On Sesame Street, the puppet characters would sing: "One of these things is not like the others..." The edutainment show was teaching its young viewers to spot contrasts.
On Seeking Alpha, I want readers to look at this graph of the equity market capitalization of public companies with CCC or lower credit ratings from S&P. Which of these things is not like the others? The answer: Uber (NYSE:UBER).
On Thursday, Uber printed an upsized $1.2B bond deal to finance part of its pending acquisition of Middle Eastern transportation company Careem. The bonds are rated B3/CCC+ by Moody's and S&P, making the debt deeply speculative grade.
The very low credit ratings and healthy equity market capitalization set up a startling contrast. One easy enough for a pre-school Sesame Street viewer to spot. Bond rating agencies are signaling that the debt issuance has a meaningful risk of default, but equity holders, who are subordinate to this debt in the Uber capital structure, are signaling meaningful optimism about the upside of the business.
From the chart above, one can see that the equity market capitalization of Uber at nearly $58B, is more than 5x the market capitalization of the next largest CCC-rated company with public equity, Carvana (CVNA). It is larger than the combined market cap of the 40 or so public companies in the graph that are among the largest companies with CCC-rated debt.
Why the disconnect between bond ratings and equity market cap? Bondholders are senior in the capital structure, but they forgo upside in exchange for priority of recovery in a restructuring. While bondholders are hoping for the timely payment of interest and return of principal, equity holders own the upside of Uber becoming a dominant global transportation and delivery company.
The bond market also is disagreeing to some degree with the rating agencies' assessment of risk. The average single-B rated company has a yield-to-worst of 6.4%; the average CCC-rated company has debt with a yield-to-worst of 11.2%. Uber, which is straddling low B and high CCC, printed bonds with eight years to maturity and a three-year non-call period at a price of 7.5%. The bond market is suggesting that risk is closer to single-B than CCC, but given that the lower of the two ratings is CCC, Uber would appear in CCC indices alongside these speculative businesses.
If you are an Uber equity holder, you should at least be aware that raising debt financing is rather expensive for the company. In a world with trillions of dollars of bonds with negative yields, Uber paying 7.5% to borrow money means that the bond market needs serious compensation for default risk. In that dire default scenario, Uber equity is likely worthless. Uber has yet to generate an operating profit and will likely burn through cash for the foreseeable future. While liquidity on the balance sheet is healthy post-IPO, there are very likely additional necessary capital raises ahead to fund continued operating shortfalls. There are limits to how much of that capital can be raised in the junk bond market, which could signal the potential for future equity dilution. Bondholders willing to lend at 7.5% to a company that is years from generating positive cash flow are likely counting on that equity cushion to provide some support for future capital needs.
In "Uber: History Suggests Poor Returns", I showed that the worst returning part of the equity markets were large capitalization companies with the lowest profitability. Below I show a matrix of the annualized returns of 25 portfolios subdivided by size and operating profitability. This monthly dataset stretches from mid-1963 through March of 2019.
With a $58B market capitalization and no profit history, Uber certainly fits into that poor performing segment of the market. Like its high market capitalization and low debt ratings, Uber will have to buck some long-standing market trends to successfully reward shareholders. For contrast (there is that word again), there was market consternation last week when Ford (F) was downgraded by Moody's to Ba1 - the highest ratings among speculative grade companies. Ford's debt is still rated 5 notches higher than Uber, but its market capitalization is $20B less.
There is certainly a bull case that the multi-billion dollars of operating losses were the price to pay to become a dominant market player in a transformative industry that is re-shaping how people move about the globe. While operating profits have been elusive to date, advancements in driverless cars could reduce costs and improve margins. A company with a dominant market-leading position gains the network effects that have come to highlight our winner-takes-most economy and stock market. That case is priced into the $58B equity capitalization. Investors should understand that a company with that type of equity cap and CCC-rated debt is anomalous indeed. Uber is not like the others.