In April the board of IBM Corp. authorized spending $16 billion in the coming year to repurchase the computer software and services company’s shares and boosted its annual dividend by one third, to $2.2 billion. Like many companies, IBM has long used buybacks and dividends to return excess cash to shareholders. But its latest move is different, both for its magnitude — the company is doubling the size of its 2006 buyback program — and, more significantly, for how it is being funded. Instead of dipping into free cash flow, IBM is borrowing $11.5 billion for the actions and will gradually repay the debt with its non-U.S. profits.
The change is monumental for IBM, which until now has mostly avoided debt. Its new approach follows the sale of several underperforming units, including its personal computer and printer arms. These moves stabilized revenues, giving the company flexibility to add debt. IBM’s shares have risen almost 12 percent since the announcement.
“We determined that the volatility of the business was reduced and we did not need the clean balance sheet we previously had,” says treasurer Jesse Greene.
IBM’s move highlights an emerging trend: With private equity buyers and activist hedge funds circling, companies are buttering up shareholders by borrowing to fund big buybacks and dividends. Buybacks increase earnings per share; dividends boost investors’ total returns. The tax deductibility of interest payments can make adding debt even more attractive. That’s particularly true for IBM, as the two major credit rating agencies — Standard & Poor’s and Moody’s Investors Service — say the extra borrowing won’t dent the corporation’s investment-grade status.
Other companies are getting more aggressive about using leverage. Last month rail freight company CSX Corp. said it will add to its $8.1 billion debt load to boost its buyback program from $2 billion to $3 billion, raise its dividend by 25 percent and invest in new tracks and technology. The company had been cutting debt since 2004 but is reversing course after a surge in demand for its services. That may please shareholders, but current debt holders won’t be so happy. Shortly after the announcement Moody’s downgraded CSX to just one notch above junk, in part because of worries over peaking rail demand.
CSX defends its move. “We’ve been driving operating efficiency; there’s a good pricing environment and good productivity,” says financial relations head Garrick Francis. “The rail renaissance is here to stay.”
Some companies will embrace even a downgrade to junk status to remain independent. Health Management Associates in January took out a $2.75 billion loan to fund a $2.4 billion dividend. Before the deal, which market wags have labeled a “self-help LBO,” the investment-grade hospital operator had hardly any debt, but its stock had been rangebound for years. Now it’s junk-rated, and its market value has fallen by half, to $2.6 billion. But the dividend payout makes shareholders less susceptible to activist agitation, and all that debt makes HMA an unattractive LBO candidate.
Whether used for improving share prices or warding off potential attackers, big doses of leverage don’t come without risk. Worries are mounting about what will happen to the wave of LBO debt when the credit cycle inevitably turns and record-low default rates return to normal. Companies leveraging up on their own may add to the pain.
“Sooner or later we will face an economic slowdown,” says Mariarosa Verde, head of credit-market research at Fitch Ratings. “Higher debt levels will leave these companies more vulnerable to default and distress going forward.”
