Leverage buyouts (or the LBO) reached a frenzied pace in 2007. Nine of the top ten largest leveraged buyouts in history occurred in 2007, as private equity shops used loose lending standards, high valuations and low interest rates to their advantage. As we know all too well, this party ended abruptly and in tears a year later, with many deals failing to close or ending in bankruptcy. The leverage buyout is a very risky strategy: load a company up with debt and hope its cash flow will exceed the interest payments. But if the economy turns or interest rates rise, watch out! While LBO’s get a lot of attention in the financial press, there is another frenzy going on that is much more sensible and may be just as rewarding to investors.
There are a large number of high quality companies with strong balance sheets and rising free cash flows that are slowly but surely taking themselves private. We call this the Underleveraged Buyout or the UBO. Companies such as Wal-Mart, Viacom, Staples, Shoppers Drug Mart, Cisco and Microsoft to name a few, are buying back anywhere between 5-10% of their stock each year. If their current pace of stock buybacks continue there won’t be any shares left of Wal-Mart or Cisco in 15 years for shareholders to buy. These high quality companies are generating so much free cash flow, after increasing dividends and capital expenditures that they have no other need for the cash. The excess cash flow is used to buy back stock which offers many benefits to shareholders.
A stock buyback is no different than a dividend. While a dividend is paid directly to shareholders and increases the investor’s pocketbook in the short-run, a stock buyback should have a positive impact on a company’s stock price. The reduction of shares means that a company’s profit is allocated to fewer shares, which lead to higher earnings per share and ultimately a higher stock price.
There is no need to speculate on which company is the next target for an LBO. The UBO is happening to many companies right before our eyes.
The author owns shares in Staples, Shoppers Drug Mart, Cisco and Microsoft. Clients of Baskin Financial own shares in Viacom, Staples, Shoppers Drug Mart, Cisco and Microsoft