The Phantom De-Leveraging of the U.S. Economy

There is a commonly held view that the US economy is in the midst of de-levering. Throughout the stock market, on a daily basis companies are raising capital through secondary equity offerings and using the proceeds to pay down the debt on their balance sheet. The “d” word has clearly become the buzzword of the moment in corporate American (maybe second only to “green shoots”).

I recently attended a Goldman Sachs conference and every presenting company commented on their de-leveraging efforts, plans to de-lever, or the benefits of de-levering.

Let us first understand what “leverage” means so we can agree what de-leveraging will look like. Leverage, for our purpose, is the amount of debt one has relative to the amount of income earned, it is not an absolute level of debt. For example, if Bill Gates has a $10m yacht loan, it would be incorrect to say that he is more highly levered than I am with my $100k in B-school student loans. Although his liability ($10 million) is larger than mine ($100k) his income earned is greater than the proportionate difference in our debts.

Let’s take a look at a simplified example of a secondary equity offering and the de-leveraging impact in the context of the current economy. The below example assumes our imaginary company, Ben’s Dance Academy, has $100 in debt, $100 in EBITDA in FY 2008, and has 100 shares outstanding. Looking into 2009 let us assume that EBITDA falls -20% to $80 for the year. Ben’s Dance Academy decides it wants to “de-lever” by selling 20 shares at $1 per share and use the $20 in proceeds to pay down debt resulting in $80 of outstanding debt.

With Equity Raise Without Equity Raise FY 2008 FY 2009 FY 2009 EBITDA $100.0 $80.0 $80.0 yr/yr change -20% -20% Debt $100.0 $80.0 $100.0 Shares Outstanding 100 120 100 Leverage (Debt/EBITDA) 1.00 1.00 1.25

As you can see the leverage profile of the business is the same post-equity raise at 1.0x debt/EBITDA that it was in FY 2008, in other words the business did not actually de-lever despite paying down 20% of their debt because of the drop in income earned (EBITDA). Without doing the equity raise, the company would have seen their leverage increase to 1.25x so the deal avoided making the company more levered but did nothing to decrease leverage.

The trading implication for investors is that economy-wide equity raises will have to be large enough to offset the fall in income earned (EBITDA) in order for any real de-leveraging to take place.

Using a universe of all US companies with market capitalizations over $200m, analysts expect EBITDA to fall roughly -10% in FY 2009 vs. FY 2008 which suggests the current level of equity raises are probably not even enough to offset the decline in earnings much less de-lever the economy. To borrow the over-used baseball analogy, it is highly unlikely that we are anywhere near the 9^th inning in this de-leveraging process. The ramifications for equity investors are that these equity offering dilute the stake of current shareholders as more shares are issued.

Disclosure: No Positions

Comments

[Dave Wrixon:]

It is doubtful whether Government or Companies are actually delevering because in most cases their incomes will be dropping even more quicky than they are able to implement savings. Most cost cutting measure tend to have front end costs, so it will take time for the savings to show through anyway.

With individuals the situation is different. Those in salaried jobs will generally not suffer a drastic reduction income. The hourly paid will however, probably lose income faster than they can reduce outgoings. Those that lose their jobs, don't have a cat in hells chance of balancing the books.

So yes, the deleveraging thing is likely to a Myth. With Uncle Sam we have seen the talk the talk, but I am not expecting much when it comes to the implementation phase. It is easy to come up with platitudes to justify you intentions, but it is far more difficult to deliver on those promises, even if the sincereity was there in the first place.

Jun 05 07:12 AM

[shootpar2001:]

No net de-levering yet.
With six million less employees to pay the deleverage of corporate america will actually start to take place some time next year. Thus, keeping a slow recovery scenario at best and no chance of gov't delevering for years to come.
As this site is for 'Seeking Alpha'.
Taking gains in Treasuries and moving out the risk scale (corps.)
are the prudent choice.

Disclosurers: (PTY), (ACG), (MSY), (PSY)

Jun 05 09:53 AM

[Maxe Paul:]

I fully expect companies to be on their second or third equity raisings before this cycle is over, and thats just the blue chips!

I understand now why Americans are not allowed to use financial products such as IGmarkets, who knows what havoc that would reap?

Jun 05 12:13 PM

[isotopes:]

Umm No.

Leverage is measured by debt to equity or debt to assets. Debt to EBITDA simply measures the ability to payoff debt based on earnings.

I'm not saying we're in the 9th inning either, but I'd argue real delevering is going on more so than he thinks. This process is long and painful though.

He does redefine leverage in his article though. That's convenient. Just ask Slick Willy what the definition of "is" is.

Jun 05 02:30 PM

[Gregman2:]

There is a forced deleveraging occurring. But that is due to capital crunch. The fact is, I think there is no real recovery yet being felt at ground level...that is, down below the altitude.

Jun 05 08:33 PM