Tuesday, April 21, 2009

Thank You Michael Milken, Two Years Too Late

Why Capital Structure Matters
Companies that repurchased stock two years ago are in a world of hurt.
—By Michael Milken, The Wall Street Journal

If you didn’t have enough reason to spit your coffee out over the newspaper this morning, what with the President of Iran calling Israel “a cruel and repressive racist regime,” there’s always the op-ed page of today’s Wall Street Journal.

That’s where Michael Milken writes the two-years-too-late observation that there are times when “even a dollar of debt may be too much for some companies.”

Milken, for those too young to remember, was the finance whiz whose grad-school observation—that a collection of junk-rated securities could actually be a safer investment than the individual ratings implied—led eventually to the last great credit crisis in America, when Drexel and the rest of Wall Street leveraged Corporate America just in time for the 1990 LBO-Bubble collapse.

And, ironic as it seems, Milken fingers much of today’s woes on the “return-value-to-shareholders” mania of yore:

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

Now, we here at NotMakingThisUp have no argument with Mr. Milken’s observation on the dangers of too much debt in a capital structure.

It’s just a little too late to matter.

By way of comparison, we’re reprinting here our take on the subject back when companies were still pedal-to-the-metal on the road to self-destruction.

Note that we spared nobody: not CEOs, not Boards of Directors, not Wall Street Investment Bankers, not Wall Street Analysts, and not even Hedge Funds, of which we are one.

Wednesday, August 08, 2007
The Shareholder Letter You Should, But Won’t, Be Reading Next Spring

Dear Shareholder:

Well, it seemed like a good idea at the time.

I am referring to your board’s decision to approve a massive share buyback and huge special dividend last summer, when the buzzwords going around Wall Street were “returning value to shareholders.”

Why we did it was this: a smart banker from Goldman Lehman Lynch & Sachs came in, all gussied up and looking sharp, and made a terrific PowerPoint presentation to the board with multi-colored slides that showed how paying a special $10 a share dividend, plus buying back a bunch of our stock at the 52-week high, would “return value to our shareholders.”

We should have thrown the fellow out the window, along with his PowerPoint slides, but what happened was, my fellow board members and I were so busy deleting emails from our Blackberries that we just didn’t notice the last slide showing (in very tiny numbers) the “Trump-style” debt we would be incurring to do so.

We also missed the footnote showing the fees that would go to Goldman Lehman Lynch & Sachs for the courtesy of their showing us how to wreck our balance sheet.

Those fees, I am embarrassed to say, amounted to more money than we made the quarter before we “returned value to shareholders.”

But the fact is, we’d been getting so much pressure over the last few years from the hedge fund fellows who own our stock for ten minutes tops, not to mention the so-called “analysts” on Wall Street (around here we call them "Barking Seals"), to do something with the cash...well, the truth is we just couldn’t stand answering our phones any more.

So, in order to finally start getting things done instead of spending all day explaining to these hedge fund fellows and the Barking Seals on Wall Street why we weren’t “returning value to shareholders,” we decided to do the big buyback and the big dividend.

And for a few weeks there, it was pretty nice.

The stock jumped, the phones stopped ringing, and the Barking Seals started congratulating us on the conference calls instead of asking us when we were going to get rid of our cash.

Unfortunately, not only did getting rid of our cash and taking on a huge debt load NOT “return value” to you, our shareholders, it actually crippled the company for years to come.

For starters, as you know, the aftermath of last summer’s sub-prime debt crisis is forcing perfectly fine companies to liquidate businesses at fire-sale prices…but we can’t take advantage of those prices, because we have no cash. And thanks to the debt we incurred “returning value to shareholders,” the banks won’t loan us another dime.

Secondly, as you also know, we’ve had to lay off hundreds of loyal, hard working employees to pay the interest expense and principal on all that debt, because unlike Donald Trump, we actually repay our debts.

Furthermore, as you probably don’t know, we’ve also scaled back some interesting research projects that had great long-term potential for the company, but were deemed too expensive to continue in light of the fact that we have no cash.

Now, I’d feel a heck of a lot worse about all this if we were the only company suckered into buying our stock at a record high price and paying a big fat dividend on top of it.

But I’m happy to report there were others who also did the same stupid thing.

For example, Cracker Barrel, the restaurant chain that depends on people having enough money for gas to get to its stores along Interstates across America, spent 46 bucks a share for 5.4 million shares of its stock early last year to “return value to shareholders.”Cracker Barrel’s stock now trades at $39.

And Scott’s Miracle-Gro, whose business is so seasonal it loses money two quarters out of four, put over a billion dollars of debt on its books with the kind of special dividend and share buyback we did.

Health Management Associates—a healthcare chain that can’t collect money from about a quarter of the patients it handles—paid shareholders ten bucks a share in a special dividend to “return value to shareholders” and then missed its very next earnings report because of all those unpaid bills and all that new interest expense it was paying.

Oh, and Dean Foods, a commodity dairy processor with 2% profit margins, returned all sorts of value to shareholders early last year—almost $2 billion worth—just before its business went to hell in a hand basket when raw milk prices soared.

So, you see, everybody was doing it.

And boy, do I wish we hadn’t.

Jeff MatthewsI Am Not Making This Up
© 2007 NotMakingThisUp, LLC

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


Martin H said...

While there were instances of over-leveraging, publicly traded companies as a class were suprisingly conservative with their capital structures since the last recession in 2001.

We're finally starting to see more bankruptcies, but the volume is still surprisingly low relative to prior major recessions.

A lot of the companies filing now have seen seismic shifts in their industries. Even with a conservative balance sheet, it is tough to remain solvent when unit sales and revenues drop by more than 30% in less than a year (e.g. home builders, building materials suppliers, RV manufacturers and anybody related to the auto supply chain).

That said, the leveraged dividend recap for public companies doesn't look great in hindsight.

Anonymous said...

"Truck" does not mean "quibble". Idiomatically, it means the opposite. Literally, it means "commerce".

cfischer said...

I got into this "debate" with a fellow b-school classmate at Stern recently. We were specifically talking about Costco, who issued about 2 billion in debt for the purposes of buying back shares. They issued the debt at around 5%, and they don't have any real liquidity concerns. However, they repurchased most of the shares in the $50-60 range while the stock now trades in the mid-40's.

You'd think that in this scenario, with the benefit of hindsight, everyone in the room would be in agreement about how risky and foolish issuing debt to repurchase shares was, especially after I backed up my point with the story of Borders group (that I remembered from this blog.) You'd be wrong.

This classmates argument was that circa 2007, with available rates so low, that the management owed it to the shareholders to issue debt to repurchase shares.

Not surprisingly, this classmate works on Wall St. It is scary just how pervasive the Kool-aid drinking actually is.

S said...

Jeff, I'm curious whether you'd agree that stock repurchases are reasonable in certain circumstances. I'm right there with you every single case where debt was issued to purchase stock. But I've seen so many companies with large cash balances make silly acquisitions. There are also cases where the companies become de facto investment funds rather than whatever primary business they first had. I've understood the pressure for buybacks was to both encourage higher returns on equity as well as discourage frivolous spending. Of course, you could also argue that bad management would make a poor choice in any case. But I definitely see use for the buyback in a situation where a sensible dividend would also be considered.

So my question, for both you and your supporters, is simply: Are there situations where you would agree with stock buybacks?

Jeff Matthews said...

'Fivetonsflax': we have corrected, thank you.

'S': good question, simple answer. Yes, of course. Western Union just bought back 9 million shares at an average price of $11.39, because they generate enormous free cash flow; they don't need the cash; and the share price was absurdly low.

WU paid less than 10X earnings--i.e. they received in excess of 10% on the cash used for those share repurchases, in an environment when their cash was generating almost no yield at all.

That's exactly what the knuckleheads of yor (DF, SMG, etc...) WEREN'T doing. They were buying stock at 52-week highs, using debt, and getting no yield for it.


Anonymous said...


Was wondering what your take was on Coca-Cola considering a buyback of shares at a 14x multiple after a recent deal fell through: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aleasVEpX3jo. That amounts to a yield of ~7%.

Jeff Matthews said...

Re Coke: I'm a bit suspicious of the Coke announcement...it smacks of keeping the Street analysts and the Fidelity managers happy, rather than jumping into the market when everyone else is selling, which is what WU did.