Leveraged buyouts and EV/EBIT

As I mentioned previously, screening for companies using EBIT / EV allows for easier comparisons between companies with different levels of debt. However, what truly matters to the investor is earnings yield (or FCF yield, which accounts for necessary reinvestment). A company can change its earnings yield simply by taking on debt and buying back stock.

I’ll take the example of Barbeques Galore, my first great stock pick, which was trading for a 5-year average P/E of 12 at the time I recommended it (in a stock bulletin board and in a defunct stock newsletter). Because the company is a retailer it has very little depreciation and amortization and thus little need for reinvestment—for these reasons earnings should be about equivalent to free cash flow. So this translates into an 8.5% free cash flow yield. There was very little debt on the books. We’ll assume for simplicity’s sake that they had no long-term debt.

BBQZ was taken private for a price of about $9.50 per share, 60% above the price at which I recommended it. This gives the company an earnings yield of only 5% (with earnings at $2 million and cost at $20 million). Was this a good deal?

The answer becomes clear when we take debt into account. Because BBQZ had essentially no debt, they could be loaded with debt to increase the earnings yield. We will assume that ¾ of the purchase price ($30 million) came from debt. With interest at about 5%, that increases the company’s interest expense by $1.5 million per year. Earnings do not fall by that amount, though. We need to look at EBIT and reduce that by $1.5 million, since taxes take a fixed proportion—not a fixed amount—of earnings after interest. Assuming a 40% tax rate, EBIT was $3.3 million before the buyout. After subtracting interest expense of $1.5 million and tax of 40%, we arrive at earnings of $1.1 million. Compared to the equity value of the company outstanding ($10 million), we now have a company with an 11% earnings yield. Not bad. Since the underlying operating characteristics of BBQZ remain the same, EBIT / EV remains the same (although EBIT/EV is lower than before the buyout was announced, since the buyout was at a premium to market price).

After adding a sizable amount of debt to the company the earnings yield doubled. This is the logic behind all leveraged buyouts (LBOs). If a company has consistent cash flow and debt is cheap, it makes sense to increase the debt to increase the earnings yield. The only time this is bad is when too much debt is added and the company risks not being able to pay its debt.

How does this matter to us as investors in public companies? We should try to examine companies by their EBIT/EV ratio rather than just their P/E ratio. This gives us a sense of how profitable the company’s underlying business is. Almost any company can look great if given a lot of cheap debt. A great example of this is Long Term Capital Management. They were a trading company run by the best of the best. They engaged in risk arbitrage. Their unleveraged profit margin was only about 2%. However, because they could obtain so much debt financing at such little cost, their investors saw 30-40% annual returns (until the company imploded, but that is another story).

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