When I started thinking about the gap between interest rates and earnings yields on stocks, one idea that occurred to me was that the "private market" value of various enterprises should increase as interest rates go down because the discount rate applied to a stream of earnings would tend to decline with declines in prevailing interest rates. This "private market" value manifests itself in various ways - usually in prices paid in LBO and cash for stock transactions. To the extent that stock prices reflect equity valuations that are sharply at odds with the "private market" value of the underlying enterprises, transactions are likely to occur which close the gap. These transactions are frequently LBOs or cash for stock acquisitions at prices higher than the pre-acquisition market price of the stock. These transactions may tend to close the gap by reducing the amount of stock in circulation and also by creating an increase in the price of stocks that speculators consider ripe for acquisition.
Click to enlargeAt any rate, in an earlier piece I demonstrated that, with very low interest rate debt, a company could increase its overall and per share earnings by making an acquisition in a cash for stock transaction as long as the earnings yield on the acquired entity is greater than the after tax cost of debt incurred to make the acquisition. Of course, for a very large company, the impact of acquiring a much smaller company upon earnings may not be significant. That is why EasyLink Services (NASDAQ:ESIC) is a good case study for this proposition. ESIC has recently acquired an entitiy which, pre-acquisition, was actually larger than ESIC itself.
ESIC is a leader in the supply chain messaging and on demand messaging spaces. Pre-acquistion, it had annual revenue in the 80-85 million dollar range. Its annual financial statements included accounting entries for tax loss carry forwards and other non-cash charges and income items and so it is a bit difficult to tease out normalized earnings. ESIC was steadily retiring debt at a rate of $10-12 million a year. Making reasonable assumptions about these accounting entries, ESIC's free cash flow was roughly $12 million a year and its earnings were roughly $6 million a year or 20 cents per share. (ESIC has roughly 29 million shares.)
Last month, ESIC announced the acquistion of the iSend and iNotify operations of PGI. These businesses are similar to ESIC's operations and, in fact, frequently bid for business against ESIC before being acquired. ESIC paid $105 million for the acquisition and financed it with notes carrying rather complex interest rate terms under which interest at closing was 4.25%. The acquired operation has gross income of roughly $113 million, EBIDTA of $26-27 million and earnings of roughly $12 million. Conservatively estimating after tax interest expense at $4 million a year, this transaction produces an enormous increase in both income and cash flow for ESIC.
ESIC has estimated $5 million worth of synergies and estimates that the combined entity will produce EBITDA of $40-45 million a year and earnings of 40 to 60 cents per share(it appears that there has not been any increase in the number of shares of ESIC associated with the transaction). Given that the transaction combines two companies that frequently bid against one another for business, this estimate may be conservative. The cash flow should enable ESIC to retire the debt in roughly 4 years.
Of course, as in any business situation, things can go wrong but the market liked the transaction: ESIC's stock was trading at $2.88 before the transaction and popped up quickly - it is now trading at $3.95. Assuming that the above projections of earnings are reasonable, it would not be surprising to see it move up to the $5-6 range, and possibly higher, after a couple of quarterly reports of the combined entity. Once the debt is repaid, $8 (or double the current price) would not be an outlandish expectation.
ESIC is not Wal-Mart (NYSE:WMT) or Coca-Cola (NYSE:KO) and is not able to borrow at .75% interest. On the other hand, its ability to bring this transaction in at a 4.25% interest rate on the debt is an important factor in allowing earnings to shoot up immediately. Because the acquisition was large in relation to the size of the acquiring entity, the impact on earnings and the stock price is substantial.
It increasingly appears that ultra-low interest rates may be with us for a long time. The Fed likes to make changes step-wise. Before it targets higher rates for short term treasuries, it would likely stop QE2, then stop reinvesting funds from maturing agency bonds, then unwind QE2, then change the "extended period" language, at which point we may be getting close to the 2012 election and the Fed does not like to raise interest rates right before an election.
Corporations may use the availability of low interest rates to do what ESIC has just done and enhance their earnings through cash for stock acquisitions. I have been reviewing acquisitions and it appears that we are seeing more cash for stock and less stock for stock, but I have not quantified it. At any rate, this is another kind of transaction which should be monitored to better understand how the unprecedented-in-recent-years gap between interest rates and earnings yields will play out.
Disclosure: Author long ESIC, WMT, KO