The Fly In The Buyback Ointment: Corporate Leverage Is At Record Levels

We’ve gone out of our way over the last year to explain that whatever monthly flow was lost to the taper was promptly recouped by corporate management teams via an endless stream of ZIRP-induced buybacks. 

Put simply, thanks to the now ubiquitous global hunt for yield, anything that even looks like a creditworthy company can borrow for nothing and then promptly funnel the proceeds into EPS-inflating buybacks. That’s great from a myopic, “let’s worry about this quarter first and longevity later” perspective, but in the long-run, it can’t possibly work as all you’re doing is leveraging the balance sheet to explain away a poor top line.

Indeed, this has become a hot-button issue on the campaign trail as Hillary Clinton, at the likely behest of Cheryl Mills, is out to attack the "tryanny of the next earnings report."

Still, “investors” are stupid (sorry, the filter is off tonight) and algos just scan headlines, so as long as the bottom line looks good, the equity continues to rise. But with Eccles QE gone (for now anyway) and with the cost of capital expected to rise in December (hold your breath), the question is this: what happens to quarterly earnings once the buyback bonanza beat is history? 

Citi is now out questioning just how long PMs are going to entertain the proliferation of financial engineering now that i) we're in a revenue recession, and ii) coporate leverage is sitting at record highs.

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From Citi

Corporate leverage continues to push higher. In Figure 3 we present the debt-to- EBITDA ratio for the average non-fin in the IG and HY markets. We see that in IG leverage rose from 1.8x to 2.1x over the past twelve months, and in HY it rose from 4x to 4.4x (Figure 3). Note that in both markets, at current levels gross leverage for our sample set is well north of the ‘09 highs. Unfortunately, we see little chance that it will decline in the near-term, or even stabilize for that matter, as the earnings backdrop appears to be too soft.

Until recently, rising corporate leverage was primarily the result of companies desire to bolster shareholder value at the expense of bondholders — issue bonds and buy stock or issue bonds and buy a company. But in recent quarters declining earnings have been an important reason for the upward trend (Figure 4).

The 3-fold increase in share buybacks in the past five years has been the key driver of corporate re-leveraging (Figure 5). In large part, buybacks have been the result of strong incentives provided to corporate managers by activists in particular and equity investors in general. 

But there are signs that this may be changing. Recent conversations that we’ve had with equity PMs suggest that they have become far more focused on revenue growth, and are placing far less of a premium on any financially engineered EPS growth.

Why might equity investors be less impressed with financially engineered growth now than they were a short while ago? One of the key reasons may simply be because default risk has risen, and historically when default risk rises buybacks tend to fall.

This relationship exists in part because equity holders have a claim on future cash flows. While buybacks increase that cash flow stream itself (per share), they also lower the probability of equity holders actually receiving that cash flow stream. After all, should a company default equity holders may very well end up with no claim at all. 

Figure 5 highlights the relationship between buybacks and the default rate over time at the macro level, and in Figure 6 we show the debt outstanding and share price relationship for a specific issuer (DAL). Note that we can find any number of examples where more debt equates to a lower share price rather than a higher one.

Given that we are clearly moving into a higher default environment we believe that equity investors may be inclined not to reward stocks that have large buyback programs. And if this is the case, corporate managers will have a diminished incentive to borrow money to finance buybacks.

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Got it. So what Citi is saying is that now that corporate leverage is at record levels, the game is officially up and once the defaults start and the cost of capital begins to rise, no sane equity investors (of course nowadays the idea of a "sane" or even a "human" equity investor is an oxymoron) will ever buy into the story nor even think about throwing money at a secondary. 

Needless to say, that's bad news for corporates that have to this point relied on ZIRP to stay afloat and it's also bad news for anyone betting on fresh highs on the S&P. This will only get worse as pressure from Presidential candidates overwhelms the whims of the 2 and 20 crowd when it comes to dictating how corporate management teams finagle the bottom line and so, if Citi is correct, expect PM's to be less impressed with EPS "beats" going forward which means either Janet Yellen will need to step back in to provide the bulge bracket with the monthly dry powder they need to fire up the prop desks, or else it may be time to take profits.