How to buy a company with no money

Posted by Cam Hui -
Perhaps you remember the late-night television commercials selling tapes and courses on how to buy real estate with no money down. One memorable character from the early 1990s ran infomercials featuring him on a yacht surrounded by bikini-clad women to emphasize how he, a Vietnamese refugee, had made a fortune from nothing. You could do the same thing if you bought his course.

 

The Wall Street equivalent of buying a company with no money down is the leveraged buyout, or LBO. The LBO was made possible by the popularization of junk bond, or high yield bond, financings, which was a financial innovation from the 1980s.

 

Even though the LBO has gone mostly out of usage, it may be time to revisit LBO targets now that high yield spreads are narrowing. I screened non-financial stocks in the S&P 1500 for LBO candidates and came up with a number of interesting insights.
 

 

It turns out that LBO candidates are relatively rare. They may be the modern deep value equivalent of Ben Graham’s formulation of stocks trading below net-net working capital or current assets minus all debt.
 

 

Introducing the LBO model

How do you identify an LBO candidate?

 

First, you eliminate financial companies from consideration because these companies already have highly leveraged balance sheets and you can’t LBO a bank or insurance company. The way you LBO a company is to pay equity holders with the company’s own money.

 

How do you do that? Here is the formula I used to identify LBO candidates?

 

LBO value = Cash + Extra borrowing power

 

Where

 

Extra borrowing power = Allowable borrowing power – Existing debt – Leasehold obligations

 

To calculate allowing borrowing power, I calculated the 5-year standard deviation of EBITDA margin divided by median EBITDA margin as a measure of the underlying volatility of the business. I then divided the results into deciles. The most volatile decile was assigned an allowable EBITDA interest coverage of six and least volatile an allowable interest coverage of two. From that:

 

Allowable borrowing power = EBITDA / Allowable interest coverage / Financing rate

 

Given the current high yield spread against Treasuries, the financing rate is about 8%.
 

 

Model characteristics

Before diving into the companies identified by the LBO model, it’s worthwhile considering the factor characteristics of the model.

 

One of the key questions is what EBITDA measure do you plug into the model? I tried three: The last reported EBITDA, a normalized EBITDA based on the median EBITDA margin as applied to last reported sales; and a forward 12-month EBITDA derived from Wall Street’s consensus forward 12-month EPS estimates.

 

The results were surprising. When measured by the ratio of LBO/Stock Price, a scatter plot of the results of LBO/Price from the last reported EBITDA and LBO/Price from normalized EBITDA were highly correlated.
 

 

As it doesn’t make a lot of investment sense to focus on last reported EBITDA as an input to a model because it represents stale data, I compared LBO to price for normalized EBITDA to forward 12-month EBITDA. The results were still highly correlated but not as correlated as the previous analysis (more on this later).
 

 

You would think that the LBO model would be correlated to the EV/EBITDA ratio. While there is tight dispersion to the scatter plot, the correlation was relatively low. This can be explained by the single dimensional characteristic of the EBITDA/EV ratio against the multi-dimensional nature of the LBO model, which incorporates margin variability and balance sheet cash in its analysis. In other words, EV/EBITDA is not a shorthand for LBO analysis.

 

 

In the end, I decided to employ both normalized EBITDA and forward 12-month EBITDA as inputs to the LBO model as a way to identify a range of possible LBO target values. I found that stocks which trade at LBO value are rare, but there were sufficiently interesting investment candidates if the LBO/Price criteria is relaxed to 0.7, or buying a company with 30% down or less.

 

I found additional insights from a scatter plot of stocks with LBO/Price of 0.7 on either the normalized EBITDA or forward 12-month EBITDA models. There were a considerable number of companies that scored well on normalized EBITDA, but didn’t score well on forward 12-month EBITDA. That’s because the forward outlook is weaker than the company’s history. These are the deep value recovery candidates.
 

 

With that preface, let’s look at a few LBO candidates identified by the LBO screen of LBO/Price of 0.7 or more.

 

 

LBO candidate examples

Tapestry, the luxury goods producer retailing under the Coach, Kate Spade and Stuart Weitzman brands is an example of a partial LBO. The company raised cash to finance a takeover of its rival luxury group Capri Holdings but was rebuffed by regulators. Now it has a $32/share cash hoard burning a hole in its pocket.

 

What will happen next? In theory, a corporate raider could swoop in and attempt an LBO. Instead, management could pay out a $32 special dividend. How do you feel about a $41 stock with a possible $32 dividend trading at a forward P/E of 9.4?

 

Asking for a (deep value investor) friend.

 

 

Speaking of deep value, here is a recovery candidate in a hated industry. Peabody Energy is a coal stock with a wide LBO target range. With the stock at about $24, the LBO target based on forward 12-month EBITDA is only $13, using a conservative allowable interest coverage ratio of 6. By contrast, the LBO target using normalized EBITDA is $23, which is very close to the current stock price.

 

Peabody Energy is an example of a deep value recovery candidate. If margins were to revert to its historical median level, the cash generative power of the company is strong, even though it is operating in an industry in decline.
 

 

In total, my LBO screen identified 22 LBO candidates with an LBO/Price ratio of 0.7 or more. The low number of stocks that fit this criteria may be reflective of an elevated stock market valuation. I will be monitoring the number of stocks that pass this screen in the future and report on the results on a regular basis. For the full list of stocks that pass my LBO screen, please contact Ed Pennock at ed@pennockideahub.com or +1 647 287-6800. This is a specialized institutional level report with institutional pricing of USD 1,000 for a single one-time report, or USD 6,000 annually for monthly reports.

 

In conclusion, I built an LBO model to identify possible LBO candidates among the S&P 1500. I found that stocks which qualify under an LBO criteria are relatively rare. This may be a modern day deep value equivalent of the Ben Graham net-net working capital model, whose candidates are usually micro-caps and not very invetable. Despite the LBO moniker, the model is a deep value one that spots companies with clean balance sheets with earnings above the of their debt capital and thematically similar to the Economic Value Added concept pioneered by Stern Stuart.

 

Many of the stocks identified by the LBO screen are blemished, each in a different way. A deep value screen like the LBO screen should be used by investors to identify stocks for further detailed fundamental analysis as there is a heightened risk of value traps in many of the names. This is not a quantitative factor that can be blindly bought because of the high degree of stock-specific risk that will be difficult to diversify away.

 

This was a summary of some specialized research that I undertook that I would normally not publish in these pages. We return to our regular programming tomorrow.