Debt is cheaper than equity. When looking at the capital structure of companies, we tend to see that debt costs less than equity, and this can be exacerbated more so in this very low interest rate environment.
We have seen absurdly low rates on corporate debt deals lately, ranging from offerings from IBM which issued 10 year paper for 1.85%, and last year, Apple offered debt in both five and 10 year increments at rates of 1% and 2.40%, respectively.
But what we saw from Verizon recently was a debt auction that dwarfs the recent historical amount that Apple offered last year. Verizon’s debt offering was for $45 billion in paper. Verizon was unable to get the rates that both IBM and Apple received given differences in credit quality and also the fact that rates have spiked since late May.
Nonetheless, the decision of Verizon to take on debt relative to other options seems to be the least costly of options in order to acquire the rest of Verizon Wireless from Vodafone.
Yes, debt is not necessarily good and tends to put companies that abuse it into very risky/detrimental positions, and yes, when analyzing a company’s financial stability, debt loads are a very integral part of the analysis in terming viability of the company going forward.
But what Verizon did was take advantage of the environment, while also not putting too much pressure on its financial stability. Verizon more than doubles their debt load (going from nearly $42 billion in debt to almost $109 billion). Annual interest expenses for the company will likely eclipse the $5 billion mark on an annual basis as well, and their debt to EBITDA will rise from a paltry 1.6x to 3.7x, which is in line with the average of the other five telecom companies in the S&P.
So, why is debt the right move for Verizon? First, with all assumptions behind regarding whether the deal was right or not, this debt deal reduces the average coupon rate on Verizon’s debt outstanding. The average coupon on all debt outstanding now is 5.52%, down from 5.70%.
Secondly, the cost of the alternative, equity, is much higher relative to debt. When looking at Verizon’s cost of equity, it is about 8%. This is much more than the interest rate due on the debt along with the cost of debt (which accounts for credit rating, spread and tax benefit) which is currently slightly below 3%.
But most of all, this is a company that currently has free cash flow greater than $15 billion, and even if we take out dividends paid by the company, cash flow is more than $10 billion.
So this is a well known, financially sound company, and despite increasing the company’s leverage, the company is still stable and sound. The dividend looks sound and the management’s decision on how to fund this deal seems reasonable. I don’t believe that people are debating this deal, but when a company more than doubles its debt load, it does provide a reason to take a look.
(All data used within The Capital Course was provided by Ned Davis Research)
