Portfolio Stocks


Poor Richard's Financial Strategies

Good and bad uses of Debt

I recently posted the following tweet and was glad to see a someone interested in this topic.  Sorry that I cannot always respond directly on twitter due to the 140 character limit.
Here is my response:
Question: Do I mean Share buybacks?
Short Answer:  Not exclusively or in all cases, but yes that could be an example.
Long Answer: Stock buy backs are typically used by the mgt of a company as a way to distribute Free Cash flow back to Shareholders.  Other common ways are through cash Dividends and retirement of debt.  The Stock buy back has the effect of causing demand for the shares, resulting in upward pressure on the share price.  It also reduces the number of outstanding shares and therefore effects the  EPS ratio in a positive way.  So whenever I see a stock buyback, I ask why mgt is choosing this path over a cash dividend, or debt retirement. And more importantly pertaining to your question, can the buyback be financed through Free Cash Flow or is management taking on debt in order to finance a stock buyback.  If that is the case then I would definitely see that as a red flag and would be looking very closely for a justification.  If a company is seen taking on debt to buy back shares and arificially prop up their share price, then I would be very interested to know why.   In the same way, if a company is taking on debt and using it to increase their dividend, I would like to know why because increases in a Companies dividend should normally be based on an improvement in the companies Free Cash Flow situation.   When I see something odd, I like to understand managements motivation.  If I am unable to determine why, then either it's currently beyond my ability to understand, so I stay away (Although I may continue to try and understand), or there may be something unscrupulous going on, in which case I definitely want to stay away.
That being said sometimes share buybacks are selected by management for legitimate reasons. For example, if a company is sitting on a ton of cash and they want to return that cash to shareholders but they do not necessarily want the shareholders to be impacted by a large cash dividend distribution (since there are tax implications).  Some people think that share buybacks are always a bad use of Cash, after all if the current shareholders want a larger stake in the company can't they simply take a larger stake themselves, why should management be making that decision for them? But I think that sometimes a buyback is a legitimate use of cash.  I think each situations needs to be viewed independently.  If you know of an example where debt appears to be financing a buy back, I would love to here of it.  I could then use that as  case study on the subject.  
As an example of misuse of buy backs, I've seen this scenario in the past.  Assume Company_X:  Company_X mgt is incentivised with specific EPS targets and these targets effect a major component of exectutive compensation.  Company_X currently has one of the most agressive share buyback plans around.  I would argue that in this case the incentive plan is misguided, and has resulted in mgt doing share buybacks when in fact a dividend might be a better use of cash for the shareholders.

There are many possible poor uses of debt.  I pose this as a question now because debt has been very cheap for at least the past 7 years and many companies may have been tempted to use cheap debt to paper over shortcomings in the companies core business performance.  When debt financing becomes harder to come by and more expensive which could happen anytime in the next couple years, companies that have misused debt will be punished as they are unable to keep up the charade.  Here are some possibilities for bad use of debt:
- taking on debt to finance share buybacks (As you have suggested)
- Taking on debt to maintain a track record of dividend increases that otherwise would not be sustainable via Free Cash flow alone
- Taking on debt for acquisitions that make no sense to the core business.
Then there may be good uses of debt:
- Capital inprovements that maintain or add to the profitability of the company inexcess of the cost of servicing the debt
- Acquisition that do the same
Then there are cases where on the surface a company appears to be taking on unsustainable and reckless debt but maybe that is not the case.  This could also create an opportunity for the investor.  An example that I have been studying lately is Kinder Morgan (think pipelines).  In an article that drew much attention recently. (See Article )  a money manager makes a strong case for KMI  (and previously KMP) taking on unsustainable debt and using it to finance dividends under the quise of capital improvements.  If I understand the argument correctly, the assumption is that the Free Cash flow if viable, should be used to finance the CAPEX projects that Kinder is undertaking.  In the past other managers have made similar arguements that Kinder would dilute shares by making stock offerings to finance CAPEX projects.  This to many appears to be a shell game on the part of Kinder management.  In most cases these analysts would evaluate Kinder as if it is a company that is producing widgets or offering a typical service. They measure KMI with the the same yardstick they would for Apple, Dell, ATT or CISCO.  I think that this is misguided however.  Kinder is very much like a utility.  Such companies do take on massive debt on extremely large CAPEX projects that are well planned and are very predictable.  They take on the debt knowing what they will recieve in fees ahead of time and the shareholder benefits from the spread between the cost of servicing the debt and the predictable fees collected.  Your telphone company does this, as does your gas and electric provider.  So does your local government when the build a toll bridge.  The revenue stream from this type of project is very predictable.  They are not building a product or service that they hope  fical consumer will like.  They are providing a service for a customer that has also sunk a huge amount of cash into their own CAPEX projects and the pipeline provides a huge reduction in the cost of bringing that customer's product to market.  In the case of Kinder it seems to me that this is the case but I am still trying to decide.  the financing of a pipeline company seems to be more complex than a typical company.  For that reason I have not yet worked it out to the point where I am confident in what is happening.  The analysts that think it is all a house of cards that will soon come tumbling down may be right.  That is what I am still trying to figure out.  My belief is that the stock has further to come down because oil most like will see further bottoms (I know it's hard to believe.  See Gary Shilling interview ) but this is a price war and pain is the name of the game.  So when oil drops further, it will be very hard for most investors view Kinder differently from other upstream oil businesses and the stock will suffer.  Meanwhile even though their customers may lose a lot of money in this price war, it is likely that they will lose even more money if they do not continue to pump the oil they already paid to develop.  Using the pipelines is the most efficient way to transport that oil and other related products so their losses will mount without taking advantage of that efficient transport.  For now I am paying close attention to what happens and may consider purchasing KMI for the DIY portfolio.  As of yet, I don't feel confident enough in my understanding so I'm still looking into it.
Disclosure: Although I don't currently hold KMI in the DIY portfolio that I track for this site, I do hold shares in other personal accounts which I have held since they they were converted from KMP shares.