Wednesday, June 20, 2007

HD's DIY LBO

Home Depot announced they would use the $10 billion they are getting from the sale of HD Supply as well as another $12 billion from debt sales to buy back about 1/3 of their shares. Let's call it the do-it-yourself LBO. Instead of waiting around for private equity to form a (possibly hostile) bid for the languishing stock, they went ahead and levered up on their own.

I'm hearing this will put leverage in the 2.5x area. I've also heard Moody's plans to downgrade Home Depot to Baa1 (from Aa3) and S&P to BBB+ (from A+).

I'm surprised there hasn't been more of this going on, and maybe Home Depot will usher in a wave of similar transactions. There are many companies that have no real need for as strong a credit rating as they currently have. I'd say most A-rated retailers, some A-rated telecoms, several technology firms (Cisco comes to mind), etc. A company like Cisco is particularly interesting (I have no position either way), because its stock price has been pretty weak, and they currently have a A-rating, but I can't think of why they wouldn't do just fine at BB.

The Home Depot transaction finally puts to bed the myth that size of the company protects bond holders from leveraging transactions. If a very large company like Home Depot can do this, there's no reason why someone even bigger, like Cisco couldn't do it also. Particularly since in a DIY LBO, you don't have to do it all at once. Cisco could sell $5 billion in debt this year, another $5 billion next year, do a spinoff here and there, and it adds up to a substantial leveraging. There was never the problem that actual LBO's face when doing very large transactions: namely a very large bond deal swamping the market and making the spread widen.

It also is example number 4,312,789 that bond holders are always stock holder's bitches.

12 comments:

Anonymous said...

Tom, I don't know how old you are, but this sort of thing was quite common in the 80s - I worked on a few of these myself - they were called public LBOs - and often the company would lever up and pay out a dividend in excess (sometimes way in excess) of current stock price. Some examples included FMC, Quantum Chemical and even RJR (the deal the Ross Johnson tried to do) What goes around comes around...

TDDG said...

Yeah, and a lot of those transactions were pushed forward by a lot of the same conditions as today: easy credit, strong stock market, good balance sheets. Companies which were falling behind the market wound up doing this kind of move.

So I'm just wondering why more companies aren't doing this now.

Anonymous said...

How exactly does it benefit Home Depot?

Or does it just benefit their stockholders?

I.e. the company and whatever it "does" are epiphenomena?

TDDG said...

The company winds up with no change in operations, slightly higher interest cost, but a big one-time benefit to shareholders.

Anonymous said...

This certainly is not the first of the current wave earlier. Another big company that recently has done something similar is Valero (with a $ 6 billion total plan and approximately $40 billion market-cap, but also a company that does benefit from being investment grade).

I am not sure that I see there is long term value in incuring more debt for the shareholders vs. simply paying out excess cash as an excess dividend. Perhaps I am too conservative in my outlook.

highlowbrow said...

I am not sure that I see there is long term value in incuring more debt for the shareholders vs. simply paying out excess cash as an excess dividend.

Classical theory is that for a company, there is a cost of debt capital and a cost of equity capital. The cost of debt is the interest expense. The cost of equity is the value of future earnings.

So for an A rated company, it maybe has a 6% cost of debt capital. If the cost of equity capital is more expensive, say 9%, the company would be better off substituting debt for equity.

I am mainly a stock market investor, but I've wondered about this question a fair amount. It seems tough to find cheap stocks in general, although I've found quite a few companies that could have much higher EPS by changing equity to debt, and still maintain a good balance sheet.

TDDG said...

I'd seem logical that you could try to find companies capable of levering up and buy the stock. You'd have a collection of strong balance sheets and potential for EPS expansion through nothing more than recapitalization.

Ryan said...

As other posters have said, this is the "eat or be eaten" mentality of the M&A 80's recasted into an LBO scenario.

Companies know that they have to get lean and lever up or else activist investors and private equity money will be right there to do it for them.

And so the corporate spreads continue to widen...

Anonymous said...

There is a lot of BS in what is being taught in business schools as classical theory of business (and as a CFA Charterholder I have seen my fair share of it on all sides of that coin).

The point against recapitalization is not a debt/equity cost argument, the point is if the equity holders actually own the company (which, by law they do) why are you incurring extra costs in the form of debt for them?

I have no objection to a company analyzing the merits of the cost of debt vs equity for expansion or reinvestment in assets (and if it is a company in which I own the stock I would hope they have a very high bar for financing anything with new equity).

I as an equity investor would take a very dim view towards any company levering up beyond BBB to finance a recapitalization, as I think there is merit in preserving financing flexability if you actually need it...

TDDG said...

More debt increases costs and bankruptcy risk. Isn't it a question of whether the increased ROE of greater leverage is worth the increased risk?

Anonymous said...

Yes, but increased cost as well as increased risk as you point out.

The other point that bears mention in this argument is that in the modern era, companies are not taking out debt to pay a dividend but to buy back stock. Paying a dividend should broaden the base of interest in the equity in a low payout stock, and demonstrates a commitment of management to sustaining a return to the shareholder.

Going back to Valero for a second, they do need to maintain creditworthiness since they have to buy enough oil on world markets to support a large refining system. However, they probably did not incur enough debt to make much of a difference to them.

Home Depot obviously incurred enough debt to make a difference to them. If business worsens, do they then pay for their buyback with a sub-investment grade rating? Furthermore, as with your Cisco example, does it matter much to their business or would the equity of either be punished for being a more risky proposition?

As I (and if I post much more I’ll register a name…) said earlier, perhaps I am too conservative in my analysis.

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