America's Latest Obsession and Its Investment Consequences: Part 2 - Financial Engineering

by: Philip Mause

Read Part 1 of this series

The obsession with the National Debt and the consequent resistance to more deficit spending to stimulate the economy requires the Federal Reserve to adopt extremely expansive monetary policy if we are to avoid the disaster of a deflationary depression in which prices constantly decline, consumers delay purchases waiting for further price decline, tax receipts decline, tax rates are raised in a futile attempt to "balance the budget," further contraction of the economy leads to further price declines, ad nauseam. This expansive Federal Reserve policy now essentially guarantees extraordinarily low interest rates on Treasury bills and notes for at least another two years.

Of course, the interest rate on Treasuries does not determine the interest rate on corporate loans and bonds but some of the large corporations now have credit ratings that are at least equal to the rating of the US Treasury. While there may be squalls in the credit markets, over the next two years and for probably quite a while thereafter, many corporations will be able to borrow on extraordinarily attractive terms. In addition, many corporations - for example, Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Cisco (NASDAQ:CSCO) - have an unprecedented level of cash on their balance sheets and will not be able to earn a significant return on the cash unless they are willing to invest in assets riskier than US Treasuries. This is likely to lead to a phenomenon which is sometimes called Financial Engineering.

The best way for me to explain Financial Engineering is to go back to my days as a lawyer in utility rate cases. In most jurisdictions, utilities are allowed to earn a rate of return on their rate base. The rate of return depended upon the capital structure. For example, if a utility was paying an average interest rate of 6% on its bonds, it would be allowed to earn 6% on that part of the capital structure. As to the equity part of the capital structure, the regulator had to decide what was a "reasonable rate of return" given risk and other concerns. A typical rate of return on equity was in the 11% neighborhood.

There was always an intervener in the rate case who argued that the utility could save a lot of money and reduce its need to raise rates if it changed its capital structure to increase debt and reduce equity. Superficially, it sounded like a good argument. After all, a utility with 50% debt and 50% equity would be entitled to an overall rate of return of 8 1/2%. If the utility changed its capital structure so that it consisted of 90% debt and 10% equity, the rate of return could be reduced to 6.5%. There was always a witness who pointed out that the new capital structure would be riskier to both debt and equity holders and that the interest rate on the debt and the necessary rate of return on the equity would both go up if the new structure were to be implemented.

Anyhow, the Financial Engineering that will be created by the new interest rate environment will be somewhat similar. It will essentially consist of a substitution of debt for equity on corporate balance sheets, or - for corporations with large amounts of excess cash, a reduction in the balance sheet cash to repurchase shares.

Corporate balance sheets can be altered in this way through at least three mechanisms - share repurchases, LBOs, and cash for stock acquisitions.

In a real sense, LBOs and share repurchases tend to produce a similar result. Stock - or equity - is retired through the issuance of debt or the use of balance sheet cash. The end result is a reduction in the amount of shares available in the market. Because corporate America(except for financial institutions) has balance sheets which are unusually unlevered, the capacity of corporate America to take on more debt or to expend balance sheet cash is enormous.

The reason that low interest rates make financial engineering especially attractive is that per share earnings tend to increase whenever a company repurchases stock which has a higher earnings yield than the after tax interest rate on the debt issued or the after tax interest earned on the balance sheet cash used to fund the repurchase. A stock's earnings yield is the inverse of its price earnings ration. Thus, a stock trading at 10 times earnings has an earnings yield of 10. A stock trading at 20 times earnings has an earnings yield of 5.

If, say, MSFT can borrow at 3% interest and its after tax interest expense is 2.5%(interest is generally tax deductible), then as long as it repurchases its own stock at PEs of less than 40, the repurchases will tend to drive up per share earnings. It is not hard to see that there are lots of opportunities here due to the fact that most corporate PEs are in the 10-16 range.

LBOs are more complex but achieve a similar result. All of the stock of a company is retired with the share retirement financed primarily with debt. The resulting new entity has considerable debt and a small amount of privately held equity. Cash for stock acquisitions retire the stock of the company being acquired and are financed with either borrowing on the part of or balance sheet cash on the books of the acquiring company.

Again, as long as the after tax earnings of the acquired company exceed the after tax interest paid on the debt, the acquisition is accretive to both total and per share earnings for the acquiring company. It is not hard to see why companies like Google (NASDAQ:GOOG) and MSFT are willing to use balance sheet cash which may be earnings less than 1% after tax interest to make acquisitions.

What does this mean for investors? Companies that can borrow cheaply or have large amounts of balance sheet cash can buy back their own stock or make cash for stock acquisitions. I have written about MSFT, Wal-Mart (NYSE:WMT), and Cisco (CSCO) in this regard and it is likely that these companies may be able to create somewhat of a floor under their stock prices through aggressive repurchase activity. Exxon (NYSE:XOM) has also been active in this area. Many,many other companies have share repurchase programs now. Investors should look past the amount of money "authorized" to be spent on repurchases and focus instead on how many shares are actually being repurchased each quarter.

I have written about a small company, EasyLink (NASDAQ:ESIC), which made a large acquisition and financed it with relatively low interest debt. Its earnings were increased by more than the after tax interest expense on the debt through the acquisition and it is throwing off cash to pay down the debt. We will see more and more of this.

One of the reasons I am relatively optimistic about the prospects for stocks of blue chip companies over the next few years is that share repurchases will gradually reduce the stock available in the market and will also tend to increase earnings per share.

The people who will benefit from all of this will be different from the people who would have benefited if we provided more money to the states so that teachers wouldn't be laid off, or extended unemployment benefits, or cut taxes on families with incomes under $75,000, or invested in the infrastructure necessary to get us off imported oil. I am not crazy about what is happening here as a matter of public policy. But it is happening and I will try to be one of the people who benefit. Sometimes, I feel a little like the guy in Breaking Bad - just trying to protect my family in a crazy World.

Disclosure: I am long GOOG, AAPL, MSFT, CSCO, XOM, ESIC, WMT.