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Why Capital Structure Matters
Companies that repurchased stock two years ago are in a world of hurt.
By MICHAEL MILKEN
Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors
who said, "I'll never own a stock again!" Meanwhile, some state and local governments as well as utilities seemed
on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved
for capital.
[Commentary] Chad Crowe
If that all sounds familiar today, it's worth remembering that 1974 was also a turning point. With financial institutions
weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds
rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged,
two-year rates of return approaching 100%.
The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which
now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low
absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter
of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies
have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations
are now raising capital through new issues of equity, debt and convertibles.
This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations
with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the
public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have
used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity.
These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.
The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure
management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a
company's securities or the risk of investing in them.
My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure
significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders
must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the
economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt
may be too much for some companies.
Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion,
companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises
with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it
happened 20 years ago, and it's happening again.
Overleveraging in many industries -- especially airlines, aerospace and technology -- started in the late 1960s. As the
perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply.
But by using the capital markets to deleverage -- by paying off these securities at lower, discounted prices through tax-free
exchanges of equity for debt, debt for debt, assets for debt and cash for debt -- most companies avoided default and saved
jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which
it was retired.)
Issuing new equity can of course depress a stock's value in two ways: It increases the supply, thus lowering the price;
and it "signals" that management thinks the stock price is high relative to its true value. Conversely, a company
that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply
and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has
shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are
seen as credit risks.
Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity
issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock
or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price
generally rises.
The decision to increase or decrease leverage depends on market conditions and investors' receptivity to debt. The period
from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late '80s, equity market values rose above
the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal
to deleverage.
In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted
in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when
companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded
in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years.
As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance
sheets. That has helped save jobs.
The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the
years before the market's recent fall. These purchases peaked at more than $700 billion in 2007 near the market top -- and
in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly
hard hit were some of the world's largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford
Financial, Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies (CBS, Gannett); and industrial
manufacturers (Eastman Kodak, Motorola, Xerox).
Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period
of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the
recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.
The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much
as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at
a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related
financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality.
The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate
is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of
the time.
History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings similar events around in
a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities
and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.
It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.
Mr. Milken is chairman of the Milken Institute.
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