For industries where Enterprise Value (EV) metrics are the preferred valuation method, the Private Equity model of “leveraging up the balance sheet”, has proven extremely effective over time. Mimicking this strategy in the public markets has been claimed by numerous value funds, but has been best quantified and popularised by Dan Rasmussen of Verdad Advisors.
The benefits are logical and real; if a company is small, levered, has predictable and strong cashflows and is paying down debt, the transfer of EV (market capitalisation + net debt) from debt to equity is very powerful. Additionally, the lack of need for a buy-out premium is a big advantage, although this obviously comes without control over capital allocation. This is why Rasmussen’s model seeks out companies whose management are already optimising for shareholder value.
This debt paydown is a surprisingly effective form of shareholder return in a leveraged equity. It not only passes value to the owners, but makes the company safer and achieves it in a tax efficient manner. Of course, leverage is a double-edged sword and too much can be crippling.
One of the fortunate things to come out of the pandemic is many old economy business models undertaking a major stress test. We now have a better idea of just how resilient many are and this is very informative with regards to how much debt a company can comfortably handle and the reliability of its cashflows.
I have been considering where the debt sweet spot is. How do you maximise the return that comes with growing equity within EV, while sleeping well at night?
As Rasmussen said in a 2018 podcast with Meb Faber (that really can’t be recommended enough), while outlining his strategy:
“If you look at the public equity markets of companies that are leveraged six times EBITDA, I’ll show you a basket of companies that are on a path to bankruptcy.”
So we can safely take that as an upper yardstick given that very few have done the empirical work of Verdad on small cap value.
There are also examples of too little leverage (at least in this respect)- what PE analysts would call a “lazy balance sheet”. Net cash is a great thing in many ways, but will dull returns to equity in proportion to EV.
I would argue that the market doesn’t give a lot of credit to a company with no debt improving to a modest net cash position. The markets are filled with companies like this (especially in Japan and Hong Kong) and while they are very safe, there tends to be a skepticism about how the funds will be used or whether they will have to be ploughed back into the business at some point.
But a peer with more debt, that generates the same returns and puts them toward the balance sheet (lowering net debt) will create significant value. Take the case of company A and B, both trading at 6x EBITDA, with consistent cashflows. The difference being A is debt free (ie. its EV is all equity), while B’s EV is 50% equity (or net debt/EBITDA 3x).
If over three years A and B both rerate to 9x EBITDA, the return to A will be 50%, while the benefits of gearing will provide B with a 100% return. Although, this would be messier in real life, with B having interest payments leaving less cash for the improvement of the business.
Adding debt paydown into the equation only makes the point starker. If both companies generate 10% of their EV in FCF and put this straight on the balance sheet (not compounded), after year 3 company A will have a healthy cash buffer and have lowered its enterprise value by the same amount. The rerating to 9x (starting)EV/EBITDA will now have given an 80% return- not bad.
However, Company B will have produced an outstanding 140% return on its equity and will now likely be much better percieved by the market, with fewer stomach ulcers amongst the executives!
This is why I have stressed in the past the importance of finding the balance between absolute safety and modest, survivable leverage. Getting this mix right should provide superior returns over the full cycle.
Below I will briefly discuss this concept with reference to several companies- two I own, one on my watchlist.
Ambev
Ambev is a Brazilian brewing giant I greatly admire. The company is a subsidiary of AB Inbev, is well run and has grown strongly in Brazilian Real terms, even managing to grow revenue 4.7% and volumes by 1.4% last year, despite lockdown impacts.
The business is diversified across the Americas, with 52% of revenue generated in Brazil, 20% in (other) South America, 16% in Canada and 12% in Central America and the Carribean. If there are market doubts about Ambev, I believe they lie with the Brazilian macro outlook- the company is a quality, cash-flowing business at a reasonable price.
Ambev produces some of the most popular beers in South America including Quilmes, SKOL and Brahma and has strong emerging market growth tailwinds behind it- both population and middle class. Current CEO Jean Jereisatti has been in the role since early 2020, but originally joined the company in 1998.
I bring the Ambev up due to its unlevered status, as it has a pristine balance sheet with net cash of R$11.4b and generated $19b in cashflow from operations last year.
TTM (trailing twelve month) EBITDA was R$24.6b, although this is likely to improve over the 2021 full year, as its markets continue to move past the pandemic. I estimate 2021 full year EBITDA of R$27b placing the company on 9.4x EV/EBITDA, comparing favourably to AB Inbev on 11.5x, Heineken on 16x and Kirin Holdings on 12x.
In my opinion, a fair EV multiple for Ambev is 16x EBITDA. An enticing 70% upside on re-rating alone, but the company is a working example of company A above. In return for its safety and stability, it will not see gains as spectacular as a leveraged competitor might.
There other reasons to expect additional returns from the business, such as continued growth and a recovery in the Central and South American economies and a pick up in the Real with current commodity price strength, but leverage won’t be a contributor.
Liberty Latin America
LILAK is a long-term holding I first bought in 2018 and wrote about briefly last year (around its rights issue). The company is a telco operating in Latin America and the Carribean with its largest markets including Chile, Puerto Rico, Costa Rica and Panama (all under-penetrated internet markets) and originates from the John Malone stable.
Malone is known for his financial wizardry and clever use of leverage, but since spinning-off from Liberty Global in 2017, the share price has made a remarkably consistent down-and-to-the-right pattern!
There have been a lot of value investors burned in the name and the mention of it generally draws groans, but under the surface the business has executed well and is expanding its subscriber base relentlessly, as well as making sensibly priced acquisitions.
LILAK measures itself on OIBDA (Operating Income Before Depreciation & Amortisation) to seperate out its core operations, but the number is similar to traditional EBITDA most years. It recorded TTM OIBDA of $1.5b to June 30, although I expect the 2021 number closer to $1.8b (or $1.7b after stock-based comp) due to the ongoing pandemic recovery and the AT&T Puerto Rico and Telefonica Costa Rica (recently fully approved) assets scaling into the mix.
The business is heavily leveraged with net debt of $7.75b- net debt/EBITDA of 4.6x, certainly the higher end of the comfort range. However, LILAK proved resilient last year and has an excellent CEO (Balan Nair) who is acutely aware of the strategy he is carrying out.
LILAK will continue to grow quickly in its markets, targeting high leverage while doing so, and is modestly priced at an EV of 6.5x est. 2021 OIBDA. Even without assuming further growth, I expect it to trade towards 10x OIBDA on improving EM sentiment and greater recognition of its fundamentals.
That LILAK’s equity is currently only 30% of its EV shows how great this return could be. Maintaining current debt levels at my target multiple would give a 175% return or $40 share price ((10x $1.7b) -$7.75), on fairly benign assumptions.
Micro Focus
Micro Focus is a UK enterprise software business, which traditionally held a great niche in buying legacy programs and adapting them into clients existing systems. This model is currently facing erosion due to cloud competition and the disastrous acquisition of HPE Software in 2018. I have written about the company before (here and here) and it is good analogy to company B above, under our debt paydown scenario.
The beauty (or curse) of the company’s high debt level is that management are forced to act in a highly value accretive manner.
Given that the company is undergoing a turnaround and its success is uncertain, paying down debt simply must happen from current levels of 3.6x EBITDA, before management can meaningfully pursue other avenues.
Micro Focus has traditionally seen very strong free cash flows, but is actively trying to fortify these now, as the business faces declining revenues. Given that it is my largest holding, I believe they will succeed, but a weak H1 result was enough to encourage fast deleveraging.
I originally bought the company in late 2019 at $14/share, before adding at $4.90 and $3.70 last year, to the point were my cost basis approximates the current price. The good news is that even after rallying back somewhat, Micro Focus is still priced for oblivion at an EV of 5.3x EBITDA- unheard of for a cashflow positive software business.
Despite this market sentiment there are reasons to be optimistic, the company’s model is sticky due to their client’s interwoven software platforms and 70% of their revenues are recurring. They also signed a deal, last year, to help customers integrate to AWS that would see Amazon take a stake in Micro Focus.
Assuming a stabilisation of the business, I believe Micro Focus should trade at an EV/EBITDA of 12x. Management are optimistic that they are gaining traction with the turnaround and a return to growth would make such a multiple very achievable.
Here we witness the leverage and debt paydown combination. Taking three years to reach 12x, with no growth included, but paying down $150m of debt from FCF each year would give an equity value of $10b or 5x today’s price (($1.14b x12) -$4.12b +$.45b).
Summary
As often in investing, on the question of how much levergage is optimal, the answer is a hard “it depends”. I hope I have explained some of my thoughts on the issue through interesting examples, as well provoking thought that runs counter to the debt=bad dogma, running heavily through value investing.
I own shares in Liberty Latin America and Micro Focus.
Guy
Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.
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