The illusion of debt-fuelled earnings

By Edward Chancellor

Low rates have forced investors into a dangerous search for yield. Just look at the surge in junk-bond and emerging-market corporate debt sales over recent years. Cheap money has also driven record levels of stock buybacks in the United States and fuelled a boom in corporate mergers.

This is evidence of what the Japanese call “zaitech” – the use of cheap capital to boost reported profitability. Like all grand experiments in financial engineering, though, this one too will come unstuck.

Japan’s infatuation with zaitech arose in the late 1980s, at a time when economic growth was slowing and the rising yen threatened corporate profits. Many companies responded to those headwinds by issuing warrant bonds in the eurodollar market, swapping the proceeds back into the domestic currency and investing in Japanese shares, which were held in special trust accounts.

While the Tokyo stock market soared, these companies enjoyed rising earnings and a negative cost of debt funding. However, after interest rates rose and stocks plummeted in the early 1990s, it was game over. Many enthusiastic zaitech players, such as Hanwa, reported large losses.

The mid-1960s witnessed an earlier experiment with financial engineering in America. This was the era of the conglomerate boom. Companies such as ITT, Gulf + Western, Saul Steinberg’s Leasco and Ling-Temco-Vought (LTV) expanded rapidly through acquisitions. Between 1966 and 1968, conglomerates accounted for more than 80 percent of U.S. takeovers. These conglomerates often adopted dubious accounting techniques to boost profits.

Take LTV, cobbled together by the ambitious Oklahoman James Ling. The company expanded from a core electronics business into meat packing, sporting goods, airlines, insurance and eventually steel manufacturing. Ling understood that investors -in particular, the “gunslinger” fund managers of the “go-go” era -were focused on earnings per share.

To deliver EPS growth, Ling issued convertible bonds and bank debt to finance his acquisitions. He also enticed shareholders to exchange stock for convertible securities, which further boosted EPS. Ling would often float shares in acquired companies (like today’s tracking stocks) and use the proceeds to retire debt.

As long as the stock market continued rising, these feats of financial engineering worked wonders for LTV’s shares, which climbed 17-fold between 1964 and 1967. After interest rates rose towards the end of the decade and the stock market turned down, the conglomerate bubble burst. LTV was forced to divest companies to pay down debt, Ling was fired, and his company ended up as a second-tier steel concern, eventually going bankrupt in the mid 1980s.

In a presentation at the Grant’s Conference in New York last month, Chicago-based hedge-fund manager James Litinsky drew an intriguing parallel between the 1960s conglomerates and today’s so-called platform companies, businesses which have grown rapidly through M&A.

Unlike the conglomerates, they are not diversified but focused on a single industry. Like the conglomerates, however, they have thrived in an era of financial repression, when interest rates have been kept below the rate of inflation. Like their predecessors, platform companies have been using debt to generate EPS growth. Similarly, they have been egged on by investors, with activist hedge funds replacing the gunslinger generation.

Litinsky highlighted companies from various sectors, including brewing (Anheuser-Busch InBev) and consumer staples (Kraft Heinz). But pharmaceutical companies dominate. One of them, Valeant, resembles a modern-day LTV. The firm has grown rapidly through acquisitions, such as of Bausch & Lomb, and slashing costs to meet cost-cutting targets.

Valeant platform companies

Valeant promised to take $900 million from Bausch’s $1.2 billion of operating expenses. Valeant’s takeovers have been funded by cheap debt – interest expenses relative to long-term debt have averaged below 6 percent in recent years. Cost-cutting, takeovers and low-cost loans have boosted Valeant’s EPS, which climbed from 29 cents (on a diluted GAAP basis) in the fourth quarter of 2012 to $1.56 in this year’s third quarter.Like LTV, Valeant has adopted complex financial structures. Its ownership stake in specialist pharmacy Philidor, which distributed some of its drugs, was held through what’s called a variable interest entity. Critics claim this structure, which Valeant is now unraveling, kept contingent liabilities off the balance sheet. What’s clear is that Valeant has borrowed a lot -long term debt has grown from around $10 billion in late 2012 to over $30 billion today.

Corporate roll-ups, from LTV to Tyco International, have tended to come unstuck when they stop growing. Valeant’s stock is down more than 70 percent since its peak earlier this year. Its high-yield bonds are now trading below par. Valeant’s days of acquisitive growth would appear to be over.

The Valeant story is not an isolated case of aggressive financial engineering. At a time of ultra-low debt costs, announced global M&A activity this year has reached a record $3.9 trillion, according to Thomson Reuters. Global non-financial investment-grade debt issuance has climbed to $1.3 trillion so far this year. Acquisition-related debt reached a record $365 billion, says Thomson Reuters.

Even more debt has been issued by U.S. corporations for share buybacks. Over the past five years, the top 100 share repurchasers have grown their EPS by 93 percent. Their return on equity has climbed to 19 percent from 13 percent during this period, according to Thomson Reuters Worldscope, and their shares have handily outperformed the broader market.

This may look impressive. But the buyback leaders have also seen their sales growth slip and leverage rise. Their median capital spending (relative to cash flow) is below the S&P 500 average. To deliver EPS growth, these companies have been leveraging up and eating their seed corn.

Valeant’s fall from grace is just another example of how debt-fuelled growth creates only an illusion of value. Real worth comes from companies investing wisely for the future and acquiring shares -whether their own or in other companies – at low valuations. While corporate revenue is declining and debt is cheap, financial engineering is an easy way out -until it all falls apart.

Published on Nov. 18, 2015

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