Message Font: Serif | Sans-Serif
No. of Recommendations: 3
Wow. Okay, I will be back later when I have a little more time but I just skimmed the thread and see that I may as well just throw Part 3 out there now.

MyCo Part III: Debt

In Part I, I mentioned that MyCo did have some debt outstanding. In fact, there’s 1 trillion of MyCo debt, which is ten times the current market cap of 100 billion. Like most things MyCo, this debt is a little unusual:

All MyCo debt is in the form of mandatorily convertible PIK bonds. Mandatorily convertible means they automatically convert into MyCo A shares at maturity. PIK means that whatever interest they pay is payable in kind, in this case that actually means A shares as opposed to more debt. MyCo has two kinds of these converts:

1. Fixed. These bonds convert into a fixed number of A shares at maturity. The interest they pay is also a fixed number of A shares, determined as the coupon rate multiplied by a stated A share quantity at inception. For example, MyCo recently raised 20 billion in ten-year, 5% Fixed Converts. The bonds automatically convert into 200 million A shares at maturity and pay 10 million A shares per year in interest. Fixed Converts constitute more than 90% of MyCo bonds outstanding.

2. Adjustable. These bonds have rates that float with the market rate. Their conversion rate into A shared also increases one for one with every percentage point drop in the stock over some preset amount. In that sense they are a lot like conventional “death spiral” convertibles. Of course if the stocks acts roughly as expected, as it has for quite some time, they just act like normal bonds.

So in total MyCo has 1 trillion of bonds outstanding (in both par value and market value), convertible into 10 billion A shares at maturity. The average maturity of this debt is around 7 years and the average interest rate is about 5%, which is the same as current market rates for an extremely highly rated issuer. Thus, annual interest costs run about 500 million A shares. As a reminder, there are 1 billion A shares outstanding and the most recent stock price is $100.

The Flair CEO is very familiar with these converts, because all her buybacks and issuances are actually conducted as debt/equity swaps. So when the Flair CEO wants to prevent the stock price from rising, she will issue stock in exchange for outstanding MyCo converts. And she will generally keep an inventory of those converts on hand so they she can use them to repurchase A shares when the stock is threatening to decline excessively. It might seem strange that Flair CEO is conducting these treasury operations via debt/equity exchanges. But this is no different from a company that conducts a secondary and uses the proceeds to deleverage, or borrows for buybacks. As mentioned in Part II, what distinguishes MyCo isn’t the way buybacks are conducted, but the Flair Value of its A shares. Because of Flair Value, the value of A shares fluctuates as the quantity outstanding increases or decreases, just as the price of Rolexes change with supply.

In Part I, I showed a table of MyCo’s losses for the last five years and mentioned that while it had sometimes generated profits, historically losses were more common. But those were operating profits, i.e. before interest expense. If you include the interest costs of its debt, MyCo has been even less profitable, having produced net income only a few times over its many-decade history.

You might wonder how MyCo has been servicing all this debt with that track record. Actually, you probably wonder something a bit different, since the debt is all PIK converts: Why hasn’t MyCo’s share count exploded under this mountain of converting debt with no profit available to pay it off? The answer, of course, is more debt. As the converts pay interest in A shares and later convert to A shares entirely, MyCo has consistently issued replacement debt. It uses its replacement debt to soak up the increase in A shares. This doesn’t mean A shares haven’t increased at all over time; they have. But not enough to lead to declines in the Stock Price greater than a Significant Amount, at least in recent years.

In that case, though, is MyCo a Ponzi scheme? How is it able to raise a trillion of debt without profits? Opinions differ, but current consensus seems to be that MyCo is like any other company with significant debt and equity market capitalization yet little to no profits: Markets and bond holders believe that while it isn’t earning money now, it does have the earnings power in the future to pay of its liabilities. Typically companies that get this treatment are sacrificing current profits for future profits or seeking scale in hyper-growth mode. But MyCo is mature. In this case, investors instead seem to believe that MyCo is unprofitable by choice, but could (and in the very long term will) decide to make enough money to pay off its stakeholders.

Investors are giving MyCo credit for 1.1 trillion in EV. This equates to (1) One trillion of present value of future profits needed to pay off the debt— this is primarily the province of the MYCO CEO who is solely responsible for both bond issuance and company operations (2) 100 billion in present value for the equity. This 100 billion for the equity is of course a little unusual because it need not all be the present value of future profits: equity holders also receive the present value of future Flair Value. As a result, it this portion of the EV is a bit of a mixed responsibility. Yet as mentioned and despite this seemingly lopsided sharing of the pie, the Flair CEO is generally considered the main protector of the share price.


Now that you know about MyCo’s 1 trillion in debt, does it change your valuation?

Does it make sense that the Company and much of the market seem to act as if the Flair CEO, with a relatively small domain compared to the MYCO CEO, is responsible for the stock price?
Print the post  


What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.