Sunday, December 31, 2017

The Credit Bubble?

Are companies loading themselves up with too much debt?

An article today in Marketwatch posits that one thing that might kill off the bull market is a building credit bubble.   They are not talking about the staggering levels of debt that some Americans are taking on - the highest since the recession - but instead the levels of debt that companies are taking on.

As I noted in another posting, companies can raise capital in a number of ways.  They can sell stock, or equity in the company, or they can sell bonds or borrow money from a bank.   Debt is really not much different from equity, other than debt-holders don't get a say in how the company is run, except perhaps in bankruptcy court, where they are often in the driver's seat.   On the other hand, a lot of these new "tech" companies are selling stock without voting rights - or the majority of stock is held by three or four investors - so your voting rights are no-existent or illusory.

And as I noted in another posting, companies can pay shareholders in a number of ways.  The most obvious way is to pay dividends.  But dividends might be taxed at ordinary income rates, and thus are not a good value for the shareholder - particularly the larger shareholders.   Increase in stock values, however, are not taxed until the shares are sold, and even then at long-term capital gains rates which are far lower than ordinary income rates.

One way to do this is to buy back your own stock, which means fewer shares are in circulation.   If, for example, ACME company is "worth" a million dollars and has a million shares outstanding, then arguably the share price should be a dollar a share.  If they buy back a half-million shares, the share price should jump up to two dollars a share.   This is not a taxable event, until the shares are sold, and even then, at capital gains rates.

As the article notes, Apple is buying back seven billion dollars worth of shares, after floating five billion in bond issues.   Leave it to the lizard people at Apple, living in their flying saucer - selling out before they return to the home planet.   I just don't trust them!   But seriously, this illustrates one pitfall of share buybacks based on debt.   If the company takes on more debt to buy back shares, then the shares shouldn't be worth more.

For example, going back to our mythical ACME company, if the the company is initially "worth" a million dollars, and they borrow $500,000 to buy back half their shares, the company is now only worth a half-million dollars, as they have this new debt on their books.  They have 500,000 shares and a worth of $500,000 - so the share price should be stuck at a buck-a-share.

But since the company is a "hot stock" we've decreased the number of shares in circulation, and thus the share price might rise just due to the laws of supply and demand.   People want to buy the stock, and now there is less of it to buy.

Since the CEO, CFO, Board Members, and all senior management of the company are paid in stock options an increase in share price can mean a windfall of millions, if not tens of millions of dollars for them.   This is what happens when we incentivize managers to increase share price - they will use whatever means necessary to increase share price in the short term, without thinking of how this will affect the long-term prospects of the company.   So managers might decide to do odious things - like intentionally slowing down older cell phones to get people to buy new ones, or perhaps cheating on diesel emissions testing to sell more cars.   Or, whatever.

As I noted in the posting cited above, some folks like to use the term "Enterprise Value" to determine what the worth of a company is.  This is a far better metric than "Market Cap" that the financial channels use.   It can be a fairly complicated calculation, but boiled down, it takes the market cap and adds the corporate debt to come up with a better valuation of the company - what it would cost to "buy" the company in a takeover.   Debt and equity are valued equally.

Let's go back to ACME company, which bought back half its stock.   Since they have hot products and are mentioned prominently in the financial press, people still want the stock - but there is only half as much as there once was.   So the share price goes up to $2 a share.  Now, if you just used "Market Cap" to valuate ACME - or the share price - you might think the company has stayed the same in value, as it's "Market Cap" is still a million dollars (500,000 shares times $2 a share).   But that fails to take into account the half-million in debt they have taken on.   If the share price goes up, arguably the "Enterprise Value" is a million-and-a-half, which makes no sense at all - the company takes on debt and is now worth more.   It is more complicated than that, of course, but you get the idea.

But this illustrates how a company can buy back shares to thwart a takeover.   If the share prices rise and the Enterprise Value rises as a result, the company will be more expensive to "buy" in a takeover and thus the potential suitor has to pony up more dough.   But of course, Apple is not a target of a takeover, so that is not in play here.

It is possible for managers to hollow out a company with debt, and we have seen this happen over the last two decades.   When Mark worked at Sheets 'N Things, the company loaded itself up with debt.  The stores were profitable, by and large, but not profitable enough to service the massive debt load.   Today, we are seeing the same thing with a whole new slew of companies, such as Toys R Us, which is going through reorganization not due to Amazon as reported in the press, but because the company is saddled with debt.

Will this level of corporate debt cause a recession in 2018?   It is hard to tell.   But I think in general, recessions are caused not by one single thing, but by a panoply of things.   You may recall in the summer and fall of 2008 when things started to unwind the last time around.   George W. Bush signed the bailout bill to prevent the economy from going into free-fall and keep Wall Street firms from going under (most of them, anyway).   Gas soared to $5 a gallon in many places.  The car companies faced bankruptcy.    Oh, and the housing bubble burst.

If you ask people about the recession of 2008, many of them today will say it never happened.   The few who acknowledge it did, will say it was caused by Bill Clinton and the "Community Reinvestment Act".  The few who are not listening to infowars, will say it was caused by an overheated housing market.   And that last explanation is true, but not the whole case.   General Motors didn't go bankrupt by trying to buy-and-flip houses.

So this time around, it may not be any one "thing" but a panoply of things.   Corporate debt, personal debt, bankruptcies of brick-and-mortar stores, trade wars, inflation, higher interest rates, higher wages and a tighter job market, exuberance over things like Bitcoin, and so forth.  And yes, maybe even over-inflated real estate prices in some markets.   Eventually, people pull back, often not out of choice, but necessity.