Making The Case For Leverage

8/27/2012


Low interest rates on Treasury bonds have prodded investors to climb further out on the risk curve toward high-grade corporate debt and junk bonds, causing rates to fall for bonds of all stripes.

With investors reaching for yield, companies are eager to meet demand and lock in historically low interest rates. Through mid-August, U.S. companies had already sold $86.3 billion in 30-year bonds — more than they did in all of 2011, according to the Financial Times. In July, U.S. companies issued $75 billion in bonds, a record high for the month. During the first two weeks of August, U.S. corporations issued $40 billion in high-grade bonds and $30 billion in junk bonds — the latter number the highest on record for the full month despite two weeks yet to go.

Leverage was frowned on during the financial crisis. But it could be wise for some companies, especially those with stable businesses and steady cash-flow streams, to become more aggressive with their balance sheets. With many companies able to issue bonds at yields well below the earnings yield (12-month earnings per share divided by share price) on their stock, substituting debt for equity can benefit shareholders.

A few companies have been doing debt right:

DirecTV ($52; DTV) inherited about $2 billion of debt from a 2009 merger with Liberty Entertainment, while much of its other borrowing has funded share repurchases. Since launching the buyback program in 2006, DirecTV has spent $23 billion to repurchase nearly half of its stock. The company continues to replace higher-yielding bonds with cheaper debt and says it could revisit the bond market again later this year. And management said it has not ruled out a dividend.


In 2008 and 2009, during the height of the financial crisis, Alliance Data Systems ($136; ADS) issued debt to repurchase $1.5 billion shares at an average price of just $51. Today, the company is using cheap debt to finance expansion in Brazil and India.


Intel ($26; INTC) issued $5 billion of debt last September, then repurchased its own stock, trading around $20 per share at the time. Intel's per-share dividend has jumped 50% over the last three years, but the total payment is up only 35%. Buybacks have trimmed the share count by 7%.

LEVER UP!
These three recommendations are already leveraging their balance sheets.
Company (Price; Ticker)
LT Debt
Issuance,
Last
12 Mos.
($)
LT Debt/
Total
Capital
(%)
Total
Debt
($)
% Debt
Due In
Next
3 Yrs.
Interest
Coverage
Ratio
12-Mo.
Interest
Expense
($)
12-Mo.
Free Cash
Flow
($)
Alliance Data
($136; ADS)
5,761
94
7,519
68
2.4
287
927
DirecTV ($52; DTV)
4,396
134
15,962
1
4.3
806
2,378
Wyndham ($51; WYN)
4,832
66
4,120
27
4.9
142
617

Below, we review two companies that seem capable of bolstering shareholder returns by levering their balance sheets.

Unlike predecessor Steve Jobs, Apple ($656; AAPL) CEO Tim Cook doesn't feel compelled to keep a massive cash stockpile on the balance sheet. On Aug. 16, Apple distributed $2.65 per share to investors, its first quarterly dividend since 1995. Apple also plans to spend a total of $10 billion on share repurchases over the next three years, principally to offset employee stock options.

In all, Apple plans to pump $45 billion out to shareholders in the next three years (implying dividend growth of 15% in each of the next two years), though it could be doing a lot more. After all, free cash flow totaled $45.67 billion in the 12 months ended June, soaring 55% from year-earlier levels and flooding the balance sheet, now loaded with $117.22 billion ($124 per share) in cash and marketable securities. Apple earned a paltry 0.77% return on its cash and investments in fiscal 2011 ended September, similar to the fiscal 2010 rate. Shareholders would be better off if Apple put its balance sheet to work.

Suppose Apple adopted Cisco Systems' ($19; CSCO) new plan of returning to investors at least 50% of annual free cash flow. Apple could double the current dividend (equating to a yield of 3.2%) and still have $5 billion left for buybacks. For now, any such move seems unlikely.

Earlier this month, Apple's stock-market value topped $623 billion, breaking a record set by Microsoft ($31; MSFT) in 1999. In the wake of a three-year run-up of 288%, the company accounts for nearly 5% of the S&P 500 Index and 19% of the NASDAQ 100 Index. A big buyback would reduce Apple's stock-market value, perhaps allowing institutions and others worried about having an excessive position in one name to become buyers of Apple again. Apple is a Focus List Buy and a Long-Term Buy.


Chevron ($112; CVX) has grown its dividend between 5% and 13% in each of the last five years. The oil giant repurchased $3.0 billion of its own stock in the first half of 2012, lowering the share count by 1%, and it expects to retire $1.5 billion more shares in the September quarter.

Chevron could accelerate repurchases by taking advantage of its credit rating, just one notch below the coveted AAA. For instance, lower-rated peer Apache ($88; APA) sold five-year bonds at 1.75% and 10-year bonds at 3.25% in April. It seems safe to conclude that Chevron could borrow at rates below its current dividend yield of 3.2%, let alone its earnings yield of 11.8%. The oil giant also seems capable of handling the debt repayment. Its 12-month free cash flow has exceeded $5 billion in each of the last nine rolling 12-month periods — and that's after accounting for capital spending of at least $17 billion in each period.

At the current share price, $5 billion in cash annually could, over a three-year period, repurchase enough stock to reduce the share count by 7% while maintaining the current dividend yield. Should we expect that kind of sharing with stockholders every year? No, especially if capital spending continues to rise. But Chevron has plenty of room to both step up its buybacks and grow its dividend, even without tapping into the debt market. Chevron is a Buy and a Long-Term Buy.

WHEN DEBT MAKES SENSE
Below we list companies that might be better off borrowing to boost their dividend yield or repurchase shares. All of the companies in the top group, those that already carry substantial debt, paid a lower interest rate on their debt than their earnings yield. We estimated the interest rate by dividing interest expense over the last 12 months by total debt. Earnings yield represents earnings as a percentage of the stock price, the inverse of the price/earnings ratio. The interest coverage ratio, the sum of trailing 12-month interest expense and operating earnings divided by interest expense, reflects how comfortably a company's profits can cover its borrowing costs. All dollar amounts in millions.
Company (Price; Ticker)
LT
Debt
($)
Total
Debt
($)
LT Debt/
Total
Capital
(%)
Interest
Coverage
Ratio
12-Mo.
Interest
Expense
($)
12-Mo.
Interest
Rate
(%)
12-Mo.
Free
Cash
Flow
($)
Cash &
Equiv.
($)
Indic.
Div.
Yield
(%)
Earnings
Yield
(%)
Cost To
Repurchase
10% of Shares
($)
Annual
Cost
To Boost
Yield
To 4%
($)
Borrowers that could keep levering
Chevron
($112; CVX)
9,872
10,231
7.0
107
251
2.5
5,357
21,463
3.2
11.8
22,038
1,730
Exxon Mobil
($87; XOM)
8,877
15,581
5.0
122
330
2.0
13,402
18,017
2.6
9.0
40,730
5,674
Google
($670; GOOG)
2,987
6,205
4.1
135
83
1.7
12,808
43,122
0.0
5.9
22,147
8,859
Intel ($26; INTC)
7,093
7,185
12.7
48
263
3.6
5,219
13,648
3.4
9.6
13,575
751
Microsoft
($31; MSFT)
10,713
11,944
13.9
62
380
3.2
22,936
63,040
2.6
9.1
25,835
3,624
Companies that could start levering up
Apple
($656; AAPL)
0
0
0.0
NM
0
NM
45,670
111,221
1.6
6.5
62,133
14,814
Bed Bath & Bey.
($66; BBBY)
0
0
0.0
NM
1
NM
958
1,687
0.0
6.4
1,536
614
EMC ($26; EMC)
0
1,622
0.0
25
116
NM
5,668
5,653
0.0
6.2
5,771
2,308
Qualcomm
($62; QCOM)
136
1,105
0.4
51
104
NM
3,663
13,395
1.6
5.8
10,914
2,607
Visa ($128; V)
0
0
0.0
NM
0
NM
3,605
7,471
0.7
4.6
8,531
2,824
NM Not meaningful because companies don't have debt or interest expense, or their debt levels are inconsistent.   
NA Not available.

 


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