Debt Can Be a Good Thing

Debt Can Be a Good Thing

Back in August, Credit Suisse analyst Kulbinder Garcha wrote in a research note that IBM had a cash flow problem and should be avoided. Since then, other Wall Street analysts have also jumped into the fray and raised concerns about IBM's high level of borrowing to support its growth and buyback program. According to SEC filings, at the end of fiscal 2013, IBM's net debt had exploded 107% since the end of 2009.

Is this a concern?
IBM has acquired about 48 smaller peers since the end of 2008, each of which is a specialist in its own field. The total consideration of these deals is unknown, but using debt to purchase these bolt-ons seems a prudent decision by IBM.

According to data from Morningstar, nearly half of IBM's total debt has an interest rate below 2%. This is below the United States' average inflation rate for the past 10 years. Put another way, IBM is borrowing at negative real interest rates after adjusting for inflation. What's more, although IBM's net-debt pile has expanded 107% to $39.6 billion during the last four years, its annual interest expense has only risen modestly. Additionally, its fiscal 2013 interest costs actually fell by about 12.5% year on year. All in all, IBM does not need to be worried about the level of debt it's accumulating. If I were running IBM, I'd actually be tempted to borrow more, as it seems the market is actually rewarding IBM's borrowing with lower rates of interest.

What's more, excess levels of cash can be damaging for shareholder returns, Investopedia explains:

High levels of cash on the balance sheet can frequently signal danger ahead. ... Cash could be there because management has run out of investment opportunities or is too short sighted and doesn't know what to do with the cash. ... Even worse, a cash-rich company runs the risk of being careless. The company may fall prey to sloppy habits, including inadequate control of spending and an unwillingness continually to prune growing expenses.

As IBM is borrowing at less than 2% and is only offered 0.25% to save, the company only has to achieve a 4% to 5% return on investment to come out ahead for investors.

Chevron is in the same position. Although the company's debt is non-existent on a net basis, Chevron actually has about $20 billion in debt, most of which has been built up recently. Nevertheless, according to data from Morningstar, the majority of this debt offers a fixed interest rate of less than 2.5%. As Chevron's return on invested capital was 18.7% for the last 12 months, the company's borrowing is easily paying for itself.

The direct results of smart borrowing
DirecTV is bolstering strong subscriber growth with multibillion-dollar debt-funded stock buybacks. DirecTV added 139,000 net subscribers in the United States in the quarter -- nearly double the gain of 70,000 that analysts had expected. Meanwhile, Time Warner Cable revealed that it had lost more than 300,000 video subscribers.

Investors aren't placing a premium on DirecTV's aggressive stock repurchases. The company has been buying back shares so fast that it has reduced its total number of shares outstanding by 58% during the last five years. Over the same period, earnings per share have risen by 230%.

While the numbers above are impressive, they pale in comparison to the total value of cash that DirecTV has returned to investors over the years. During the past five years, DirecTV has returned $20.6 billion to investors through buybacks funded by both free cash flow and debt. This works out to $32 per share based on the current number of shares outstanding. It would be hard to beat this return anywhere else.

Foolish summary
Debt at IBM, Chevron, and DirecTV is growing, but these companies are borrowing at very low rates of interest, and the returns they are achieving easily justify high levels of borrowing. Indeed, both Chevron and IBM are effectively being paid to borrow. With interest rates at record lows, these companies only need to achieve a return on investment of 4% to 5% in order to justify the borrowing. DirecTV, meanwhile, is buying back stock with its borrowing and is giving shareholders some of the best returns on offer.

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Fool contributor Rupert Hargreaves owns shares of Chevron and International Business Machines. The Motley Fool recommends Chevron and DirecTV. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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