Sunday, October 13, 2013

The Verizon Deal: Big Numbers, Big Debt

When the deal was announced, some surely gasped.  The fact that Verizon Communications decided to purchase all of Vodafone's stake in Verizon Wireless was not a surprise.  Vodafone had decided to sell its stake and units in mobile phones.  What likely caused market observers and headline writers to turn their heads in wonder was the size of the deal, the big numbers. They were huge.

Deals and big numbers excite investment bankers and can spur them to pant and salivate. In the Verizon case, they certainly will, once Verizon gets around to handing out advisory and underwriting checks for fees. Deals and big numbers tend also to cause hiccups and coughs among some investors, research analysts and bank risk managers.

This deal is big, one of the largest ever. Perhaps it sends too many hopeful signals that an era of super-size deal-making has returned.  Verizon Communications announced it will pay a whopping $130 billion for Vodafone's stake. To raise $130 billion to pay Vodafone, it will issue about $60 billion in new stock and tap various other accounts and reserves for billions in cash. It will borrow another mind-boggling $49 billion in bank and debt markets in one of the largest debt deals ever.

While some industry experts applauded this announcement, the stock market gulped, trying to figure out the true impact of Verizon digesting all this new debt onto its balance sheet. Verizon's stock value fell 3% on the day of the announcement.

The deal will probably be approved by regulators, will likely be executed, and will just as likely work--meaning, shareholders will gain value because of it and debt-holders, while crossing their fingers, will receive the regular cash interest payments due to them each quarter.

But some flags emerge. They send signals to investors and credit-risk managers that the deal is not a no-brainer.  It must be assessed carefully.

1.  Verizon already has over $40 billion in long-term debt.  Now add $49 billion in more debt, and that sums up to over $90 billion in total debt.  To manage this mountain of debt, Verizon must generate over $3 billion of year in cash flow to handle just the interest expense.

Is the company capable of handling this burden?  The company operates at a pace today of generating about $10-12 billion/year that can be used to handle debt obligations.

That translates roughly into a Debt/EBITDA ratio equal to about 9.0. MBA finance students know well how this ratio can be used to compute a back-of-the-napkin analysis of whether debt levels are manageable.  It suggests that for Verizon, while the debt is manageable, there may be little wiggle room if cash flows from Verizon businesses fluctuate, as they easily can.

Routine business operations must generate the flow of cash to manage this extraordinary debt load. But there may be periods when something else must take a back seat:  Shareholders, for example, in one quarter may not get all of their entitled dividends, something they've grown accustomed to.  And when substantial new investments are necessary, they will likely be funded by issuing new stock.  The existing financial framework couldn't bear more debt--at least for now.

2.  Verizon's balance sheet spurs a few questions, too.  This is a capital-intensive business, so its nearly $90 billion in plant and equipment is no surprise.  This is also a technology business, so its nearly $100 billion in intangibles and goodwill (from acquisitions, copyrights, patents and more) is not a surprise.  But those assets are supported by "only" $34 billion in equity capital.

After the Vodafone deal, equity capital will increase substantially, but so will the amount of intangibles and goodwill---legitimate assets in the eyes of accountants, but assets that can't be touched and felt, in the eyes of investors and debt-holders (assets that also don't generate a steady flow of cash flow from quarter to quarter).

When analyzing a company, analysts prefer to subtract out intangibles/goodwill when computing the book value of a company (equity account). At Verizon, net tangible equity is computed to be a negative amount before the deal and after the deal. That often implies that debt funds all activities on the balance sheet, and there is little room for error, if the company runs into economic headwinds, and earnings (and cash flow) start to bounce around.

3.  Unlike other large companies with significant cash reserves,  Verizon may not have a comfortable stash of cash to meet unexpected cash shortfalls or required investments.  It would rely on external markets, sometimes in times when external markets wouldn't be kind.

What do ratings agencies think? They are in the ballpark.  Moody's and S&P currently rate the company Baa1 and BBB+, respectively--about what you would expect when there is already a significant debt burden and if bad times could jeopardize paying what's due on debt. With "stable" outlooks, the ratings agencies also observe that Verizon will be able to make investors happy.

Why would investors buy the debt? It's all about the interest-rate returns that investors can't get in other fixed-income investments. One tranche or segment of the new debt will yield 5.22% to investors over 10 years, a return that's not easy to obtain in a low-interest-rate era (even with recent interest-rate volatility and spikes, given uncertainty in Washington). That yield is enticing, and in the eyes of some, worth the risks described above.

Tighten up your belts.  This is a corporate-finance deal that can work, but there could be some bumpy moments along the way.

Tracy Williams 

See also:

CFN:  Libor in Crisis, 2012
CFN:  Why Is Dell Going Private, 2013
CFN:  Merger Mania, Boom Times Ahead, 2013

No comments:

Post a Comment