Share Buybacks – Borrow While You Can?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 17th, 2015

Share Buybacks – Borrow While You Can?

  • Following on from our recent work on dividends, we examine the other main avenue of capital return to shareholders – stock repurchases. We identify those companies that could take advantage of the low rate environment while it lasts to finance a share buyback without bringing debt/capital ratios above the high end of long term levels.
  • Using companies’ most recent debt offerings as a proxy, we calculate the additional interest expense that would be generated and analyze the impact on coverage ratios. Restricting the sample to those that would maintain EBITDA/interest coverage ratios above the long term average gives the following names: AGCO, ARG, CRS, DD, DOW, FLR, GWR, KMT, KSU, OLN, PPG, SNA, and TRN. Of these stocks, PPG and DD would still be more than one standard deviation above their long term coverage ratios.
  • Interest rates may stay lower for longer but few would argue that a period of rising rates is not well on its way or overdue, suggesting the time to borrow and repurchase is now – interestingly, while we saw that dividend growers have outperformed over the past 15 years regardless of the rate environment, the largest share repurchasers over this period have only outperformed in falling rate environments. The magnitude of outperformance is roughly half of that for the highest dividend growers.
  • Exhibit 1 plots those companies (listed above) that could take on this debt without lowering coverage ratios below long term averages against current discount/premium to normal value on our models, cheap stocks having an additional motivation to repurchase shares.
  • Companies that screened as interesting in both the dividend and the buyback work include TRN, DD, PPG and CRS. TRN and CRS have the greatest valuation support.Both this work and the dividend work would suggest that DD is spending on the wrong things.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

The repurchase analysis follows a similar outline as our dividend work:

  • Start by identifying companies that have the capacity to add debt – where are debt/capital levels below long term levels
  • Calculate the amount of debt that could be added without bringing debt/capital above the high end (+1 standard deviation) of the long term range, and the amount of shares this debt could purchase at current prices
  • Analyze the impact of the increase in debt on interest coverage ratio (EBITDA/interest expense) using the coupon on a company’s most recent offering as a proxy for the additional interest expense – can a company take on this debt without dropping coverage ratios too low

Our dividend work was somewhat conservative in its upside assumptions, but we are taking a more aggressive approach with the repurchase analysis as if there was ever a time to borrow it would appear to be now. Rates may very well stay lower for longer, but they will rise at some point. Over the past 15 years the top 20 stock repurchasers (measured by shares repurchased as a percentage of beginning shares) have outperformed the rest of the Industrials & Materials universe only in periods of declining rates – Exhibit 2. Contrast this to the
high dividend growth stocks
, which outperform regardless of the rate environment. The magnitude of outperformance for the top repurchasers is roughly half of that for the top dividend growers.

Exhibit 2

Source: Capital IQ, SSR Analysis

The Potential Share Buyback

For all the companies in our coverage that are not already at a critically high debt level (i.e. those companies that are less than one standard deviation above their long term debt/capital ratio), we have calculated the increase in debt that would bring the ratio to that long term higher level. In Exhibit 3 we show the list of companies that, at current prices, could buy back 10-30% of their outstanding shares with the debt proceeds.

Exhibit 3

Source: Capital IQ, SSR Analysis

Interest Coverage

To consider the interest coverage implications of this proposed debt increase, we used a company’s most recent offerings to approximate an appropriate coupon rate and added this additional interest expense to the normalized EBITDA figure from our models. For many of the companies considered, the additional interest would not reduce the EBITDA/interest coverage below the low end of the long term range (one standard deviation below the average). Restricting the sample to companies that would maintain interest coverage ratios above the long term average yields the names in Exhibit 4. DD and PPG are the only companies that could increase debt as we suggest and still be one standard above their long term coverage ratios. TRN screened well in our dividend work and its showing here highlights the multiple capital allocation options available to the company.

Exhibit 4

Source: Capital IQ, SSR Analysis


Appendix: Potential Buyback Calculations

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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