I read a very nice article in Barron's this morning by Andrew Bary, titled "Who's Afraid of Leverage? Not the Buyout Kings." In it, the author talked about the wave of leveraged buyouts (LBOs) that have taken place recently, gave a nice overview of some of the risks, and ended with a smart warning that if the stock market doesn't keep going up, things could end badly for the companies that took on tremendous amounts of debt in the process of being bought out.
The article quoted Henry McVey of Morgan Stanley as saying that a $50 billion buyout could be possible. That would be a big deal. But I had to wonder if LBO madness is setting in when I started reading some the names mentioned as candidates.
The LBO way
Let me say that leveraged buyouts are not a bad thing. In fact, sometimes they can be an important catalyst to help struggling companies turn around and create value. That's because one way LBOs work is to bring in a new management team with a new set of incentives to create value through increased growth or increased cost-cutting, squeezing every bit of margin out each sale. Another way LBOs can create value is by simply adding more debt to an underleveraged balance sheet. An increase in the use of debt can lower the cost of capital, increasing the spread between returns on capital and costs. This can create value, up to a point.
So in a nutshell, LBOs can bring in a new management team to run the business for its new stakeholders, and they can add risk to increase return. It is with these thoughts in mind that I came away a little confused on some of the names that were present in the article.
Strange bedfellows
The first name I read as a possible candidate was Gap (NYSE:GPS). Gap has been struggling, so maybe I shouldn't have been so surprised, given that a change in management might be a good thing. But didn't Gap just pay down a ton of debt to relieve that burden?
Bed Bath & Beyond (NASDAQ:BBBY) doesn't currently have any debt on its balance sheet, although its operating leases certainly act like debt instruments. So you could definitely make an argument that adding some debt to recapitalize the balance sheet could add some value, especially since the company has been aggressively buying its shares over the last few years.
Of the two, Bed Bath & Beyond certainly could be a candidate. But this next retailer is one that makes no sense to me: Costco (NASDAQ:COST).
Are you going to bring in a better management team? I doubt it. Are you going to raise prices and increase margins in order to increase shareholder value? That's certainly possible. But in the process, I think you would destroy the culture and the fabric of what makes Costco a great company. Its business model is based on passing along savings to customers in order to keep them renewing their memberships and shopping at Costco, as well as attracting new customers. That's why it has an advantage. As soon as you start tinkering with its successful business model, I think you're more likely to destroy it than make it better. And not only that, I bet you'd have to pay a healthy premium to get the opportunity to screw up a great business. That's why Costco as an LBO candidate doesn't make any sense to me.
Here's another strange one. Nike (NYSE:NKE) is underlevered for sure, and being a product company, it doesn't carry the same operating risks as a retailer. But it already generates an incredible amount of value, given its high and rising return on invested capital. So are you going to find a better management team to run the company? Probably not, since that culture has been carefully put together. Would it be a good idea to lever the company up in order to generate an incremental benefit to compensate for making the company more risky? I have to wonder about that one as well. But LBO firms have heavy incentives to get deals done, not merely to generate returns. That's because private equity firms make money on all sorts of fees, not just on returns.
The last names I don't really understand are homebuilders like DR Horton (NYSE:DHI), Toll Brothers (NYSE:TOL), and MDC (NYSE:MDC). Then again, I don't make a living doing leveraged buyouts. But these companies already have significant amounts of debt, are cyclical, and have high operating leverage (i.e., if homes don't sell or home prices fall, there are still large, essentially fixed costs to cover, lowering profits). Perhaps the time is right. Homebuilders have been beaten down pretty heavily over the last year or so. And if a few deals could get done before the next cyclical upswing, a company willing to take that chance could generate some pretty incredible returns along the way. But it sure seems like a leveraged buyout of a homebuilder would be a pretty risky way to allocate "other people's money."
Fool's final word
There's no denying that any company is a potential buyout candidate. But some are better candidates than others. There's also no denying that huge private equity funds have been created, and money is flocking toward the hottest investment vehicles in town. But I have to wonder if things have gone too far when the companies mentioned above are making the lists of potential buyout candidates.
Related Foolishness:
Gap and Bed Bath & Beyond have been recommended in both Stock Advisor and Inside Value. Costco is a Stock Advisor selection. MDC is a Hidden Gems pick. You can try any of the Fool's fine newsletters free for 30 days.
Retail editor and Inside Value team member David Meier owns shares of Nike, but does not own shares in any of the other companies mentioned. He is currently ranked 88 out of 14,219 investors in The Motley Fool's CAPS stock-rating service. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.
