more cash. Executives now realize that a healthy
balance sheet, one with little debt, provides much needed “wiggle” room, in
a recession.
A
financially strong balance sheet is insurance protection for investors.
Healthy companies have reduced downside risk, and have the ability to
weather a storm, and to fight another day.
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