Last month I researched a group of companies I normally shun: ones with lots of debt. And despite this group sharing many of the qualities I look for in a business, my concerns over EBITDA valuations, variable-rate loans, and unexpected risks kept me on the sidelines—for the most part. I did wind up investing in one of them—Sinclair Broadcast Group—and at the end of the post, I’ll briefly discuss “why”. But I mainly want to focus on the similar qualities between these highly-leveraged companies, and my concerns about them.
- Debt to EBITDA ratios greater than 4
- Free cash flows exceeding net income
- Tax rate less than 35%
- EBITDA based metrics
- Dependence on variable interest loans
- Highly acquisitive management
- PE/LBO history
- “Outsider” CEOs
The companies I researched operate in stable industries and are run by financially-minded managers. Operationally, they follow the same pattern: use debt to fund operations; take any excess cash generated by the business to acquire other companies, pay dividends, or fund buybacks; rinse, and repeat. By using debt, they're able to magnify returns, yet also lower income (which reduces taxes). So it shouldn't be a surprise that these eight companies have trounced the S&P 500 since 2008.
- Charter: Second largest US cable operator
- Transdigm: Aerospace parts supplier
- Domino’s Pizza: Pizza delivery franchise
- John Bean Technology: Airport and food processing equipment manufacturer
- Masonite: Door manufacturer
- Sinclair Broadcasting: Second largest television station operator
- POST: Food product holding company
- BlueBird: School bus manufacturer
While the results would appear to speak for themselves, three concerns still keep me on the sidelines: a heavy reliance on variable rate loans, liberal use of EBITDA metrics, and the inevitability of unexpected risks disrupting business.
"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
- Warren Buffett
Variable Rate Loans
When a company already has a lot of debt, they're perceived by lenders (i.e., banks) to be higher risk. For which a higher interest rate is charged. But companies are able to reduce these rates through "variable rate loans”, which—unlike traditional loans where the interest rate is fixed—adjust based on the market’s current interest rate (plus some additional amount). So while today's rate may be lower, the borrower is taking on the risk that interest rates will rise in the future.
Predicting the timing and impact of changing interest rates on a company's prospects falls outside my circle of competence. But with rates at historic lows, odds are they’ll only move higher. I have no idea when this will be, though when it does, companies with which loaded up on variable rate loans may face a stiff increase in their interest expense. This is fine if the business’s prospects increase along with interest rates, but if they don’t, it could spell trouble for leveraged companies.
The good news is if you believe in EBITDA, interest isn’t really an expense. With this perspective, variable rate loans simply have no impact on the business!
“It amazes me how widespread the use of EBITDA has become. People try to dress up financial statements with it. We won’t buy into companies where someone’s talking about EBITDA. If you look at all companies, and split them into companies that use EBITDA as a metric and those that don’t, I suspect you’ll find a lot more fraud in the former group. Look at companies like Wal-Mart, GE and Microsoft — they’ll never use EBITDA in their annual report. People who use EBITDA are either trying to con you or they’re conning themselves… Interest and taxes are real costs.”
- Warren Buffett
EBITDA is commonly used to value companies, and it seems particularly preferred by the managers and investors of highly-leveraged ones. But EBITDA does a poor job of reflecting economic reality. By removing the effects of interest, taxes, depreciation and amortization, marginally-profitable firms are suddenly flush with money. Implicit in EBITDA-based valuations is the notion that these are not real costs. I never understood this. Is the interest paid on a monthly mortgage not a real, recurring expense? To think it’s not, is, to quote Hank Hill “just asinine.”
“True wisdom is knowing what you don't know”
A business can go a long time—sometimes decades—without ever being affected by a recession, natural disaster, act of terrorism, hacking, or other low-probability/high impact event. The infrequency of such events causes investors and managers to make a grave misjudgment: mistaking low-probability events for zero-probability events. This is dangerous thinking for any company, but especially so for a leveraged one. If costs can’t be covered when these situations do arise—and they will, eventually—debt only makes the situation worse. Just ask Long Term Capital Management.
But certain businesses are more insulated from sudden shocks by nature of having stable, recurring revenue streams regardless of the current economic climate. This enables them to tolerate higher levels of debt. So while a maker of luxury goods is sure to hurt during a recession, companies like a Campbells Soup, ConEdison, or even Sinclair Broadcast Group are likely to keep chugging along.
SINCLAIR BROADCAST GROUP
SBGI is a boring business. The Maryland company is an old fashioned TV broadcaster, operating primarily in the South and Midwest US. Their revenue comes from two sources: selling advertising time on their 160 channels, and "retransmission fees", which are fees charged to video service providers (e.g., DirecTV, Comcast, etc.) for the right to carry Sinclair's stations. The stock has underperformed because a high debt load and rapid changes to how media is consumed and delivered have made investors nervous.
But the worry that "cord cutting" will ruin Sinclair is overblown, because 1) there has been no evidence of any impact and 2) local news—which is SBGI’s specialty—is still in high demand. So I think the long-term threats are exaggerated. I’m also not as concerned about the debt, because the retransmission fees provide a steady, recurring revenue stream that is unlikely to be interrupted by sudden economic shocks like a recession. And making the company even more appealing is the CFO’s recent pledge to bring leverage down 50%.
At the end of the day, SBGI is a rather straightforward investment idea. It’s not dependent on any “catalysts”, and no aggressive growth targets need to be be met. The market is simply asking a fair price (9x FCF and 6.5x operating earnings) for a good business, so I made it 10% of my portfolio.
And yes, it’s cheap on an EV/EBITDA basis too…
Despite the many positive characteristics of these eight companies, I was unable to overlook their variable-rate loans, EBITDA valuations, and unexpected risks. But occasionally I’ll make an exception if I’m confident that the business model can sustain a lot of debt—like SBGI. With a stable revenue stream, attractive valuation (on a non-EBITDA basis), and plans to deleverage, Sinclair Broadcast Group looks attractive to me. Time will tell.