Capital Allocation- Resiliency Back in Focus
We have worked our way through the majority of the 2Q corporate reporting season and broadly speaking we still see significant amounts of capital being generated by companies.
Significant capital generation puts a lot of optionality into the hands of management teams—namely how and where they allocate that capital and how that decision will create value for stakeholders. In this vein, we find that understanding management intentions to be one of the most useful analyses one can do when trying to figure out the direction of a future capital structure—getting riskier, more conservative, or balanced—and thus the risk-adjusted return potential of a particular bond.
Many think of capital allocation as having zero-sum dynamics – for instance, cash that goes toward paying down debt isn’t available to be paid out as dividends and therefore benefits creditors and not equity holders. We disagree, as we feel that effective capital allocation can enhance resiliency, increase optionality, align incentives, and create value for all capital structure constituents. In our experience, capital allocation strategies that optimize value across the capital structure are a hallmark of some of the best investment opportunities.
One capital allocation strategy that we believe creates value across constituents is using excess cash flow to pay down debt when times are good. The benefits to lenders are obvious, but there are definite benefits to shareholders. While this cash doesn’t get sent out to shareholders for immediate gratification, it does create future financing optionality (more future debt capacity when the business may face cash outflows) and resiliency for the business (lower default risk, lower refinancing risk, lower fixed cash outflows in the future), both of which create option value for shareholders.
This earnings season we have seen an uptick in creditor friendly capital allocation, with Ford Motor, Murphy Oil, Lumen Technologies, KAR Auction Services, Post Holdings, and Delta Airlines among companies that have recently announced tender offers to repurchase debt or utilized make whole call options to take out debt early. Many other companies have called bonds, paid down credit lines, or bought back debt in the open market. Most of these actions are focused on reducing the amount of debt outstanding with near-term maturities, but others are geared toward lowering the cost of capital or buying back debt at a discount to par.
To be clear, we don’t see share repurchases or dividends going away, but we do see management teams taking a balanced approach to capital allocation in response to potential dark clouds gathering on the horizon. Should the fundamental outlook deteriorate, we would expect more management teams to emphasize optionality, resiliency, and defensiveness within capital allocation strategies. At Smith Capital Investors we look to align our credit investments with management teams that similarly prioritize these capital allocation frameworks.
INSTITUTIONAL INVESTOR USE ONLY
Limited Near-Term Refinancing Risk
Source: Goldman Sachs Credit Strategy Research August 12, 2022
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