European corporate debt danger signals are flashing ever brighter as companies push cash at shareholders, but the bonanza will continue because credit markets are ignoring the rising risk. Under pressure from shareholders and the threat of being taken over by private equity specialists, some firms have taken to selling assets and borrowing to keep payouts to investors coming.
"I think it's definitely going to continue because there are companies who can clearly afford to put debt on balance sheet and earnings are above mid-cycle returns," said Andrew Lynch, a European fund manager at Schroders.
"The bigger threat is that companies go too far and take on a level of debt that is excessive and they are then also faced with an economic slowdown." Credit markets have so far not blinked in the face of companies' more aggressive moves to reward shareholders. Spreads on investment-grade euro corporate debt are close to their lowest in two years, according to data from Merrill Lynch.
So there is no brake on the replacement of equity finance by debt. Dutch chip equipment maker ASML, for example, issued bonds to partly fund its $1.3 billion share buyback this month.
German utility E.ON late last month said it would buy back $9.4 billion worth of shares and also proposed raising its dividend, which boosted its shares to a record high. This week, as a result, Standard & Poor's doled out a two-notch cut in E.ON's credit rating. Swiss drugmaker Novartis has said it would step up the pace of share buybacks given a spate of recent divestments as it focuses its business on health care, that has boosted its cash position.
Some companies fear private equity take-over specialists will do the job for them if they fail to manage their balance sheets. "Private equity is certainly highlighting the cost of capital differential, as well as forcing management to raise their game as guardians of shareholders' capital," said Piers Hillier, head of European equities at WestLB Mellon Asset Management.
There is pressure from shareholders too. Investment group Efficient Capital Structure, which owns just 0.0004 percent of Vodafone's equity, is urging the telecoms firm to issue bonds to shareholders by taking on around 34 billion pounds ($67.10 billion) worth of additional debt.
Vodafone said ECS's plans would send its credit rating to junk. Strong cash flows and corporate margins near record levels are providing companies with leeway to boost payout ratios. In the United States, S&P 500 stock buyback activity set a new record and accelerated during the first quarter of 2007. Standard & Poor's Index Services estimated that $117.7 billion was spent on stock buybacks in the first quarter, a 17.5 percent rise from the first quarter of 2006.
Some in the credit market are growing concerned that the cocktail of higher government bond yields and more aggressive financial structures are sowing the seeds of the next downturn, but that current market conditions - where demand for corporate bonds far outweighs supply - mean the market is not able to correctly price risk.
Despite the danger signs, credit strategists at Lehman Brothers said in a recent note that the underlying deterioration in credit fundamentals remained gradual, especially in Europe, and was not an immediate threat to corporate credit spreads.
They noted that although the aggregate debt-to-equity ratio for European companies had been rising, it was still some way off the peak in 2002. Capital returns from European companies have risen to near 2 percent of total market capitalisation in 2006 from 1 percent in 2003, said Jonathan Stubbs, head of European equity strategy at Citi.
"More generally, larger-cap companies tend to have stronger balance sheets and are trading on lower multiples. So, aggressive buybacks often make sense for many European large-cap companies," he said. Firms were paying special attention to boosting shareholders' returns at a time when profit growth was slowing down from above-average levels.
"The slowing rate of earnings/profits growth means dividend growth could outpace earnings growth for the first time in several years in 2007," Stubbs said. Many buybacks can be earnings accretive so this will benefit some companies too, he added.