FOOL ON THE HILL
Many investors consider corporate debt a four-letter word and stick to investing in companies with little or no debt. But good management can use debt to its advantage. In the case of medical technology firm Stryker, debt provided a low-cost source of funding for an advantageous acquisition. With the stock market a less attractive source of funding, investors should keep their eyes open for similar instances where using debt will prove to be a smart move.
 |
|
|||||||
|
||||||||
|
||||||||
By
Evaluating a company's management team is one of the trickiest areas in business analysis for the individual investor. Many investors want to invest alongside "good management," but what exactly does that mean? Sell-side analysts give "buy," "hold," and the occasional "sell" ratings to stocks, and debt rating agencies like Moody's and Standard & Poor's give different rankings for corporate bonds and other debt instruments. However, there are no real third-party sources for ratings on management. Whether a management team is "AAA" in quality or merely a "market underperformer" is left for investors to decide on their own. One way to determine whether management has its collective head screwed on right is to examine how it has done over time with capital allocation decisions. This refers to what has been done with the cash a company produces, or -- if it doesn't produce any cash -- how the firm's management has gone about raising cash in the past. Just as you can learn a lot about a man from his wallet, you can tell a good deal about a firm's management team by looking at how it handles the company's finances. One common investor rule of thumb is to shy away from managements that load companies down with debt, just as you should be skeptical of doing business with a fellow whose wallet is crammed with credit cards. In recent years, many companies simply took advantage of the high-flying stock market and raised money by selling more and more stock, rather than writing out IOUs to banks and corporate bond holders. Existing shareholders have generally put up with this practice, allowing many companies to keep their balance sheets debt free. Companies with a lot of debt, on the other hand, have ended up being as ignored as Jan Brady. Outside of the telecommunications and trash hauling worlds, it's hard to find examples of companies that have decided to take on substantial amounts of debt to expand their businesses in recent years. Sure, some companies have sold a few bonds here and there, but typically managements have used debt as a secondary funding source behind operating cash flow and stock sales. This has only helped solidify the image in many individual investors' minds of debt as a nasty four-letter word. Corporate debt isn't always bad, though, and management teams aren't always taking huge risks on the part of shareowners when they choose debt over other sources of funding. Sometimes using debt turns out to be the best capital allocation decision a company can make. This has been the case with orthopedic, surgical, and medical products maker Stryker (NYSE: SYK), which took on a big slug of debt in 1998 to take out one of its major rivals in the joint replacement market. Many shareholders were put off by this capital allocation decision when it was made, and the stock had a rough go of it for awhile. Those who hung onto their stock despite the debt, though, have laughed all the way to the bank. When Stryker acquired rival Howmedica from drug firm Pfizer (NYSE: PFE) for $1.65 billion in late 1998, it decided to borrow the money rather than trade away shares. Considering that Stryker's balance sheet sported only $75.2 million in total debt -- and $725.8 million in shareholders' equity-- at the time of the deal, it was plain to see how adding Howmedica would dramatically change the firm's financial picture. Upon the deal's closing, Stryker's ratio of debt to total capital shot up to 68% from 9%. And for the first full fiscal year with Howmedica on board, Stryker recorded $122.6 million in debt-related interest expense, which ate up a whopping 67% of fiscal 1999 operating profit. Such numbers would no doubt send chills down many a debt-averse investor's spine. But as it turns out, the debt load hasn't been a big menace for Stryker. The joint replacement business is a pretty steady cash flow generator, and the Howmedica acquisition cemented Stryker's place as one of the worldwide market leaders. Benefiting from the combination, the firm's cash flow from operations has ballooned to $332 million in 2000 from $154.5 million in 1998. With the boost in cash, Stryker has been able to rapidly pay down its debt, which stood at 53% of total capital at the end of the recently completed first quarter. Meanwhile, its ratio of operating profit to interest expense -- a metric commonly referred to as interest coverage -- ticked up to 6.4x in Q1. Total debt today stands at just under $1.1 billion, and at the recent quarterly pay down rate of $50 million it could shrink by another $150 million before the end of the year. All of the remaining debt could conceivably be gone in a few years' time. Taking on debt may have muddied Stryker's balance sheet in the short term, but in the grand scheme of things, it has turned out to have been well worth the risk. The company took out a major rival and shored up its long-term growth prospects at what has turned out to be a very low cost. On its Q1 conference call, management stated that the average interest rate on the credit facilities that account for the bulk of the debt load is 7%. Furthermore, half of the remaining debt is of the floating rate kind, which can only be a positive in an environment of falling interest rates. Thanks to the excellent returns generated from the Howmedica acquisition, Stryker's stock has shot up 150% since the deal closed. For the company's shareowners, the deal couldn't have turned out better. They have management to thank for that. The company's management made a smart capital allocation move by picking up Howmedica in the first place, then padded their good sense by funding the deal at a low cost with debt. For investors looking to evaluate a management team's capital allocation skills in the coming years, the Stryker example is a good benchmark. With the general decline in stock prices, selling stock has dried up as a financing option for a number of firms. This may mean debt will be looked to more in the near future for funding than it has been in the past. Like it or not, individual investors will have to get over their fear of liabilities on the balance sheet and get used to the idea of investing in companies with some debt. But debt isn't necessarily the end of the world. Let's say it together: "Debt can be your friend -- as long as it's in the hands of smart management." Brian Graney has been known to carry around some personal debt of his own -- but not too much. At the time of publishing, he was a shareowner of Pfizer. The Motley Fool is investors writing for investors.
RSS Headlines
Fool UK
