Mar 25, 2008


One followup point on my Bear Stearns post that I received a question about. I said leverage is bad and that leverage always causes these problems. The question was around what is an appropriate amount of leverage. That's a tricky question.

Leverage is useful to a point. Microsoft is a great example here. Microsoft has zero leverage. They have no real debt. Technically they are levered 2X but their liabilities are essentially short term in nature. Things like accounts payable. This is mainly due to Bill Gates paranoia about the speed with which technology changes. I've never seen attribution but it has been said he wants enough cash on hand to be able to operate for a few years if needed with no money coming in. Technology may change quickly but nothing really ever makes a dent in Microsoft's finances.

This may surprise you. In 1998 Microsoft's stocks was around $30. 9 years later it is around...$30. One might think, given the popularity of Apple news, that Microsoft is flailing. Let's look at their revenues over that period.

Not exactly suckage. How about net income?

More non-suckage. Net income went from $4B to $14B. I don't care how you cut it, that is a stable business in terms of earnings power.

Now, debt is much cheaper than equity. I can raise $10 by raising debt or I can do it by selling a piece of my company. Microsoft can probably raise $10B at 5-6%. Equity holders expect something like a 10-12% return. Debt is cheaper. So in Microsoft's case, if you believe they can earn $14B a year going forward, they should go to Wall Street, raise $100B and buy back stock and pay $5B in interest a year. Effectively transferring the funding of the company from equity to debt which is cheaper. The stock would go up 50% the day that was announced. It's leverage would be significantly higher. This is financial engineering and it can have a real effect on a company's value.

So why not raise $300B? Because then they would be paying $15B a year and that is not a sure thing. There's some risk they could default on the debt and go bankrupt. Therefore the stock would go down.

So there is some correct amount of leverage a company should have to maximize the value of the stock. But since cash flows are generally not perfectly predictable it's hard to say what that is and it's hard to know what the 'market' feels is an appropriate amount of leverage. Microsoft could leverage more.

This is how LBOs work. One of the more famous LBOs, RJR Nabisco, was bought by KKR using debt. Same principle. RJR's finances were quite stable. People buy cigarettes and cookies when times are good and when times are bad. Therefore with stable cash flows a certain amount of debt made sense. KKR felt RJR was underlevered and bought it using leverage effectively saying the management was mismanaging the company.

For the brokers like Bear Stearns their earnings can be stable for reasonably long periods of time. But liquidity and credit problems always happen. They always happen. And then their earnings look like crap. You can't be 20X, 30X levered when you have a crap year every five or ten. You are going to go bankrupt at some point.

So the leverage you can take on depends on the stability of your earnings over reasonably long periods of time. Stable earnings + high leverage = OK.

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