A business with less risk than ADP would be hard to imagine. It dominates the processing of payrolls and health-care contributions in America. Both of these markets demand massive economies of scale and a reputation sufficient to pacify nervous human-resources departments and ever-more-intrusive regulators, two attributes that favor an established player. Current returns are good; future returns look likely to be the same.
A benign outlook, however, was not enough to prevent the loss in April of rare AAA credit ratings, the best possible, from Standard & Poor’s and Moody’s. The cause of ADP’s downgrade was entirely voluntary: the company wants to spend the $700 million it expects from spinning off a small division on share repurchases, instead of keeping or otherwise investing the cash.
ADP is hardly the only firm levering up its balance-sheet, by adding more debt relative to equity, thus adding a dollop (or more) of risk. On May 20 Morningstar, another ratings service, noted that Time Warner was issuing new debt specifically to increase its leverage. The proceeds will probably be used to pay for share buy-backs. Across the economy, debt issued by creditworthy (or “investment grade” in the industry parlance) firms has increased to 2.7 times EBITDA, a measure of profit, from about 2 times three years ago, reckon analysts at Wells Fargo, a bank (see chart below).
One consequence is to create a bit of excitement in at least one corner of the financial universe. Banks may be reluctant to extend credit, but the capital markets are clearly open. Last year set a record for the issuance of both speculative and investment-grade debt. This year the speculative side of the market, once derided as “junk bonds,” is not quite so strong, but issuance by investment-grade companies is running 10 percent ahead of last year, reckons Hans Mikkelsen, an analyst at Bank of America Merrill Lynch.
Companies are increasing their borrowing for three main reasons. The most obvious is that interest rates are low, meaning a key cost, borrowed money, can be obtained cheaply. That can result in higher returns to shareholders. Moreover, rates are likely to rise, which is encouraging companies to lock in low rates while they can.
A second driver is the resurgence of activist investors which, emboldened by a benign economic environment, are pushing firms to return to shareholders cash that had been retained for a rainy day. There are weekly announcements of one hedge fund or another pushing a company to buy back shares, as much for short-term reasons — a large buyer in the market might temporarily push up the price of a stock — as for longer-term ones.
And then, inevitably, there is tax. Many large companies are quietly following the well-publicized example of Apple by issuing debt to fund dividends or buy-backs rather than repatriating cash held overseas that would trigger large tax payments. Aside from the quirk of holding cash abroad, debt itself offers tax benefits: interest payments are tax-deductible and push down taxable earnings.
All this goes some way towards reducing the structural disadvantage long-established companies have in competing with private-equity firms and other more recently structured listed partnerships which pay little or no taxes. It is also fueling a boom of buy-outs, since a finite span of cheap money suggests a finite opportunity to buy another firm. This is happening despite the risk of lowering the credit rating of the new, combined entity. Typically these deals and buy-backs are announced along with statements of confidence about cost savings, expanded marketing reach and better days to come.
One plausible inference of this penchant for borrowing and deal making is that America’s economy is at last gaining traction. Another is less sanguine. Underlying cash flow of big companies has been growing at 2 to 5 percent annually, reckons George Bory, an analyst at Wells Fargo. Corporate debt, in contrast, is growing at a rate in excess of 10 percent a year.
A bit of this disparity may be overstated. Bory notes that higher corporate debt is at least partially offset by higher holdings of cash (though some of this is awkwardly offshore). Even so, the sharp tick-up in corporate leverage ought to sound a warning to investors. It may suggest that increasing returns to shareholders are coming not from genuine growth but from stretching balance-sheets. To some, that will sound depressingly familiar.
©The Economist Newspaper Limited, London, May 31, 2014