We’ve all watched the talking heads as everyone just tries to make sense of the current situation. Anyone who tells you they know for sure what will happen in the short term is either naive or worse. But let’s take a look at the horizon and we can make some rationalizations.
The era of financial engineering is over
The funny thing about black swans – real black swans – is that no one really sees them coming. I wouldn’t really classify the housing crisis of 2008-2009 as such. Many saw it coming. If you did your homework, it wasn’t really that hard for the smart few to make a ton of money, or at the very least avoid danger. But one of the longer-term results of the housing bubble has been cheap access to money. And with cheap access to money came good ideas.
- Take on a ton of debt and make good private equity buyouts
- Take on a ton of debt and redeem your stocks
- Take on a ton of debt and increase the dividend
- Take on a ton of debt and pay special dividends
- Take on a ton of debt and make acquisitions
And why not? You can’t blame a good, smart CFO for taking cheap money and doing powerful things with it. If you were an aspiring young CFO and boasted that you had money on hand “just in case something happened,” you probably wouldn’t have been in your position for too long. So they did it with incredible success.
I first wrote about HR (NYSE: HR) in the summer of 2017 – How To Short Your Own Stock 101. I didn’t have a strong opinion on the stock at the time, but it had created some smart debt securities that allowed it to borrow money. money for almost zero and buy back half his stock. By using convertible bonds, the company placed on the market 5,131,214 additional potential shares maturing in 2019 and 2020 and used the proceeds of these instruments to buy back its shares for an amount of 20.22 million shares – as well as cover collars. He basically bet the company that it could execute on its vision, increase the stock, and pay it all back – and/or roll it over.
I warmed to the idea in a follow-up article in March 2018 – RH A Very High Risk/High Reward Retailer. Cash flow was on point (at the time). Execution was on track. Although still defining risk, at $75 it looked like a great opportunity. A little lambasted, I deduced that a price target of $200 was not out of place. This price target was reached in November 2019. (Full disclosure, I exited the position at $165 as I was not very impressed with the cash flow at the end of 2019).
There are no victory laps on Seeking Alpha, and this isn’t really an HR article. The point is not that the situation initially worked out well. The goal is to examine what has happened since. RH dropped from $250 to less than $80 in one month.
Financial Engineering is aptly named with a slight negative connotation. The idea is that cheap money is borrowed in many different forms. Current popular incarnations are conventional loans, convertible bonds, asset-based loans, sale-leasebacks, etc. They are formed from the opportunity of cheap money and booming business cycles that can result in spectacular success. But when a black swan strikes, these businesses are most at risk.
This is not limited to publicly traded companies. Most, if not all, private equity firms are made up of debt. You invest a hundred million and buy a business worth over $400 million. This can be a manufacturer or a small retailer. You bring in a high-level CEO from a bygone era and run the business with great EBITDA and leverage. You then pay off the debt and everyone wins.
The problem in the current situation is that the music has stopped playing. There is currently no appetite for sale-leaseback buyouts, asset-based loans or convertible notes. It is going to be very difficult in the new risk aversion scenario for these highly indebted companies, with sudden large impacts on their cash flows, to borrow more or refinance on reasonable terms.
The funny thing about these situations is how grounded even large companies can be. Why AT&T (NYSE:T) have $161 billion in debt on a market capitalization of $206 billion? At a time when companies could have extra cash to buy their shares at a value, these types of companies – which in many cases bought shares much higher – are now limited on options. Even the real blue chips have gorged themselves on debt. Why Coca Cola (NYSE:KO) carrying 65 billion in debt with 21 billion in equity? Well, they bought their shares well above book value of course. Haven’t they made enough money over the years to not have so much debt? Well, yes but… silver is cheap and makes a lot more sense for income engineers. Now Coke is one of the best – there are far worse with real revenue declines to come. The thing is, cheap money is irresistible without Black Swans on the horizon (and of course there are never any on the horizon).
There will be many “dividend aristocrats” who may be forced to cut or limit their dividend. Worse still, many companies won’t be able to repay their debt – looking at you GNC (NYSE: GNC). Worse still, there will be many private equity firms that you will never hear about in droves as they struggle to survive.
It’s the death of financial engineering – until the next boom cycle of course. This event with revenues for some companies down 60%, 70% and even 80% was simply not modeled. No one asked the question “yes, but what if we had to close our 75 stores for a month” during presentations to private equity investors.
So what for us common people
I believe this will be one of the defining events of our generation that will result in the greatest transfer of wealth in human history. This is not a statement I make lightly. To the winner will go the spoils. Businesses and individuals with cash will reign supreme. There are a lot of moving parts with government bailouts, too-big-to-fail scenarios, and a lot of uncertainty. But one thing we can say for sure, we’re going to get through this. Opportunities are found with the lucky, the bold and those with cash.
The era of “Cash is Trash” is over
In the longer term, there will be injuries. Companies that survive this near-death experience will have boards that aren’t so inclined to weigh down the balance sheet with debt or buy back their shares at record highs. This will impact the future growth rates of our economy, but that’s not necessarily a bad thing. The golden rule will be in effect. Those who have the gold will make the rules.
Hello, my name is Warren and here is a preference with a 10% yield and convertibility rights.
For the conservative portfolio, I position myself as follows. I will avoid highly leveraged companies that have debt refinancing issues. I will buy a mix of beaten companies with excellent business models and fair balance sheets. I will carefully examine particularly difficult situations (airlines) and try some opportunities based on the intervention of large shareholders to protect their investments and government assistance – but these are much more speculative. Growth stocks with good balance sheets will always win in the long run.
Companies that survive and thrive will be better off in the long run through market share gains and opportunities for future growth. The objective now is safety and avoiding the big “zero”. I will share this analysis via the analysts corner and with the fundamental assistance of Robert Honeywill. We will check balance sheets, cash flows and trading conditions to derive a model portfolio for the new era. Good luck to all of us and stay safe.