Jubak: How cheap debt overinflates stocks

Discussion in 'Wall St. News' started by MattF, May 8, 2007.

  1. MattF


    Good read.


    "Today's availability of easy money distorts calculations that are used to determine whether stocks are overvalued or undervalued and makes the markets hard to read.

    By Jim Jubak

    It all comes down to cheap money.

    Cheap money is fueling the buyout boom.

    Cheap money is prompting companies to buy back billions of dollars' worth of their own shares.

    Cheap money is fueling big increases in corporate dividend payouts.

    Perhaps best of all -- for investors long on the market, anyway -- cheap money is keeping the current rally running, even as the U.S. economy runs out of steam, by convincing investors that stocks are undervalued even as they hit historic highs.

    So how does cheap money work its magic?

    Sallie Mae's dance with debt

    Let's start with a recent deal, the $25 billion buyout of student-loan giant SLM Corp. (SLM, news, msgs), better known as Sallie Mae.

    On April 16, private-equity investors J.C. Flowers and Friedman Fleischer & Lowe, along with Bank of America (BAC, news, msgs) and JPMorgan Chase (JPM, news, msgs), announced a $25 billion bid for Sallie Mae.

    At $60 a share, the offer represented a 50% premium above the pre-buyout bid price of the shares. As you can imagine, shares of Sallie Mae rocketed toward the offer price -- though thanks to saber rattling by Washington politicians, the stock stalled short of $60. It seems some folks on Capitol Hill think having private investors control a company that makes government-guaranteed loans might be a bad idea. (Wherever do members of Congress get these notions?)

    The deal also lighted a fire under the shares of other companies that provide student loans. Nelnet (NNI, news, msgs) shares climbed 15%, and shares of The Student Loan Corp. (STU, news, msgs) rose 5%.

    It also goosed the prices of shares in the financial sector in general. Investors had thought that financial stocks, because regulators frown if they load on too much debt, were likely to be left out of the buyout boom. But if Sallie Mae can get a bid, why not other financials? In the days after the buyout news broke, shares of Countrywide Financial (CFC, news, msgs) rose 6%, and those of CIT Group (CIT, news, msgs) climbed 9%.

    Debt, of course, is critical to the Sallie Mae deal. The four investors are putting up $8.8 billion in cash, but most of the deal will be financed with debt. As in any leveraged buyout, that debt, more than $16 billion of it, will be piled onto Sallie Mae's balance sheet.

    All that debt will sink Sallie Mae's bond rating. Rating agencies Standard & Poor's, Moody's and Fitch have already said that they're likely to downgrade the company's credit rating from its current A in S&P's system. That's not the highest grade in S&P's system but clearly qualifies as investment grade. A downgrade to one of the speculative grades, say five steps down to double-B, would drive up the interest rate that Sallie Mae would have to offer investors to get them to buy its bonds.
    An easy entry for the banks
    But here's where the wonders of the current reign of King Cheap Money comes in. Because money is so cheap right now, the downgrade wouldn't cost the company very much. Right now, the coupon interest rate on Sallie Mae's debt is 6% to 6.4%. In the current market, a drop to a double-B credit rating would cost the company less than 2.1 percentage points. That would drive the coupon that Sallie Mae has to offer up from, say, 6.4% to 8.5%.

    That's not chicken feed when you're talking about $16 billion in debt. Annually, it comes to an extra $340 million in interest that Sallie Mae will have to pay. But that bill is still, historically, cheap. The median increase in yield from such a downgrade over the past 20 years is more like 3.1 percentage points. That would add an additional $160 million a year to the interest bill at Sallie Mae.

    (Owners of Sallie Mae's current A-rated bonds aren't likely to think the downgrade is cheap. Bonds fall in price when they suffer a credit-rating downgrade, and the price of Sallie Mae's bonds took a 5% hit in the days after the deal was announced.)

    Cheap money makes it possible to do this deal. The investors -- or, rather, Sallie Mae -- will pay just $1.3 billion a year on the $16 billion borrowed for the purchase. That modest interest plus the $2.2 billion in cash each is paying make this almost certainly a bargain for the banks in the deal: JPMorgan Chase and Bank of America get almost half-ownership of the biggest player in the extremely lucrative market for student loans, a market where they clearly want to gain market share.
    Poof! An inflated P/E disappears
    But let's look at the effects of the deal on the market as a whole. The buyout pushes up the price of Sallie Mae shares by 50% and of other financials by 5% or so. That's all reflected in the market indexes.

    Any jump in price makes stocks seem more expensive, of course. But the way this and other deals work minimizes the jump in stock-market "expensiveness." Sallie Mae's price-earnings ratio jumped from 17 before the deal to 24 after it was announced.

    But Sallie Mae, the stock (and the inflated P/E), will be no more when the deal is done. Same with the jump in risk represented by that $16 billion in debt and the $1.3 billion in annual interest payments. As soon as the deal is completed, the company will go private, and all these numbers will vanish. The increased P/E ratio for Sallie Mae shares will disappear from all calculations of stock-market valuation.

    Buyout deals that take higher valuations out of the public market aren't the only way that cheap money is distorting calculations that are frequently used to determine whether stocks are overvalued or undervalued.
    Overpaying the shareholder
    Take the practice of using borrowed money to buy back shares. Bet you thought all those buybacks that companies are announcing were funded out of current cash flow. Think again. Even big players such as IBM Corp. (IBM, news, msgs) are piling on debt to repurchase their own shares.

    Since 2003, IBM has purchased 203 million of its own shares at a total cost of $30.7 billion. That's a huge percentage -- about 52% -- of the company's total operating cash flow of $59.5 billion during the period. It looms even larger if you add in the $17 billion IBM spent during this period on capital expenditures, the $8.8 billion it spent acquiring businesses and the $5.3 billion it spent paying dividends to investors. All that -- added to the spending on buying its own shares -- comes to 104% of operating revenue.

    Or look at it another way. In 2006, IBM used the equivalent of 67% of its total net income to buy back shares. In 2005, the percentage was 82%. In the two years before that, 64% and 42%, respectively.

    If you add in dividends, 2006 payouts to investors came to 85% of total net income at IBM.

    That's the level of payout ratio that sends up a red flag to investors, I've been taught, because it's clearly not sustainable over the long run. In fact, from its financial statements it looks like IBM is borrowing to keep up this level of payout while keeping its business running as usual. Cheap money makes that possible.

    It's the kind of payout ratio more common to utilities than to stocks such as IBM. Utilities keep their payout levels so high because regulators don't allow them much of a profit margin -- at least not in the good old days -- and to build power plants they have to raise money in the capital markets. The high payouts are necessary to make their bonds and stocks attractive to investors. In essence, they're using high payouts to increase the attractiveness of their financial offerings.

    IBM and other companies using cheap money to fuel buybacks and dividends are clearly doing the same thing. For example, because of those buybacks, IBM had about 203 million fewer shares outstanding in 2006 than in 2003. That added about 65 cents a share to IBM's earnings per share in 2006. In other words, if the company were still spreading out its earnings across 1.76 billion shares, the number it had outstanding in 2003, 2006 earnings per share would have been $5.41 instead of $6.06. And IBM's earnings-per-share growth from 2003 to 2006 would have been 25% instead of 40%.
    Undermining the bullish argument
    Extend IBM's practices across the stock market -- and I think you should given the prevalence of share repurchases and dividend increases paid for with debt -- and you get a serious data problem.

    If companies' earnings per share are being inflated because of repurchases funded with cheap debt, that means the market's price-earnings ratio, now at 22.8 for the S&P 500 Index ($INX), is being artificially depressed by cheap debt.

    And if companies are using cheap debt to increase their payouts in the form of share repurchases and dividend payments, then valuation measures that look at the stock market's yield are seriously inflated. That's not a minor point because the calculation that the market now yields about 5.3%, according to Standard & Poor's, when the yield on 10-year U.S. Treasurys is just 4.64%, is a key argument used by bullish investors who want to show that stocks are still undervalued.

    To my mind, the ready availability of cheap debt is what makes the stock and bond markets -- and the U.S. and global economies -- so hard to read right now. The influence of cheap debt on traditional valuation measures is just one more example of that.

    In my next column, I'll take a look at why the bears are right about this market on the fundamentals and how cheap debt has made them wrong where it counts most: in the wallet."
  2. Great read. It's well written and it would be interesting to read more detail on the topic...someone doing analysis on other major players and each of these mega-buyouts would be interesting as well.
  3. Wow.. What a great read!

    I do agree, it is very well written. This opened up a whole new can of worms in my world.

    Thank you!
  4. The ROW seems to want nothing more than our debt and since we are the ultimate capitalists we are finding ways to get to them. China has no interest in selling US bonds as long as we can keep creating debt for there people to make a living on. Doesn't sound that bad if you are in the debt creation business which is really what Wall Street is, but it certainly makes the longterm seem unstable.
  5. Its a house of cards thats for sure, and the sad part is they have to keep juggling all 10 balls to keep things rolling along.

    One day it will unravel, just make sure you have a pile of cash and you can reap the rewards that can change your life.
  6. Lotsa cheap money like gas on the fire...

    Hedge funds at 250% leverage owning other hedge funds at 250% leverage, and those owning funds of funds at 250% leverage.

    Works great when everything is going up and money is cheap.