3 Companies Doing the Right Thing with Debt

Many investors see debt as always being a bad thing. But when rates are low, taking on debt can be the smartest move a company can make.

Back in August, Credit Suisse analyst Kulbinder Garcha wrote in a research note that IBM (IBM 1.05%) had a cash flow problem and should be avoided. Since then, other Wall Street analysts have also jumped into the fray, raising concerns about IBM's high level of borrowing to support its growth and its buyback program. According to data from MarketWatch.com, at the end of the third quarter, IBM's net debt had exploded 160% since the end of 2009.

Wall Street is not always right, however. IBM has the backing of Warren Buffett, so the company can't be all bad. Indeed, it seems IBM is actually doing the right thing by binging on debt now while rates are low.

Since the end of 2008, IBM has acquired more than 40 smaller peers, each of which are specialists in their own fields. The total consideration of these deals is unknown, but using debt to purchase these bolt-ons seems a prudent decision by IBM.

According to data from Morningstar, nearly half of IBM's total debt has a rate of interest below 2%, which is below the United States' average inflation rate for the past 10 years. Put another way, IBM is borrowing at negative real interest rates after adjusting for inflation. What's more, although IBM's net-debt pile has expanded 160% to $36 billion during the last four years, its annual interest expense has only risen modestly, and its fiscal third-quarter interest costs actually fell by about 30% year on year. All in all, IBM does not need to be worried about the level of debt it is accumulating. Actually, if I were running IBM, I'd be tempted to borrow more, as it seems the market is actually rewarding IBM's borrowing with lower rates of interest.

Elsewhere
IBM isn't the only one making the most of low interest rates. Chevron (CVX 0.44%) recently had to explain to analysts why it was not worried about the company's rising borrowing activity. In a conference call with investors, Iain Reid, an analyst with Jefferies, raised concerns that Chevron was spending more on capital expenditure and stock buybacks than the company was generating in free cash flow.

Chevron CFO Patricia Yarrington replied that the company was taking a medium-term view on the matter and that with a 12% debt ratio, the company was not worried about its debt load. Indeed, it would appear that debt is almost of no concern to Chevron; according to the company's debt profile on Morningstar, approximately half of the company's $20 billion debt pile demands interest payments of less than 2.5% annually. Considering this, I'm not worried about the company's debt. In fact, borrowing to buy back stock while it is trading at such low levels will guarantee better returns for investors in the future. What's more, additional borrowing should allow Chevron to buy some smaller peers to boost its own flagging production.

Expiring patents
In addition to IBM and Chevron, Merck (MRK 0.10%) is also aggressively buying back stock with debt, to the extent that the company's long-term debt expanded by 35% between the company's fiscal first and second quarters. This buyback is designed to offset some of the pain the company will feel when a number of its key patents expire. What's more, much of the debt the company has taken on recently has low financing costs, with Morningstar noting that $4 billion of the company's debt carried a fixed rate of interest between 0.6% and 1.3%. Moreover, if rates stay low a bit longer, Merck could refinance some of its higher-rate maturing debt at an even lower cost.

Still, Merck's debt binge to finance its stock buyback will not totally offset the sales declines owing to patent expirations. Investors need to pay careful attention to the company's patent pipeline, which is solid with 43 programs currently in place. This indicates that if some of these products make it to market, the company's EPS will be much higher than previously, as the buybacks currently taking place are funded with free debt.