Debt Down = Stock Up
A simple catalyst for unlocking significant value for shareholders
Our quest to uncover low-quality earnings leads us through the financial statements of hundreds of companies a year. Along the way, we occasionally uncover simple sources of value that the Street is failing to appreciate. This is often because the company has fallen out of favor due to a negative event or is a cyclical name that is currently on the downswing of the cycle. So far, this may sound like the typical deep value strategy, but what makes the source of value we will explore today unique is that it comes with a catalyst that clearly lights the path to unlocking the value. The catalyst is the impact that paying down debt has on a company’s enterprise value.
Ordinarily, we are very skeptical of a company with high debt. Debt is risky- and the debtholders get paid before the equity investors do. However, if a company is able to generate the cash flow to pay down a high debt level, the value will flow to the equity investors. Enterprise value is calculated as follows:
Enterprise value = common stock + preferred stock + debt - cash
Let’s consider a company with an enterprise value of $100 million consisting of an equity market capitalization of $50 million, total financed debt of $50 million, and $0 in cash. There are a million shares outstanding and the stock price is currently $50. Suppose the company uses $5 million of free cash flow to retire $5 million of the debt and the enterprise value stays flat at $100 million. The debt will decline to $45 million and the value of the equity will rise by $5 million driving the stock price up to $55 and generating a 10% gain for the equity holders. What’s more, the lower debt will result in lower interest expense which will drive earnings growth, and the reduction in leverage will reduce the risk profile of the company, both of which will likely cause the market to eventually expand the company’s multiple resulting in more capital appreciation.
There are several factors investors should consider when evaluating a potential play:
This situation requires a company to generate positive free cash flow and a strong case for that to recur or improve.
A dividend consumes free cash flow - so make sure it doesn’t consume it all.
Look for wild-card Items that may help or hurt free cash flow:
lower/Higher capital spending
working capital changes
a pending acquisition
prior restructuring charges that consumed cash and may go away
Below we will take a look at three companies that we believe have the potential to unlock significant value for their shareholders by reducing their debt. One is well on its way to doing so and two appear to be in the early stages.
If you are not already a subscriber, be sure to sign up to see next week’s report which will continue our examination of companies in research-intensive industries that are understating the true cost of developing new technologies.
For now, let’s get “Behind the Numbers.”