We fell down a very slippery slope in 2008. As earnings fell, corporate asset values collapsed. With this, the potential recovery of principal by the creditors plummeted. That meant higher rates of interest, lower earnings, and lower chances of refinancing. All that increased the likelihood of default. It was vicious.
Today we see the opposite. Examining the 400+ nonfinancial firms of the S&P500, we're seeing fundamentally stronger firms, quarter by quarter. Our calculations show far higher recovery rates, improved debt servicing structures, and higher interest coverage ratios, even when all of the calculations are done very conservatively.
That means better financing and refinancing terms from lenders, which further improves the balance sheet's overall strength. It also means cheaper costs of debt, and therefore better earnings and, more importantly at this stage of the market cycle, lower risks of default.
For the purposes of this argument, we focus on the 9.5 sectors out of 10 that aren't banks. Suffice it to say, however, that in examining the rest of the economy, we can still glean a bit about the banks' health from the credit health of that major customer base.
The Higher the Recovery Rate, the Less Need for Recovery
The chart below shows our calculation of aggregate recovery rates for the approximately 400 nonfinancial firms in the S&P500. What we're seeing are strong balance sheets relative to debt, as strong as we've seen in a decade. The 2012 recovery rate is at a peak level.
In 2007, recoverable assets on the books of companies were below 85% of the debt that the companies had. That was a serious issue. When credit got tight, and lenders became more worried about not getting their money back, companies with lower recovery rates didn't make the lenders' checklists for potential refinancing.
Into and out of 2012, recovery rates skyrocketed to over 100%. Today, there are more total recoverable assets on the books of companies than there is debt. That's one reason that credit default swaps have been collapsing in recent months. It's the realization that 2011's observable recovery rate of 100% didn't fall back, but actually strengthened in 2012.
(For more on the improvement in credit default swaps, please see my prior article in SeekingAlpha.)
The Devil is in the Details
Unfortunately, we can't rely on traditional net debt calculations, debt-to-asset values, or coverage ratios to perform this analysis. The main reason is that financial statements under GAAP (Generally Accepted Accounting Principles) allow for similar economic activities to be reported in totally different ways. Maybe more importantly, activities of a totally different economic nature are to be reported with the same value on the books.
That's not the fault of the accountants or GAAP. The real role of the financial statements should be to simply report activity, not to attempt to report value. Value should be a judgment on the part of the users of the financials. Unfortunately, the financials have become a hodge-podge of historically stated, re-stated, and misstated values of financial activity. The credit health of a firm can hardly be detected from the assets and cash flows as they are reported in the financials.
Imagine a company with assets composed of $1 million of plant, equipment, land, and throw in accounts receivables aged less than 30 days. You might take those assets strongly into consideration when making the company a loan. However, would you feel as protected if the firm's $1 million of assets were composed of pension goodwill, a deferred tax asset, and capitalized in-process research and development costs from a prior merger? They can all show up as "assets" on the balance sheet.
To calculate recoverable assets, one needs to rebuild the asset calculation from scratch. It makes sense to almost completely ignore book asset values of capitalized leases and intangible assets like capitalized research and development. It would be unlikely to get much value from those "assets" in a post-default scenario. It would also serve us well to dramatically haircut the values for receivables, inventories, and currency-deflated plant and equipment.
On the other hand, one ought to assume that payables and other current liabilities will be paid in full and reduce the value of recoverable assets. We'd even recommend offsetting the recoverable assets by the full book value of deferred revenue, though that's probably being a bit too conservative. The real liability behind deferred revenue is the cost to deliver the goods and services, and not the full revenue amount.
There are a number of other adjustments to make, including industry and company-specific adjustments. Regardless, while being conservative, our calculations remained consistent. In aggregate, the year-to-year comparability allows for very reliable directional analysis. And that direction is up, way up, as is the credit worthiness of the S&P 500 constituents.
Without Near-Term Defaults, What Near-Term Collapse?
Another important perspective is to look at the cash on the books relative to the total debt payments over the next few years. In doing so, we don't net debt against cash. Instead, we count how many firms have cash on the books that exceeds the next one, two, and three years of debt service.
What we see is a decade-high number of companies with cash balances exceeding near-term to mid-term debt service. Of the 400 companies studied in the S&P500, 350 had more cash on hand than the first year debt payments, 320 had more than first and second year's debt service put together, and almost 300 had more than the first three years of debt service.
The risk of default comes from an inability to service debt. Clearly, we have the smallest population of companies with that default risk, at least as far as single "cash to near-term debt" metric can portend.
The Second Vice is Lying: "Net Debt"
The first vice, as the Ben Franklin saying goes, is having debt. The second vice is lying about it. One of the greatest lies we've seen in equity valuation models is the inclusion of a net debt calculation. These errant models take cash on the books, deem it "non-operating," net it against the debt outstanding, and display the firm as one with a lower debt level than it actually has.
So prevalent is this "net debt" practice that many analysts forget why the netting is done in the first place. The models are just carried over from last year or from someone else. It's a shortcut that greatly fails to reflect the true economic nature of a company's balance sheet and riskiness.
If net debt is the right way to think about debt on the books, certainly Nokia's (NOK) creditors disagreed vehemently last year. With over $9 billion in cash, Nokia's $3 billion in debt was trading at 75 cents on the dollar. Clearly no netting was being done in those creditor's models and for good reason.
Even larger cash balances are often not "non-operating" in nature. Business-to-business firms ("B2B") like Microsoft (MSFT), Oracle (ORCL), and hundreds of others show cash levels that never fall below four times and five times research and development costs, regardless of special dividends or stock buybacks. As one head of sales of a billion-dollar B2B firm said, "Try selling a client a $100 million ERP system without showing five years of R&D in cash on the books. The sale doesn't happen because they're afraid we won't be around to service them."
If the debt exists, the risk of default exists along with it, and it ought to be modeled as such. However, even with this more conservative approach of not netting debt, corporates still look the healthiest we've seen in 10 years.
Happiness: Annual Income Twenty Pounds, and Annual Expenditures…?
We don't need to depend on the asset side of the balance sheet to cover debts if there's enough cash being generated by the firms to cover their debt service in the first place. The result of the last five years of lean manufacturing, cost-controlling, and asset-life extending activities has not been in vain. Overall, management teams in the S&P500 nonfinancial firms have shown an amazing discipline through some awfully tough times. Coverage ratios from multiple perspectives are showing this.
The fact is that companies really are generating more cash, and not spending it. The lack of spending is not terrible right now. As long as the threat of default looms, it's much better to prove credit worthiness first and grow later. That's what we're seeing, as the S&P 500 nonfinancial firms are showing total EBITAP (Earnings Before Interest, Taxes, Amortization, and Pension Expense) exceeding interest expense by the highest ratio in a decade.
Naturally, the market wants to see business growth; however, that growth is moot if the company shows risk of default. Economic cycles show distinct periods where companies first build up credit worthiness, then later invest in growing the business.
Apologies for the over-simplicity of "EBITAP"
As he was writing the book, A Brief History of Time, Stephen Hawking's editor told him, "For every equation you have, you will cut your readership in half." So, for the spirit of this advice, I showed something as blunt as an "EBITAP to Interest" coverage ratio to measure credit health, and thereby saved another 2,000 words of performance measurement theory and practice for another article. Plus, when better to refer to Stephen Hawking than in article about massive long-term cycles?
I would not suggest using the EBITAP metric for single company analysis, as there are far more sophisticated means of measuring cash flow to debt service. However, it's far superior to an EBITDA/Interest ratio.
The very-popular and overly-relied-upon metric, EBITDA, is earnings calculated before interest, taxes, depreciation, and amortization. However, depreciation expense reflects a real cash cost of maintenance capital expenditures that would not otherwise be available to servicing debt in the mid to longer-term. It's a bit aggressive to believe that a firm won't spend to maintain its asset base over the near to mid-term debt service.
On the other hand, EBITDA makes no adjustment for pension expenses, despite the fact that much of the pension expense calculation has little to do with actual pension cash contributions. On top of that, a firm can avoid pension capital contributions for quite some time, and service its debts instead.
No doubt, some of the rise we've seen in aggregate EBITAP/Interest coverage stems from the falling cost of interest. All things being equal, corporate debt interest rates should increase as the Fed begins to raise rates. That will happen at some point when the economy shows more definitive expansion and inflation looms more closely.
However, a rising interest rate environment alone is hardly a reason to suspect increasing corporate credit defaults. The corporate debt rates will be at least partially offset by the fall in credit default swap prices that stems from the reduced risk of default from much stronger balance sheets and firm cash flows.
The Virtue of Patience
Having asset values well in excess of existing debt outstanding bodes well for both ends of the firm's capital structure. Producing sufficient operating cash flows to cover debt-servicing is as good for a firm's equity holders as it is the debt holders. Our aggregate asset and cash flow metrics are showing both the income statement and balance sheet related metrics to be on a strong upward climb since 2008/2009.
The biggest threat to price multiples and equity values in general is the threat of default. As the equity holders are the last holder of value, in default, the equity is worth nothing. One of the first stages of a bull market lies not in outright growth, but simply in continued, reduced risk of default. By itself, the reduced probability of default leads to valuation multiple expansion.
At this stage of the bull, it's not a terrible thing for companies to hoard some cash. It gives time for the credit markets to realize the safe management of balance sheets that we've been seeing consistently into 2012.
The vicious risk to equities is the default risk of credit, and that risk is falling steadily. Company fundamentals are supporting a virtuous appreciation in equity values as the market cycles repeat themselves. Our aggregate fundamental analysis is providing increasing evidence of a virtuous cycle that is here to stay.