I am strongly considering getting a standard graphic for "debt" given how many entries on the subject have been popping up lately. The latest is on the wonderful Conglomerate Blog which points us to a Wall Street Journal article (subscription required) on the topic of debt laden IPOs. Gordon Smith over at Conglomerate hits it right on the head, I believe, with this analysis:
Is debt a bad thing? We are still having the same debate about debt that was raging in the late 1980s: debt-as-burden v. debt-as-discipline. This is a silly debate in the abstract because getting the right amount of debt is the trick. Easier said than done.
Indeed. Find some balance.
The Journal makes a point of singling out Sealy, a transaction I touched on earlier, making reference to their debt warning paragraphs in their S-1/A and 424(b)(4) filing. Here's the passage they used:
Our ability to successfully operate our business is subject to certain risks, including those that are generally associated with operating in the bedding industry. For example,
- ...our level of indebtedness (approximately $961.8 million as of November 27, 2005) may adversely affect our ability to generate cash flow, pay dividends on our common stock, remain in compliance with debt covenants, make payments on our indebtedness and operate our business.
Setting aside for a moment the very obvious (at least for Going Private readers) question that pops into the mind, "How is massive debt generally associated with the bedding industry'?" one has to assume that "sophisticated investors" who bought into the IPO knew what they were getting into. They should have had no problem reading the "Use of Proceeds" section anyhow:
Of the approximately $294.2 million of net proceeds we expect to receive from this offering, we intend to use approximately $86.7 million to redeem the outstanding principal amount of our PIK notes and pay a related redemption premium thereon, approximately $54.3 million to redeem a portion of the outstanding principal amount of our 2014 notes and pay accrued interest and a related redemption premium thereon, approximately $125.0 million to pay a special dividend to our existing stockholders, approximately $17.2 million to pay a transaction-related bonus to members of management and $11.0 million to KKR in order to terminate our future obligations under our management services agreement. We will not receive any proceeds from the sale of shares of our common stock by the selling stockholders, including pursuant to the underwriters' option to purchase additional shares.
If that's the case, then they are all betting on growth to fund their gains. They certainly aren't buying much today and, therefore, it is the continued deleveraging that will, in theory, allow the new shareholders to see some gains. Conglomerate takes John Coyle, the JP Morgan guru quoted in the Journal article, to task for his inelegant description of this:
"As a company deleverages, it adds to its earnings capacity. So in a way, investors in these IPOs know there is some future earnings growth that is already in the bag -- as the leverage comes down, earnings will go up."
Maybe I am quibbling about semantics here, but deleveraging does not add to what I consider "earnings capacity." There is a reason it is called Earnings Before Interest Taxes Depreciation and Amortization. Deleveraging simply reduces interest expense. Sheesh, even Paulie "gives the true picture of a company’s profitability" Walnuts knows that. Of course, all that debt pulls out a lot of cushioning should the market go south. This is part of the mindset that contributes to the wrong headed impression that financial structuring of this kind alone improves the fundamentals of a firm. And how's that been working for investors today who bought in at $16-17? Well, let's just take a look:
And should we be surprised that someone who should know better from JP Morgan would be babbling on so? Perhaps something in the prospectus will give us a hint?