The Wall Street Journal is reporting that aircraft parts supplier TransDigm Group (TDG) is planning to float $425 million worth of debt for the primary purpose of giving a special dividend to shareholders. Management has said that $360 million of the debt offering will be used to pay a special cash dividend expected to be $7.50 to $7.70 per share. The article in The Journal makes some points as to the rationale behind such a move.
The added debt increased TransDigm’s borrowings to 4.3 times its earnings before interest and taxes, compared with 3.1 times before last week’s deal. The expected dividend of $7.50 to $7.70 a share is equal to nearly all of the net income that TransDigm reported since the end of fiscal 2003, according to Moody’s Investors Service.
Moody’s said the dividend “illustrates the company’s aggressive financial policy.” Moody’s gave the new debt a junk rating if B3, even though the ratings firm said TransDigm’s “strong operating performance will enable the company to service the increased debt level.”
Sean Maroney, director of investor relations at TransDigm says the “stability of our business, high profit margins and consistent cash flow” give the company “the ability to support this level of leverage.”
Borrowing from bondholders to pay shareholder dividends is “a hallmark of an earlier credit era,” Jeffrey Rosenberg, head of credit strategy at Bank of America Merrill Lynch, wrote in a report Friday. Such deals were popular in 2003 and 2004, the last time the Federal Reserve lowered its benchmark interest rate to historically low levels, keeping it at 1% for more than a year. — Borrowing for Dividends Raises Worries, The Wall Street Journal 10/5/2009
This is a bold move for TransDigm to take right now, but we have to wonder, how does this makes sense? Of course, management is pointing to the fact that the cost of capital is comparatively low right now with interest rates where they are. Furthermore, capital markets are easily able to accommodate such a loan. However, in our analysis an increased debt load is never a good thing unless it facilitates growth in sales and earnings. Instead of using this capital to grow its business, TransDigm is shoveling this money out the door as soon as it comes in. Are they signaling to their shareholders that no further growth potential exists?
The article points out that this sort of behavior was not rare earlier in the decade, but to float debt just to pay shareholders seems to be a very risky proposition in this still fragile recovery. One company that did something similar relatively recently was Health Management Assoc. (HMA), a hospital operator, which paid its shareholders a $10 special dividend March 2, 2007. Of course, the company issued debt in order to pay out this exceptional dividend. On that day, the stock predictably dropped almost $10 (about half the market value). It slowly started to march upwards as the market was topping all-time highs, but the risk of ramping up its debt was made apparent when the recession began to take hold. The debt hung around their neck and dragged the stock down, at one point below a dollar. It is safe to say that there were doubts as to whether they would be able to survive the down turn.
HMA has since recovered from those lows and rallied more than 700% since the low. However, HMA is still more than 30% below where the stock was after that dividend was paid. Although HMA still looks solid as far as their current ratio, they have a debt to equity ratio of 13.5, which is as much as 10x higher than some of its closest competitors. There is no doubt that the special dividend and debt issuance have made a fairly stable stock become much more volatile. Of course, it is too soon to really know what the long term effects are, but I would not invest in a company so that they can use the earnings to pay off debt.
These one time dividends may be a great deal for the current shareholders and executives (aside from this being a taxable event), but future shareholders will have to shoulder the weight of this gift. We still maintain that companies should use debt responsibly, as an instrument to foster growth. In this circumstance, it seems that executives are running up the company credit card so-to-speak and destroying future shareholders’ value. We hope that such “aggressive financial policy” does not become commonplace, but with the benefit to current shareholders including the management of these companies, it would not be a surprise to see more of these deals.