nhrand Too much attention is given to factors that Wall Street values for the short term and not enough to the factors that make a railroad stronger in the long term.
And there lies the rub. "I" want my money now, not 20 years from now...
Larry Resident Microferroequinologist (at least at my house) Everyone goes home; Safety begins with you My Opinion. Standard Disclaimers Apply. No Expiration Date Come ride the rails with me! There's one thing about humility - the moment you think you've got it, you've lost it...
I'll try to be clear -- I'm not against borrowing at low rates. What I question is replacing equity with debt, using cash to buy back stock or loading the balance sheet with debt. What makes a railroad stronger is expanding revenue, controlling costs, and increasing efficiency and productivity. Boosting the company's stock price benefits management and short-term traders. Inflating a company's stock price by manipulating the balance sheet does not strengthen a railroad -- in the longer run it may hurt. Too much attention is given to factors that Wall Street values for the short term and not enough to the factors that make a railroad stronger in the long term.
Using debt when interest rates are low makes sense. Let's say it's not a large business.. let's say it's a gas station you own, and you want to expand by adding a couple of service bays. Do you borrow or do you look for a business partner to finance your expansion? I would borrow.. adding a partner dilutes the ownership.. you give up control as you now have a partner in the business. And the partner gets a share of the profits as long as the partnership lasts..of the whole business, not just the two additional bays. Works the same way with a large publicly traded business.. do you issue more shares.. i.e. give up equity.. or do you borrow at low interest? I also wouldn't borrow to buy stocks.. too risky.. but that's just me. I know people who borrowed heavily and sunk their money into Beyond Meat, Netflix, Tesla, Amazon. Good for them.. its a high risk proposition, but its paid off handsomly for those who have the stomach for it. Maybe the way to go now is to short these highly overvalued companies.. there's probably as much money to be made going down as up.. but again.. not recommended if you enjoy sleeping at night.
Let me see how this works. I borrow a few hundred thousand with a 3.5 percent mortgage and put it all into the stock market buying at the high current levels. Stock prices fall, my stocks are worth 25 percent less and I have to continue paying the mortgage, principle as well as interest. Of course, if I wait long enough my stocks will regain the loss and maybe if I'm lucky the stock prices may go high enough to recoup the annual costs of my mortgage and maybe I'll even come out a little ahead. All I have to do is wait long enough and ignore the volatility of the stock market. If I live long enough the stock market may actually gain the 7 percent cited as a long term average appreciation. I'm not against investing in the stock market but I think leverage is risky, i.e., borrowing to buy stock. Also, regarding railroads replacing their stock with debt, I think it mainly shows that management is mainly concerened with the current book value of the company, and their own personal wealth. Return on equity is just a snapshot view of the present. The future of the company seems to be of secondary concern.
BaltACD Leverage is great when it is working for you, that being said, when things turn you can be bankrupt before you can read the bankruptcy laws.
Leverage is great when it is working for you, that being said, when things turn you can be bankrupt before you can read the bankruptcy laws.
True and easy to manage with a fixed interest rate on the borrowed funds. However some companies get seduced like individuals on the lower interest rates on variable rate loans and if your not careful.........that is where you will get into trouble. Additionally, amount of leverage with fixed rate loans can take a toll as well. So if I become a cash out refi person so to speak. My credit rating will fall expenses will rise in other areas as I am not as credit worthy. So vendors I do business with (most especially in Insurance and Banking) are not going to extend to me the best price say for insurance policies or leasing rates. So even with fixed rates there is a cap on what you can borrow before it starts to boomerang and bites you back.
As long as my FICO Score remains above 735-740, I am happy. Once it starts to fall below that I start to get concerned as it can snow ball quickly into far more negative territory and even result in cash flow issues.
I agree it is the low interest rates. Even if your only fair at investing it makes sense to cash out refi your mortgage and invest the money in the stock market. You pay 3-4% interest on the mortage but the stock market returns over time average a min of 7%.....you keep the spread on the borrowed money that does not even belong to you, plus some of the capital gains.
I have done this twice over the last 20 years, I can afford to pay off my mortgage completely now several times over but I am going to wait until retirement to do so as I would rather compound the outstanding mortgage principal via investing.
Also invest my Emergency Fund for the same reason that I can earn higher rates of return investing than via CD rates. As long as I am careful with stop loss orders to protect most of the principal in the Emergency fund. It also makes sense to do it there as well.
Same concept applies to railroad debt. Once new borrowing costs rise to a threshold you'll see the railroads start to move away from heavy reliance on new debt.
Never too old to have a happy childhood!
Well, given the prevailing low interest rates, it likely makes sense to borrow instead of issuing new stock to raise capital. Keeping the number of shares outstanding to a minimum (by borrowing needed funds) and buying shares back appreciates the value of each remaining share. I think I just answered my own question..
nhrandwhat happens when times change and you can't move as fast as you thought or didn't even consider what you would do when interest rates rose, loan availability fell and revenue declined.
Look what happened to 'prudent' cash and asset-rich firms in the '80s.
The point of buybacks is that with fewer outstanding shares, equity is perceived as worth more and that 'should' be reflected in the stock price.
MP173 wrote "...debt becomes an issue when it cannot be serviced". I'm old fashioned and not in tune with modern finance but it seems to me that prudence is ignored when you load the balance sheet with debt and buy-back stock. Modern management focuses on today and seems to hope tomorrow will take care of itself. It is easy to service debt today but what happens when times change and you can't move as fast as you thought or didn't even consider what you would do when interest rates rose, loan availability fell and revenue declined?
(This is a copy and paste from another thread where i had entered it so to those who have read it already, my apologies. It is specific to UP but could apply to any of the railroads)
The big issue with long term debt for corporations is if they can afford its carrying cost (i.e. interest expense).
It depends on what the maturity dates are on the various debt issuances UP owns. If they intend to roll them over at maturity, as long as interest rates stay low, and assuming steady revenue streams to continue making interest payments, there is no problem.
On the other hand, if interest rates rise when they have to roll over their issuances, that is where profitabilty takes a hit.
A 1% rise in the interest rate that UP is paying would result in $250 million more in interest expense on $25 billion debt, if it hits all $25 billion eventually. A 5% rise ergo would result in $1.25 billion more in interest expense.
At that point in time the stock value would drop because it would impact earnings - more money going to interest expense is less money dropping to the bottom line.
Of course, UP will have its various debt instruments set up in a "ladder" of maturities so that it all does not have to be refinanced at one time. So a rise in interest rates could result in interest expense for the whole of its debt creeping up over time instead of shooting up all at once.
UP has a little over $16 billion outstanding shareholder equity as of 12/31/2020, so its net income of about $5.3 billion was about a 30% return on shareholder equity.
Part of that $5.3 billion will go out in dividends over the next quarters in 2021 and more than likely additional debt will be issued to finance additional share repurchases, which will increase the return on shareholder equity in coming years.
As interest rates rise, unless UP has significant additional revenue coming in from additional traffic or price increases, one would expect UP to continue to be profitable, but not to the point of a 30% return on stockholder equity with more operating net income going to pay interest expense before falling to the net income line. If that does happen, at that point the share price would drop.
If the share price drops too low, perhaps someone would come in and take the railroad private. Heck, Warren Buffet (Berkshire Hathaway) owns a railroad and Bill Gates owns a big chunk of a railroad (CN). Perhaps it could even be a "prime" target. (Pun intended)
Just a few thoughts from a financial perspective.
The Rock Island left bankruptcy in 1984 with $400 million dollars in cash and assets (land) after paying off creditors. Chicago Pacific became a holding company, with some home appliance companies within it's holdings. It was merged into Maytag in 1988. A couple of mistakes by Maytag led to a situation that looked a lot like the RI saga being replayed, complete with one of the major players, the Crown family.
I've read that Crown bought up RI bonds at $0.25 on the dollar. In an interview UP's Kenefeck gave to Don Hofsommer, Kenefeck said in the early 1970s he approached the RI, twice, with an offer. That if RI would stop soliciting traffic for Tucumcari and Denver, instead soliciting for traffic for UP via Council Bluffs and Kansas City the UP would pour enough traffic to RI at those locations to make it profitable. He said the RI refused the offer. It's been discussed some by those who were there and no one knows why it wasn't jumped at.
I've thought that it was Crown who didn't want it. I think by then, he wanted his money fast, through merger or sale, not by the few years it might take by income based means.
Jeff
PS. The Schneider book ("Rock Island Eequiem") doesn't mention Kenefeck's proposal. On the old RITS list, he mentioned that he was awarre of it and maybe should've at least mentioned it as a footnote. He said it was offered after the UP-CNW affiliation had started. I'm not sure of that. I think it wasn't mentioned because the book has Crown has a saint, that the railroad's collapse was mostly due to the evil government and employees.
In the Rock Island bankruptcy, the estate was never closed. At the various properties were sold, the bonds were paid off in full and the trusteeship was withdrawn. The company changed its name to Chicago Pacific Corp and continued in business.
MP173Long term debt is extremely cheap these days, particularly those with excellent credit ratings. Companies can issue LTD at 3%-4% for 30 years (a bargain) and then purchase back shares thus leveraging their balance sheet and thus increasing their return on equity (ROE), one of the major metrics in valuation of a company. The earnings are solid for railroads. Free cash flow (FCF) is huge. Rails also invest a large amount yearly in their physical plant...usually 15% of more of their revenue and still there is FCF (FCF is defined as cash flow less investment). Thus companies are finding that they can replace shares with debt and also fund the physical investment. I am not a big advocate of leveraging debt, but it is a reality these days. Most railroads have incentive contracts with C level executives based on a number of factors, including "return on invested capital" (ROIC). If the balance sheet can be adjusted to replace equity (usually a 15% hurdle rate) with LTD at 4% it lowers the ROIC considerably, thus making the company more attractive and bumping their ownership thru restricted stock which is the typical form of payment for executives past a salary. When the interest rates climb this practice will probably change. I have watched Coca Cola load their balance sheet with massive debt over the past 10 years not only for that reason, but also due to 80% of their earnings are offshore and the tax implications of repatriating those earnings. Ed
The earnings are solid for railroads. Free cash flow (FCF) is huge. Rails also invest a large amount yearly in their physical plant...usually 15% of more of their revenue and still there is FCF (FCF is defined as cash flow less investment). Thus companies are finding that they can replace shares with debt and also fund the physical investment.
I am not a big advocate of leveraging debt, but it is a reality these days. Most railroads have incentive contracts with C level executives based on a number of factors, including "return on invested capital" (ROIC). If the balance sheet can be adjusted to replace equity (usually a 15% hurdle rate) with LTD at 4% it lowers the ROIC considerably, thus making the company more attractive and bumping their ownership thru restricted stock which is the typical form of payment for executives past a salary.
When the interest rates climb this practice will probably change.
I have watched Coca Cola load their balance sheet with massive debt over the past 10 years not only for that reason, but also due to 80% of their earnings are offshore and the tax implications of repatriating those earnings.
Ed
Financial chicanery constructing houses of cards subject to collapse.
No, the debt actually enhances the valuation of the company...as long as debt can be serviced. "OPM" is being used (other people's money).
when debt becomes an issues is when it cannot be serviced. As long as FCF can adequately cover debt and leave room for investment (and hopefully return to owners in form of dividends or stock buybacks) then all is well. Another issue with railroad debt is that it is usually secured. In other words it is backed by some asset, such as rolling stock, locomotives, or physical plant. Thus, back in the 70s when Rock Island fell, the bondholders were in a spot to come out quite nicely.
Often the bonds were purchased at a fraction of the $100 face value and when the estate was closed, the bond holders were first in line for payment. Lets say one (such as the Crown family) purchased these bonds at $60 and held to duration, they would collect the full $100. They were first in line. That was one reason why Rock Island fell instead of being restructured. It was worth more dead than alive.
I always thought no debt was best...that is how I live my personal life, but most corporations use a mix of debt and equity to structure their company.
Again, it is all well while the money flows in.
Coke has a lot of debt relative to cash/current assets as well. Costco on the other hand has 12 billion in cash/cash equivalents verses 7.5 billion in long term debt...looks much better to me.
One has to wonder if all of that debt drags down the valuation of the stock/company.
Long term debt is extremely cheap these days, particularly those with excellent credit ratings. Companies can issue LTD at 3%-4% for 30 years (a bargain) and then purchase back shares thus leveraging their balance sheet and thus increasing their return on equity (ROE), one of the major metrics in valuation of a company.
In part, poison pill against 'activist investors' or hedge funds and the like, I think.
In part, the almost ridiculously low interest rate, likely to persist in 'recovery'...
All railroads appear to have alot of longterm debt on their balance sheets, and the debt is going up relative to cash and short term assets. What's driving the increase in debt?
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