04/01/2022
Deleveraging the Balance Sheet
Read an interesting article this week on Moneyweb written by Ciaran Ryan in which he highlights the steady deleveraging recently by companies on the JSE as interest rates start to edge up again. The obvious implication is that companies are trying to get as much debt off their Balance Sheets as possible as their debt servicing costs start to rise.
However, is this really a sensible strategy?
Certainly, companies who fear that they will not be able to service debt or are on the verge of a ratings downgrade at their current debt levels, would be well advised to reduce debt levels, but this would apply regardless of the interest rate outlook. The article, for example, mentions Sasol and Aspen as companies who have cut debt aggressively, but they were very much forced to by ratings agencies and Investors who demanded action to trim the high and unsustainable leverage levels. For them, the deleveraging process started even before COVID reared its ugly head and really had nothing to do with the impending interest rate rise.
If there is a drive to deleverage right now due to interest rates rises, it is most likely because management are trying to protect earnings. Makes obvious sense. Higher interest costs on the Income Statement leads to lower Headline Earnings Per Share (HEPS).
The problem is that deleveraging solely to protect short term earnings, is likely to cause a more fundamental problem with the company’s Weighted Average Cost of Capital (WACC). As debt is reduced, equity capital becomes more a prominent feature in the company’s overall capital structure (Capital Employed = Debt + Equity) and, since equity is generally much more expensive that debt and will also tend to rise as interest rates rise, having more of this in the capital structure is likely to raise the WACC.
The implications of this is that, as we emerge from covid and companies reinvest to rebuild their businesses, companies with a high cost of capital is going to find it harder to identify those investment opportunities (Projects or M&A) which generate a return higher than their WACC. Shareholders are therefore likely to see a destruction shareholder value as investments struggle to make the hurdle or see their company not making any new investments at all and being left behind by the competition.
So why would management want to deleverage just to protect short term profits? Well, call me a cynic, but could the fact that, in most cases, management bonus incentives are based on HEPS growth might have something to do with it…?
I won’t speculate, but suffice to say Investors should question any aggressive deleveraging exercise and, in particular, the effect it may have on WACC.
Frank Vein – Founder, Future Capital
