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Why the Cheap Debt Frenzy is Great for Stocks: MSFT, DELL, CSCO, HAS, AGN, HD, HPQ, LO, INTU, VRSN, DISCA, DTV

Back in the 1970s, with interest rates hovering above 10%, investors could earn a lot more money by simply owning bonds instead of stocks. Now, with interest rates at all-time lows in the modern era, the bonds vs. stocks debate is getting turned on its head. With bond yields stuck at low levels, stocks are comparatively much more attractive.

That point has been noted by the Chief Financial Officers (CFOs) at a wide range of blue-chip companies. These companies are increasingly realizing that they can alter their balance sheets to provide some much-needed support to their flagging stock prices. And that's a buy signal you shouldn't ignore.

When leverage is appropriate

For a long time, many companies (especially in the field of high-tech) preferred to hold lots of cash and carry no debt. High cash balances were seen as a sign of strength in case any major economic slowdowns forced companies to burn cash to keep afloat. (Memories of the imploding dot-com bubble of a decade ago die hard.) Yet as we saw in the recent economic crisis, most large tech companies such as Microsoft (MSFT), Dell (DELL) and Cisco Systems (CSCO) stayed profitable. And their massive cash balances suddenly looked like an unnecessary precaution -- especially when that cash is earning almost no interest.

So we're now seeing an increasing number of companies issue debt, and that could portend some real gains for per share profits and share prices. To boost earnings per share (EPS), many of these companies are using some of their borrowings to buy back stock. With borrowing costs so low and stocks sporting such low multiples, the math gets pretty compelling as the following example shows…

Each of these companies has similar sales and operating income. While the first has $100 million in cash earning just 2% interest, the other has spent all that cash and borrowed another $100 million at a 4% interest rate in order to buy back $200 million in stock. That move has helped to boost earnings per share by more than +20% as the share count has fallen even faster than net income:

Buyback Benefits --Company ACompany B
Share Price$20$20
Sales*$500$500
Operating Income*$100$100
Interest Income*$2$0
Interest Expense*$0$4
Net Income*$102$96
Shares Outstanding (in millions)4030
Earnings Per Share$2.55$3.20
*figures in $ millions
That's precisely what Hasbro (HAS) is doing these days. As I wrote back in May:

"(An) improving profit trend led management to embark on plans to issue debt simply to buy back stock. The $625 million plan, announced last month, could reduce the share count -15% by the end of next year. There is a precedent: buybacks reduced shares outstanding by an average of -10% in 2006, 2007 and 2008. Put another way, shares outstanding, which stood at 197 million in 2006, could fall below 140 million by the end of next year."

[See: A Toy Maker That's Minting Profits]

A bond bonanza

Just this week, U.S. companies have issued more than $50 billion in debt, according to Standard & Poor's. Demand for these bonds is very strong, as rates are low enough to be enticing for bond issuers and high enough to provide a better return than CDs or government bonds. Healthcare firm Allergan (AGN) was able to issue 10-year bonds with a yield of just 3.375%.

Home Depot (HD) just sold $1 billion in bonds at an interest rate below 4%. What will the home improvement chain do with the proceeds? Buy back stock, just as it has before. The retailer had 2.3 billion shares outstanding in 2004. Six years later, the share count has dropped by 700 million, thanks to ongoing buybacks. That's a sure-fire way to boost earnings per share, and why many expect the company to post sharply higher EPS when the housing market is finally back on track.

Buybacks surging

As companies decide to hang on to less cash, they are increasingly looking to buy back stock. August saw a flurry of new buyback announcements, highlighted by a $10 billion announcement from Hewlett-Packard (HPQ). In addition, Lorillard (LO), Intuit (INTU), VeriSign (VRSN) and Discovery Communications (DISCA) all announced buybacks of at least $1 billion last month, with many more companies announcing smaller buybacks.

Satellite firm DirecTV (DTV) announced plans to buy back $2 billion in stock, which is going to help boost per share profits at a fast pace, as I noted in this article [See: This Company is Raking in the Cash].

Action to Take --> Look for this trend to continue. For a long time, investors assigned little value to excess cash sitting on the balance sheet. But if you come across companies with lots of cash and a depressed stock price, then a buyback may be in the offing. Companies with small amounts of debt that have room to take advantage of low rates and issue more debt could make a similar move. Use the exercise above to figure out what earnings per share would look like if your investment targets sought to buy back stock. If the results are intriguing, then it's a good reason to think about pouncing on the shares.

[/url]david-sterman-signature.jpg

-- [url=http://streetauthority.com/users/david-sterman]David Sterman


David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research atIndividual Investor and a Managing Editor at TheStreet.com. Read More...

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

About the author:

Street Authority
ValueExpectations.com, by the founders of The Applied Finance Group and Toreador Research and Trading, provides institutional quality research to the investment community. Select Research Topics Include: Equity Valuation Analysis; Management Quality; Market Outlook and Impact Discussions; Recent Market Movement Reviews; Macro Valuation Trends; Sector Analysis; Political Impact on Markets; and Special Studies. The term Value Expectations is derived from our ability to calculate market expectations embedded in stock prices, sectors and indexes.

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Comments

Sivaram
Sivaram - 3 years ago


STREET AUTHORITY: "These companies are increasingly realizing that they can alter their balance sheets to provide some much-needed support to their flagging stock prices. And that's a buy signal you shouldn't ignore."

You can create a lot of wealth by financial engineering, but when many are doing it, it's doubtful there is any advantage. Management are generally very poor investors and it's doubtful they know what they are doing now any more than when buying back shares a few years ago at high share prices.

The risk with everyone leveraging up is that you are basically making a bet against the market--in this case the bond market. You better be sure that the market is mispricing bonds on a grand scale or else these companies are going to see serious financial problems in the future.

Finally, it is probably better to buy companies that are fundamentally increasing sales and profits, rather than ones that do so through share buybacks or mergers and acquisitions.
paulwitt
Paulwitt - 3 years ago
Maybe share buybacks will help with the problem of ETF's treating stocks as commodities (as opposed to ownership of a business)

cm1750
Cm1750 premium member - 3 years ago
Sivaram said:



Finally, it is probably better to buy companies that are fundamentally increasing sales and profits, rather than ones that do so through share buybacks or mergers and acquisitions.


I generally do agree with his statement, but I see many of my stocks as mini-LBOs but with less debt. PM, DTV and HD are using their massive FCF to buy back cheap shares.

I finally think MSFT is cheap enough where it fits this model. I just bought some at $23.85.

Unlike EBAY, CSCO, DELL and others, MSFT does not, as a general rule, overpay for acquisitions. If MSFT utilizes 80-90% FCF on buybacks and dividends and institutes a one-time tender for $25-30Bn of shares, I would be happy.

Owner earnings (economic FCF) ex-interest is roughly $2.28. At the current share price of $20.85 (after subtracting $3 excess cash), one gets an 11% (largely tax-free) perpetual bond-equivalent yield even if FCF growth is zero. The key is to get a 10%+ return on that FCF via buybacks/dividends.

The only issue is the lack of clear catalyst. Even so, the risk/reward is very favorable - much better than cash or taxable bonds.

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