Article / 19 June 2017 at 8:34 GMT

The power of corporate deleveraging — #SaxoStrats

Head of Equity Strategy / Saxo Bank
Denmark
  • Saxo quant model tracks shareholder yield
  • Metric useful for measuring debt reduction effects
  • Corporate deleveraging can be very powerful for shareholders

Debt
Debt reduction can have a powerful effect on a company's share price. Photo: Shutterstock

By Peter Garnry

Our in-house developed quant model, Equity Radar, is fast becoming our household product for screening the global equity market. It scores the 1,200 largest stocks on six equity factors (value, yield, quality, momentum, reversal, and volatility) normalised within each industry. 

The model generates a top 40 list as well as flexible tables across all continents with filter options across country, sector, and industry.

Yield is not only dividends

Most investors think in terms dividend yield when we talk about yield on a stock. Our quant model, however, uses shareholder yield on non-financial companies, which is a broader measure but also makes for a better comparison. Shareholder yield measures the cash flow returned to shareholders through dividends, buybacks, or debt reduction. The first two make sense for every investor, but the last is more complicated. Let's explain...

Profitable companies generate operating cash flow that is used for acquisitions or capital expenditures (production capacity etc.). The leftover is called the free cash flow and is the surplus available for shareholders and creditors who are basically both eating from the same pie (although creditors stand first in line). Reducing net debt is a de facto dividend yield because the cash flow used could have been used on dividends or buybacks, unless of course that the company is forced to reduce its debt.

Valeant: the exponential power of reducing debt

The Equity Radar currently scores Valeant Pharmaceuticals at 5.6 on yield (you can think of the score as a close approximation of the normal standard deviation), so it has a significantly larger yield than the industry. But the company is not paying any dividends or buying back its own shares, so the yield comes exclusively from reducing debt.

Following a series of scandals, the former high-growth pharmaceutical firm has run into a debt wall as its net debt levels are unsustainable relative to its earnings power in the long term. The growth engine has stopped and consequently the focus is now on reducing debt. Over the past 12 months, the company has reduced its debt level by $3.65 billion, close to the full EBITDA (operating earnings) and a huge number relative to the firm's market value of $4.3bn.

Valeant fundamentals
 










What happens if Valeant continues to reduce debt by the same amount over five years? If the market puts the same EV/EBITDA multiple on the business, then as debt is reduced the residual market value on the equity goes up. 

In fact,  the market value increases by 39.3% annualised over a five-year period. 

There are a lot of variables in the equation that changes over time such as cash levels, revenue, EBITDA, divestments of businesses etc. In our example, we have kept everything constant over the whole period, so zero growth. 

It's simplistic but useful for illustrative purposes. It shows that an overleveraged company can see an exponential increase in its market value by reducing debt by the same amount.

Debt reduction example
 
 







If the example above holds and Valeant after year five stops reducing debt after year five and instead uses the $3.65bn to pay out dividends, then the dividend yield would be 16.2% It's very likely that the market would immediately increase the value of a company with such a dividend yield further increasing the market value.

Hopefully we have clearly demonstrated the link between debt and equity, and shown how powerful the corporate deleveraging of an overleveraged company is for shareholders. It reduces risk and has the potential to increase the shareholder value exponentially.

Equity Radar's top 40 

Below are the first 20 stocks in our model's top 40 list. Cyclical stocks dominate the list. We issued a buy recommendation on one of the top names, Petrofac, last week.

Equity Radar top 40
Source: Saxo Bank 

— Edited by Michael McKenna

Peter Garnry is head of equity strategy at Saxo Bank

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