Low Interest Rate Impact on Equity Valuations Confirmed: EasyLink Case Study Revisited

Mar.17.11 | About: EasyLink Services (ESIC)

I have been working on the question of the impact of ultra low interest rates on equity valuations. Much of my focus has been on "financial engineering" - steps that companies can take to enhance share valuation by taking advantage of the ability to borrow at very low rates.

Share repurchase financed by borrowing at very low rates is an obvious example, and one article demonstrated how Wal Mart (NYSE:WMT) can and actually does increase earnings per share using this strategy. Refinancing debt at lower interest is another such strategy and another article illustrated how Coca Cola (NYSE:KO) has successfully pursued this strategy.

On November 12, I did a piece on EasyLink Services(NASDAQ:ESIC), a company providing on demand electronic messaging and transaction services. ESIC had just roughly doubled its size by borrowing $105 million and acquiring Xpedite Business, a similar operation. ESIC's stock traded up from $2.88 to $3.95 on the transaction. This week, ESIC announced its earnings for the quarter ending January 31, 2011. In what could generously be called a "challenging" market, ESIC's traded up, closing on Wednesday at $4.48.

The quarterly financials confirm that ESIC has at least doubled its size and become a company grossing roughly $180 million per year. The interest expense reflected in the financials and discussed on the conference call suggest the borrowing costs are in the 5-6% range(pre-tax). It is a little hard to tease out exactly how much cash flow has been added by the transaction(there are some synergies that are still underway and the first quarter reflected some one time costs) but the additional cash flow before interest expense is probably in the $15-20 million neighborhood. This means that ESIC has added a huge amount of cash flow after interest without adding any shares; the market has begun to understand this by pricing the shares at a higher level.

It appears that the company throws off total free cash flow (after interest expense and capex) in the $35 million a year neighborhood. I have been watching the balance sheet closely. The balance sheet for the quarter ending January 31, 2011, reflects a reduction in net debt (total debt minus cash) of some $7 million. There were some one time expenses in this quarter which will not recur and some of the synergies will be more fully reflected in future quarters. In addition, every time the debt is paid down, the interest expense will tend to be reduced (depending as well upon what happens with rates). Thus, an $8-9 million reduction in net debt per quarter is not an unreasonable expectation.

If valuation is based on enterprise value (which now stands at $233 million), then even if there is no operational improvement and enterprise value stays the same, the debt pay down should lead the equity portion of enterprise value to increase by $8-9 million per quarter or more than $1 per share per year. Of course, earnings will tend to increase as the debt level reduction leads to a reduction in interest expenses. This is a conservative projection that does not include any increase in valuation due to increased sales, reductions in costs, or a higher multiple - all of which are reasonably likely and would add to the increase in stock valuation.

ESIC has a savvy management team and has executed the transaction smoothly. The company will have to integrate the acquisition effectively and continue to perform well in a competitive market. Results will depend in part upon the company's ability to grow market share and the economy's continued recovery. But there will be a powerful tailwind due to the debt pay down.

ESIC's performance illustrates the ability of companies to increase shareholder value by executing cash-for-stock acquisitions where the acquired entity throws off cash flow in excess of the after tax interest rate on debt incurred to make the acquisition. The math is really pretty easy - as long as the cash flow yield on the acquired entity is greater than the after tax interest expense on the debt, the transaction will increase cash flow per share. ESIC's management deserves a lot of credit for identifying an attractive opportunity and executing the transaction and its integration smoothly. Nonetheless, low interest rates played a role here. It would not have been as easy nor would it have been as lucrative to try to execute this transaction in a world of 10% interest rates.

There has been a lot of talk about pending rate increases (as there was about a year ago) but there are powerful forces that will keep short and intermediate term rates low for a considerable time. If this continues, we should see more acquisitions at higher prices. In a world of low interest rates, these acquisitions will likely increase the per share earnings of the acquiring firms and lead to a fat pay day for the shareholders of the firms being acquired. It's tough to "fight the Fed."

Disclosure: I am long ESIC, WMT, KO.