Monday, May 6, 2013

A Tale of Two Capital Structures

Investment, not financing, decisions are the primary source of value creation. This does not mean, however, that capital structure choices are unimportant. The wrong capital structure can destroy or trap shareholder value. This fact was illustrated this week by a pair of different decisions by two very different types of firms.

Apple reluctantly agreed to address investor concern over its growing cash hoard with a $100B three year shareholder distribution program involving share repurchases and dividends. This concern was one of the many issues over hanging its declining share price. The others being reduced growth and a maturing product line. Once announced, the program was very favorably received reflected in about a 10% raise in the stock. Part of the increase resulted from the decline in investor concern over the possible misuse of the excess cash in value destroying over priced acquisitions like those incurred by HP and other maturing tech firms.

Apple initiated the program with a $17B debt financed share repurchase program. They used varied instruments including fixed and floating with maturities ranging up to 30 years. They received AA1/AA+ ratings from Moody’s and S&P respectively. The debt was widely over- subscribed despite being priced very aggressively.

The tax benefits to shareholders were particularly interesting. First, using debt instead of repatriating some of their $145B in foreign cash avoided about $9B of taxes. Second, the use of debt created a tax benefit of $6B representing the capitalized value of the interest tax shield. This illustrates the scope of the problem with their previous highly inefficient ‘no debt’ capital structure.
Also announced this week, but smaller and less well covered was Deutsche Bank’s (DB) Euro 2.9B (approximately $4B) equity offering. This represented almost 10% of their preannouncement market capitalization. DB is a large German based global bank with a depleted capital structure due to crisis related losses and scandals. Like Apple, it reluctantly agreed to a capital structure change only after substantial regulator and investor pressure. Investors were especially concerned that DB’s weak balance sheet would reduce financial flexibility, hamper their on-going restructuring program and increase the risk of being forced to issue equity in a difficult market at depressed prices. Ordinarily, when equity is issued, the firm’s share price drops around 2-3% or about 20% of the equity raised. Except for growth firms with strong investment prospects, equity issuances are seen as negative signals.

Surprisingly for DB, their share price actually increased by double digits on the announcement. Investors seemed relieved that DB was raising capital when it could, at an identified priced instead of being forced to issue at a potentially lower price. Thus, the financial uncertainty surrounding DB was reduced. The new equity also puts DB at the top of its peer group regarding capital strength. This increases their financial flexibility and the possibility of successfully completing their restructuring program in a difficult European economic environment. These benefits more than offset potential dilution concerns.

The lesson is correcting inefficient capital structures, under leveraged at Apple, and under capitalized at DB, can unlocked formerly trapped shareholder value. Another lesson is sometimes management needs to listen to pesky shareholders.


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