More than half of share buybacks are now funded by debt. Here is why it's a problem

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The era of low-cost borrowings favors the activities that appeal most to American corporate investors: share buybacks.

Indeed, more than half of all redemptions are now funded by debt. And while some argue that buybacks benefit stock prices and investors, at least in the short term, one may wonder whether highly leveraged companies should do so. A bit like mortgaging your house up to the guard and then using it to organize a lavish party.

Borrowing tons of money to buy back stocks at the end of a business cycle, when stock prices are at record highs, may seem particularly dubious for highly leveraged companies such as AT & T and American Airlines. Redemptions as such are not, by their nature, an error, writes Lance Roberts, chief investment strategist at RIA Advisors, on the Seeking Alpha site, but "when they are associated with accounting gadgets and massive levels of debt to finance them … they become problematic ".

Lower interest rates have been a major catalyst for buybacks for years, and further rate cuts can only fuel corporate momentum for more action. The US Federal Reserve has reduced its benchmark quarter-point short-term benchmark last month and the futures markets expect at least two more cuts in 2019. The US Treasury Note at 10 years, which calls for long-term corporate bonds, yields 1.59% per year, half of what it was last November.

Disturbingly, companies are paying more money to investors than they are producing in free cash flow, for the first time since the Great Recession, according to Goldman Sachs. "Unless earnings growth accelerates substantially, companies will likely continue to finance their spending by taking cash balances and increasing debt," said David Kostin, Goldman's chief strategist in the United States. -United.

Buybacks are a powerful catalyst for the bull market. In fact, they are a more important factor that economic growth, concluded a study last year in the Financial Analysts Journal. The research covered 43 countries over two decades.

Last year's buybacks in the US hit a record $ 806.4 billion for the S & P 500, surpassing the previous high of $ 589.1 billion in 2007, according to the S & P indexes Dow Jones. Goldman expects them to end up close to $ 1 trillion in 2019. In the first quarter of this year, S & P 500 companies, which account for 80% of the US stock market valuation, have repurchased $ 205.1 billion, up 8.8% from the same period in 2018.

With fewer shares of a company available, the very important metric of earnings per share swells – much to the delight of investors. They are also happy to receive a lot of money for their actions. In addition, higher EPS, even if artificially enhanced by a buy-back, often guides executive compensation.

Why debt dominates

According to Yardeni Research, in 2018, loans financed 56% of this year's record purchases. Existing corporate liquidity, which is abundant, is less often used.

Why is it? The extremely low borrowing costs mean that the interest is relatively minimal, which is a rounding error. As a result, money can be stored in case it is suddenly necessary. And the costs are low, even for long-term bonds, which the Fed does not control rates. We are talking about the 10-year Treasury note, the benchmark for companies to set their own bond rates.

Indirectly, a low rate environment keeps long rates low. Long rates are so low in Europe and Japan, and often negative, that the 10-year T-note is extremely attractive to foreign investors – just like its safe haven status despite international turmoil. This raises the price, which decreases the yield. Bond prices and yields are moving in opposite directions. US corporate bonds react by lowering their rates.

In addition, US corporate bonds receive tax relief on the interest they pay. Not as good as before, but not bad either. Before the 2017 tax reform, they could deduct 100%, but the reform brought it back to a 30% ceiling of EBITDA (earnings before interest, taxes, depreciation and amortization).

In addition, the need for debt to finance future buyback programs will be even greater, because the huge cash reserves of companies will probably decrease. This is because after a long period of ruckus, earnings growth seems to be falling. Revenues generally feed the cash repository. According to FactSet figures, S & P 500 earnings in the second quarter decreased by 0.7%.

The redemption reflex

Buybacks are an area dominated by large corporations, many of which are long-time technology titans. The top 20 redemptions accounted for 51.2% of the total for the 12 months ending in March, S & P Dow Jones indices said.

The all-time champion is Apple, which set a quarterly record for redemptions, with $ 23.8 billion for the January-March period of this year. In the last 10 years, $ 284.3 billion has been spent on redemptions. In the last 12 months of March, Oracle ($ 35.3 billion), Cisco Systems ($ 22.8 billion), Bank of America ($ 21.5 billion) and Pfizer ($ 15 billion) also made the exchange of their voracious buyers.

All in all, they have very good balance sheets. But what about highly indebted companies? Take AT & T, which, thanks to its acquisition of Time Warner in 2018, now called WarnerMedia, is weighed down on a dizzying debt. In the second quarter, long-term debt was $ 159 billion. Nevertheless, Chief Executive Randall Stephenson said at the July 24th earnings call: "We will be looking closely at the allocation of capital for share buybacks in the second half of the year." 39; year. "

His justification? The company is in the process of reducing its debt, after reducing it by $ 12 billion in the first half of the year, and an additional $ 18 billion expected in the second half of the year. A spokesman for the company added that the buybacks benefit all shareholders, including the 90% of US employees who hold AT & T shares. The problem is that, according to Goldman, the Altman Z -Scale of the telecommunications giant, which measures the credit risk, is currently 1.1, which means that it is very risky (more than 1.8 is in the security zone). On the other hand, it is still classified in the investment category, rated BBB by Standard & Poor's.

The same can not be said of the American Airlines group, which is a poorly ranked BB and whose Altman Z score is 0.8. But the airline, which is buying 50 new aircraft, is also launching its latest share buyback program, having spent $ 1.1 billion on the $ 2 billion authorized for redemption. It disbursed $ 600 million in the first quarter of this year.

The long-term debt of the airline is $ 21.2 billion and net debt to EBITDA multiplied by 4.5, as measured by Goldman. A spokesman for the company said the company's priorities were to reduce debt, invest in the company and return money to investors. At the end of 2018, CFO Derek Kerr said that "our stock is undervalued". Since February 2018, the stock price has fallen, losing half of its value. The global economic slowdown, the commercial war and the grounding of the Boeing 737 MAX probably stem from the global economic slump, according to analysts.

But this does not prevent Americans and others, despite their high leverage, from paying investors for their shares. And aside from a recession, which generally provides for buyback programs by keelhauls, one should not expect companies to relax their buybacks.

But once the recession inevitably arrives, the result may not be nice for heavily indebted companies, largely because of redemptions. As corporate debt now exceeds its scary peak at the end of 2008, Robert Kaplan, president of the Dallas Fed, warned that companies with too much debt "could amplify the severity of the recession."

Why debt dominates

The redemption reflex

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