Capital Structure and Some Cheap Stocks

Over the last few years, a common shareholder activist strategy has been forcing companies to recapitalize. Where investors saw stable, fat cash flow, the thinking was "this company could use a healthy amount of debt." It makes sense, academically. Increasing debt as a percent of the capital structure lowers the weighted average cost of capital (due to interest payments' favorable tax treatment, and the equity risk premium), immediately increasing the value of future cash flows and the value of the company-at least in theory.

The cost of debt is easy to calculate - what I've become skeptical of is penalizing equity as a higher cost of capital because of a stock's beta and the equity risk premium. The capital asset pricing model actually penalizes a company for having a conservative, cash-rich balance sheet. If a company had massive, stable cash flow, it could borrow for 6-7%, buy back huge amounts of shares and end up with a leveraged balance sheet and a lower WACC and higher ROE.

On paper, the change in capital structure immediately increases the value of future cash flows. Six months ago this sounded great, but now we're in an environment where people worry more about near-term profits and liquidity than they do about Return on Equity and 10 year DCF models. Firms that were once cash-rich now have to worry about debt covenants and coverage ratios. Modigliani and Miller found that "the appropriate level of Debt to Equity in a company will then be the point at which the benefits of the tax shield provided by debt financing are outweighed by the costs of financial distress." I think the beating we've seen in debt-laden companies is proof that investors are re-evaluating the level at which a debt load becomes a "financial distress."

Look at Caterpillar (CAT). A few months ago it looked like a huge, well-run company whose wares were tied to the never-ending commodity boom. Confidence in commodities markets and infrastructure spending enabled investors to be comfortable with CAT's $34billion in debt - with quarterly EBITDA of about 7 times quarterly interest expense. The stock looked cheap at a "below market" multiple of 13 times this year's expected $6 per share in earnings. With the market's dive, forced selling, fund redemptions and recession fears, people now look skeptically at a company with $2 billion in cash and $34 billion in debt. After plummeting 50%, the shares still trade at an EV/EBITDA multiple of 8. If things slowdown markedly, the market might price CAT shares at 6-8 times reduced EBITDA.

Here's a thought - if CAT's EBITDA falls by a third and the market values it at an EV/EBITDA of 6, guess what the market cap and stock price would be? Zero.

I don't expect this to happen, because it would imply that the company will default on its debt - but it's worth considering. It is truly frightening how quickly the common stock can get wiped out in an EV/EBITDA multiple revision. If there's huge cash on a balance sheet, people net it out when looking at the PE ratio - it isn't as if they're completely ignorant of that fact until a company engages in a recapitalization.

In addition to lowering the WACC, levering up increases return on equity - in many cases a component of calculating executive compensation. You increased ROE, big deal. So did investment banks that took leverage from 15 times to 40 times, while return on assets (crazy thought I know) declined. It's financial engineering, and does not create as much value in the real world that it does on paper and in pitchbooks.

Going back quickly to CAT - as the company's stock price has dropped this year, its debt as a % of the capital structure has risen - meaning more of the WACC is now debt financing, and the future cash flows are more valuable. Why should the selloff in common stock immediately increase the value of 2011's cash flow?! In this environment, I think a better metric is Free Cash Flow yield. It's straightforward and makes for easier comparisons between asset classes.

Cisco's (CSCO) FCF for FY2008 roughly equals 12% of its enterprise value. Even if John Chambers' 12-17% topline growth targets prove aggressive, Cisco stock is pricing in some serious declines in earnings, and has good upside. For Cisco to trade at a FCF yield closer to 20%, it would trade at a forward PE (net of cash) near 5 reduced estimates - possible but unlikely.

Western Digital's (WDC) FCF yield for 2008 is nearly 25%, which is why I bought shares recently. Price-to-Sales of .4 neglects the $500m of net cash, and the trailing PE is 3.8. It’s an exercise in futility to argue for higher PE multiples for WDC or other storage companies, so I won’t do it. Worries about flash encroaching upon or destroying the market for WDC’s products are legitimate but overstated. Just over a year ago, Kevin Hunt of TWP described the thinking of the flash executives at IDEMA DiskCon: “They seem to really believe that a $1,000 premium for one-third the storage capacity on an $800 notebook is a great deal.”

Flash drives use less power and are smaller and lighter than disk drives, but are many times more expensive. WDC should still have running room as the greatest global PC growth is in developing markets, where demand is for cheaper PCs and notebooks, making flash prohibitively expensive. By the time competition from solid-state drives becomes a mortal threat, a buyer of WDC would’ve reaped well over the purchase price in free cash flow. The company’s heavy CAPEX spending (50% higher than D&A currently) will enable it to introduce new products to offset (and potentially reverse) ASP declines.

In May 2007, Barron’s touted WDC when the stock was at 18 and expected EPS was 1.92. Now the stock is at 16.50 and EPS estimates at 3.41. I think that the stock could return to 30 soon.

I am not specifically arguing for lower WACC for unlevered firms, or lower cost of equity in general. I'm suggesting people turn a closer eye towards the dangers of using debt to increase a firm's value, and the issue of a falling market cap increasing the value of future cash flows.

Disclosure: Long CSCO and WDC.

Comments

[Nom De Plum:]

Worthwhile piece.....a rarity on this site.

2008 Nov 06 12:43 PM

[mkreisel:]

The market seems to have priced WDC as bankruptcy candidate.

2008 Nov 12 02:36 AM

[Eric Wu:]

I, too, have found WDC to be nonsensically cheap. Yet, as its share price continues to fall relentlessly, I have doubted my judgment; is everything I know about business valuation wrong?

I'm glad to have read your article Brendan. Your clear thinking and well-constructed arguments have provided me with at least a modicum of confidence that I am not going insane.

2008 Nov 19 10:25 PM