Would you pay a premium for financial leverage? For most of my career – barring a short period before the financial crisis – investors would have answered an emphatic no to this question. It is not difficult to see why. Financial leverage acts like an amplifier for shareholder returns. It can enhance returns in the good times, but significantly increases the risk profile by making shareholders more exposed to unexpected negative events. With a generally weak and politically uncertain global economy, it is entirely understandable why highly leveraged companies would warrant a lower valuation.
But today strange things are happening in the consumer sector.
In my previous post, which discussed the recent 3G Capital backed Kraft Heinz bid for Unilever, I questioned the business and financial logic of ripping out cost and leveraging the balance sheet at a company like Unilever. What does the stock market think of this approach to business? Take a look at the following table.
The table shows a comparison of two companies across three subsectors in the consumer sector. In the blue rows are the companies that are backed by 3G capital. You can see that they all have significantly higher financial leverage than the more conservatively financed comparison company. Despite this, in all cases the equity valuations are actually higher for the more leveraged companies. The market is paying a premium for financial leverage.
The obvious justification for this premium is superior financial performance. The 3G backed companies have delivered and are forecasted to deliver higher earnings growth. Rather than paying a premium for financial leverage, perhaps the market is paying a premium for superior management. This is possible, but as I argued in the previous post, I think more time is needed to properly judge the long term impact that radical cost cutting strategies may have on branded consumer goods companies.
Also note that this phenomenon does not only apply to 3G backed companies. For example, in the tobacco sector, British American Tobacco (BATS) has recently bought Reynolds American and in the process has leveraged its balance sheet to 4.6x net debt / EBITDA1. It’s share trades on 18x p/e. Japan Tobacco, the least leveraged of the global peers at 0.1x net debt / EBITDA, trades on 16x p/e, an 11% discount to BATS2. Arguably the less financially leveraged companies should actually be valued at a premium since they have option of using their balance sheet capacity to increase equity earnings but they do not currently have the same level of downside risk were an unexpected negative to hit them.
Remember that much of the superior earnings growth of these companies is a consequence of the acquisitions themselves. It is not difficult to create earnings growth when the cost of debt is so low, since the earnings yield of the asset purchased is almost certain to be higher than the cost of the debt used to fund it.
But don’t confuse this “earnings accretion” with genuine value creation. The latter is much more challenging to achieve because it requires the overall return on investment to be higher than the hurdle rate or “cost of capital”, which for most businesses would be a high single digit rate. Because recent deals in the consumer sector have been done at such high valuations, even on the managements’ own forecasts most of them will need 5-10 years before the overall return exceeds the cost of capital. As a generalist, I find this surprising and somewhat concerning. In any other sector, investors would not applaud this sort of capital allocation behaviour.
I have no fundamental problem with any of these companies and nor do I think that financial leverage is necessarily a negative. Rather it is a question of risk and reward. And here I think that investors are seriously mis-judging the risk profile. A valuation premium for financial leverage is a sign of the times. It suggests the market is already discounting the positives whilst potentially ignoring the negatives. Against such a backdrop, investors would be wise to stick with more conservatively financed and lower valued companies3.
1. Source: Moody’s estimates, January 2017<
2. Source: Bloomberg estimates, 01/03/2017
3. This is an opinion. It is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.