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Why Do Companies Hold Long-Term Debt?

14 September 2010 4 Comments

I’ve become a bigger investing nerd recently.  As I mentioned the other day, I’ve been reading some annual reports from companies, namely Wal-Mart Stores, Inc. (WMT) and Philip Morris International (PM).  Two stocks that I do invest in and discuss frequently on this blog.  One of the interesting components of the annual reports that I read over a few times is the comments on the long-term debt that each of these companies hold.

Another company that I’m fairly familiar with is Apple, Inc. (AAPL).  Interestingly, Apple holds no long-term debt and hoards a ton of cash ($40 billion plus).  Why does a company like Apple hold no debt, yet companies like Wal-Mart and Philip Morris do?  Clearly, Wal-Mart and Philip Morris are successfully managed companies, as is Apple, so what gives?

Here are my thoughts…

Shareholder Return

Both Wal-Mart and Philip Morris are focused on shareholder return.  Both have increasing dividend payouts and share buyback programs that are in place.  Apple does not pay dividends as of now.  Now, returning money to shareholders via dividends and buybacks does not necessarily warrant debt.  You can definitely fund these programs via the loads of operating cash that their businesses are generating.  With that said, the debt allows these companies to have significant levels of liquidity while at the same time funding dividends and buybacks.

Apple could still have high levels of liquidity and do some level of dividends, but they choose not to for some reason.

The question from management is where is the best return?  Apple feels like the cash can be used to generate larger returns maybe via acquisitions or other investments into their business.

Wal-Mart and Philip Morris do invest some money into their business, but at this point perhaps in the growth cycle, they feel that they can return value to shareholders via buybacks and dividends.  Furthermore, if management feels their share price is undervalued, then borrowing money to purchase shares could actually be very lucrative – of course, this has indeed backfired with many companies before.

If shares are undervalued and the cost of debt is cheap, it can be a good situation for shareholders.  You just hope management makes the right call here.

Inflation

Another interesting aspect of this scenario is inflation.  If inflation is indeed around the corner and is to be higher in the future, then borrowing money at insanely low rates – most of the long-term debt for Wal-Mart is in the 5% range – is a no-brainer.  Inflation rewards the borrower and kills the saver.  If inflation is a certainty, than as a shareholder, you don’t want Apple sitting on a pile of cash.

If inflation is coming, you want your company to borrow money to buyback shares and distribute dividends to shareholders.  You want that money now so you can reinvest it.

When Debt Can Back Fire

The biggest problem for companies that carry debt is higher rates.  If interest rates increase, the cost of servicing the debt can shoot up as companies roll over debt into new issuances.  If the debt servicing costs shoot up, it can really impact liquidity and earnings.

If cash and/or earnings power dries up, companies might find it difficult to get financing and enter into a liquidity crunch.  This is sort of what happened in late 2008 when companies simply could not get funding and had to close up shop.  As a buddy of mine recently told me, companies rarely go under due to losses, but more due to a lack of liquidity.

Stability

Wal-Mart and Philip Morris both represent high quality businesses with very stable cash flows.  Both businesses are sort of recession-resistent and have relatively stable demand for their businesses and products that they sell.  Businesses with high degrees of stability don’t worry me too much if they carry some debt – assuming the debt levels remain manageable.  Contrast this with a startup or a business that is highly dependent on a cyclical economy.

Obviously, less debt is better, but as interest rates hit historic lows, companies with stable cash flows can take advantage of cheap money and work to generate outsized returns for their shareholders.

4 Comments »

  • TaJ said:

    The companies might also be hoping for the possibility that in the future the global desperation for stability and yield will decrease, allowing them to buy back their debt more cheaply than they issued it. If you believe that there's a bond bubble, as many people do, and you're in the position to issue high-quality bonds… well, why wouldn't you? Sell high, buy low… or something like that.

    It strikes me as a win-win proposition for large, stable companies, as long as they don't go overboard. Of course, knowing when to quit is always the problem, isn't it?

  • Mrs. Money said:

    I think it's interesting how companies hold long term debt too. I guess if I was operating a large company I would do my best not to have debt, but I guess not everyone agrees. :)

  • BPG said:

    For some of these companies, they may not even need the debt. Investors are so hungry for bonds, and they can be issued at such low rates, companies are taking on debt they don't even need at the moment. Just look at Mcdonalds. In July it issued 10 year notes at 3.5%, the lowest of any company since 1995. It's called "opportunistic financing." I would bet some of them just feel like cash is so cheap right now they would be dumb not to capitalize on it.
    http://dividendpig.blogspot.com/

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