Wednesday, August 8, 2018

Corporate Debt is a killer especially in Oil and Gas

You may have noticed that when you tried to get a mortgage that the bank is more concerned with how much you make than what the property is worth.  That is because you pay back the principal and interest out of your income rather than by selling securing assets.

The same is true for corporations, including publicly traded companies. In fact, lenders are here even more focused on the corporate revenue and earnings than when dealing with a mortgage. You see, a company that makes no money is slated for bankruptcy, which means management can't generate enough revenue to pay off debt and interest. Selling assets off during bankruptcy hopefully returns some of the lender’s money but they would have preferred that your company generated profits and revenue from which to repay your debt.
Fig 1. Relatively healthy company
So, having too much debt may paralyze or even bankrupt a company. In our example spreadsheet, the company’s revenue is $1000 which covers the costs of goods, the admin to run the company and its operating profits. Interest payments are not part of operating profit; the latter are sometimes called EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).

When you sell a product you make an operating profit that is, in part, used to finance the company's purchase. The down payment in your house is comparable to share holder equity, while money borrowed to buy or build the company are the mortgage. Now lenders don’t care about assets as long as you pay the interest; repayment of debt is nothing more than shifting the financing structure. Paying off some debt means you increase the shareholder equity or down payment.  The lenders prefer you never repay the debt as long as you pay them interest including inflation. De government recognizes this interest as the costs of doing business and thus it is deducted from operating income prior to taxing it.
Also, when a mine or oil company produces its reserves, it converts those reserves into money while depleting the reserves. The depletion has to be replenished by new reserves for the company to survive. The same with a manufacturing company that wears out, i.e. uses up its equipment over the years. The annual costs to replace new machinery for the worn and obsolete stuff, that is depreciation and it Is paid as a capital expense. That capital to replenish depreciated machinery has also to be paid out of operating profit. Amortization is the costs of wearing out real estate – same thing as worn out equipment but now that we’re dealing with worn out buildings it is called amortization. 
EBITDA minus depreciation and minus interest payments are called taxable earnings over which the company has to pay income taxes. What remains are the NET Earnings or AFTER-TAX earnings. Shareholders finance the business in order to share in the profits. Part of the profits are paid as dividends; the proportion of earnings paid to shareholders as dividends is called the ‘Payout Ratio’ and it can range from 0 to over a 100%. Of course, if a company pays more dividend than it earns, the money has to be borrowed and that increases debt. 
What is left of the net income after dividend payment is added to the company’s equity or bookvalue.  This money is used for expansion of the company, for acquisitions or for debt repayment. This left-over is also referred to as ‘Free Cash Flow’.  If a company has no free cash flow, it cannot grow and the corporation stagnates which often means it will lose market share and gradually disappears from the face of the earth.
In the first spreadsheet you see all those numbers in a relatively health company. It has $1000 debt which is $50 dollars per year in interest paid out of an EBITDA of $300. You see, it is very important to know your EBITDA. It is more important than your ‘GROSS’ profit margin or operating margin.  With $1000 in revenue and a profit margin of 30% you make $300 EBITDA but if you have an operating margin of 15% and revenue of $2000 you also have $300 EBITDA. Basically, in both cases the Enterprise value is the same (total share value or market capital plus debt = Enterprise value). 
Market Capital is not the same as shareholder equity. It is the price the shareholders can sell their shares for in the stock market. It is the Market capital, the value of the Company's shares plus corporate debt that equals the Company’s Sell Value or Enterprise value. It is the price you sell your house for minus debt, i.e. home owner capital which can be a lot more than just your down payment. Get it?
Net Income owned by all outstanding shares is $40. When a share trades at a Price/Earnings (P/E) ratio of 10 that means a company earning $40 dollars is worth 10 times $40 or $400.  If the P/E is 15 then the company is worth 15 x $40 = $600 in market capital.  Thus our spreadsheet company has a Market Capital of $600 plus $1000 in debt and its Enterprise value totals $1600. 
If you have $1000 debt and interest has to be paid out of EBITDA than the DEBT/EBITDA is an important ratio because it indicates how much FREE CASH flow a company makes (depending on interest rates and outstanding debt and payout ratio).  So by itself an DEBT/EBITDA ratio of 3.3 doesn’t say much about FREE CASH Flow other than that it will take 3.3 years of operating earnings to pay out all debt.
Fig. 2  Increased debt to $1400 results in a significant dividend cut or severely reduced free cash flow.
Now say that the company has $1400 in debt. Then it must pay 5% interest or $70. Its Net Income falls and it would have fallen even further, did not the increased interest reduce taxable income and thus taxes. And look you have now only free cash flow of $12 instead of $20. A lot less money to spend on expansion. But, ouch! You think the stock market likes a dividend cut from $20 to $12 dollars. Not likely and the market cap falls just based on fundamentals from $600 to $340 or nearly 43%!  If market psychology caused by the dividend cut drove the P/E down further as well, share holders would have lost even more.
Management could increase the Payout ratio to ‘maintain’ the dividend as companies often do. In this case to 84%. But OOPS, Free Cash flow is nearly gone to zero  and that means NO growth for this company. You realize the problem?  Oh and Debt/EBITDA has skyrocketed from 3.33 to 4.67.
Figure 3. $1400 with dividends maintained. Destroys Free Cash Flow.
What if Debt was increased to $2000?  Oops, NO FREE CASH FLOW and the company’s dividend went to zero no-matter the payout ratio.  It takes now 6.67 years of EBITDA to repay the debt and the shares are worth NOTHING!
This company is now owned by the ‘BANK’ and it won’t be able to grow. It is bankrupt and even lenders are unlikely to get all their debt repaid.  You can build a simple spreadsheet like this for yourself and see the effect the debt load has on the company whose shares you own or want to own.  Just as an exercise, go back to the healthy company with $1000 debt. 
Imagine this is an oil company and oil prices fall by 30% from $100 to $70 per barrel. That means without any further changes its revenue falls 30% to $700. Oops, its free cash flow dropped to MINUS $32. The company is bankrupt and even its lenders won’t see much back of their loans. A price drop in oil from $100 to $70 is not unheard of. In fact, in 2015 we dropped all the way to $26 per barrel. To say that this industry was in dire street was an understatement. In fact nearly every oil company was broke in those days!
Fig.4 A debt load of $2000 destroys the company utterly.
If you wonder why Justin Trudeau is so hated along with Rachel Notley then just look at the devastation caused by an oil price drop from $100 to $26 per barrel! With Alberta hurting in semi-death rattle, these two  implemented carbon taxes! Trudeau helped Bombardier, a company living only of government subsidies and based in Quebec, with a $300 million bail out loan, while sabotaging every pipeline proposal and not sticking out a finger in financial help.  To top it off, Alberta had to pay Quebec $11 billion in Federal Taxes and other Transfer payments; Quebec claiming to balance its budget while denying port access for an important pipeline with the excuse of Beluga Wales. And 3 months after TransCanada moved its pipeline port it announced to build a commercial port at the Beluga site instead.

If you think that Alberta Separatism is not an issue, then look at the economic devastation on these simple spreadsheets. What would have happened if something like Ontario’s auto industry was hit like that?  Now let's talk about B.C. and Horgan... It is hard to have someone more despised as that thing in Alberta. 
Fig. 5 Drop in oil price from $100 to $70 per barrel destroyed this relatively healthy seeming company.
Do you think that Saudi Arabia was smart starting a price war in those days when its government spending was largely financed from oil revenue?  No, I think they were imbeciles. Only, when OPEC got its act together and cut its production, oil prices somewhat recovered. The good news is that oil service companies and employee salaries all came down as well and thus the COST OF GOODS (I.e. drilling costs, mineral rights and many other costs collapsed as well – probably by half, that is what saved the oil and gas industry's bacon but the results were severely reduced landsale revenue and royalties for government and a lot of unemployed oil patch staff. The unemployment rate amongst geologists and engineers was nearly 80%!  We still have a lot of unemployed oil patch workers but there is light at the end of the tunnel.

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