When debt can be good in picking stocks (yes, I just said that)
August 29, 2009
– Comments (13)
In this blog I am going to take a look at situations where a company having a considerable amount of debt can be advantageous for investors. I'll present two basic principles of why this can be so.
The first principle is market sentiment related: the market prices debt very negatively, (and, conversely, prices cash on a balance sheet very positively). Imagine two companies with identical p/s's p/e's book value/share, etc. Book value for each stock is 10, lets say. One has $10/share in debt, one has $0 debt and $3 of cash. It seems to me, from my observations of the markets pricing of stocks, that the company with debt may be priced at $6 while the other may be priced at $15.
In essence, imagine that Wall Street values $1 on a balance sheet as worth 3 bucks, while $1 of debt on a balance sheet is worth negative 50 cents or something. It seems, strongly, to me that Wall Street prices debt quite negatively and cash very overly positively. The good reasons for this are many. A company with no debt and cash is more recession resistant, shock resistant, possibly more able to invest and grow, etc., etc., etc.
So principle #1: its well established that the biggest money is made buying things that are out of favor, because being out of favor produces favorable pricing, as in out of favor produces cheap stocks. Debt is intrinsically out of favor while cash is intrinsically in favor. This produces one reason why companies with debt, as investments, may have (at times, there are of course times when debt is crushing, which we'll cover later) an advantage.
And now here's principle #2: fully manageable debt provides built in earnings growth. Like this:
Company X has $5 billion of revenue, $500m of cash flow, $250M of profits, and a market cap of $2B, and $2B of debt. It pays down debt at a rate of about $100m per quarter. Lets assume that business never improves and stays flat for 5 years. In year 1 it makes $250M. In year 2 it has only $1.6B of debt because it paid down $100M/quarter. So in year 2 it has $400m*8% less interest, or $32M interest, earnings would now be $282M. Cash flow would also improve... and they could pay down debt that next year to $1.17B. Saving an additional $35m of interest, earnings rises to $317M. The next year? $350M. The next year? $385M. The next year? etc, etc, etc, etc, etc. They'd top out at $410m of profits without any actual growth. And ...
And principle #1 would come into play as they moved from a company that is priced too low because of debt to a company priced more favorably due to low debt.
The stock could easily double without any improvement. $2B for a p/e of 8 when it had debt. And perhaps $5B for a p/e of 12 when it was debt free (higher earnings due to the paying down of debt and a higher multiple due to now being a "low-debt" company).
Now, there are of course very well documented risks to debt. A company could violate a covenant, get a higher interest rate and huge penalties due to the resulting default. Debt has destroyed many companies in the current crisis. Its driven others to the brink and permanently lowered shareholder value in others. Debt can be very very bad.
But in select cases where the debtload is clearly manageable, frankly, I think companies with a significant debtload and represent unusually good investing opportunities. For the 2 reasons above: intrinsic earnings leverage and the ability to improve valuations that the market tags them with as debt is paid down.
3 companies come to mind in this area:
1. ASH. ASH got sent from $70 to $5 over debt related to their purchase of Hercules. Sicne then its recovered about 1/2 way to the mid $30s. ASH's debt was, in my view, always clearly manageable and I think it'd be silly to think today that it isn't. They've lumped off debt to the tune of 100's of millions in the few quartesr since the purchase and should continue to do so. The reduced interest coverage should create intrinsic earnings leverage, and ... and beefore I had this thought about the intrinsic earnings leverage of debt thats being paid down (due to lower interest costs) I had thought my ASH holdings ... possibly overvalued. I'm more comfortable holding ASH when viewed from this light. My ASH holdings are hedged.
I don't konw if I'd be a buyer of ASH today or not, but I'm very comfortable holding it and frankly I think its overwhelmingly likely that in the fullness of time it moves significantly higher.
2. BZ. BZ has been ona rocket ride lately, doubling in a few days last week/early this week. BZ is a similar case. They have considerable debt at $1B for a market cap thats much lower than $1B. But they are lumping off debt relatively quickly, and with each chunk of debt thats lumped they increase earnings for the next quarter by reducing interest expenses. Same basic story as ASH and I think that I'm not a buyer of BZ here, but I will be a buyer on a significant pullback, and in the fullness of time BZ drifts higher than today by an amount worth waiting for.
BZ and ASH are both profitable and both lumping off debt very rapidly. And... they demonstrated this well before their shares approached current prices, providing a nice buying opportunity under the thesis of this blog. Both BZ and ASH have drastically cut costs to attain profitability in a rough environment and that additionally levers their earnings to an improvement in the top line from economic recovery or even just inventory restocking.
3. MGM. MGM has massive, massive debt, many times its market cap. If MGM can start to lump that debt off, it will free up cash flow from reduced interest coverage, allowing more lumping off of debt, freeing up more...
and creating a situation where MGMs shares may trade at a multiple of today. In the fullness of time, it certainly doesn't have to happen soon and the onus is on MGM to demonstrate that they can start lumping off that debt in the coming quarters.
I offer not that one should seek companies with debt. I simply offer that one should not automatically exclude them, because of the 2 reasons above and those reasons ability to create a situation in which both earnings and the multiple that the stock trades at improve even without growth or an improvement in business.
ASH was an easy, obvious call in February, BZ was a really good one a couple months ago, and I think I'm a bit ahead of the curve with thinking MGM can get a grip on their debt, start paying it down, and show good earnings in coming years here.
I can always be wrong, and frequently am. I don't recommend anybody ever take my thoughts on short term market moves as anything but random blatherings, lol
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