How Today's Debt Lowers Tomorrow's Returns
It's not just an increase in risk that happens once a company
has a lot of debt. It is also a decrease in stock buying back
ability and dividend paying ability. This is one reason why
EV/EBITDA is important in all cases, but especially important to
private equity buyers.
Let's use the word "excess" to mean a more than normal amount - a more than "right" and "sustainable" amount in our opinion - of something. Well then excess cash is cash a company should pay out. And excess debt is debt a company should pay down. In this sense, debt is anti-cash. And cash is anti-debt. A stock can swing from negative $5 of cash (which we call $5 of debt) to positive $5 of cash. Often, we would just say that positive $5 of cash adds $5 of value. But, what if the "right" amount of debt for a certain stock to have was almost certainly $5 of debt per share - and yet it had $5 of cash. Does it really have $5 of cash? Yes. But can't we also say it has $10 of excess cash?
That's a weird way of putting it. But it's not an entirely wrong way of putting it. And it's a very helpful way of thinking about a stock.
From the time you buy a stock till the time you sell it you want three things to happen:
1. You want the P/E to rise
2. You want earnings to grow
3. You want as much cash as possible to be paid out to you
As a rule, buying a company with a low price and spare debt capacity - a low EV/EBITDA - is a blessing on those three fronts. Meanwhile, buying a company with a high price and a heavy debt load - a high EV/EBITDA - is a curse on those three fronts.
It's important to think about returns in time and over time. Debt can be good. But it is the change in debt that we want. We do not benefit from buying a company that already has a lot of debt. We benefit from buying a company that can add a lot of debt in the future.
In this article, I'll set aside the critical issue of what a company actual plans to do with its cash and debt. Here, I'm just going to talk about what a company could plan to do. This is where EV/EBITDA is helpful.
Imagine a company has $20 a share of cash and $5 a share in free cash flow. Many people will see this company as being worth either $75 a share (15 times free cash flow) or $90 a share (15 times free cash flow plus net cash). But the reality of your return in the investment is actually a little different from that.
If you hold the stock for let's say 10 years and the stock can be sold for 15 times free cash flow at the end of that period then you can earn a return based on that sale. But, you can also earn a return based on the free cash flow you harvest in the meantime. That is, you can have your cake and eat it too. You can consume the free cash flow for the 10 years you hold the stock. Then you can sell the future free cash flow - year 11 and beyond - to somebody else for 15 times a single year's free cash flow.
Now, imagine a company is safe enough - like a food, beverage, tobacco, etc.-type company - to be loaded up with 4 times free cash flow in debt.
This is what that same stock would look like under those circumstances:
$20 a share of debt
$4.50 a share in free cash flow
Now, let's look at what this stock might sell for in 2023. A share price of 15 times (very leveraged) free cash flow still seems reasonable for a dependable business. That would be $67.50 a share. However, we now have an extra $40 a share to use. That is the money that came from taking the $20 in cash off the balance sheet and adding $20 of debt.
We can use the $40 a share to buy back stock. In fact, if the price of the stock stayed around 15 times free cash flow, we could buy back 60% of the shares. We would also have annual free cash flow over the 10 years of $4.50 a share. The result would look something like this:
FCF per share growth caused by buying back 60% of shares over 10 years: 9.6% a year.
So we have manufactured nearly 10% a year in annual growth just from a stock buyback. And, really, just from a one-time recapitalization. In fact, there would still be the $4.50 a share in free cash flow - if the company never paid down its debt. This free cash flow could be used to buy back even more stock, pay out a dividend, etc. Depending on whether you bought back stock in a big gulp at the start of the investment period, evenly over time, etc. the dividend you could pay on the original purchase price would vary. If used entirely as a buyback, this company could - theoretically, it would be very hard to do practically - increase its EPS by 18% a year over 10 years just through going from $20 a share of net cash to $20 a share of net debt once at the start of the decade and then always using every penny of free cash flow to buy back stock.
Notice, however, that if the debt level is kept steady the whole time the buyback can only create about 9% annual growth. It is the original recapitalization from $20 of net cash to $20 of net debt that creates the other 9% to 10% a year of EPS growth potential through buybacks. This is a one-time occurrence caused by an underleveraged balance sheet moving to an overleveraged position. It's basically equivalent to an LBO of a company that stays public.
Next, what is the risk that a company with $20 a share in cash will deleverage in the future?
And what is the risk that a company with $20 a share in debt will deleverage?
I think the risk of the $20 a share in net debt company deleveraging is higher. If the company chooses to deleverage completely, you - the new buyer at the end of 10 years - will have to forfeit five years of having your cake and eating it too. You will have your cake. But for four to five years, while the $4.50 to $5 in free cash flow is used to pay down the $20 in debt - you will not be able to eat your cake too.
Yes, risk rises when a company has debt. But return also decreases. The company has already spent the leveraging up ammo it had. It can't do that twice. It can maintain its current position - giving you the same free cash flow yield - but so can a company with net cash. And it can go back from a high leverage position to a neutral position. That could cost you several years of free cash flow. Years will pass but there will be no harvests for shareholders. Only the bondholders will get fed. We don't want to own a stock during those years.
For this reason - just like with dividends - it is often better to look for a company with the capacity to leverage up rather than look for a company that is now leveraged up. After a company has leveraged up and bought back stock - if the market rewards this - is the worst time to buy the stock. It may be a good stock to buy. But if we were trying to time the purchase of that stock, it would be best to buy when the stock is cheap on an unleveraged P/E basis. The very best purchase to make is one where the P/E is 8 today, the company has net cash, etc., but the P/E will one day be 16, the company will have net debt, etc.
Some investors - and I know Warren Buffett is this way - are looking ahead 5 to 15 years or so and asking what kind of returns they will get in the stock. Paying down debt is a very low-return activity.
Right now, the average stock buyback may return anywhere from 4% at the very worst to a little over 10% in the very best stocks. For many U.S. companies, paying down debt actually returns less than 4% a year. Remember, the company is doing something that has negative tax implications. So, a 4% pre-tax cost is actually an exaggeration of what the company is paying after tax. It is very hard for me to find any companies today where paying down debt seems to create more value for shareholders than buying back stock. In some cases, the differences are huge.
I am looking at Weight Watchers ( WTW ) right now. The question of what they will do in terms of leveraging, deleveraging, etc., over the 3 to 15-year holding period I imagine is key to understanding what I think the stock will return. There could be a huge difference between what the company grows by and what the stock returns.
You can see this in the history of Weight Watchers since the 1999 takeover by Artal (buying from Heinz). The company's sales - including acquisitions - have grown 12% a year over the last 14 years. Meanwhile, Artal (the private equity owner) has earned way more than 25% a year. The reason is the low amount of cash Artal put in and the constant releveraging and stock buybacks.
So it is not just a question of risk. Leverage increases risk. But it also increases return. When you have a lot of debt right now, you have both a higher-than-normal risk today and a lower-than-normal return in the future.
Of course, that is assuming normal (leveraged) prices. In other words, this would be true if the market were leverage agnostic in how it awarded P/E ratios. That's not exactly true. The market tends to recognize a very high-debt company may need a lower P/E and a company with a lot of cash may need a higher P/E. But very often the market undercompensates for this.
The real issue for the investor - in terms of returns during her holding period - is not the level of debt or cash itself. Rather, it is the change in debt and cash. Cash on the balance sheet is cash that can be paid out without being produced in free cash flow. If I buy a stock with $1 of free cash flow and $12 of cash and hold it for 10 years, I can receive cash payments of $22 during that time not just $10. Unfortunately, the reverse is also true, if I buy a stock with $1 of free cash flow and $12 of debt, I can receive cash payments of zilch during that time, not the $10 you might think I'm entitled too. It depends on where the company puts the cash. A DCF should be a discounted calculation of all cash flows through the stock - not just a record of the company's recorded earnings, free cash flow, etc.
I think Eddie Lampert and John Malone's behavior may make more sense when seen in this way. John Malone would like to pay down as little debt as possible and pay as few taxes as possible while he owns a business. He - like a private equity owner - wants to take cash out of the business, buy back stock, make smart acquisitions, etc. Then he would like to sell it to someone else with debt attached. He would also like someone else to have to pay the taxes. So he wants an approach that maximizes his ability to add leverage while he holds a stock while minimizing the need to pay taxes today. The best way to do that is to target high EBITDA and low reported earnings. In fact, he wanted to avoid reporting earnings at TCI. Once that business becomes mature enough that it has a good EPS appearance, it is no longer a strong investment candidate because it is now more taxed in the present. So John Malone often looked at a business in terms of its debt capacity. How much debt can I add? He didn't want to be the debt owner. He wanted to be the equity owner who would benefit from all this debt.
Value investors outside of private equity often overlook the potential of an underleveraged business becoming a leveraged business while you own it. In fact, the best way to make money in stocks is not 100% from growth, 100% from payouts, etc. It is from having your cake, eating your cake and growing your cake all at the same time. The best business is something that can grow 5% a year without needing any more capital, that can pay out all its free cash flow (or use it all to buy back stock) while you hold the company, and then can be sold for 15 times free cash flow when you're done with it.
Thinking this way will help you in both your Buffett-style investments and your Graham-style investments. For example, it will help you understand why buying a profitable company at a negative enterprise value is a good investment. It is not just a guarantee of a bargain. It is also the possibility of a better return. A negative enterprise value is the best indicator of an underleveraged company. All value investors see the bargain nature of such a purchase. But some do not see the upside potential. These same investors are unlikely to see the downside potential - to return rather than risks - in a company that already has a lot of debt.
Cash and debt are not just numbers to consider in a liquidation analysis. They are not just static figures. They can be changed. Often, they will be changed while you hold the stock.
There may come a time when an underleveraged company pays out cash, buys back stock, makes an acquisition, etc. When this happens the P/E ratio will tell you what the EV/EBITDA ratio always told you.
Nothing lasts forever. If a company has too much cash or too much debt you need to do more than compliment or criticize management for their past decisions. You can't earn returns on the past.
Current levels of cash and debt - and how they can determine the amount of future free cash flow that goes your way - are important points for investors to consider. They are most important in the context of time.
If you look only at free cash flow now you are assuming that the accumulated past of a company need never be dealt with. That is true only to the extent the balance sheet you are buying into is "normal" now and will be "normal" forever.
If you are buying into an underleveraged company, you may get more than your fair share of free cash flow while you hold the company - because you bought the stock at the right time in terms of the balance sheet. When you buy into an overleveraged company, you may get less than your fair share of free cash flow while you hold the company - because you bought the stock at the wrong time in terms of the balance sheet.
There is nothing wrong with capital allocation timing a stock. Timing your purchase to get the best future capital allocation is as sensible as timing your purchase to get the best price.
In both cases, we can't know what the absolute turning point will be. But we can certainly buy into stocks that are more likely than not to be at unusually low prices and more likely than not to have unusually good capital allocation in their future.
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