ONE SIZE DOESN’T FILL ALL

Back in the day, it was easy to compare the EV/EBITDA valuations of fundamentally similar companies.  EV/EBITDA is now failing as a useful valuation metric due to disparate credit issues.  A low and sustainable cost of capital is a valuable asset versus debt with a near-term maturity or a likely covenant breach.  Yet, even if estimates are adjusted for refinancing, the impact won’t show up in the standard EV/EBITDA calculation.

We can blame the markets, dumb financial management, the government, and so on.  Pick your scapegoat but the credit environment has changed dramatically in the last 6-9 months.  The easy money era is over and companies can no longer financially engineer returns.  Consider: 

·         For more leveraged companies, credit spreads have blown out from several hundred basis points to several thousand basis points

·         For less leveraged companies, bonds have gone from trading in the mid single digit yields to high teen yields

·         The CMBS market has largely become inaccessible

·         Banks have a much smaller appetite for risk, even at generous spreads, as they seek to shore  up their balances sheet

·         Underwriting future cash flow or giving credit for non-income producing assets is a rarity

·         Loan-to-Value (LTV’s) are down from 75% to 50%, with much more conservative assumptions on the “V” portion

·         Leverage covenant tolerance is down from 7.0-8.0x to 5.0x

·         Senior leverage tolerance is down from 5.0x to under 3.5x

·         LIBOR floors are the new future - say goodbye to sub 5% all in rates

Prospective or distressed borrowers are facing very large mark-ups in interest cost when they refinance or issue fresh debt.  For companies that rely heavily on bank debt, the mark up will be particularly ugly, as new credit facilities will not only be materially more expensive, but also a lot smaller, forcing these companies to tap the high yield market.  Even when fundamentals stabilize and begin to recover, companies may not get any cash flow benefit, as much of the EBITDA improvements will be eaten away by higher interest costs.  Therefore, simply applying historical EBITDA multiples will not capture the new reality of higher capital costs.

Unlike EBITDA, FCF accounts for differences in capital structure, and therefore we believe it is more appropriate to apply a multiple to FCF when thinking about valuation for leveraged sectors such as Gaming & Lodging.  Of course, fundamentals, stability, and growth can justify disparate multiples as they’ve always done.  Now, cost of capital can vary significantly across similarly leveraged and fundamentally exposed companies.  FCF yields and multiples do a better job of capsulizing that important metric.


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