The recession between late 2007 and mid 2009, highlighted by a gray bar on the Graph of every Value Line Survey equity report, brought the role of debt to the forefront. Indeed, a housing market recovery continues to be hindered by an overhang of debt. The government is also wrangling over debt and long-term obligations, such as pensions. Many have highlighted the role of debt in this country’s current woes.
However, debt is not, at its core, a bad thing. It is merely a tool with no inherent good or bad intentions of its own. Such leverage can be used to one’s benefit or, if used unwisely, to one’s detriment. Therein lies the problem.
Governments and individuals aren’t the only users of debt. Corporations make extensive use of debt in the form of bank loans, bonds, and other, more exotic, debt instruments. The Capital Structure box contained in Value Line reports shows the amount of debt a company currently has. Heavy equipment maker Caterpillar (CAT – Free Value Line Research Report), for example, had $25.2 billion of debt on March 31, 2011. Of that total, some $19.9 billion was long-term debt. By contrast, Microsoft (MSFT – Free Value Line Research Report) has about $1.2 billion of debt, all of which is long term.
Dollar figures alone only tell you how much debt a company has, not how leveraged the company is. To figure that out, one should compare debt to total capital (debt plus shareholder equity). This figure is generally found along with debt in the Capital Structure box. For Caterpillar, the debt makes up 61% of total capital. For Microsoft, debt accounts for just 18%.
The decision to take on debt and to what extent depends on many factors, from a company’s business to its desire to leverage shareholder returns. Each company is different and each handles debt differently. That said, it is important to take note of debt and the way it used when considering an investment.
Caterpillar builds heavy machinery, which requires large and expensive factories. Thus, debt makes sense to some degree. Moreover, as the Capital Structure box highlights, $15.4 billion of its debt is related to the company’s financing arm. Since Caterpillar products are expensive, the company has stepped in to help customers purchase its earth moving equipment. Again, another logical use of debt in the circumstance.
This compares to Microsoft, which mostly creates and sells software, where factories and customer financing aren’t material issues. For Microsoft, the reason for taking on debt has been a combination of factors related more to the current low interest-rate environment and the desire to avoid taxes that it would have to pay if it repatriated debt held in foreign markets. So, the corporate decision was to take on debt for such things as share buy backs and dividend payments.
Interestingly, Microsoft’s decision to use debt took place only recently, as the company remained essentially debt free until 2008. This is clearly visible in the historical portion of the Statistical Array, where a long line of dashes (denoting no debt) ends in 2009. This allows one to clearly see the leverage impact that debt can have. In the years prior to 2009, Microsoft’s Return on Total Capital and Return on Shareholder Equity are equal—with no debt, Total Capital is, effectively, comprised only of Shareholder Equity. From 2009 on, the numbers differ, with the return on Shareholder Equity inching higher than that for Total Capital.
Watching these two numbers over time compared to the increasing or decreasing levels of debt can actually provide investors with a little insight into how well management is using leverage. Indeed, as debt increases, one would expect the difference between Return on Total Capital and Shareholder Equity to at least stay the same or increase—suggesting that the additional leverage is resulting in better returns for shareholders. That said, if increasing debt levels are paired with a narrowing of the spread between these two metrics, one should ask why additional debt is hurting shareholder returns.
Unfortunately, Microsoft’s decision to take on debt coincided with the recession, so it is difficult to make meaningful comparisons between the pre-debt period and the post-debt period. However, between 2009 and 2010 the spread between Return on Total Capital and Return on Shareholder Equity did, in fact, increase along with an increase in the company’s debt burden.
Debt, however, is not always beneficial. The recent recession’s impact on Caterpillar’s results clearly demonstrates this. The company’s Sales per Share fell from $85.86 in 2008 to $51.32 per share in 2009. That is a nearly 40% drop. Earnings, meanwhile, fell from $5.71 per share in 2008 to just $1.43 in 2009—a nearly 75% falloff. The declines in Return on Total Capital and Return on Shareholder Equity were 68% and 83%, respectively. Although there are many factors beyond debt in the picture, debt clearly exacerbated the impact of the revenue decline, since debt has to be serviced no matter how much a company earns or loses.
In the end, both Caterpillar and Microsoft are financially strong companies, earning Financial Strength Rating of A and A++, respectively (this information is contained in the Ratings box). However, for multiple reasons Caterpillar is clearly more leveraged than Microsoft and, thus, earnings are more sensitive to swings in revenues. While this can be a benefit in good times, it can be a detriment in bad times. Shareholders need to make sure they are cognizant of this when examining any company for potential investment.
At the time of this article's writing, the authors did not have positions in any of the companies mentioned.