How LBW See’s It
2015 was full of notable events: American Pharaoh captured the Triple Crown, the new Star Wars movie was released, and the Federal Reserve (“Fed”) increased the federal funds rate for the first time in nine years. The Fed had been indicating an increase was imminent throughout the year as they continued to see increased productivity in the US economy. On December 17, 2015, the federal funds rate increased by a quarter of a percent from 0.25% to 0.50%. Chair Janet Yellen specified that future increases will be gradual in nature and likely be below their normalized projection for some time.
So, what does the Fed’s action truly mean for interest rates? The Fed does have the ability to effect interest rates by changing the rate at which banks borrow from each other, also known as the federal funds rate. However, the Fed is not the “be all” for interest rates. There are other influences, such as inflation, that dictate the actual market rates. As inflation increases, generally so do interest rates. For example, if you were to lend money to a friend and inflation was 5%, would you lend it to them at 4% or 6%? This simple question shows that you would lend your friend money at 6%, because in reality, due to inflation, your real rate of return (return [6%] – inflation [5%] = Real Rate of Return [1%]) is 1%. The point is, the Fed is just one piece of the interest rate puzzle, and inflation is an important factor when considering the future of interest rates.
The unknown is the frequency at which the Fed will increase the federal funds rate going forward. If they increase the rate at a rapid pace, this means that inflation and U.S. economic production are most likely increasing as well. Thus, causing overall interest rates to increase quickly, limiting the cost effectiveness of borrowing money and the ability to finance existing debt for companies. This could cause a problem with companies moving forward. Next, Nathaniel will profile the question of raising interest rates and apply it to a company. Welcome to…
Nathaniel’s Beautiful Mind
When doing research, it is very important to take a company’s debt balance and interest costs under consideration. If the company’s cash flows are unable to support its debt load and interest costs, and thereby pay the debt back when it’s due, the company could potentially default, and common stock shareholders could become owners of worthless shares. This threat is exacerbated when interest rates rise because the company may have to refinance its pre-existing debt at higher interest rates.
Debt can be a great thing if utilized correctly. Take the company National Oilwell Varco (NYSE: NOV), a provider of equipment and components used in oil and gas drilling, completion and production operations, as well as oilfield services to the upstream oil and gas industry as an example. As of 9/30/2015, it had a long-term debt balance of $3,981MM and a cash balance of $1,846MM for a net debt balance ($1,846MM - $3,981MM = -$2,135MM) of $2,135MM. NOV’s debt structure is as follows:
9/30/2015 (in millions)
Senior Notes, interest at 1.35% payable semiannually, principal due on December 1, 2017 - $500
Senior Notes, interest at 2.60% payable semiannually, principal due on December 1, 2022 - $1,396
Senior Notes, interest at 3.95% payable semiannually, principal due on December 1, 2042 - $1,096
Commercial paper - $946
Other - $45
Total debt - $3,983
Less Current Portion - $2
Long-term debt - $3,981
Notice how NOV structured their debt with staggered dates. NOV’s management did this so they wouldn’t have to repay their debt so quickly to the point that their cash flows could not keep up. This also gives management flexibility in allocating capital (utilizing debt if need be) to wherever they can achieve the highest returns, which may include organic growth, acquiring other companies, or share repurchases. The biggest portions of debt are not due until 2022 and 2042 (6 and 26 years, respectively), giving themselves plenty of time to invest the debt and earn back the required funds plus a healthy return from those investments. So long as the company has higher returns on its investments than the debt’s interest rates, it makes sense for NOV to invest with debt. As a result, the common stock shareholder benefits from management’s intelligent capital allocation skills.
In a nutshell, regardless of whether we are, or are not, in a rising interest rate environment, effective debt management is imperative. Even if interest rates rise, NOV is well positioned to pay its interest costs and debts on time, and has enough funds to intelligently invest for the foreseeable future. NOV has a management team with intelligent capital allocation skills and appropriate debt utilization, and is an example of companies we search for that inherently mitigate macro factors such as secular changes in the interest rate environment.
 source: National Oilwell Varco, Inc., FY15-Q3 Form 10-Q for the Period Ending September 30, 2015 (filed October 30, 2015), p.11, from SEC website, http://www.sec.gov/Archives/edgar/data/1021860/000119312515360063/d96908d10q.htm, accessed January 7, 2016.