Over the past several years, there have been two primary sources of upside for the stock market: trillions in corporate buybacks, as companies themselves engaged in record repurchases of their own stock, often at price indiscriminate levels in a bid to not only raise the stock price but also the stock-linked compensation of management , and a similar amount of dividend payments which in a time of negligible yields, became one of the main drivers for buyers to scramble into the "safety" of dividend paying stocks. Collectively these account for an unprecedented amount of payouts to shareholders.
Today, Barclays' head of equity strategy Jonathan Glionna quantifies just how much corporate cash flow has and will be used to fund these payouts.
Glionna finds that in aggregate the companies within the S&P 500 are returning a record amount of cash to shareholders through dividends and buybacks. Since 2009 dividends have increased by more than 100%, reaching $98 billion in the most recent quarter. Meanwhile, gross buybacks have tripled and Barclays forecasts that they will reach $600 billion in 2016. In fact, buybacks plus dividends could surpass $1 trillion in 2016, for the first time ever.
Just like Goldman Sachs, Glionna says that "we believe the substantial increase in distributions is one of the primary justifications for the gains in the price of the S&P 500 during this business cycle (Figure 1).
However, this unprecedented surge in distributions may be coming to an end and as Barclays puts it, "alas, nothing continues forever. The growth rate of payouts, which has averaged 20% since 2009, will all but disappear in 2017, in our opinion."
While companies have "taken advantage of a recovering economy and generous credit market to enhance both dividends and buybacks" for six years, they may not be able to push them higher much longer.
And here is a fascinating statistic: over the last few years payouts have exceeded earnings for the S&P 500, which is rare. It almost happened in 2014, when the total payout ratio was 99%. In 2015, it did happen. It will happen again in 2016, based on Barc estimates, as net income is likely to be less than $900 billion against $1 trillion of dividends and buybacks. Prior to 2015, companies in the S&P 500, in aggregate, had paid out more than they earned only six other times during the last 50 years. It has never happened more than two years in a row (Figure 2).
In addition, cash outflows for dividends and buybacks have been exceeding cash flow from operations after capital expenditures. We discussed this in The end of financial engineering? (February 29, 2016), which highlighted the S&P 500’s growing reliance on the investment grade credit market to cover its cash flow deficit. Based on our measure, companies in the S&P 500 have spent more than they generated in free cash flow every year since 2013.
The kicker: Glionna estimates that non-financial companies in the S&P 500 have a cash flow shortfall of more than $115 billion per year (Figure 3). In other words, companies will spend promptly send every single dollar in cash they create back to their shareholders, and then use up an additional $115 billion from cash on the balance sheet, sell equity or issue new debt, to fund the difference.
Why does Barclays believe that 2016 will be the last year with an unprecedented surge in payouts? Two reasons: insufficient cash flow creation, and too much debt to lever up meaningfully higher from existing levels. Here is the full explanation:
For the S&P 500 dividends plus buybacks exceed net income. After funding capital expenditures, dividends plus buybacks also exceed cash flow from operations. This is true even after accounting for equity issuance. But so what? Why can’t companies continue to pay out more than earnings, even if it reduces book value? Why can’t companies continue to spend more than their cash flow if the investment grade credit market is willing to provide cheap financing? We see a compelling reason–leverage ratios will get too high.
Companies have been able to spend more than they generated in cash flow because leverage measures were low coming out of the financial crisis. But they are not low anymore. Since 2013, the total amount of debt owed by non-financial companies in the S&P 500 has increased by almost $1 trillion. Net of cash the increase has been even more meaningful, as the growth rate of debt has exceeded the growth rate of cash and equivalents.
Meanwhile, EBITDA has stagnated. As Figure 4 shows, the median ratio of debt-to-EBITDA for companies in the S&P 500 (excluding financials) was just 1.53x in 2010. Now it stands at 2.33x, the highest point in at least 20 years. The total ratio of debt-to-EBITDA for the S&P 500 (rather than the median ratio) has reached 2.56x, excluding financials. And the increase has not just been caused by the Energy sector. If Energy is excluded in addition to Financials, the total debt-to-EBITDA ratio is 2.50x and it too has been rising rapidly.
As Figure 4 shows, leverage measures are quickly passing key thresholds. The dashed lines represent the median debt-to-EBITDA ratio of companies in the investment grade credit market by rating category. To be sure, the credit rating agencies take many factors into account when setting corporate ratings, but leverage measures such as debt-to-EBITDA are among the most important.
Figure 5 shows the number of companies in the S&P 500 that have a debt-to-EBITDA ratio above 2.5x. It too is increasing rapidly. This is leading to lower coverage ratios, as shown in Figure 6. These trends are unlikely to continue for the same reason why we predicted that IBM's formerly ravenous buyback appetite would grind to a halt: the vast majority of companies in the S&P 500 are investment grade rated and they want to stay that way. Being investment grade brings with it access to cheap, reliable, and plentiful funding. Few investment grade companies, in our opinion, would be willing to adopt a high yield leverage profile just to facilitate buybacks. Therefore, the increase in leverage ratios must soon come to an end.
But, as Barclays notes, the rapid increase in debt-to-EBITDA ratios will not stop unless the growth rate of payouts declines. In other words, if companies keep increasing payouts then debt-to- EBITDA will continue to go up. This is displayed in the sensitivity table shown in Figure 7. In fact, it will take a decline in payouts just to stabilize the S&P 500’s debt-to-EBITDA, based on our estimate of 2% EBITDA growth. While we do not expect payouts to decline this sensitivity table showcases that continued rapid growth is likely unsustainable. The table provides estimates of debt-to-EBITDA measures for the S&P 500 excluding financials based on various growth rates of payouts and EBITDA.
To be sure, there is always the possibility EBITDA will increase faster than expected, allowing more flexibility to add debt. For example, if EBITDA increased by 5% in 2017, which would bring it towards an all-time high, then debt-to-EBITDA would likely stabilize at 2.56x or below.
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What the above analysis means, stated simply, is that even assuming no material increase in rates, companies will have no choice but to moderate their aggressive payout practices, the same practices that were instrumental in pushing the S&P to its all time highs. The constraint: balance sheets levered to the gills with record amounts of debt. And unless a new cash flow impulse emerges that sends EBITDA surging, CFOs and Treasurers will cut down on shareholder friendly activities, instead focusing on cash harvesting. This has already been observed in the recent sharp decline in stock buybacks, which however at least for the time being has been offset by an increase in dividends.
As we said, all of the above assumes no increase in rates. However, if as the Fed warns rates are set to rise, however gradually, all of these trends will simply accelerate, resulting in a revulsion toward risk and leading to liquidation of risky assets.
Or, as Barclays would put it, the "party is almost over"