by Amit Kumar
Operating leverage results from the high fixed costs required to run a business, such as the costs to run a manufacturing plant, pay employees, or rent storefronts. The most common operating leverage ratio is percent change in operating profit to percent change in sales. Companies report these fixed costs either as operating expenses (salaries, rents, etc.) in the income statement or as fixed assets (i.e., property, plant, and equipment) in the balance sheet.
Leverage can lead to additional revenues and possibly greater profits for stockholders. Because stockholders do not need to invest any extra money to earn these additional profits, added leverage boosts their returns or upside when the business is doing well. However, if the business, industry, or economy takes a wrong turn, leverage can lead to an equally disastrous downside. Excessive leverage behaves like a ticking time bomb during troubled times if companies are unable to service their debt.
Off-Balance Sheet Items: Commitments, Contingencies, and Special-Purpose Vehicles
Not all liabilities are reported as debt on the balance sheet. Accounting rules and treatments of certain debt or leverage-like transactions allow companies to report liabilities as off-balance sheet items. For example, lease treatment rules for operating assets allow companies to report them as off-balance sheet items in special notes, unlike capital assets.
Companies may enter into other forms of commitment, such as purchase commitments with their suppliers, capital commitments to purchase assets or decommission plants, construction commitments, third-party guarantees, and licensing agreements. We cannot get an accurate picture of liabilities without including such commitments because these items are reported separately, outside the balance sheet.
Contingent liabilities and claims may arise due to the occurrence of specific external events such as legal, patent, tax, regulatory, environmental, or pension-related claims. Such liabilities may also arise from other future events that lead to payment obligations for the company, such as claims related to product warranty, a line of credit tapped by a bank customer, or liabilities arising from derivative commitments.
Special-purpose entities (SPEs) and special-purpose vehicles (SPVs) became infamous during the Enron scandal when Enron set up SPVs and entered into bogus transactions with them to generate fake revenues. SPVs can either be set up as subsidiaries of the parent company or as independent companies to hold assets. Creditors of the parent company cannot lay their claims on these assets in the event of a bankruptcy. SPVs are common among financial services companies and banks.
During the subprime lending boom, banks had set up SPVs, such as structured collateralized debt obligations, structured investment vehicles (SIVs), and other investment conduits, to buy the inventory of subprime loans and structured products that were financed largely by short-term wholesale loans. In theory, banks were not liable if the value of assets bought by these SPVs dropped; the lenders to these SPVs were on the hook for losses. So, why should we have paid attention to these SPVs?
In 2007, HSBC took the high road to bring the SIVs onto its own balance sheet and Citigroup followed suit. HSBC maintained that its earnings would not be materially impacted by this bailout. However, both HSBC and Citigroup were forced to take massive write-downs as credit conditions deteriorated.
Leverage Thrills but Kills
Leverage is a double-edged sword. When sales are growing at a company with high operating or financial leverage, its operating profit can grow even faster. When a company’s business model fails, growth falters, or sales decline, leverage can magnify its losses. The balance sheet does not balance when these losses flow from income statement to balance sheet, forcing shareholder equity to absorb the losses. A streak of losses can even wipe out shareholder equity.
Takeaway
Financial leverage increases with borrowings, while operating leverage increases with fixed costs. Both can accelerate profits as well as losses. Leverage can be hidden in commitments and contingent liabilities.
Companies can have both financial leverage and operating leverage. Let us take a closer look at some leveraged businesses. I will begin with a short thesis on Office Depot that I published in 2010. I have highlighted the key parts of my analysis of this company’s stock.
CASE STUDY:
OFFICE DEPOT (ODP)
In June 2009, Office Depot received a $350 million convertible preferred investment from BC Partners, giving the private equity firm up to a 20 percent stake in Office Depot. Sales at Office Depot had been slumping by more than 10 percent for two consecutive years amid the recession and a challenged office supplies retailing market. This investment had eased liquidity concerns. However, nine months later, Office Depot’s sales continued to slide in the face of increased competition and tough economic conditions.
In February 2010, CNN Money reported on a U.S. Securities and Exchange Commission (SEC) investigation that was in the final stages of settlement and a fresh probe into whether Office Depot overcharged its government customers. I became interested in Office Depot and started going through their public filings.2 I stumbled upon several indicators of downside risk unrelated to the investigation. There seemed a high likelihood for some of the risks to materialize soon.
Balance Sheet
The $660 million debt on balance sheet or debt-to-equity (D/E) ratio of 0.85 did not reflect the company’s true leverage. After making an adjustment for a $1.25 billion off-balance sheet revolver and $2.16 billion of capitalized leases, the D/E increased significantly to 6 ($2.16 billion of capitalized lease based on $270 million of operating leases and approximately 8× rent; 40 percent of Office Depot lease terms were more than 5 years).
With a fixed coverage ratio close to 1, continuing negative free cash flow, and operating profits, Office Depot seemed to risk breaching its credit covenants and entering the zone of insolvency. Office Depot had both financial and operating leverage.
Profitability
Office Depot’s return to profitability was not only a function of how aggressively the company formed a restructuring plan but also of the improvement in economic conditions, a lower unemployment rate, and rational price competition by competitors. Office Depot earned an average of 10 percent return on invested capital (ROIC) between 2000 and 2007; however, the company continued to face lower operating margins and higher debt costs over the next two years, which lowered its likelihood to return to mid-single-digit ROIC.
Office Depot also renewed its government contracts in the first quarter of 2010. The company’s pricing was expected to suffer from the budget constraint of state governments, especially California.
Shareholder Dilution and Dividends
In October 2009, Office Depot requested shareholder approval for conversion and voting rights for BC Partners’ preferred shares. The preferred convertibles had a strike price of $5, and ODP shares were trading at ~$8. Convertibles were deep in the money with a high likelihood of conversion that could dilute the current shares by 76 million (more than 20 percent).
Office Depot had never declared or paid cash dividends on common stock, and its asset-based credit facility limited payment of dividends based on its current fixed charge ratio threshold. Office Depot paid preferred dividends in the form of pay-in-kind notes.
Lack of Management Incentives
Management employment contracts were revised after the October shareholder vote to trigger a change in control and enhanced severance benefits of $11.3 million to the chief executive officer (CEO) and a combined $6 million to two other key executives. Under the new contract, Steve Odland (CEO) was eligible for a $5 million retainer, which vested over the next three years. Under the revised contract, Odland was also entitled to a cash severance payment of two times his base salary and a bonus of no less than $5.2 million.
Similar golden parachute agreements with other executives signaled misaligned incentives for management, as the executives were completely protected in the event that the shareholders’ returns suffered. The criteria for the performance goals of
management were not clearly laid out and depended on earnings per share (EPS), net earnings, net operating profit after tax, return on equity, comparable store sales, etc., or a combination of these factors; also, these goals were subject to arbitrary adjustments by the company board. The management did not seem to be accountable for a swift turnaround of the company.
Competition and Struggling Industry
The U.S. office supplies industry totals approximately $300 billion, with $170 billion in retail sales and $130 billion in contract sales. It is a highly fragmented industry, with the top three retailers—Staples, Office Depot, and OfficeMax—having a combined 10.6 percent and 12.3 percent market share in office retail and contract solutions, respectively. Through the financial crisis, Staples opened stores in geographies where Office Depot and OfficeMax struggled; however, comparable store sales for all three retailers declined during this period (figure 2.1).
The remaining market was shared by large warehouses, merchandisers, and superstores, as well as smaller and niche local office suppliers and internet retailers. Amazon, Sam’s Club, Costco and a few other low-cost competitors entered the office supplies business in 2009, elevating concerns on pricing in an already price-sensitive industry.
FIGURE 2.1 Staples, Office Depot, Office Max same store sales 2004–2010. Source: Company SEC filings.
Top Shareholders (as of March 2010)
In an 8-K filing, ODP announced, “On October 14, 2009, Office Depot shareholders overwhelmingly approved the conversion, at the option of the holders of our Series A and Series B Preferred stock (BC Partners), into shares of common stock.” It is important to note that BC Partners is not listed as a shareholder in table 2.2 because they had not yet exercised their conversion option.
Valuation
At 20× consensus of the 2012 estimated earnings, Office Depot seemed to price the best case scenario of 10 percent sales growth over the next two years. In that case, Office Depot could earn diluted $0.4 per share after BC Partners’ conversion. At $8 per share, the stock was priced for perfection (tables 2.3 through 2.5).
Table 2.2
Office Depot’s top shareholders
Source: ODP SEC filings.
Table 2.3
Office Depot’s earning sensitivity to sales and EBITDA growth
Source: Artham Capital Partners LLC.
Table 2.4
Sensitivity analysis: Impact of sales and EBITDA growth on EPS
NA, not available.
Table 2.5
Key financial data for Office Depot (as of March 13, 2010)
Source: ODP SEC filings.
Risks to My Short Thesis
This thesis is not without risk. First-quarter earnings are seasonally strongest for Office Depot, and the stock typically rose after the first-quarter earnings release. Also, office supplies sales are negatively correlated to levels of unemployment, so an improvement in unemployment numbers could drive the stock up. Lastly, Office Depot had a high short interest ratio of 10 percent, which could result in significant stock price volatility due to a short squeeze.*
How Did Office Depot Play Out?
Office Depot was scheduled to report earnings on April 27, 2010, a month after I published the report. On April 26, 2010, a bulge bracket analyst upgraded Office Depot to neutral, citing channel checks indicating that the company was slowly getting over the disruptions from poor integration from a prior acquisition. The stock rose 10 percent on the upgrade. I was blindsided by the analyst upgrade, especially because the upgrade happened one day before the earnings announcement. Interestingly, the risk section of the analyst upgrade report pointed to some of the issues I had raised about Office Depot. I remained bearish. On April 27, 2010, Office Depot announced earnings that missed street expectations. The stock fell 21 percent that day and continued to fall to near half of its value over the next six months.
Takeaway
It is hard to find shorts with as many negative catalysts as Office Depot: losing market share, structural issues with business model, high debt levels, share dilution, and poorly aligned management incentives.
CASE STUDY:
SOUTHWEST AIRLINES (LUV)
Airline stocks had fallen 20 to 60 percent in 2008 amid rising oil prices. Southwest Airlines was an exception, up over 10 percent in 2008, because it had hedged half of its fuel needs for 2008 and 2009. Southwest was a better airline operator that steered away from the traditional hub-and-spoke airline model to a point-to-point flight model geared toward shorter-distance travelers. Southwest had better debt service ratios, with a debt-to-EBITDA ratio of ~2.0 versus ~5 for most other airlines, including American, Continental, US Airways, and others. Most airlines had announced capacity cuts, but Southwest planned to buy 14 additional planes in 2008, expecting an ROIC of more than 15 percent on new planes. However, Southwest’s cost model was no different from other airlines (table 2.6).
Table 2.6
Comparative statistics for airlines in the first quarter of 2008
Source: SEC filings.
NA, not available.
The cost model for the capital-intensive airlines industry is marked by high operating leverage from salary expenses, fuel costs, and landing and maintenance fees. Fuel and wages constitute 50 to 70 percent of revenues. Airlines have little control over costs and a limited ability to pass along cost inflation to passenger fares. Financial leverage resulting from fixed obligations, such as aircraft leasing and airport property financing, adds interest costs to the operating expenses. The inherent leverage in airline business models makes these companies more susceptible to failure during economic downturns or oil price crises. The industry saw hundreds of bankruptcies since 1990 triggered by an airline’s default on interest payments.
Although Southwest would most likely survive the ongoing oil crisis due to its fuel hedge program (table 2.7), its earnings would suffer once the hedge program stepped down from 70 percent of fuel needs in 2008 to 55 percent in 2009 and 30 percent in 2010. Southwest had reported the value of its hedge to be worth $5 billion; the value would be closer to $6.5 billion if jet fuel prices continued to remain high at ~$3 per gallon through 2012.
Table 2.7
Southwest’s 5-year fuel hedge program
Source: Southwest SEC filings.
However, if crude oil and jet fuel prices stayed so unprecedentedly high, Southwest’s EBITDA would likely fall by half and result in losses by 2009. Fuel prices would need to fall by at least 33 percent in order for Southwest to maintain its EBITDA margins; however, the value of its hedge program would be cut by half to ~$3 billion (more than 30 percent of Southwest’s market cap). Therefore, Southwest would have lost money whether fuel prices went up or down.
Fuel costs seemed to be a negative for the stock, as did airline demand. The International Air Transport Association (IATA) reported in a May 2008 press release that slowdown in airline demand growth continued on the heels of the sharp downward trend that began in December 2007, and the airline industry had begun to feel the impact of the U.S. credit crunch. In a subsequent press release in the same month, IATA said, “North American carriers recorded 3.8 percent demand growth in international passenger traffic as capacity continued to shift to international markets. This was outstripped by capacity expansion of 6.2 percent.”3
There were signs of cyclical downturn in the airline industry. Recent attempts by American Airlines and United to increase fares were met with a decline in passenger demand. Southwest traffic had showed signs of slowdown with a 0.7 percent increase in June, a seasonally strong month, despite a 5.7 percent increase in capacity. Historically, summer had been a strong season for airlines, especially Southwest, which had historically reported strong second-quarter results.
Southwest’s enterprise value was ~$12.2 billion and the stock seemed overvalued, trading between 14× and 15× the estimated EBITDA for 2009, given the current demand outlook and high oil prices. The upside risk for shorting Southwest Airlines seemed limited as compared to other
airline stocks, which had fallen by over 50 percent and were more likely to surge if crude prices fell.
I recommended shorting the stock after the company reported second-quarter earnings results on July 28, 2008. My short thesis was not without risks, including a possible consolidation wave in the airline industry, Southwest’s $500 million stock repurchase, a possible return in airline demand, Southwest’s change in expansion plans, or shelving expansion plans altogether. The last risk seemed unlikely because 45 percent of its fleet was older than 17 years.
How Did Southwest Airlines Play Out?
Southwest Airlines posted a strong second quarter as I expected, and the stock rose 5 percent to close at $15.76 on July 29. However, airline demand kept falling as IATA reported a continued decline in August and an alarming drop in September. Oil prices sold off 30 percent from July highs after the Federal Reserve chairman said that high oil prices had caused significant demand destruction within the United States. Southwest’s hedge lost value amid falling oil prices, leading them to post the first loss in 17 years in the third quarter of 2008. Lehman Brothers filed for bankruptcy on September 15, 2008, leading to a severe credit crunch and the longest recession since the Great Depression of 1929. Southwest stock fell sharply with the rest of the airline stocks in the ensuing macroeconomic slowdown.