The era of ultra low interest rates has created issues in equity valuation that are unfamiliar to analysts who grew up in a world of much higher interest rates. The purpose of this piece is to demonstrate how a company whose growth prospects are bleak can still trade at a relatively high multiple in world of low interest rates. I expect that the article will attract some skeptical commenters and so I want to make a couple of points clear at the outset. First of all, there is no company exactly like the company whose pro forma I will describe in this article. I am trying to set forth some fundamental metrics that may be useful in comparing the hypothetical company in the article with real companies to isolate pluses and minuses. Secondly, as an investor I would not pay 16 times earnings for stock in the hypothetical company. The reason is that there are lots of better bargains in the market even now after a long uptrend. However, the fact that a case can be made of 16 times earnings strongly suggests that, if an investor can buy stock in a similar company for 8 or 9 times earnings, the investment is attractive. Finally, it is a commentary on the bond market that buying stock in this hypothetical company at 16 times earnings is more attractive than most bond investments.
The Hypothetical No Growth Company. The hypothetical no growth company (HNGCO) has 100 million shares and earns $100 million a year or $1 per share. It has a clean balance sheet (no net debt, no net balance sheet cash). Capital expenditures equal the sum of depreciation and amortization. The dollar value of the deduction from earnings for share based compensation is sufficient to buy back enough stock to maintain constant share count after stock options are exercised. HNGCO's growth prospects are bleak; both gross revenue and income grow at the rate of inflation. The company's share of the total economy is actually declining and does not keep up with nominal GDP growth. Inflation is projected at 2% per year as far as the eye can see so that next year's income will be $102 million dollars. The company trades at $16 a share and has a market cap of $1.6 billion. The company has one very valuable asset in the form of a management adept at financial engineering.
Strategy 1 - Dividends and Repurchases. One strategy HNGCO can use is to use cash flow to return funds to shareholders in the form of dividends and share repurchases. Under this strategy HNGCO can generate steadily increasing dividends and per share earnings. Dividends of 48 cents a share can be paid, producing a 3% dividend yield. In addition, 48 million dollars can be devoted to share repurchases each year reducing share count by 3% per year. The reduced share count also reduces the outlay on dividends so that dividends can be increased 5% each year (2% due to increased earnings and 3% due to decreased share count). Per share earnings will also increase 5% a year due partly to decreased share count. Dividends will roughly double every 14 years and will be nearly $2 a share 30 years from now when a 30 year Treasury bond finally pays off. A 3% yield increasing 5% per year looks very good compared to anything one can find in the bond market right now. After all the dividends and repurchases, HNGCO would still have $4 million a year to pile up on its balance sheet.
Strategy 2 - Borrow and Buy Back. The second strategy involves a major share repurchase effort financed by borrowing. HNGCO would borrow $320 million at an average pre-tax interest rate of 4.5%; because interest is tax deductible, after tax interest expense would be roughly 3% or $9.6 million per year. After the dust settles, HNGCO would have earnings of $90.4 million and 80 million shares (having bought back 20 million shares) and per share earnings of $1.13. Executing this strategy over a few years could contribute 3 0r 4 percent per year to per share earnings growth. Because after tax interest expense is so much lower than earnings yield, this strategy provides for a virtually automatic mechanism to increase per share earnings.
Strategy 3 - Borrow and Acquire. This strategy involves borrowing to make a cash for stock acquisition of a company at the same multiple as HNGCO. HNGCO would borrow $400 million at an interest rate of 4.5% pre-tax and acquire small hypothetical no growth company (SHNGCO) for $400 million or 16 times annual earnings of $25 million. No synergies would be identified or implemented. The post-acquisition HNGCO would have earnings of $113 million or $1.13 per share because the after tax interest expense of $12 million is less than the additional earnings of $25 million. Share count would remain the same because no new shares would be issued in connection with the acquisition. If this strategy is implemented over a few years in the form of smaller acquisitions, a 3 or 4 per cent earnings per share tailwind can be created. This strategy was employed by EasyLInk (ESIC) before it was taken over with a nice reward to patient shareholders as described here.
The implications of this analysis are that slow growth or no growth companies can still create shareholder value. If a non-risible case can be made for valuing such a company at 16 times earnings, then the opportunity to buy at 10 or 11 times earnings becomes very attractive. Of course, each individual company has differences from HNGCO - some companies have lots of balance sheet cash or generally have capital expenditures below depreciation deductions. It is interesting to compare Cisco (CSCO) with HNGCO - CSCO has substantial balance sheet cash, generally has capex below depreciation and probably has better growth prospects than HNGCO. Yet, CSCO trades at roughly 10 times earnings per share. Seagate (STX) is another interesting comparison for value investors.
The bottom line is that in a low growth, low interest rate world, a company with virtually no growth potential can still be an attractive investment. Of course, the fact that Apple (APPL) is trading at less than HNGCO's hypothetical multiple is truly remarkable. Needless to say, I am bullish on AAPL, CSCO and STX