David Stockman: The Debt Zombies Kept On Coming

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David Stockman, Budget Director under President Reagan, then a partner at private-equity firm Blackstone Group, and now author of the bestseller, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA, skewers in this installment from Chapter 25 the residue of the Fed-induced LBO craze: mega companies too loaded up with to survive in a free market – should there ever be one again.

All the founders of the LBO industry – KKR, Blackstone, Apollo, TPG, and Bain Capital – have been stuck in giant deals that have turned into debt zombies. Accordingly, the outbreak of mega-LBO mania during 2006–2007 was not simply the result of one or two firms becoming overly exuberant. Instead, it reflected a financial market deformation that sowed mania and recklessness across the entire private equity space.

The eventual result might best be described as turnkey bidding wars. Syndicates of the big Wall Street banks offered turnkey financing packages consisting of multitudinous layers of secured, unsecured, and exotic “toggle” and “second-lien” debt to competing private equity bidding groups. The latter only needed to “slot-in” a 20–30 percent equity commitment at the bottom of these turn-key debt structures in order to reach a total bid price for giant companies put up for auction by other groups of Wall Street investment bankers.

The heated bidding wars among the top tier private equity houses thus resulted in a “topping-up” of transaction prices which were being set in the yield-crazed debt markets. In this frenzy even the most disciplined private equity houses lost their heads because by now a second fatal assumption had planted deep roots on Wall Street—namely, that the Fed’s Great Moderation guaranteed that GDP would not falter and that financing markets would remain buoyant.

The $28 billion buyout of First Data Corporation, the nation’s largest processor of credit and debit card data for banks and merchants, dramatically illustrates the sheer insanity of these LBO bidding wars. In theory, First Data might have escaped the zombie debt trap since – for better or worse – credit cards have been a growth industry and, in fact, the company’s revenues have risen at a 7 percent rate since 2007, notwithstanding the Great Recession.

But First Data has actually made no progress at all in reducing the $22 billion LBO debt it took on in September 2007 for a single overpowering reason: the speculative climate fostered by the Fed was so frenzied that even the gray eminence of the industry, KKR, was induced to acquire a good company at a preposterous price. The $28 billion price tag thus represented an astounding 51X the pro forma operating income of the company during 2007 and nearly 16X EBITDA.

It goes without saying that the company’s modestly growing sales and cash flow have been no match for $2 billion of annual interest expense. Accordingly, during the eighteen quarters since the buyout, First Data has recorded nearly $7 billion in net losses. After netting capital spending and minority partner payments against income from operations, the company generated less than $450 million of free cash flow during the entire period. Needless to say, at that rate ($25 million per quarter) it would take First Data 220 years to pay off its debt!

In truth, a crash landing has been prevented so far only because billions of LBO debt has been subjected to “extend and pretend.” During the first quarter of 2012, for example, the company refinanced $3 billion of bank debt at higher interest rates, thereby deferring these maturities from 2014 until 2017. At free market interest rates, by contrast, First Data could never refinance its $23 billion of loans as they come due. Keeping the debt zombies alive, therefore, is just one more deformation that flows from the Fed’s financial repression policies.

Clear Channel Communications: Debt Zombie On A “Stick”

In May 2008 Bain Capital and Thomas Lee saw fit to pay fourteen times operating income for a company that was the communications industry equivalent of the proverbial buggy-whip maker. Clear Channel Communications, in fact, had been a speculator par excellence in the humble business of owning what were called radio “sticks,” or FCC licenses, to operate AM and FM radio stations.

By the time of its $23 billion LBO, it owned 850 radio stations, and it could not be gainsaid that radio stations were profitable. During 2007 Clear Channel had generated about $1.6 billion of operating income, a figure which amounted to a healthy 24.1 percent of its $6.8 billion in net revenues. Thus, the deal sponsors did not hesitate to pile on the debt, pushing the company’s borrowings from $5 billion to $20 billion in order to fund an $18 billion payday for the current stockholders. This massive debt load was readily raised, however, because radio “sticks” were a favored offspring of the Greenspan bubble era.

Due to abundant and increasingly cheaper debt financing, LBO operators large and small had driven the value of radio sticks steadily higher, from less than $8 per pop (population served) to nearly $20 per pop at the peak in 2007–2008. At that point deals were being valued not on their operating income, but on their resale value; that is, based on stick flipping.

Accordingly, Clear Channel’s $23 billion LBO reflected the trading value of its massive collection of sticks and billboards, not the company’s operating income which had increased at only a prosaic 4.5 percent rate during the four years ending in 2007, and even much of that was due to acquisitions. The magic value gains of radio sticks, however, rested on a double helping of bubble finance; that is, consumer advertising growth and cheap debt.

Radio advertising revenue grew moderately during the bubble era because the heaviest advertisers—auto dealers, home builders, restaurants, and bars—were the beneficiaries of the housing boom and consumer spending obtained from their home ATM machines. In effect, valuations rose because consumers were spending borrowed money which fueled radio station advertising and cash flow. And then, cheap financing for leveraged radio deals caused stick valuation multiples to be bid up even further.

Needless to say, the music stopped in September 2008. Radio advertising has not recovered from the sharp decline triggered by the violent collapse of the auto and housing industries. And now radio operators are also confronted with gale-force headwinds owing to the migration of advertising dollars from broadcast to the Internet, and to competition from alternate technologies such as Internet radio (e.g., Pandora).

Not surprisingly, Clear Channel’s financial results have headed irrevocably southward. During fiscal 2011 its revenues were still 10 percent below 2007 levels, but, more importantly, the fat profit margins which once reflected the state-bestowed gift of scarce radio spectrum are now beginning to rapidly erode in the face of genuine free enterprise competition.

Thus, by 2011 Clear Channel’s historic 24 percent operating margin had diminished to just 16 percent. Consequently, the double whammy of lower revenues and rapidly weakening margins has taken a huge bite out of operating income. In fact, its 2011 figure of just $1 billion was down nearly 40 percent from the pre-LBO total of $1.65 billion reported in 2007.

So its $2 billion annual interest bill is now double its operating income, meaning that the game of “extend and pretend” is getting increasingly dicey. The company is now leveraged at twenty times its operating income, yet faces a huge debt maturity cliff in the immediate future: $4 billion is due in 2014 and another $12 billion of debt must be repaid in 2016. Yet by then advertising revenues will be in deep secular decline due to competitive venues, and the value of its “sticks” will be vaporizing. The digital technology revolution is, in fact, turning the company’s portfolio of FCC licenses into the world’s largest collection of buggy whips.

Stay tuned for the next LBO installment. Check out his book at your favorite bookstore or at Amazon…. THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.

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