Photo courtesy of Canadian National Railway.
As valuations of equities continued their uninterrupted slide this week The Dividend Express kept chugging along. Despite being down 8.87% YTD Canadian National Railway (CNR;CNI) made an announcement on Wednesday that quietly flew under the radar of investors and the broader market. When cashflow is king and the cost of capital becomes prohibitive companies who are able to secure cheap financing benefit from an important competitive advantage that places them in a position to continue operating without impairment through any economic crisis.
On Wednesday (February 18th) CNR announced it would issue $550M of 10-year bonds priced at 295 basis points above a 10-year US treasury bond. The bonds carry a coupon of 5.55% with a maturity in 2019 and carry a control clause that if CNR were ever taken over bondholders could redeem the bonds at a premium price.
Why is this announcement significant?
There are a lot of companies looking to raise capital that are finding a difficult environment for affordable financing. It’s easy to overlook these important activities of business with analysts touting their buy or sell targets and pundits on TV talking about BUY BUY BUY or SELL SELL SELL, but the basics of business are pretty simple in this economic environment: borrow cheap and spend smart.
Let’s examine a few other financing activities to shed some light on how important CNR’s recent financing really is to me as an investor who owns shares in the company.
On February 3rd Harley-Davidson (HOG) priced an offering for $600M of senior unsecured notes in order to secure financing for its lending activities. Davis Selected Advisors and Warren Buffet (through Berkshire Hathaway) each committed to purchase 50% of the financing with the notes due in 2014 and providing an annual coupon of 15%.
On February 13th Tiffany & Co. (TIF) priced an offering for $250M of debt all going to Warren Buffett (through Berkshire Hathaway). The issues of $125M of 8-year debt and $125M of 10-year debt will each yield 10% on an annual basis.
On February 19th Precision Drilling (PD.UN) planned a bond offering for 10-year debt worth $250M to replace short-term bank loans in an attempt to strengthen its balance sheet after last year’s acquisition of Grey Wolf. With the prospects of having to pay a 12-15% coupon on the bonds in what the company called “unfavourable market conditions” and announced its closure of a $172M sale of equity.
I do acknowledge that these are only three recent examples of companies issuing debt at a restrictive cost of capital, but it demonstrates the clear disadvantage that many companies are experiencing when others, such as CNR, can issue debt at only 5.55% over a 10-year term.
If you owned a company and had to pay investors 2.7 times the cost of what your competition could raise money at you stand at a substantial disadvantage regardless of your business model. Whether you intended to use the proceeds to pay off short-term debt or buy assets such as equipement or inventory no advantage in pricing, branding or operations will dramatically offset the high costs of financing.
Another strong bond offering came from Honeywell (HON) on Friday (February 20th) when they announced a public offering of senior notes worth $600M with a coupon of 3.875% due in 2014 and $900M with a coupon of 5.00% due in 2019.
The cost of capital is providing an important lesson to companies who took on too much debt or ignored the importance of developing a strong credit rating during the past few years when debt was cheap and easy to come by. As lending continues to constrict more and more companies will find that financing can be prohibitive and put them at a serious disadvantage versus their competitors. Investors should take the time to look beyond the commentary in the markets and get back to analyzing the basics of companies they are considering for investments.
When companies such as CNR or HON can issue debt at such substantial discounts to their peers they can directly benefit from this strengthened capital position now and in the future. Over the short-term the noise of fear may drown out these debt offerings as investors look to more exciting developments and speculation, but the fundamentals remain that any competitive advantage has the potential to accelerate a business forward versus their competition if capital is properly allocated within the business.
Excellent point Brad.
A coupon rate of 5.5% today is extremely good especially when many good companies are desperate for cash and end up financing at far too high rates.
What really surprised me on Wednesday was the fact that CNR’s issue was priced at under 300bps over a US 10-year bond considering the strength those tresuries have had with the flight to safety. It doesn’t appear they had any trouble filling their intended amount so you could almost make the case that the company can’t afford to issue more at such a discount to their peers. With their equity at such an attractive level (undervalued IMO) this would be one of the cheapest ways to raise capital. They might even come back to the market if they identify a strategic acquisition but likely not on the scale of the recent Roche bond issue to fund the Genentec purchase.