According to news reports, Home Depot has agreed to sell its Supply division for $10.3 billion and then repurchase $22.5 billion of HD stock. Now, that's a story you don't read about every day.
Does Home Depot have the difference, $12.2 billion, stacked up in the office safe? Alas, no. The balance sheet on 29 April 2007, as published in a 10-Q report, shows that Home Depot held less than $2.1 in cash, cash equivalents, and short-term investment. So, it would appear that they will have to borrow at least $10 billion, plus any proceeds from the sale that can't be converted to cash or have to be paid in taxes.
The company's long-term debt at the end of April was $11.6 billion, and stockholders' equity was $25.7 billion. Therefore, debt/equity was 45 percent.
What will debt/equity be after these transactions? The numerator will increase by $10 billion, give or take, as mentioned above. The effect on stockholders' equity is less certain. If we assume that the sale of the Supply unit doesn't result in a gain or loss, it seems that stockholders' equity would have to drop by the $22.5 billion spent on the stock buyback: from $25.7 billion to $3.2 billion. This is such an extreme result, we hope to be proven wrong (and to learn a lesson along the way).
Could debt/equity really change to (11.6 + 10.1) / (25.7 - 22.5) = 21.7/3.2, or almost 7:1. Would this allow the company finance the modernization of its stores?
This is our reasoning:
1. Sale of Supply unit: We're making two crude assumptions: (1) the sale only affects the composition of the company's assets, but not their total value; and (2) the sale doesn't result in a gain or loss. We're effectively (and simplistically) modeling the sale as an event that increases the company's cash by $10.3 billion (the sale price) and that reduces the value of the company's property, inventory, and other assets by the same amount. The reality will undoubtedly be more complicated.
2. Issuing Debt: When the company borrows $10 billion, assets (the cash borrowed) and liabilities (the debt) will both increase by the same amount and stockholders' equity will be unaffected.
3. Stock Repurchase: When the company spends $22.5 billion on its stock, cash assets will be reduced and stockholders' equity will drop to maintain the balance.
19 June 2007
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The 22.5 billion dollar share repurchase really sounded great at first, but then to hear it's so heavily debt financed, it doesn't seem so great anymore. What's your opinion?
ReplyDeleteHD's capital structure will become much more leveraged. Too much so? We don't yet have enough information to tell, but that is definitely a risk if the housing market slows further. Certainly, operating cash flows that could have been re-invested in the business to spiff up the retail stores and hire more experienced staff will instead go to interest payments, although reduced dividend costs will help somewhat. While long-term interest rates are presently low, the company won't get the best rates on its debt because they will borrowing so much. We really need to see GAAP post-sale, post-buyback financial statements to assess the capital structure and cash flows. The company might be planning (or might be forced) to sell or shutter poor-performing stores to conserve cash. Although this doesn't qualify as a leveraged buyout, there are certain similarities and the management might be forced to do some of the same things that happen after an LBO. You can read the purchase and sale agreement between Home Depot (HD) and the entity buying the HD Supply division by downloading the 8-K from the SEC web site. There are some interesting information tidbits among the legalese, but not enough to answer our questions.
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