Original Article in link-- (all copyrights, content belongs to Forbes)
In the boom years before the
pandemic, the Fed encouraged S&P 500 titans to binge on trillions in debt,
now the central bank is propping them up to avoid an economic catastrophe.
When
chief executive Doug Parker took the pilot’s seat at American Airlines
in December 2013, it seemed as though clear skies were ahead. His U.S.
Airways had finally bagged a major partner by agreeing to combine with bankrupt
American. The new company would emerge with modest debt as the nation’s largest
airline, with only three domestic carriers left among its global
competitors.
The
financial crisis was well in the past, the economy was humming and travel
seemed to be entering a new golden age. Carriers like American had mastered the
science of dynamic fare pricing, and now nearly every seat on every flight was
full, maximizing revenue and efficiency. Hailing the arrival of a “new American”
by early 2014, Parker was eager to please Wall Street. “I assure you that
everything we’re doing is focused on maximizing value for our shareholders,” he
said on a call with investors.
Over
the next six years, Parker borrowed heavily, tapping capital markets no fewer
than 18 times to raise $25 billion in debt. He used the money to buy new planes
and shore up American’s pension obligations, among other things. A host of
passenger fees for additional baggage, more legroom, in-flight snacks, drinks
and more helped swell the bottom line to $17.5 billion in combined profits from
2014 to 2019. Keeping his pledge, Parker declared a regular dividend in
2014—American’s first in 34 years—and began buying back billions of the
airline’s stock.
“Holding more cash than the company needs to
hold is not a good use of our shareholders’ capital,” he reasoned. That was
music to hedge funders’ ears as they piled into American stock. Even Berkshire
Hathaway’s Warren Buffett bought a chunk of the company. Out of bankruptcy, its
stock took off almost immediately, doubling during Parker’s first year on the
job. For his managerial brilliance, Parker was rewarded with annual
compensation surpassing $10 million.
Fast-forward
to April 2020, and a contagion known as SARS-CoV-2 has leveled the travel
industry. American Airlines is flat broke, in part because of Parker’s
profligate spending. Now the U.S. government has agreed to advance it $5.8
billion in the form of grants and low-interest loans—the largest payment to any
airline in the government’s $25 billion industry bailout package. Many hedge
fund investors have sold their shares, as has Berkshire Hathaway. American
stock is now worth just one-third of the $12 billion Parker spent on buybacks
alone.
Despite
recent boom times, American’s balance sheet is a disgrace. Over the last six
years, Parker added more than $7 billion in net debt, and today its ratio of
net debt to revenue is 45%, about double what it was at the end of 2014.
American says it plans to pay down its debt “aggressively” as soon as business
returns to normal.
Debt-laden
American Airlines is not an outlier among the nation’s largest corporations,
though. If anything, its financial gymnastics might well have been a playbook
for boardrooms around the country. Year after year, as the Federal Reserve
pumped liquidity into the economy, some of the biggest firms in the United
States—Coca-Cola, McDonald’s, AT&T, IBM, General Motors, Merck, FedEx, 3M
and Exxon—have binged on low-interest debt. Most of them borrowed more than
they needed, often returning it to shareholders in the form of buybacks and
dividends. They also went on acquisition sprees. Their actions drove the
S&P 500 index ever higher—by 13.5% on average annually from 2010 through
2019—and with it came increasingly rich pay packages for the CEOs leading the charge.
The coup de grâce was President Trump’s 2017 tax cut, which added even more
helium to this corporate-debt balloon.
Blue Chip Debt Junkies
Few
companies have been able resist the lure of leverage. Below are some of the
biggest borrowers.
According
to a Forbes investigation, which analyzed 455 companies in the
S&P 500 Index—excluding banks and cash-rich tech giants like Apple, Amazon,
Google and Microsoft—on average, businesses in the index nearly tripled their
net debt over the past decade, adding some $2.5 trillion in leverage to their
balance sheets. The analysis shows that for every dollar of revenue growth over
the past decade, the companies added almost a dollar of debt. Most S&P 500
firms entered the bull market with just 20 cents in net debt per dollar of
annual revenue; today that figure has climbed to 38 cents.
But
as the coronavirus pandemic cripples commerce worldwide, American corporations
face a grim reality: Revenues have evaporated, but their crushing debt isn’t
going anywhere.
A
year ago, Federal Reserve chairman Jerome Powell sounded an alarm, but he could
barely be heard above the roar of the ascendant stock market. “Not only is the
volume of debt high,” said Powell last May, “but recent growth has also been
concentrated in the riskier forms of debt. . . . Among investment-grade bonds,
a near-record fraction is at the lowest rating—a phenomenon known as the
‘triple-B cliff.’ ” Powell was referring to the fact that a large number of
companies’ bonds were dangerously close to junk status. “Investors, financial
institutions and regulators need to focus on this risk today, while times are
good.”
Powell
has stopped preaching. Facing the frightening prospect of widespread corporate
insolvencies, the Fed on March 23 announced a credit facility designed to
support the corporate bond market. Two weeks later, the central bank stunned
Wall Street by saying it would go into the open market to buy some junk bonds
as well as shares in high-yield bond ETFs.
In the last two months alone no fewer
than 392 companies have issued $617 billion in bonds and notes, piling on
still more debt that they may not be able to pay back.
All
told, the Federal Reserve is now earmarking $750 billion, supported by $75
billion from taxpayers, to help large companies survive the pandemic—all part
of its $2.3 trillion rescue package.
“We
have a buyer and lender of last resort, cushioning pain but taking over the
role of the free market,” groused Howard Marks, the billionaire cofounder of
Oaktree Capital, in a memo April 14. “When people get the feeling that the
government will protect them from [the] unpleasant financial consequences of
their actions, it’s called ‘moral hazard.’ People and institutions are
protected from pain, but bad lessons are learned.”
The
lesson to corporate-debt junkies is clear: Taxpayers be damned, the federal
spigot is wide open. In the last two months alone, according to Refinitiv, no
fewer than 392 companies have issued $617 billion in bonds and notes, including
a record number of triple-B issues, piling on still more debt that they may not
be able to pay back. As Warren Buffett observed during Berkshire’s annual
shareholder meeting on May 2, “Every one of those people that issued bonds in
late March and April ought to send a thank-you letter to the Fed.”
America’s foremost corporate
citizens—companies found in nearly every retirement account—did not become debt
dependents all by themselves. It took some prodding, mostly by Wall Street’s
savviest participants. Take the case of McDonald’s, known for restaurants in
nearly every town in the U.S., its iconic golden arches offering fast,
budget-friendly meals to billions.
It
all started before the 2008 crisis, when billionaire investor Bill Ackman began
agitating the Chicago-based burger behemoth, demanding that it divest most of
its 9,000 company-owned stores to independent operators in order to buy back
$12.6 billion in stock. McDonald’s successfully repelled the hedge fund
activist, but during the recovery, its growth stalled.
Starting
in 2014, McDonald’s chief executive, Don Thompson, began piling on leverage to
fund share repurchases. A year later his successor, Steve Easterbrook, amped up
Thompson’s strategy by selling company-operated restaurants to franchisees,
just as Ackman had wanted. Today, 93% of the 38,695 McDonald’s worldwide are
operated by small entrepreneurs who cover maintenance costs and pay the parent
company rent and royalties for the privilege of operating in its buildings,
using its equipment and selling its food.
The
new and improved “asset light” McDonald’s no longer manages cumbersome assets;
instead, it receives those payments and is sitting on tens of billions in debt.
From 2014 through the end of 2019, McDonald’s issued some $21 billion in bonds
and notes. It also repurchased more than $35 billion in stock and paid out $19
billion in dividends, returning over $50 billion to shareholders, far in excess
of its profit ($31 billion) over that period.
That
was just fine by Wall Street. McDonald’s became a hedge fund darling, its
shares more than doubling during Easterbrook’s tenure, from 2015 to 2019. His
reward was $78 million in generous pay packages over five years.
The
risk added to McDonald’s balance sheet has been dramatic, however. In 2010, the
company carried just 38 cents in net debt per dollar of annual sales, but by
the time Easterbrook was fired in late 2019 amid news of a workplace affair, it
had $1.58 in net debt per dollar of revenue.
Today
its net debt stands at $33 billion, nearly five times greater than before the
financial crisis. Its bonds are rated triple-B, two notches above junk, down
from their A rating in 2015.
A prolonged recession could push some
overleveraged firms toward insolvency, especially if interest rates rise and
the Treasury’s multitrillion-dollar “save the economy at any price” plan makes
inflation do the same.
With
most of its restaurants nearly empty during the pandemic, McDonald’s stock
initially fell by almost 40%. Thanks to the Fed’s intervention, though,
McDonald’s debt, which at first slumped to 78 cents on the dollar, recovered
along with the stock, as the company quickly raised an additional $3.5 billion.
McDonald’s insists that it entered the crisis with a strong balance sheet and
overall financial health. It recently suspended its share repurchases.
The
startling truth, though, is that the burger giant’s leverage is actually modest
compared to one of its foremost competitors, Yum Brands, the $5.6 billion
(revenue) owner of Pizza Hut, Taco Bell and KFC. After Greg Creed took charge
as CEO in 2015, activist hedge fund managers Keith Meister, of Corvex
Management, and Daniel Loeb, of Third Point, took big positions. By October of
that year, Meister was on Yum’s board of directors; days after his appointment,
the company said it was “committed to returning substantial capital to
shareholders” and spinning off its Yum China division, which generated 39% of
its profits.
Over
the next year, Creed borrowed $5.2 billion to fund $7.2 billion of stock
buybacks and dividends. Yum retired some 31% of its common shares, and as
expected, its stock price doubled to over $100 by the end of 2019. Shareholders
were thrilled, but Yum’s financial staying power was severely compromised. In
2014, Yum had just $2.8 billion of net debt, accounting for 42% of net revenue;
by 2020, that figure had swelled to $10 billion, or 178% of net revenue.
Heading into the coronavirus economy, Yum was a basket case, but thanks to the
Fed and a $600 million bond issue in April, it will live to see another
day.
Yum
management scoffs at the idea that the Fed helped in any way. “We’re not aware
of Federal Reserve intervention in the high-yield market or in our ability to
issue $600 million of high-yield bonds,” the company says.
Like
McDonald’s, Yum sold many of its company-owned outlets to independent
franchisees. Without access to capital markets and the Fed’s largesse, their
future isn’t so certain. Yum is giving some of its franchise owners a 60-day
grace period to make their royalty payments. David Gibbs, who replaced Creed as
CEO in January, speculated at the end of April that if need be it would take
over the franchises and sell them off.
Of
course, some argue that the de facto leveraged buyouts of publicly traded
companies like McDonald’s and Yum were actually prudent given the Federal
Reserve’s decade-long easy-money approach to monetary policy. “As a corporate
finance matter, it was almost irresponsible to overfinance with equity given
that [debt] was unbelievably cheap,” says Arena Investors’ Dan Zwirn.
According
to the St. Louis Federal Reserve, as of the end of 2019, non-financial business
debt totaled $10 trillion, climbing 64% from the beginning of the decade.
“Every penny of the quantitative easing by the Fed translated into an equal
match of corporate debt that went into share buybacks, which ultimately drove
the share count of the S&P 500 to the lowest level in two decades,” says
economist David Rosenberg. “This was a debt bubble of historic proportions. . .
. Then again, nobody seemed to mind as long as the gravy train was still
operating.”
If
there were an award given for corporate recklessness, however, few
would challenge mighty Boeing, the world’s largest aerospace and defense
manufacturer and the nation’s single biggest exporter. Once the pride of
industrial ingenuity in America, Boeing has been hypnotized by the lure of
financial engineering.
Starting
in 2013, the Chicago-based company decided it would make sense to commit nearly
every penny of profit, and then some, to its shareholders. It sent $64 billion
out the door—$43 billion worth of buybacks and $21 billion in dividends—saving
little under CEO Dennis Muilenberg to cushion against the industry’s expected
hazards, such as manufacturing difficulties, labor disputes and
recessions.
After
two of its 737 MAX planes crashed within five months and the FAA grounded the
aircraft in 2019, Boeing’s aggressive financial policies were exposed, and it
was forced to turn to debt markets for emergency cash. The company, which had
essentially no debt in 2016, ended 2019 with $18 billion in net debt. This
March, Boeing drew fully on a $13.8 billion credit line to contend with the
grounding of air travel, and Standard & Poor’s downgraded its credit rating
to the lowest rung of investment-grade.
Boeing
flirted with a bailout, initially asking the government for $60 billion for the
aerospace industry. But in late April, chief financial officer Greg Smith told
investors the Defense Department was taking steps to bolster its liquidity, and
that the Coronavirus Aid, Relief and Economic Security (CARES) Act had helped
it defer some tax payments. Boeing also began weighing funding options from
programs run by the Treasury and Fed. “We believe that government support will
be critical to ensuring our industry’s access to liquidity,” said Boeing’s new
CEO, David Calhoun, on April 29. The next day, Boeing launched a $25 billion
bond offering, eliminating the need for a direct bailout. The issuance, which
includes bonds that aren’t redeemable until 2060, was oversubscribed, as
institutional investors no doubt assumed that Boeing’s recovery was a matter of
national importance to the government.
While
delivering cash back to shareholders was an obsession of Boeing’s CEO, becoming
a giant in entertainment via acquisitions has been the hallmark of Randall
Stephenson’s 13-year tenure as CEO of AT&T. Since his start atop the 143-year-old
company once revered as Ma Bell, Stephenson has spent more than $200
billion—mostly on acquisitions of DirecTV and Time Warner, among others, but
also on stock buybacks and the telecom’s $2 annual dividend. All told,
Stephenson piled on almost $100 billion in new net debt. “AT&T is the most
indebted non-financial company the world has ever seen,” says telecom analyst
Craig Moffett.
Race
To The Top
Corporate
debt has skyrocketed to more than $10 Trillion, according to the St. Louis Fed,
but it may ultimately be overtaken by the government. Said Fed Chairman Jerome
Powell on 60 Minutes recently: “We’re not out of ammunition by
a long shot.”
Hedge
fund shareholder Elliott Management minced few words when it comes to
Stephenson’s antics: “It has become clear that AT&T acquired DirecTV at the
absolute peak of the linear TV market,” Elliott said of the $67 billion
purchase in a September 2019 letter to the board. As for the $109 billion
Stephenson spent on Time Warner, “AT&T has yet to articulate a clear
strategic rationale for why AT&T needs to own Time Warner.”
Elliott,
long known for rattling corporate cages, contended that Stephenson’s worst deal
was his $39 billion run at T-Mobile in 2011. “Possibly the most damaging deal
was the one not done,” Elliott said in the same letter, referring to the
year-long waste of corporate resources capped by AT&T’s ultimate withdrawal
from the deal, which forced it to pay T-Mobile a record $6 billion breakup fee.
“[AT&T] capitalized a viable competitor for years to come,” Elliott’s
letter said.
Elliott
and other investors were no doubt feeling ripped off by AT&T. Unlike
Boeing, whose debt gorging and buybacks caused its stock to soar, AT&T’s
shares have gone nowhere for a decade. What the debt-dependent duo do have in
common is that financially, at least, they bear little resemblance to their former
blue-chip selves.
Shocking
as the pandemic of 2020 has been to the global economy, the fallout
from a decade of debt binges by corporate giants might be only beginning. The
landscape is littered with companies suffering from self-inflicted wounds. A
prolonged recession could push some overleveraged firms toward insolvency,
especially if interest rates rise and the Fed’s multitrillion-dollar “save the
economy at any price” plan makes inflation do the same.
Altria,
the seller of Marlboro cigarettes, increased its net debt from $10 billion to
$26 billion over the past decade, spending most of its operating cash flow on
dividends and share repurchases and wasting $15 billion on stakes in Juul Labs
and cannabis company Cronos Group with little payoff. The cigarette merchant
now holds $1.31 of net debt per dollar of annual revenue, up from 58 cents in
2010.
For
most of its 118-year history, Minnesota’s 3M, the maker of N95 masks, Post-It
notes and Scotch tape, carried almost no leverage. From 2010 to today, however,
its net debt has swollen 17-fold to nearly $18 billion, or 55% of revenue.
Standard & Poor’s downgraded 3M’s bonds in February, and it was among the
first issuers to tap unfrozen bond markets in late March.
O’Reilly
Automotive, the $10 billion (revenue) Missouri-based auto-parts retailer, has
been one of the decade’s stock market darlings. The family-run business
discovered cheap debt in the 2010s, using it to buy back $12 billion in stock
and retire nearly half its outstanding shares. Over the decade, its net debt
ballooned almost 12-fold to $4 billion. O’Reilly took on another $500 million,
just in case, on March 25.
General
Dynamics, known for its Navy ships, Gulfstream jets and government contracts,
had little debt in 2010, but since CEO Phebe Novakovic took over in 2013, it
has bought back about $13 billion in stock and paid out $6 billion in
dividends, finishing last year with $11 billion of net debt.
IBM
has been a buyback champion for years, paying 90% of its free cash flow to
shareholders to return $125 billion to them from 2010 to 2019. Big Blue’s debt,
including customer financing, has grown from 17% of net revenue to 70%, with
$52 billion in net debt currently outstanding.
Even
Berkshire Hathaway got caught up in the great debt binge. In 2013, Buffett
teamed up with Brazilian private equity firm 3G Capital, cofounded by
billionaire Jorge Paulo Lemann, to buy H.J. Heinz for $28 billion and, two
years later, Kraft Foods for $47 billion. The resulting company was stocked
with brands of yore such as Jell-O, Velveeta and Oscar Mayer—as well as $30
billion of debt. After floating a $143 billion takeover of Unilever that would
have reportedly required $90 billion of additional debt, business at the
massive food conglomerate began to spoil.
Kraft’s
market capitalization has plunged from $118 billion at its peak in February
2017 to $38 billion, and Berkshire Hathaway’s shares, which are carried on its
books at $13.8 billion, now trade for just $10 billion. In February, both
S&P and Fitch cut Kraft’s bonds to junk. Kraft Heinz maintains that its
balance sheet, and the demand for its brands, are strong.
In
the oil patch, meanwhile, many are too sick even to take advantage of the Fed’s
generosity. Vicki Hollub, the CEO of Occidental Petroleum, has increased its
net debt nearly fivefold since she took over in 2016, to $36 billion, not
counting the $10 billion in preferred financing Hollub took from Buffett. Her
$55 billion takeover of Anadarko Petroleum closed last August—just in advance
of the worst oil-price plunge since the 1980s as Russia and Saudi Arabia
flooded markets with supply early this year. With West Texas Intermediate crude
hovering near $30 a barrel as of press time, Occidental looks to be heading for
restructuring or even bankruptcy.
If
Oxy is allowed to go bust, though, it will probably be the exception. The U.S.
government can’t afford to let market forces alone dictate the future of too
many companies. Already, retailers Neiman Marcus, J.Crew and JCPenney have
filed for bankruptcy. The Federal Reserve has made it clear that to try to avoid
global economic devastation worse than that seen during the Great Depression,
it regards the nation’s largest publicly traded companies as, basically, too
big to fail. “The Fed and Treasury have essentially created a new moral hazard
by socializing credit risk,” wrote Scott Minerd, CIO of Guggenheim
Partners.
BlackRock
is predicting an expansion of the Federal Reserve’s balance sheet by a
“staggering” $7 trillion by the end of the year.
In
some ways, it seems, the Fed’s actions are tantamount to trying to cure
addiction by increasing the dosage of the very substance the addict is
abusing.
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