It's Not The Record High Debt That Is The Biggest Risk, It's This

Earlier today, Bloomberg "discovered" that "Corporate America Has Quietly Re-levered", reporting that "one of the biggest post-financial crisis imbalances sits on corporate balance sheets" citing a Goldman report.

Actually it hasn't been quiet at all: while to some this is news, our readers have been well-aware of this trend since January 2014 when we first reported that "Corporations Have Record Cash: They Also Have Record-er Debt, As Net Leverage Soars 15% Above Its 2008 Peak", and then most recently this weekend when on Sunday we reported, again very unquietly, that "Corporate Leverage Is At Record Levels."


Furthermore, as we further noted in "Why The Stock Buyback Spree Is Ending" that "the 3-fold increase in share buybacks in the past five years has been the key driver of corporate re-leveraging. In large part, buybacks have been the result of strong incentives provided to corporate managers by activists in particular and equity investors in general."

Two days later, Goldman also confirmed this observation: "So, does this mean the levered re-cap is dead? In our view, the answer is yes for the broad market, though legacy Tech should prove an exception given substantial balance sheet capacity"

Goldman added even scarier overtones overnight, when it said that "like a bad dream, imbalances have been building the last few years. Corporates have levered up and the M&A boom has driven goodwill to multi-year highs. With the United States on the verge of the first interest rate hikes in almost a decade, we question the sustainability of these trends. Companies that have “manufactured earnings” vs. generating organic growth and reinvesting in their businesses are in the spotlight with investors rewarding high-returning stocks while punishing those with weak balance sheets, outsized buybacks and/or EPS growth."

Bloomberg wasn't too far behind in admitting what we have said three years ago when in November 2012 we revealed "Where The Levered Corporate "Cash On The Sidelines" Is Truly Going", i.e., buybacks.

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But while even Goldman has admitted that rising leverage and the soaring buybacks are, "like a bad dream", the major problem for corporate imbalances, the truth is that surging debt is not the full story, nor is it the scariest aspect of this story.

The real risk is that while debt is rising on both a relative and an absolute basis, EBITDA, or cash flow, of both junk companies as well as Investment Grades, has been declining for at least one year. Or rather, while junk-rated companies have seen their EBITDA decline consistently over the past 5 years, the big inflection point came in early 2014 when IG EBITDA also plateaued, and has been declining since.

It is this ongoing decline in actual cash flows, which tracks the third consecutive quarter of declining Y/Y revenues (the decline in EPS is far slower as hundreds of billions in shares have been removed from the market, keeping the EPS ratio higher than where it would be) that is the biggest risk to both the S&P500 and the market, if such a thing still existed.

Even Goldman is unable to provide a counterfactual case:

Now, the counter-argument one hears is that the cost of this debt has never been this cheap with the average interest rate paid dropping from close to 6% to 4% in 2015. Put another way, as debt has more than doubled, the amount of interest expense has only gone up by 40%. This is all good until you normalize EBITDA. Indeed, if EBITDA was at “normalized levels” (which we define as median NTM EBITDA from 1Q07-2Q15), leverage would move to 1.75X, over 30% higher than the average over the last 10 years.

But here is the real kicker: with even Goldman admitting that buybacks as a shortcut to creating "engineered" earnings will no longer work and instead may be punished by investors, companies refuse to accept this. Certainly don't tell that to McDonalds, which earlier today defied S&P to announce a major debt increase to boost shareholder returns, even if it meant its A rating would be lost as it was downgraded to BBB+. Contrary to Goldman's take, it was rewarded by shareholders.

So even as cash flows continue to decline, companies will engage in this one and only line of defense against sellers and shorters as in a world where 2% growth is the new norm (and that with the benefit of $13 trillion in central bank liquidity). And instead of investing in the future, replenishing their asset base, this asset stripping of corporations to reward shareholders will continue.

Until it can't, an threshold which will certainly be catalyzed by any Fed rate hike(s).

At that point, desperate for cash companies (loaded to the gills with debt) will again try to access the bond market and be unsuccessful. It is then when the bulk of the S&P, cash flows declining, will resort to the oldest form of capital raising in the book - selling equity. From that point onward, it will be all downhill for the market.

The only question is how many savvy shareholders will try to frontrun it and sell while they still can, not when they have to, and are competing with management to find willing buyers.