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Thursday, 23 November 2017

ECM 2006: Driving shareholder value

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Think of the balance sheet as a blank piece of paper, rather than an amalgamation of years of activities, and one begins to understand the new face of the modern corporation. Faced with limited opportunities for investment and growth, stockpiles of idle cash, and the ever-present threat of a leveraged buyout, US corporations are loading up their balance sheets with the goal of driving value to stockholders. Stephen Lacey reports.

The capital markets are playing an increasingly important role in the shift toward more shareholder-friendly activities, with convertible bonds, hybrid debt securities, and bank loans all gaining popularity as vehicles to finance shareholder repurchases. And, despite near-record levels of debt, the trend is likely to accelerate as companies look to offset a slowdown in profit gains as the economy slows down later this year.

At the end of the first quarter, non-financial US companies carried a record US$5.5trn of debt, a 6.3% increase over levels one year ago. Another 7% was probably added in the second quarter, suggests John Lonski, an economist at Moody’s Investors Service. More accommodative lending standards, helped at least in part by the growth of collateralised loan and debt markets, have made it easier for companies to take on a greater amount of debt. Debt grew at 2.7% and 5.1% in 2004 and 2005, respectively.

Current debt levels are not particularly troublesome, for a number of reasons. Cash levels are also at near-record levels and companies have not had as many capital projects in recent years. The additional debt has lagged earnings growth – 16.3% for the S&P 500 in the second quarter – giving companies additional borrowing capacity. Corporate default rates for high-yield credits were just 2.3% in July 2005, above a 1.4% low in March 1995 but well below a historical average of 5.1%.

The principal targets for that additional debt have been stock buybacks and M&A, both of which result in the elimination of equity. Net debt grew by US$332bn in the first quarter, while US$439bn of equity has been taken out of the market.

“If you look simply at the funding gap, the difference between cash flow and what is needed for capital expenditures, net borrowing would be negligible,” noted Lonski. “The reason you have seen an increase in borrowing over the past several years is equity buybacks and M&A activity.”

One of the primary motivations for more aggressive capital structures can be traced to the increased activity of leveraged buyout firms. LBO firms raised a record US$131.1bn in 2005 and, with an US$88.9bn of commitments through the middle of August, are on pace to surpass that total this year.

“We continue to see the ripple effect of the private-equity firms and, to a lesser extent, shareholder activists forcing companies to look at their balance sheets and question the amount of cash they carry and whether they should have more debt,” notes John Kolz, head of convertible bond origination at Goldman Sachs.

Convertible alchemy

Convertible bonds have been a natural beneficiary of that trend. In their simplest form, convertible bonds allow companies to sell their stock at a premium, which has historically appealed to high-growth companies. Enhanced by the concurrent repurchase of stock and derivatives transactions, however, the asset class has become little more than a low-cost debt alternative.

About two-thirds of the US$40.4bn raised by 77 US companies has been accompanied by concurrent share repurchases. And Kolz estimates that 56% of that volume has included a derivatives transaction known as a call-spread overlay, whereby the issuer uses proceeds to purchase the embedded call option and offsets the costs by selling warrants at a higher strike price.

The inclusion of net-share settlement provision, which requires the issuer to repay the bond’s principal amount in cash and just any residual value in stock, allows for Treasury stock method accounting. Repurchasing stock, increasing the conversion premium, and limiting dilution to levels above the conversion premium generally mean that convertible bonds are accretive to earnings.

Amgen was among the first companies of the year to turn to such a solution on a two-tranche, US$5bn CB in February. The five- and seven-year notes priced with coupons of 0.125% and 0.375% and conversion premiums of 10.50% and 11.00%, respectively. The biotech giant bought back US$3bn of its stock on the deal and spent another US$726m (net) on the call-spread transaction to boost the effective conversion premium on both notes to 50%.

The financing was immediately accretive to earnings by about 1.5%, given the higher interest income on cash balances relative to the rates paid on the CB. The attraction of the security for investors lay in extreme equity sensitivity and the ability to pre-hedge allocations by selling stock back to the company. Amgen shares rose 1.4% over the one day marketing period and added another 1.4% the day after pricing.

The fact that a US$90bn market-cap, A2/A+ rated company would use converts to repurchase stock was seen as a validation of the asset class. A flurry of copycat transactions followed. In April, Medtronic repurchased 50m shares in conjunction with its two-part, US$4.4bn convertible. Shortly thereafter, Gilead Sciences bought back 8.4m shares alongside its US$1.2bn convertible, which was also structured with staggered five- and seven-year maturities.

By May, drilling-rig operator Nabors Industries understood enough about the intricacies of the financing to land US$2.75bn on a 0.94% five-year convertible to repurchase US$1bn of its stock. The terms were so attractive that Citigroup and Lehman Brothers were forced to re-offer the security at 99, wiping out any fees in the process. The transaction added US$0.26 and US$0.56 to 2006 and 2007 EPS, and increased cash balance to over US$2bn.

For many of the same reasons, REITs have recently turned to the asset class’s low costs to fund share repurchases. While not ideal candidates historically because of dividend requirements, a run-up in equity prices caused dividend yields to contract and volatility to spike. Eleven REITs have raised US$5bn through convertible bonds, generally 200bp lower than unsecured straight debt, that were used to buy back stock near all-time high levels.

The relative level of convertible issuance devoted to share repurchases, rather than growth capital, is staggering: Amgen, Medtronic, Gilead, and Nabors alone account for one-third of overall volume this year in the US.

Just a few years ago, the exact opposite was true. Following the excesses of the late 1990s, companies were looking to plug their balance sheets with equity. “We’re once again seeing a convergence of debt and equity capital markets,” notes Dan Simkowitz, vice chairman of capital markets at Morgan Stanley. “But, unlike the 2002 timeframe, companies are approaching the market from a point of strength, saying: how do I use leverage to drive shareholder value?”

Activity accelerates

Indeed, cash is fungible regardless of its source. The straight-debt markets welcomed a US$5.5bn deal from Cisco Systems in February, its first public debt offering, to fund a similarly-sized repurchase of stock. A new class of hybrid preferred securities allowed Washington Mutual to gain Tier 1 credit on a US$2bn raise in March, which was subsequently used to support a US$2.1bn accelerated share repurchase.

Companies repurchased US$99bn of their own stock in the stock quarter, according to Standard & Poor’s. Exxon Mobile, Procter & Gamble, and Time Warner all tapped into cash reserves to repurchase stock during the quarter. While the buybacks can juice near-term earnings, they can realistically have little impact on balance-sheet liquidity over the long term.

Microsoft tapped into its cash hoard of US$34.2bn to buy back US$3.8bn of its stock, about 1.5% of outstanding, in August. The total is far less than the US$20bn authorised under its tender offer, a bullish sign that suggests shareholders would rather retain the shares. Morgan Stanley's Simkowitz points out that even if it bought back all of the US$36.2bn of stock currently authorised through open-market purchases, Microsoft would easily replenish its cash coffers by the time the programme expires in 2011 (fiscal 2007 Ebitda alone is projected at US$20.3bn).

Cash flow, not earnings, is the primary metric that motivates buyout firms and public companies will have to adopt a similar view toward debt. “I would be surprised if the size of buyouts looks the same a year from now,” noted Simkowitz. Eventually, the pendulum will swing back the other way and companies will once again look to deploy growth capital by selling equity.

That, however, may be quite a way off. “There has to be growth in capex from something like the internet or a massive shock to the system, neither of which we see happening,” said Simkowitz. “I expect that we’ll see a lot more convertibles tied to share repurchases – some of the biggest and most obvious candidates for these transactions have yet to act,” added Kolz.

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