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  • Leverage and the world in 2009

    Posted by Carl from Chicago on January 5th, 2009 (All posts by )

    A recent article focused on satellite radio and the merger of XM and Sirius. In an interview with CEO Mel Karmazin, he said:

    Ironically, one rationale for the merger was the expectation that the combined company could borrow money more cheaply. “The bankers who covered the deal believed that one of the synergies of the merger was the ability to refinance at a lower level,” says Mr. Karmazin. Consider this: five years ago, Sirius, with 300,000 subscribers and no hint that Mr. Stern would be gracing its channel lineup, borrowed money at 2.5 percent interest. Those days are long gone. “Warren Buffett managed to get a 10 percent coupon from G.E. and Goldman Sachs,” says Mr. Karmazin, speaking of the interest rate that Mr. Buffett, the Omaha investing legend, was promised for his recent investments in both companies. “So if you are Sirius XM, what should the coupon be?”

    Thus the Sirius / XM stock ticker, which peaked at $9 in 2005, now trades at 12 cents. Approximately $3B in debt is outstanding for the company; since they are not cash flow positive to any significant degree and raising money through stock offerings is extremely difficult when you are a penny stock, their balance sheet is killing the company, and possibly the entire satellite radio industry as a result.

    There are two keys to this analysis – 1) the interest rate on a START UP industry which was inherently risky was only 2.5%, amazingly low (stupidly low, because the bankers are going to get burned if the company goes under) 2) at almost any price no one is willing to finance risky companies today – the liquidity is gone and the markets are essentially frozen. As Mr. Karmazin notes above, a rough guess would be that they would have to pay maybe 20% interest rates to roll their debts, which would mean that interest alone (no principal) would be $600M on $3B in debt, for a company with marginal cash flow in the first place (they currently pay around $60M+ in interest expense today).

    On what seems to be an unrelated note, let’s look at the consulting company BearingPoint. BearingPoint is a management consulting company spun off from the former KPMG (one of the “Big Six” consulting firms, now “Big Four”) with a long history. I have a lot of personal experience and contacts with this firm.

    As of the end of Q3 2008 (9/30/08), the consulting firm had approximately 15,000 employees, the vast majority of whom are consultants that bill at an average rate of about $140 / hour (estimates based on Q3 financials, assuming about 80% utilization). These employees are experienced (probably average 8-10 years of work experience) and many have advanced degrees (virtually all have bachelor’s degrees).

    And what is this company worth, a company employing so many smart people at such high billing rates? Virtually nothing. The stock ticker has been de-listed and now they trade on the pink sheets.

    Their value has been destroyed because of their balance sheet. At the time they went public, they used a lot of the IPO cash proceeds to buy out CISCO’s share of a joint venture, and then they added what seemed to be a modest amount of debt later (part of it is reasonable because they picked up Arthur Andersen’s former consulting unit cheaply when that firm imploded under investigation). However, almost any amount of debt is crushing when a company generates only a modest amount of cash flow. Like the satellite radio industry, Bearingpoint likely assumed that they’d be able to “roll over” their borrowings in a liquid market at a reasonable rate.

    While both of these companies have had problems and made management missteps (satellite radio in paying so much for talent, Bearingpoint in having financial reporting problems and a difficult IPO), they are both relatively sound businesses that in past years would have been able to refinance and climb out of their balance sheet troubles. But in the current market, both face a difficult if not dire situation.

    Pretty much anyone with small or declining cash flows (which represents MANY companies) that has debt payments coming due or a need to refinance is in a VERY bad situation right now. Unlike private home borrowers, who can seemingly always refinance at very low long term rates (about 5% for a 30 year loan) due to government intervention with Fannie and Freddie, businesses in similar situations face interest rates up to 20% if they can find any kind of lender at all. Even the companies that received Federal bailout funds are unlikely to pour more good money after bad into further loans to companies like satellite radio and consulting. And even if those companies received 20% loans, they’d soon be out of business anyways due to the crushing debt burden of servicing such rates.

    It is a new world order. If a business requires cash or needs refinancing, their equity share holders better prepare to be savagely hit if not completely wiped out.

    Cross posted at LITGM

     

    9 Responses to “Leverage and the world in 2009”

    1. Jay Manifold Says:

      This comports well with a statement by my employer’s CFO, during a division-wide teleconference less than three weeks ago, to the effect that “investor-grade” companies are being charged 15% interest by banks — fifteen points above the (effectively zero) federal funds rate if your business is prospering!

    2. Carl from Chicago Says:

      Yes it is very scary. Essentially if you need financing your business better be putting up amazing margins, because the financing costs will kill you.

      Meanwhile, you can get a mortgage on your house at 5%. Makes no sense…

    3. Obloodyhell Says:

      .

      Satellite Radio always stuck me as a stupid idea in the first place. It’s got an uphill battle convincing people to pay for something that’s always been “free”. And most importantly, by the time the infrastructure gets fully into place (esp. the receiver units) it’s almost certain to get supplanted by universal wireless internet and streaming media. Why listen to a canned station when you can play your own station?

      As far as the general problem, I think a part of this is still a holdover from the “dot-com” “New Economy”. People thought all the old rules didn’t matter — that somehow a company could operate forever without any cash flow. How and why they though that I’ve never quite grasped.

      Not to say I don’t believe the economy is in substantial flux. It is — it is in the process of changing from an Industrial, Manufactured Goods based economy to an IP & Services based economy, and the inherent properties of IP vs. Mfr. Goods are a phase change — like ice to water to steam.

      There are entire new business models and designs to scope out, and the changes will be as significant as the change from an Ag economy to an Industrial one — There are major problems with the heirarchical corporate design structure when applied to an economy based on information flowing unimpeded. Further, the cost of IP is almost entirely front-loaded — all the real expense is in making that “first” item. All of them after that are cheap as hell (esp. if you place the support costs under a separate “services” heading, which can be and often is decoupled from the IP itself). Production “Overhead” costs can thus approach zero after paying for that initial unit.

      That’s going to have a lot effect on how the economy works. The last time, it rendered the entire old economic structure — Lords, Ladies, and the Feudal Enclave (Manor House, Castle, etc.) completely irrelevant, and took 250 years, and several wars (finalizing mainly with WW-I) to clear it all out.

      I don’t think many people have addressed this shift — certainly not much, if at all, on the “popular” level. Most people sense that things are changing, but few, if any, really know how. The “Economy 2.0” was just a rough draft. The idea is still correct. We’re working on the second set of revisions even now.

    4. Dan from Madison Says:

      OBH – “Satellite Radio always stuck me as a stupid idea in the first place. It’s got an uphill battle convincing people to pay for something that’s always been “free”. And most importantly, by the time the infrastructure gets fully into place (esp. the receiver units) it’s almost certain to get supplanted by universal wireless internet and streaming media. Why listen to a canned station when you can play your own station?”

      I love my satellite radio in the car – no ads, 250 stations playing whatever type of music I want to listen to and NO ADS – another big difference between satellite and over the air radio. I pay something like $14 per month for XM and would die if they went belly up. I stream it through my computer as well when working at home and even in the office at times. I used to buy recorded music – no more. I haven’t bought a CD or downloaded an iTune for several years, since I got satellite radio. For me is is a huge winner product. I wish I could get a walkman type gadget so I could listen to it on the treadmill or exercise bike. My only one nitpick on the whole thing.

      As far as getting the infrastructure into place, XM came already installed on my car. So zero cost there.

    5. Carl from Chicago Says:

      The issue isn’t satellite radio per se nor is it consulting. The issue is that you simply can’t finance a business through debt right now, unless you already have financing locked in, or can afford to pay exorbitant rates.

      I agree with Dan too on satellite radio.. and now it is impossible to go back to listening to commercials. Commercials assume that your time is worth like 2 cents… on radio at least.

    6. david foster Says:

      Inflation expectations are key here. If you get debt financing at 11% and inflation over the next several years is at 4%, you may be OK. If there’s no inflation, or if there is sustained deflation, you’re probably going to be in trouble.

    7. TMLutas Says:

      Absurdly high spreads for profitable businesses means that there’s a business opportunity in financing such businesses if you have money available. So where are the people trying to gather new pools of savings and arbitrage the ridiculously high interest rates away? Something’s missing here…

    8. Jonathan Says:

      I think there’s enough uncertainty about future inflation, counterparty risk and govt policies for allocation of TARP funds to make lending risky until the economic, tax and regulatory outlook becomes more clear.

    9. Carl from Chicago Says:

      Agreed that there are opportunities if you have “money available”. But most businesses are leveraged up and rely on debt.

      Regardless of the Fed funds rate or what you pay for a mortgage, the minimum return has just shot way up for businesses that require debt financing. It used to be low, maybe a few percentage points, but now you need 20% to try to pay off debt and make a profit.

      Very few businesses meet that hurdle, especially with so many other businesses trying to survive, cutting margins all around.