Get in Touch with Your Private-Equity Side

Many investors who have watched the slew of private-equity deals undertaken over the past couple of years might say to themselves, "What are these guys thinking? How can you make money buying companies for premiums?" While bids can certainly be opportunistic as companies trade near unreasonable or cyclical lows, there is also a very straightforward, simple principle that is also often times at work--debt is usually cheaper than equity, a disparity that can become particularly large for companies that generate strong, regular cash flows and use very little leverage. While debt requires regular interest payments, equity holders require a higher rate of return due to their subordinated claim to a company's assets, a less rigid or defined payback structure, and the higher risk of the asset class. This simple truth can have powerful consequences.

Though some industries such as drug development or technology have inherent risks that might make taking on additional debt prohibitively risky or expensive for early- or investment-stage companies, there are a number of mature firms with stable cash flows in these and other industries that I think could unlock value with more leverage, even very large companies that are unlikely to be the targets of a leveraged buyout. In most cases I am envisioning debt potentially being used to buyback a significant chunk of equity, though other capital allocation decisions such as boosting dividends can have similar effects. This analysis assumes that the company's stock is trading below our fair value estimate in the case of share buybacks. I am admittedly grossly oversimplifying the situation in order to make the point that chronically inefficient capital structures can depress a company's valuation. Conversely, underleveraged balance sheets can also provide a somewhat hidden means of appreciation if and when the structure is changed.

A traditional and often quoted way to gauge leverage is debt to capitalization, where capitalization is a company's book value (the worth of assets in excess of liabilities). This is horribly antiquated unless you are a collateralized lender, and makes little sense in many modern industries where intangible assets have replaced holdings like heavy machinery and land. A better gauge is net debt (debt minus cash and equivalents) to net enterprise value (debt plus market capitalization minus cash and equivalents), as this is usually the calculation used to determine the weight of debt and equity in a calculation of a company's weighted average cost of capital.

It should be noted that these two variables are not independent, the cost of equity is a key component of the WACC. However, the WACC also takes into account the portion of the company's capital structure that is made up of debt, and therefore the company's WACC will tend to go down the more leverage it uses. This is only true to a point, however, because the company's cost of debt is also a function of the amount of overall debt it uses, and the cost of equity and debt will both increase as the amount of debt increases (though this usually tends to happen in step functions due to the sway of ratings agencies rather than along a smooth curve). Companies certainly can reach a point where they are dangerously over-leveraged, as is the case with  Spectrum Brands (SPC), which has a net debt/enterprise ratio of 85% and is counting on an asset sale to stay solvent.

Because beverage companies are my primary field of expertise, and because they have the added benefit of operating in a noncyclical industry with fairly stable and predictable cash flows, I will use three examples to demonstrate a spectrum of leverage, from vastly underleveraged to what I consider to be the upper boundary of responsible and controllable leverage.

 PepsiCo (PEP) first pops to mind when I think of an overly conservative capital structure, as net debt to net enterprise value is less than 1%. Though I have been a long-time fan of PepsiCo and have given it a Morningstar's Rating of 5 stars quite frequently over the past few years, the company clearly could stand to step up its share-buyback activity. PepsiCo has a cost of equity that is essentially equal to its weighted average cost of capital because it has so little debt on its balance sheet relative to its market cap. While I continue to think that PepsiCo makes a great investment and has attractive international investment opportunities, the company also has a somewhat hidden bonus. It could enhance shareholder value significantly by buying back shares, increasing the dividend, and increasing the amount of debt on its balance sheet. This will become especially apparent when its international growth slows, though this could be several years off.

In the middle of the spectrum is a company like  Anheuser-Busch (BUD), which has been using leveraged to increase its dividend and buyback shares. Anheuser-Busch is currently pulling the debt lever in order to enhance what would otherwise be a pretty slim return for shareholders as growth opportunities in the American beer market dry up. The company recently announced that it would be increasing the amount of leverage in its debt structure, and speculation was that this was a bid to fend off some rather preposterous rumors surrounding private equity interest. Rather, this was a very natural maneuver, in my opinion, for a company in an increasingly mature industry with limited investment opportunities. We expect the company's current COE to WACC spread of 50 basis points to slowly and steadily increase over the next few years as its leverage and buyback activities increase. The company's net debt to net enterprise value is about 17%.

The most aggressive use of leverage on my coverage list is  Constellation Brands (STZ), which is in many ways a do-it-yourself private-equity firm. The company came to an interesting point lately after it reported disappointing results and a weak forecast for the 2008 fiscal year. Management decided that it was going to continue its spree of leveraged buyouts, and that the cheapest company in the space by far was--itself. The company recently undertook a $500 million stock buyback, financed with debt. Before the buyback, Constellation had a COE/WACC spread of about 120 basis points, which I see increasing slightly over the next year. While this leverage no doubt increases the volatility of Constellation, I believe that companies can be both judicious and aggressive using debt. I see Constellation as a private-equity firm with the bonus of creating synergies between its investments. Also, the relatively steady cash flows generated by a purveyor of alcoholic beverages are a good offset to the amplified volatility of returns from a highly leveraged investment. Prior to the latest buyback, the company's net debt to net enterprise value was about 42%.

Looking outside of the beverage space, the grand-daddy of all potential leverage scenarios might be  Microsoft (MSFT), which generates cash faster than it knows how to distribute it. Microsoft's net debt to enterprise value is negative 11%. A prolonged period of more-aggressive buybacks seems likely after the company fell short of its target in a buyback tender offer in August 2006, and the possibility of another large dividend cannot be dismissed. Still, the company's capital structure remains horrendously inefficient at present, in my opinion.

A few wide-moat companies with low or negative net debt to net enterprise value that I think should be on long-term investors' radar screens include  Johnson & Johnson (JNJ) (under 1%),  Dell  (negative 1%), and  Cisco (CSCO) (-1%) as well as narrow moat companies such as  E.ON  (10%--very low relative to its peer group) and  Expedia (EXPE) (negative 2%). While this list is by no means exhaustive, and the attractiveness of recapitalization will sway with each company's share price, investment opportunities, and the interest-rate environment, it is an issue that warrants consideration when making an equity investment. We cannot say what will ultimately cause a management team to pull the trigger or not regarding balance-sheet leverage, but investors should be aware of all of the tools in a management team's bag.