Used Wisely, Debt Can Be An Asset
For corporate America, today's unusually low interest rates make it a good time to borrow. Just ask Intel ($23; INTC). Last month the semiconductor giant sold $5 billion of debt in its first traditional bond offering since 1987. Other prominent players, such as Hewlett-Packard ($24; HPQ) and AT&T ($29; T), have also done bond deals of $5 billion since May.
Companies of all stripes — even those with solid balance sheets and plenty of liquid assets — are issuing debt to take advantage of cheap financing. In the first half of 2011, U.S. companies sold roughly $448 billion of investment-grade debt, nearly 33% more than a year earlier and the highest since a record-setting first half of 2008, according to Thomson Reuters. The $161 billion in newly issued high-yield debt represented the highest first-half total on record.
In today's low-interest-rate environment, many companies have borrowed to refinance existing debt, pushing out maturities and increasing their financial flexibility. Some companies, such as Intel, have earmarked the proceeds from debt offerings to repurchase stock, while others have built reserves for acquisitions. In a few cases, companies such as Google ($539; GOOG) and Microsoft ($26; MSFT) sold bonds in part because some of their cash is tied up in offshore accounts they can't tap without significant tax consequences.
Higher debt increases a company's risk. But borrowing has several advantages over issuing stock to raise capital:
1) Debt does not boost the share count and dilute per-share earnings. Investors tend to dislike dilution and punish stocks for equity offerings.
2) Debt is cheaper than equity. One way to look at financing costs is the earnings/price ratio, the inverse of the P/E. Based on the S&P 500 Index's P/E of 13.5, investors are demanding an "earnings yield" of 7.4% to own stocks. Compare that to the 4.1% to 5.3% yield of investment-grade corporate debt, and selling equity looks expensive. Corporate tax laws also favor debt financing, allowing companies to deduct interest expense.
3) Adding debt can boost return on equity, which measures how efficiently a company generates profits from its shareholder equity base.
The lesson for investors: Not all debt is bad. Our studies of debt and its effect on stock returns indicate shares of high-debt companies do not underform shares of low-debt companies, suggesting investors shouldn't avoid companies simply because they have debt. Listed in the table below are 13 companies not afraid to use debt. All 13 have debt-to-total capital ratios of at least 40%, well above the average for their industries. Importantly, all 13 also generate healthy cash flow and free cash flow to service the debt and provide flexibility. Below, we profile three of those companies.
Alliance Data Systems ($95; ADS) has leveraged itself heavily. Long-term debt more than doubled to $4.63 billion over the last two years and now accounts for 98% of invested capital. That aggressive debt position has helped increase return on equity in each of past three years. Alliance generates plenty of cash to service its debt load; free cash flow for the 12 months ended June was $792 million, up 49% and more than twice the company's annual interest costs.
Alliance provides credit-card programs, loyalty programs, consumer-database marketing, and e-mail marketing. Even in today's challenging environment, the credit-card industry appears healthy, with many large banks seeing favorable trends in credit quality. At the end of August, Alliance said the delinquency rate at its private-label business was 4.8%, down from 5.9% a year earlier. The stock is a Focus List Buy.
DirecTV's ($44; DTV) long-term debt as a percentage of capital has risen in six consecutive years, as the company continues to tap an inexpensive bond market. In March the company issued $4 billion of debt at interest rates of 3.5% for five-year bonds, 5.2% for 10-year bonds, and 6.35% for 30-year bonds. Those funds repurchased about $1 billion in older bonds with higher interest rates and also funded stock buybacks. DirecTV cut its share count 8% in the first half of 2011 and nearly 40% since mid-2006. In August, DirecTV borrowed another $3 billion, intending to refinance more high-interest debt and buy back additional shares.
DirecTV CEO Mike White called subscriber growth "very, very good" at a Sept. 22 investor conference and described churn trends (customer defections) as excellent. As for the subscribers who do depart, DirecTV blames the economic downswing, not a cultural shift away from traditional pay-TV services. DirecTV is a Focus List Buy and a Long-Term Buy.
In March, Rogers Communications ($35; RCI) issued $1.49 billion in 10-year bonds at 5.35% — less than two percentage points above the Canadian government equivalent. Less than a week later, Rogers repurchased $100 million of its own shares. The company also used some of the borrowed money to retire $800 million in bonds with yields above 7%. Historically, Rogers has generously shared cash with investors. Over the last three years, Rogers has boosted its dividend 50% and repurchased 14% of its outstanding shares.
Rogers, a media conglomerate, is upgrading its wireless infrastructure by deploying Canada's first commercial long-term-evolution (LTE) network. The company plans to install the LTE (also known as 4G, or fourth generation) network in four cities by the end of the year. Rogers expects share repurchases to pick up in the second half of the year, after activity slowed in the June quarter. Rogers is a Long-Term Buy.