Time to take on the debt recovery trade?

“While a speculative capitalization structure throws all the company's securities outside the pale of investment, it may give the common stock a definite speculative advantage... Because of this fact there is a tendency for speculatively capitalized enterprises to sell at relatively high values in the aggregate during good times or good markets. Conversely, of course, they may be subject to a greater degree of undervaluation in depression. There is, however, a real advantage in the fact that such issues, when selling on a deflated basis can advance much further than they can decline.” [Security Analysis, B.Graham and D.Dodd, 1934 ed, p466]

Consider two companies, A and B. Operationally both are identical in all respects. Both have £1bn in revenue, £150m in EBITDA, and an annual £20m maintenance capex requirement (2% of sales). Over the next three years revenues, margins and capex at both businesses will be flat. So these are reasonable businesses - defensive, but with little growth prospects.


The only difference between the two companies is how they are financed. Company A is entirely equity financed, while company B is levered to 3.5X net debt/EBITDA. Mr Market has decided that the enterprise value for these businesses is £800m - i.e 0.8X EV/sales, a low valuation in normal times for businesses such as these but not inconceivable in current markets. So company A has £800m market capitalisation, while company B has only £35om because it is carrying £450m in debt. Because company A has no debt issues the Board has decided that it should pay out 100% of its free cash flow as dividend. Company B has decided that it will pay out only 50% of its free cash flow, so that the other 50% can go into paying down the debt burden (which the market does not like).


Lets consider what a simplistic p&l and cashflow will look like for these two companies.





Under these (admittedly very simplistic) assumptions, it is clear that the "overlevered" company generates a superior total return. Why is this the case? The reason is that the company is still highly cash generative. Each year the debt is paid down by the cash flow, which means the equity portion of the EV rises as the debt portion falls. Meanwhile shareholders are also picking up a sizeable dividend yield on the smaller equity base.


So, does this mean we should be buying companies with debt? Not necessarily. Clearly the above example is only valid if a number of factors are in place.


1) The market must be valuing the EV and equity of the company in this way - i.e. the equity must be at a suitably depressed price versus unlevered peers.

2) There must be a high level of confidence in the EBITDA and cash flow forecast for the levered company. If this is not the case then the financial leverage could quickly see the cash flow dissapear and hence there will be no capital appreciation. This will tend to mean companies that have reasonably defensive revenue streams.

3) There must be no big refinancing looming. Or, if there is, one must be sure that it is not going to have adverse consequences for the company.


In the UK market there are a number of companies (mostly mid-cap) that potentially satisfy these criteria such as: Informa, Premier Foods, Meggitt, FirstGroup, Melrose.