It’s the capital structure,stupid!


Whaddup, it’s your boy, the Greedy Dragon, back up in this motherfucker! It has been almost 8 months since I started working a 9-to-6, and I realize that some of the premises I once held were just fucking stupid. Like when the time I thought that you could even come close to retiring on 300k Ringgit and a fully paid-up house. Shit happens and will continue to happen. Few hundred bucks to fix this, few hundred bucks to fix that; at the end of the month you realize that you fucking outspent your paycheck, again. Maybe my lifestyle is a tad too baller for my income bracket, maybe I just had a string of bad luck. Whatever it is, I sure am fuck glad that I already have some capital to work with as I don’t think I have the right temperament these days to scrimp and save like regular folk. Anyway, let’s take a look at how a bad capital structure can keep an otherwise decent business down.

Update on the Greedy Dragon portfolio: Since my last article,  I sold 4,000 shares in Hua Yang at RM0.81 per share and 500 shares in Maybank at RM9.26 per share for liquidity purposes.

Say you invested in a car wash in Albuquerque that’s really a front to launder meth money, and it makes $80 million in EBIT a year. The car wash’s capital structure consists of $400 million in term loans with a 4% interest rate and $100 million in common equity; there are 50 million shares outstanding. To keep things from getting overly complicated, we’ll assume the corporate tax rate is 0% which will give the car wash a net profit of $64 million or $1.28 per share. All of a sudden cocaine starts taking a bite out of meth’s market share, and EBIT at the car wash falls 50% to $40 million.  

It’s just gonna suck for a while, right? After all the meth behind the car wash is 99.1% pure, customers will come back. Ain’t no thing, right? That may very well be the case, however, the term loans will mature in less than two years, and the banks that lent the car wash money don’t want to rollover the loan. Some time passes, and the car wash starts to get desperate and seeks alternative sources of funding. It eventually takes a $400 million loan with a 9% interest rate from a private equity firm. The car wash also has to give the PE firm warrants to purchase 20 million common shares at a really low exercise price as a sweetener.

Now I don’t blame PE firms for making huge profits to supply capital to companies in a bind. In fact, I think it’s beautiful. First off, it’s a voluntary transaction. There are higher risks involved in lending to distressed companies. The new injection of capital also gives struggling companies a lifeline to turn things around instead of just waiting around to die. Don’t hate the player, hate the game. In fact don’t even hate the game, the game is fucking intoxicating. It rewards intelligence, discipline, and guts, and no leftist pussy will ever convince me that this is a bad thing.

Anyway, the car wash will suddenly see its interest expense rise to $36 million from $16 million, and net profit will fall to $4 million. Let’s say that the meth business does eventually turn around and starts making $80 million again, the share price recovers somewhat, and all the warrants get exercised. The car wash will now be making $44 million in net profit. With the larger number of shares outstanding, earnings per share will clock in at $0.63; approximately half of what it used to be at the beginning of our story, and that’s assuming profits recover fully.

You might have noticed that I didn’t talk about the share price at all. Well, it’s because it is not fucking important; what’s important is the profits that each share is entitled to (unless the share price is higher than what you paid for it, which is doubtful due to the significantly lower earnings per share).   

Here are some things to look out for when evaluating a company’s capital structure:

1)      Obviously a low debt-to-equity ratio is a good thing, but what is considered low depends on the industry, and even then what is conventionally considered a safe ratio may not hold up when the shit hits the fan. But a high component of equity just might put some sort of a floor on the price of the stock, which will give the company more options in terms of funding sources.

2)     When conducting your stress test, make sure to include a 6-8% increase in the cost of debt (this is just based on my own experience, you can do your own research on what would be a more appropriate increase) to whatever other negative things you are factoring in to your model.

3)      How far into the future are the company’s debt maturities? Will it be able to recover its earnings power by then to convince the financial markets to let it refinance its debts?

4)      Is the company generating enough cash flow to fund its CAPEX program without having to take on additional debt?

5)      Does the company have any contractual obligations that require significant cash outlays that can’t be paid for through cash on hand and cash flow?

The list is by no means extensive, as I’m still learning about the investment game. I know I’m still a long way off from becoming the Heisenberg of capital allocation. Anyway, thank you for staying with me on my journey to build my empire, even though I rarely post no more (because I’m a lazy puta). Take care and stay rational.