Lessons From The Levered Edge

The Spanish economy is in serious trouble no matter how you slice it. I tend to focus on the macro perspective, but there is a lot to be said from the bits of dispersed information coming out of the micro world. Last Friday, Joe Calhoun and I were talking Telefonica and how it related to the unfolding mess. He was adamant that the dividend was history, but that there was value to the company. They have the assets, but the downside is clearly its balance sheet.

By Wednesday, the company confirmed Joe’s thesis by cutting its 2012 dividend completely, as well as canceling its stock buybacks for the year. Obviously this was a move intended to increase the company’s liquidity profile in the face of the economic hurricane. Of course, being the dour macro-focused type, I took it as a confirmation that Telefonica sees not just a rough road ahead for its operating marketplace, but perhaps the worst case. Why cut the dividend to zero right now?

Our colleague Doug Terry, being more level-headed and pragmatic, instead did the actual research. He came up with the following:

–declining sales
–dividend payout ratio 99% last yr, 117% TTM
–leverage 6:1, leveraging a lot of goodwill/intangible assets
–current interest coverage 2:1

Doug went on to note that, “to raise 1 year’s interest expense, TEF would have to sell 10% of the equity in the company. This would be both very costly from a cost of capital perspective but increasing the 6:1 leverage, increases risk, subsequently raising overall cost of capital more.”

Given all that, it is very likely that TEF looked at the shape of the credit markets in Spain and Europe and decided that liquidity is the order of the day. But that does not make the company an unwitting casualty of the wider euro currency battle, far from it. The company willingly sourced funds through debt, lured by the embedded monetarism of the common, ill-fitting currency regime. There is no doubt it was intent on leveraging its attractive asset base. Now, in the storm of economic uncertainty, an encumbered asset base is a hole below the water line, in many ways a self-inflicted wound.

None of this is to say that TEF is a dead stock trading. Rather, it serves as a cautionary tale to the wider investment marketplace about the role of leverage. Debt has a place in this business world, but sometimes companies get ahead of themselves and seek to use it as an easy shortcut. For all the real productive value in TEF, it may not matter in the end. Beware both sides of the balance sheet, no matter how enticing the asset side may look. This is still a dynamic world and a favorable asset side can always be sunk in the wider maelstrom of liabilities.

Being stuck in the hurricane of illiquidity doesn’t help either.

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