The mass misallocation of capital

24th Jan '18 by kalkanite

28 comments 10436 reads

I've become increasingly worried about the size of and attitude towards corporate debt over the last couple of years. I think that the recent collapse of Carillion is just the canary in the mine.

BOND PROXIES

With such low yields from bonds and a potential collapse in bond prices should inflation rear its ugly head, many (especially FTSE 100) companies have become increasingly more popular as bond proxies to serve as part of income portfolio's. This has had the effect of increasing PER's and subsequent market caps and stretching their valuation to a point where upside potential is low while risk to the down side is high.

But at what price does the high yield come at? It appears that some companies are being overly generous with their dividends to a point where they are borrowing money to pay them. Like Carillion who paid out £441m in the last 6 years alone, this appears to be misallocation of capital on a grand scale

To give a few examples, and this is by no means extensive research, I have listed 5 companies below. The following figures are taken from Stockopedia stock report and cash flow account.

VODAFONE

Mkt Cap - £60.9bn
Ent Value - £90.3bn
Net Debt - £29.4bn (48% of current Mkt Cap)
NTAV - £20.3bn
Dividend – 5.65%

What makes the Vodafone debt even more surprising is that it sold its Verizon holding in 2014 for $130bn (£84bn at the time). Rather than totally eradicating its debt it paid a very generous £51bn in special dividends.

Average net profit over the last 3 years (post Verizon sale) is -1.47bn euros (yes that's minus), however it has paid out £11.66bn euros over the same period.

Vodafone forecasts for the next two years average at 2.88bn euros/year. So in order to pay back this debt at the current expected net profit it would take 11.7 years to pay the debt back (ignoring interest savings on reduced debt) and this would be at the expense of zero dividends.

Mean while back at Vodafone towers the FD has decided that it is prudent to pay a dividend of 5.65%, completely bonkers. Most of the crown jewels were sold off in 2014 leaving NTAV of £20.3bn, how much of…

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kalkanite

26th Jan '18

For the record, when paying interest on loans/debt it is tax exempt while paying down capital is not. So my mistake adding back tax in the above post when paying off capital/debt. This means that at forecast net profit and assuming future year 2020 profit to be the same then The AA can only expect to pay £183m back over the next three years from profits and thus reducing debt to £2.495bn.

Apologies for error.

gus 1065

28th Jan '18

Hi kalkanite.

The discussion thread prompted me to re-visit Severn Trent (LON:SVT) to assess whether it really is an over leveraged basket case as its poor stock rankings and recent share price underperformance might imply or whether there is more to it than that. By way of background, in a previous life I spent a fair bit of time analysing the sector from the time of the privatisations in the late 1980’s and financed a couple of acquisitions in the early noughties.

For investors, one of the good things about a regulated utility is that there is a huge amount of publicly (and via the internet) readily accessible data with which to work. For example, anyone wanting a reasonably thorough trot through the business and it’s finances could do a lot worse than start with the attached presentation from the company website:-

https://www.severntrent.com/content/dam/stw-plc/our-plans/results-2017/investor-roadshow-pack-november-2017.pdf

For those with the mind to there is a mass of further data backing this up via various statutory bodies such as OFWAT, DWI and EA.

There are numerous ways of valuing the business but one of the simplest is to look at its Regulated Capital Value (“RCV”). This is the value agreed from time to time by the company and its economic regulator OFWAT for the assets of the company with which it conducts its regulated business (i.e. water and sewerage services). Although there are some excluded non-core businesses Severn Trent (LON:SVT) is pretty focused so represents the majority of its operations.

Under the current regime, Severn Trent (LON:SVT) is entitled to bill customers for its services via a (complex and much gamed) formula and earn a permitted return that is sufficient to fund, inter alia, its cost of capital. This permitted return factors in both the cost of all debt and a cost of equity, including an agreed dividend. The quid pro quo is that OFWAT wants decent quality water and sewerage services and accepts that to fund both the Opex and substantial Capex required to update an antiquated Victorian infrastructure, it has to allow customer charges sufficient to attract capital. One of the beauties of this arrangement is that provided the Capex is agreed by OFWAT, it becomes a part of the RCV such that infrastructure investment returns are guaranteed. Notwithstanding some of the talking head politicians, I personally think the UK regulatory model has actually worked pretty well.

Anyhow, to your original point - is Severn Trent (LON:SVT) horribly leveraged? Without rehearsing all of the analysis, I’d point you to one number on page 12 of the presentation. This is the ratio of the total debt to the RCV. In the case of Severn Trent (LON:SVT) this is 59.9%. In simple terms, Severn Trent (LON:SVT) has a permitted statutory monopoly income of a blend of (60% cost of debt + 40% (higher) cost of equity) on 100% of its regulated asset base (roughly £8.5 billion) with which to service debt. Further, unlike other businesses where there is a propensity to try and pay down debt principal this is not the case here as the income stream is closely correlated to the effectively perpetual RCV such that interest coverage rather than interest plus capital repayment is the relevant consideration. While this kind of leverage might be scary in an operationally risky business, for a “safe” regulated utility it is actually quite conservative - by way of reference I have seen debt structures approaching or even in excess of 100% of RCV used in the past. Accordingly, IMO, Severn Trent (LON:SVT) actually has quite a conservative leverage ratio.

As with any company there are risks. For Severn Trent (LON:SVT) they may c**k up massively either day to day the operations or the ongoing financing (for example end up having to pay substantially more than the costs agreed with OFWAT) but assuming management are not downright negligent or incompetent this seems unlikely. The other big risk is the political one of a hostile Labour government looking to take down the existing water industry regulatory framework (which most commentators appear to think works) at which point all bets are off. Remarkably stupid thing to do, but when did that ever stop politicians (of either side of the political spectrum). Hubris aside, I would hope they have easier lower hanging fruit to go after with a reforming axe.

One final throw away thought. With an EV of about £10bn and an RCV of about £8.5bn, the valuation on Severn Trent (LON:SVT) is currently about 117% of RCV. Although I’m a few years out of the markets, these businesses have been valued at in excess of 130% of RCV, suggesting an EV of £11.5bn or a Market Cap of £6.5bn (ignoring any other non regulated assets or other liabilities such as pension shortfalls) i.e. about a 30% premium to the current share price. I suspect if the share price falls further, the pencils of the infrastructure funds and private equity folk will be being sharpened.

Gus.

Damian Cannon

Thanks for a very clear explanation of the economics driving a regulated utility Gus. The fact that agreed capex goes straight into the RCV, giving a guaranteed return on the capital, is a definite bonus. I can see why Severn Trent (LON:SVT) would be of interest to anyone creating an income portfolio whether at the private investor or fund level.

Damian

Richard Goodwin

29th Jan '18

Thank you @Kalkanite and respondents for thought provoking posts. Corpirate debt is an addiction. It is interesting how we often don't notice it sneak up on us. I always look at it when buying shares but do I keep as close an eye on debt levels as the years go on? No, I tend to watch the P&L.

mercury61

RE AA (LON:AA.) I tried to apply for their newly launched savers account series 6 and was met with such gobbledy gook instructions I gave up.and applied to another organisation. If the AA can't make instructions which don't contradict and confuse potential new customers... there little hope for them I'm afraid.

Thank you Richard, Gus, ISAallowance and others for your contribution. With the Bank of England base rate at 0.5%, current interest rates are very low. However if rates were to go up by say 2% then the increase in interest repayment for the £29.4bn owed by Vodafone would increase by £588m per year, it may be the case that Vodafone (LON:VOD) have fixed their bank rates or through bonds (I haven't looked into it that deeply) but if so for how long?

Any inflationary increases such as those in the late 60s or late 70s could be seriously detrimental to investors in the high debt companies, most probably through dilution or in the case of Carillion, collapse.

mojomogoz

1st Feb '18

@kalkanite @ratioinvestor + Others interested in AA (LON:AA.)

Excuse me showing up late to the discussion. AA has been on my radar since latter part of 2017 so interested in viewpoints. My work on it is really light so far so not very informed and interested in in feedback

My view is that AA is a great business with a bad capital structure. This is interesting and could lead to opportunity for me. Margins are very high. This is as it sells reassurance as much as actual real product. I see the move to electric vehicles over time as an opportunity to sell its very high margin reassurance brand and do even less than it does now!

My near term outlook on AA is that a financial event is very likely imminent (IMO inevitable) under the stewardship of new CEO Simon Breakwell (explained below).

The options:

1) meaningfully dilutive equity issuance
2) debt for equity swap
3) Take private / takeover
4) Dividend suspension

4 is an absolute certainty IMO. Its only worth £50m retained cash but Breakwell needs it to fund growth strategies for the business. Look at his past (founded and grew Expedia and then developed Uber Europe) and it is easy to see that this is a guy you have as CEO to grow and develop the business and not run it as sparsely as possible just to pay back bondholders. Paying back bondholders is a necessity and he will try and grow to do it rather than prune and shrink. He needs the £50m to invest...and I am not sure on the debt covenants (haven't done that level of work) but the firm is obviously fearful of breaching them and must be too close for comfort.

On to option 2. I don't think the PE firms that IPOed AA are bondholders so its all new money (nearly all the debt was issued in 2013). That means that debt for equity is not likely, at least not without really severe stress on share price first, which does require a turn down in trading to catalyse such an extreme. This outcome seems unlikely in short term.

However, a hugely debt for equity swap shouldn't be dismissed as an outcome, as unhindered with debt AA is easily a £3bn market cap company (i.e. debt guy get their money back). This is probably the rational way ahead for everyone...but institutional inertia and conventions likely prohibit it unless there is a terrible mess. The debt guys are in a bit of a bind as the AA does not have assets to pay them back with...it has very high margin franchise.

Option 1: A dilutive rights issue is problematic as it will be hard to generate enough equity from current valuation to make a big enough dent in the debt pile for the exercise to be worth it. Throw in the auto-reactiveness of a hint that cash from share issuance is needed and it becomes even more impossible to do well.

So what about option 4 take private? How would it happen? The bidder is going to want to pay as close to zero for the equity as possible if it is to take on the debt load and pension deficit. The share price is too high right now to make this possible. When Breakwell suspends dividend and announces plans for future including significant investment in growth, whilst paying back debt of course, the price is going to fall. How much? Dunno. But probably not enough to catalyse option 4.

If Breakwell's plans stumble over coming couple of years and execution is bad or earnings naturally decline then option 4 will happen.

I have left out an option 5 which is selling assets. Only the motoring school could be sold but for the little money this would raise it doesn't make sense to get rid of that brand identity with new drivers.

Conclusion: Wait for Breakwell to make a move and then see if creates opportunity.

(I'm going to cut and paste this into a general AA post as I'm interest in views)

2nd Feb '18

Lavinit

Interesting post. The problem with AA (LON:AA.) is that it has wasted the best part of two years in dealing with this problem and handing out cash in dividends of £76m during this period.

A great time to roll out options 1 or 2 would have been the 12 months period that the share price jostled between £3 and £4. Unfortunately we are now in a down trend with a share price currently at 133p.

I think that with a healthy balance sheet this company could easily command a PE of 20 which would roughly value the company at £2.7bn so similar to your valuation of £3bn but this would be at much dilution to investors.

A good question would be if the dividend was cancelled, what would be a reasonably manageable debt level? I see from the 2017 AR that interest payments (see note 6) on the loan was £147m for the year which translates to extra net profit of £118m after (20%) tax plus £129m forecast net profit leaving £247m if all debt was paid off.

So how could AA (LON:AA.) achieve this? Using option 1 or 2 at the current share price of 133p to eradicate say £2.5bn would add a further 1.88bn shares so a total of 2.49bn shares which would then translate to an EPS of 9.9p. Multiply this by a PER of 20 and you get a share price of 198p which is roughly 50% higher than the current share price.

That all looks good but can AA (LON:AA.) achieve this at a price of 133p? What happens if the share price continues down further and interest rates rise? This could end up being sold in a fire sale.

I hope the new CEO does get a grip of this because it is as you say "a great business with a bad capital structure".

Kalkanite

Too much risk involved for my liking.

Agree

21st Feb '18

Looking very bad for AA (LON:AA.)

Down 46% since I posted this article on 24th Jan just four weeks ago. Latest strategy update states the bleedin obvious, it is basically laying out what ought to be day to day processes and brings nothing new since the strategy update of Mar 2015 which is here....

https://www.stockopedia.com/share-prices/aa-LON:AA./news/aa-plc-results-strategy-amp-proposed-refinancing-part-1-urn:newsml:reuters.com:20150325:nRSY3959Ia/

Sound familiar? We know what followed this...

YEAR.....EBITDA

2015.....£430m
2016.....£415m
2017.....£403m
2018.....£395m
2019.....£340m (e)

So they have kicked the debt can down the road into a future period that looks to bear rising interest rates while their EBITDA and business is in decline. Debt is like ivy, if left to grow into a critical mass it will destroy its host. By putting off repayments to the future it looks very much like critical mass has been reached. The company will survive but it will be the credit holders that will own the £AA.

22nd Feb '18

Seems I'm not the only one concerned about water company debts and dividend payments, it appears also that the government are getting fed up with water utility companies becoming over in debted while directors are paying themselves handsomely and paying out high dividends to share holders......

Michael Gove tells water firms to clean up their act.....

http://www.bbc.co.uk/news/business-43139857

"Environment Secretary Michael Gove has warned water companies he is ready to give their regulator new powers if they cannot address public concerns over prices, leaks, executive pay and payments to shareholders....

He told the BBC that he was ready to give Ofwat new powers....

The privatised water companies have come under attack in recent years after studies revealed they had increased their levels of debt and paid out big dividends to shareholders...

He said the regulator also needed to bring in a form of dividend cap, where if payouts to shareholders became too great, prices would be cut accordingly.

Much of the article is aimed at Thames Water but is a warning to all water utility companies

So many inconsistencies in what Gove (and Corbyn for that matter) have to say on the rights and wrongs of how the water industry works in the UK. Presumably they’d like the tens of billions of Capex required to update a creaking infrastructure that was built by the Victorians to fall off some magic money tree rather than pay a market return to whoever (debt or equity) is prepared to stump up the cash.

Meanwhile Corbyn wants to renationalise the industry buying out shareholders (no mention of lenders) with government funded bonds - sounds a bit like the much despised PFI in all by name (that Gordon Brown allowed to grow like topsy under his stewardship as Chancellor).

As per my earlier post, the water and sewerage system works surprisingly well in this country (turn on your tap and you get potable water. Flush the loo and the poo disappears) and at a cost to most of us of a few pennies a day. Don’t you wish all the public services in the UK had these kind of problems? Water will have its day(s) under a cloud while the politicians have their sound bites for being guardians of the public good until they decide to poke a stick at next week’s bug bear. Makes a change from Brexit and the NHS I suppose! Sooner or later the last few companies still listed will be cheap enough to be taken private. That’ll do wonders for public accountability etc..

Gus.

"the water and sewerage system works surprisingly well in this country (turn on your tap and you get potable water. Flush the loo and the poo disappears) and at a cost to most of us of a few pennies a day"

That depends on how you calculate a few pennies a day, are you simply looking at the bill that we consumers pay? Isn't the real cost that of government subsidies (payed by tax payers) and the debt that these companies owe and the impact of pollution in the rivers and waterways due to under funding?

I'm certainly not trying to bash privatisation of public utilities although there are good arguements on both sides of that debate (I hold no firm views either way). My concern is that unsustainable debt is building up while excessive dividends (excessive in terms of alternative equity income) are being paid out, this debt will have an impact at some point on either the company (share holders), banks or the government (meaning the tax payers) in the mean time we can only hope that the infrastructure is keeping up.

Hi kalkanite.

The average UK household water and sewerage bill for 2017 was £395 per household - roughly 115p per dwelling or maybe 40p per person assuming just under 3 people per location.

https://www.water.org.uk/news-water-uk/latest-news/household-water-and-sewerage-bills-2017-18

Barely the cost of a pint of milk per day for a pretty essential service that is the envy of many other countries. Not sure there are significant additional government subsidies other than the direct costs paid by domestic and commercial consumers regulated by OFWAT and built into the charges outlined above. On pollution and other environmental issues I am no expert but would suggest the UK is ahead of the game compared to many countries and the amount of capital investment post the 1989 privatisations has (necessarily) been massively increased.

Funding for this has to come from somewhere and whether it is debt or equity this has a necessary cost to attract that capital. Part of this cost is a negotiated (with OFWAT) return built into the capital base of these companies. There seems to be the impression that the water utilities are off on a frolic giving outrageous dividends to shareholders while forever ramping up debt to pay for it - this is simply not the case. While fully accepting there is plenty wrong with some of the fat cat salaries paid to the executive management of public utilities etc., neither the debt or equity returns seem particularly excessive for the risks involved. In a competitive, open market both get bid down to a level sufficient to attract the required investment capital. This breaks down either where the management cocks up or where an exogenous risk comes in to disrupt the status quo.

Perversely, this is what you have at the moment. The more the politicians kick the industry and threaten penal regulation (or renationalisation) the higher the perceived risk premium and, sadly, the higher the future costs to consumers as capital becomes more expensive. The continuous fall in the Severn Trent (LON:SVT) and other quoted utilities’ share prices illustrates the market’s requirement for a higher dividend yield for the higher perceived risk premium every time one of the Westminster talking heads spouts off. So far as I’m aware it is not a function of the failure on the operational side to improve service levels, customer satisfaction, water quality etc., which by and large are steadily improving across the board (based on various statements from the various industry supervisory bodies).

Like you I’m not doctrinally wedded to any particular model of utility ownership provided the service is reliable and affordable. On the principle of “if it ain’t broke don’t fix it”, however, I do wish our dear elected representatives would find some more reprehensible windmills to tilt at. Rant over - back into the strait jacket for me.

Gus.

Maddox

23rd Feb '18

Hi kalkanite,

The choice of financing a business with (currently) cheap debt versus expensive equity is an important business decision specifically as financing risk rises exponentially with the proportion of debt. It is often the compounding of business risk and financial risk that is the killer. So it is important to understand the level of financial risk a business can safely support. A large diversified business or one in a stable market can thus afford to take on a greater level of financial risk.

You have in your analysis managed to lump together shares with very different businesses, and circumstances that can only really be looked at individually.

Of your chosen examples Vodafone (LON:VOD) is the only one I can talk about. On the face of it looking at the figures the picture is as you describe. However, the accounts are very complex and difficult to interpret. Vodafone (LON:VOD) made many acquisitions at high valuations (e.g Mannesmann in Germany) using its own highly valued (at the time) equity. The excess valuation ended up on the B/S but has subsequently been written-off through the P&L - making the profitability look poor (but with the advantage of reducing the tax bill). We've then had the enormous Verizon disposal and financial reconstruction then the huge investment in Project Spring. This investment more than accounted for the free cash flow - then making the dividend payment look unsustainable.

However, the picture you describe probably explains why shareholders are finding Vodafone (LON:VOD) unattractive and hence on a 6.5% dividend yield. Whether, Vodafone (LON:VOD) turns out to be a Carillion we'll have to see but I very much doubt it.

Regards Maddox

FreakNomad

27th Feb '18

That announcement is dated 2015. As per the 2017 annual report (note 20):

£175m need to be rolled over on 31.7.2018
£ 248m on 31.1.2019

I can see this stressing management quite a bit.

It looks like a decent business that has been totally destroyed by too-clever-by-half financial engineers.

I'd wait for the distressed sale.

Link to AR: http://www.theaaplc.com/~/media/Files/A/AA-Plc-V2/results-presentations/2017/aa-ar2017.pdf

FreakNomad

The 2015 AR reference was to the "strategic plan" that the company released that year to grow revenue/profitability, it is much the same as the recent strategy hence refering to the following years metrics.

The 2018 & 2019 figures you quote have been rolled over once again. See here...

https://www.stockopedia.com/share-prices/aa-LON:AA./news/aa-plc-half-year-report-part-1-urn:newsml:reuters.com:20170926:nRSZ7732Ra/

AA Bond Co Limited, a subsidiary of the AA plc, issued a single class of Sub-Class A6 Fixed Rate Notes under its multicurrency note programme listed on the Irish Stock Exchange and used the proceeds to redeem the remaining Sub-Class A1 and Sub-Class A4 Fixed Rate Notes. At the same time, the AA group used available cash resources to reduce by 98m its senior term debt and extended that facility through the replacement of its existing Senior Term Facility with a new Senior Term Facility. The new facility extends the maturity of the senior term debt from 31 January 2019 to 31 July 2021.

We issued 250m of new Sub-Class A6 Fixed Rate Notes on 13 July 2017. The coupon of 2.75% is payable semi-annually in arrears and their maturity is at 31 July 2023.

@Maddox

Agree with what you say. I could have used FCF, PTP, EBIT or EBITDA as a proxy for payback period but preferred the PTP figure in this case as it gives the kind of margin of safety that has served me well over the years. After all, the only constant in EBITDA is the 'B' :-)

Gus made a good case why utilities debt can be considered differently. Perhaps I am old fashioned but I think borrowing money to pay dividends especially at a rate that is multiples of what you can get in a bank or building society is mismanagement of capital.

3rd Jun '21

An old thread, but there was some discussion of the merits of the regulated water and sewerage utility Severn Trent (LON:SVT) as an investment . In the comments, I highlighted that one of the metrics for valuing these utilities is to look at the price of the company relative to its RCV (regulated capital value - the agreed (by OFWAT) capital base of the company from which it can derive its permitted return/customer billings). Currently the ratio of EV to RCV is about 127% (EV £12.7bn, latest RCV approx £10bn). Today Pennon (LON:PNN) acquired the smaller Bristol Water Group at a premium to its RCV of 44%. There is not much M&A activity in the sector any more (most of the minnows have been swallowed up and the many of the bigger players taken private) so today’s announcement is a rare opportunity to see what the market is currently prepared to pay for regulated water assets.

https://www.investegate.co.uk/....

At risk of comparing apples with oranges and fully accepting Severn Trent (LON:SVT) is a much bigger fish/Pennon as a trade buyer (benefiting from merger synergies) is likely to be willing to pay a higher price than a financial buyer, if we apply the same 44% premium to Severn Trent (LON:SVT) the current EV would be approximately £14.4bn. Taking the £6.5bn debt out of the equation, the implied market cap thus rises from £6.2bn to £7.9bn, about a 27% increase on the current market value or in share price terms the current £24.80 is notionally worth about £31.50. Definitely a back-of-the-fag-packet assessment, but the takeaway message to me is that if I were still buying utilities, I’d be running a very detailed ruler over Severn Trent (LON:SVT) as a potential bid target.

Gus.

shamusj

I was curious about this, and thought that there may be director buys to confirm this thesis. Unfortunately I found the opposite with massive director selling at around the current price which puts me off. Your thesis may still be totally correct though!

Hi shamusj.

My (admittedly 20 years old) experience of dealing with Water Company executives was very much the case that they saw share options as part of their salary and tended to exercise and sell as soon as the options vested rather than seeing such options as giving them an ongoing stake in the business. Similarly, when approached with the opportunity to MBO their business they were more concerned about long term job security than making the business more efficient/having a material personal equity in the business. It was more like dealing with a group of 40 year career civil servants rather than PLC entrepreneurs. I suspect they’re a bit more sophisticated these days; it’s me that’s missing the obvious and the current share price is overvalued so sell!

As ever, time and the market will tell.

The mass misallocation of capital

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Kalkanite

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