Why Record Corporate Debt Might Not Be So Bad: 8 Debt Laden Blue Chips: Part 1

2020-05-21

Introduction

Since the Great Recession corporate America has been binging on debt.  According to S&P Global over the last year, corporate debt maturing through 2024 that is rated by S&P Global Ratings increased by 3%, to $10.6 trillion.  As a result, according to an article in the website Common Dreams, corporate America’s credit rating has collapsed over the past two decades.  They point out that only two companies, Johnson & Johnson and Microsoft, are AAA rated compared to 60 companies that held that coveted rating in the early 1990s.  Moreover, they also point out that half of all investment-grade corporate debt is rated BBB or lower, and 1/3 of those companies are rated BBB-, which is only one notch away from junk status.

Moreover, many of our most iconic and recognized major corporations are showing negative equity and/or book value.  This includes stalwarts such as McDonald’s (MCD), Home Depot (HD) and Starbucks (SBUX).  Yet despite all three currently reporting negative equity, they have all dramatically outperformed the S&P 500.  This begs the question that if debt is so bad, then why are these companies’ stock performance doing so well?

To find the answer, I felt the logical place to start was by asking the questions: how much debt have they all taken on, and how much has it destroyed shareholder equity (book value)?  In other words, what was their motivation -and is it helping or hurting shareholders.  The following screenshots look at the growth of the debt for each of these three iconic dividend growth stock stalwarts:

Balance Sheet Perspectives: McDonald’s, Home Depot and Starbucks

Strong balance sheets represent the foundation of a company’s quality and its value.  However, balance sheets have become significantly more difficult to evaluate in our modern economy.  Stated colloquially, the balance sheets of today’s companies are not our grandfather’s balance sheets.  Changes in accounting rules and the nature of service businesses with intangible assets versus industrial businesses with tangible assets create challenging comparisons.  In short, price-to-book value no longer serves as a sacred valuation metric.  In fact, many of our most revered companies today report negative equity and yet continue to outperform for years and years.

Although I will be discussing eight debt laden blue chips with this article, for brevity’s sake I offer the following summary balance sheet, cash flow statement and income statement analysis of three iconic brands: McDonald’s, Home Depot and Starbucks.  What might be shocking for many to learn is that each of these blue-chip dividend growth stalwarts currently report negative equity (book value).

McDonald’s: Long-Term Debt and Total Debt Since 2008

The following FUN Graph (fundamental underlying numbers) looks at total debt and long-term debt on both a per-share and a total in millions basis.  Later, I will show common shares outstanding (share buybacks) over the same timeframe.  I believe it is important to evaluate debt from both these perspectives.

McDonald’s: Debt per Share

McDonald’s long-term debt per share and total debt per share have increased by 19.2% and 19.3% respectively.  However, it is also important to note that most of their debt is long-term in nature.

McDonald’s: Long-Term Debt and Total Debt Plus Common Equity in Millions

McDonald’s gross long-term debt and total debt has increased by a compound annual growth rate average (CAGR) of 16.1% and 16.2% respectively.  Importantly, this led to the destruction of common equity (book value) by 2016.  Negative shareholders equity has continued to balloon ever since. 

Home Depot: Long-Term Debt and Total Debt Since 2008

The following FUN Graph (fundamental underlying numbers) looks at total debt and long-term debt on both a per-share and a total in millions basis. Later, I will show common shares outstanding (share buybacks) over the same timeframe.  I believe it is important to evaluate debt from both these perspectives.

Home Depot: Debt per Share

Home Depot’s long-term debt per share and total debt per share have increased by a compound annual growth rate average (CAGR) of 16.5% and 15.8% respectively.  However, it is also important to note that most of their debt is long-term in nature.

Home Depot: Long-Term Debt and Total Debt Plus Common Equity in Millions

When measured in millions, Home Depot’s long-term debt and total debt have grown 11.4% and 12% respectively.  Home Depot turned common equity negative in fiscal 2019 ending in January, and by fiscal January 1, 2020 negative common equity has continued to increase.

Starbucks: Long-Term Debt and Total Debt Since 2008

The following FUN Graph (fundamental underlying numbers) looks at total debt and long-term debt on both a per-share and a total in millions basis. Later, I will show common shares outstanding (share buybacks) over the same timeframe.  I believe it is important to evaluate debt from both these perspectives.

Starbucks: Debt per Share

Starbucks’ long-term debt per share and total debt per share have increased by a compound annual growth rate average (CAGR) of 33.6% and 33.8% respectively.  However, it is also important to note that most of their debt is long-term in nature.

Starbucks: Long-Term Debt and Total Debt Plus Common Equity in Millions

When measured in millions of dollars, Starbucks’ long-term debt and total debt both increased by a compound annual growth rate average (CAGR) of 35% per annum.  The company currently reports negative shareholder equity as a fiscal year-end September 2019.

Income Statement Perspectives: Shareholder Buybacks (common shares outstanding) McDonald’s, Home Depot and Starbucks

McDonald’s Share Buybacks (common shares outstanding) Since 2009

McDonald’s has reduced their share count from 1.11 billion shares in 2009 to 765 million shares through December 2019.  Through March 2020 shares have fallen to 743.5 million (not shown).

Home Depot Share Buybacks (common shares outstanding) Since January 2009

Home Depot’s common shares outstanding went from 1.69 billion shares on January 2009 to 1.1 billion shares by January 2020.

Starbucks Share Buybacks (common shares outstanding) Since September 2008

Of these three iconic brands, Starbucks has reduced their common shares the least.  In September 2008, the company had 1.48 billion shares outstanding, by September 2019 common shares have only fallen to 1.23 billion shares.

Cash Flow and Income Perspectives: McDonald’s, Home Depot and Starbucks

As I previously stated, in today’s day and age of massive share buybacks, I believe it is both useful and enlightening to look at important fundamental metrics on both a gross and a per-share basis.  Share buybacks do reward existing shareholders by providing them a larger stake in the business.  Consequently, existing shareholders do benefit from buybacks and of course through greater dividends as a result.

On the other hand, share buybacks are clearly also a form of financial engineering that companies can utilize to improve their numbers (for example: earnings and dividends per share).  However, from a non-shareholder’s perspective, I believe it is also useful to look at gross numbers to see to what extent improvements in earnings and dividends are attributable to engineering versus organic business success.

McDonald’s: Gross Revenues and Cash Flows Versus Per-Share Revenues and Cash Flows

McDonald’s has seen moderate growth in operating cash flow and free cash flow.  However, gross revenues have slightly fallen since December 2008.

Nevertheless, when looked at from the perspective of per-share data, McDonald’s revenues did show a positive growth rate of 2.7% annualized.  However, operating cash flow and free cash flow per share both experienced accelerated growth compared to the gross data numbers falling.

Home Depot: Gross Revenues and Cash Flows Versus Per-Share Revenues and Cash Flows

Home Depot did report strong gross double-digit annual operating and free cash flow growth and more than 5% annual revenue growth.  This growth occurred organically irrespective of buybacks.

However, because of share buybacks, all metrics reported significantly accelerated levels of growth.

Starbucks: Gross Revenues and Cash Flows Versus Per-Share Revenues and Cash Flows

Interestingly, Starbucks reported strong and consistent double-digit revenue growth despite share buybacks.  Although operating cash flow and free cash flow growth were also strong, they were not as consistent or predictable.

Once again, share buybacks did accelerate the growth for all metrics.  Nevertheless, operating cash flow growth was erratic as was free cash flow growth.

FAST Graphs Analyze Out Loud Video Debt Versus Cash Flow: McDonald’s, Home Depot, Starbucks

In the following FAST Graphs analyze out loud video I will look at these three highly debt laden iconic companies with the objective of evaluating whether they can handle their current debt levels or not.  Balance sheets have become weaker than ever in recent years because of the low cost of debt.  This is clearly reflected in the deterioration of credit ratings discussed in the opening paragraph.  The real question is, does the low cost of debt suggest that it is prudent for management teams to utilize it in lieu of equity?

Why Has Corporate Debt Exploded So Much over The Last Decade?  8 Iconic Debt Laden Companies

With the three examples above I showcased three cases where blue-chip highly successful and well-regarded businesses have dramatically increased debt while simultaneously using it to buy back shares.  I only showcased these three iconic names out of the eight that I promised in the title.  I limited the above analysis to those three strictly for brevity.  In part 2 of this series I will cover additional examples of my master list of eight.  However, next I want to examine the why behind such explosive growth in corporate debt in recent years.

The following graphic looks at three important metrics that perhaps helps explain why so many high quality and even conservative companies seem to be behaving so recklessly with debt.  In addition to the three companies above, I offer the additional five well-known companies where I look at return on invested capital (ROIC) their weighted average cost of capital (WACC) and finally their after-tax cost of debt.  What should be clear from the below graphic is that debt is currently a very inexpensive and even efficient way for companies to capitalize their businesses.

Interest Rates Stimulating Corporate Demand for Debt

The following 10-year treasury bond yields since January 1960 illustrate just how cheap it has become for corporations to borrow money by issuing bonds.  When thought about from the perspective of the above graph in conjunction with the below graph, it is not a stretch to say that corporations taking on debt are seeing it as almost “free” money.  For example, consider Home Depot that is borrowing money at 1.72% while earning a return on invested capital of 40.5%.  Anyone in their right mind would gladly take that deal.

Book Value: High Debt Is Destroying Book Value (shareholder equity) – or is it?

The simple definition of book value is the difference between total assets and total liabilities.  However, as simple as that equation looks to be, accurately valuing assets are a real challenge under today’s accounting standards.  I had my son Colt prepare an analysis to try to evaluate the safety of the following high-profile eight companies with lots of debt.  Many of them are currently reporting negative equity and/or negative book value on their balance sheets.  The objective is to ascertain whether these companies can handle and eventually retire their debt and remain ongoing concerns.

What does all of this mean?

The reason for this analysis is to compare the market value of treasury stock a company has compared to its debt. The idea is that the company will be able to sell treasury stock to retire partial/all of its debt when due in the future. Debt is extremely cheap currently, and our theory is that as long as the company can maintain an investment grade credit rating, it will issue as much debt as it can to buy back shares and fund the operations of the company. We would like to believe that management is doing this to position the company for success, but we also understand there may be some pocket padding for management as well. Regardless, debt is an extremely cheap way for companies to raise money currently, and as long as they have “ammunition” (cash and treasury stock) to pay back the debt, these high levels of debt may not be as bad as we all originally were taught to believe.

One caveat is in order: Companies may experience trouble if the price per share of its stock falls too low and renders the treasury stock method of paying back debt useless.  Of course, this risk has been temporarily heightened due to the financial stress from the Covid 19 economic shutdown.”

Here the explanations for the columns in the above graphic:

Treasury Stock at cost (in millions)

This is found on the balance sheet under Shareholder equity. It is the total cost of all treasury stock that the company has bought and holds. In other words, it is how much the company has spent to acquire its treasury stock.

Treasury Stock Shares (in millions)

The total number of shares, in millions, of treasury stock that the company has. This is either reported by the company, or found from the difference between Common Shares Issued and Common Shares Outstanding

Treasury Stock Avg Cost

This is the average cost per share of treasury stock that the company owns. This is calculated by dividing the number in the Treasury Stock at cost column by the number in the Treasury Stock Shares column and multiplying the quotient by -1.

Stock Price for MV Calc

This is the stock price used to calculate the total Market Value of treasury stock found in the Treasury Stock MV column. This price is the closing price from 5/13/2020.

Treasury Stock MV (in millions)

This is the total market value of treasury stock based on the 5/13/2020 closing price. In other words, how much cash the company could raise by selling treasury stock (ignoring taxes). This is calculated by multiplying the number in the Treasury Stock Shares column and the number in the Stock Price for MV Calc column.

Treasury Net Value (in millions)

This represents the net gain (loss) if the company sold all their treasury stock based on the 5/13/2020 closing price. This is calculated by adding the number in the Treasury Stock MV column and the number in the Treasury Stock at cost column.

Total Debt (in millions)

The market value of total debt the firm has.

Net Debt (in millions)

The market value of total debt the firm has minus cash and cash equivalents.

Summary and Conclusions

The accelerated use of debt to fund the capital needs of publicly traded companies is clearly attributed to today’s unprecedented low cost of debt.  Although we have all been trained and perhaps even indoctrinated into the belief that debt is bad, these are clearly unusual circumstances.  However, it is not just the low cost of debt (low interest rates) that have stimulated corporate America’s debt buying bench, there are other considerations as well.

In part 2 of this series on debt, I will focus more on discussing what some professionals are referring to as growing sources of balance sheet distortion.  Stated more clearly, many professionals believe that balance sheets prepared under generally accepted accounting principles (GAAP) are doing a very poor job of reflecting the true value of shareholders equity (book value).  In other words, are corporate America’s balance sheets stronger than they are currently being reflected to be?  If that is true, then perhaps debt levels are not actually as high as they appear and/or today’s debt levels may not be all that bad.  I will present the theory and let you decide for yourselves as I am trying to do for myself.  We live in very interesting times.

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