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Thursday, May 16, 2013 - 13:00

This Classic Value Stock Has Up To 57% Upside

Thursday, May 16, 2013 1:00 PM

Apple (Nasdaq: AAPL) made history last month with the biggest corporate bond issue ever: $17 billion in six different maturities. That's more than the GDP of the 29 smallest countries combined -- and Apple did it by promising to pay just 1.4% a year in interest.

Everyone caught the news, but many overlooked the huge consequences it has for the market. This deal has the potential to push a lot of stocks higher and not just those tied to the Cupertino, Calif.-based giant.

Apple will be using the debt to return $100 billion to shareholders through dividends and stock repurchases over the next two years. Evidently, the Street likes the plan, with big investors like David Einhorn buying more shares and pushing the stock up more than 15% since its low just before the announcement.

The best part? Apple will save $9.2 billion by using debt instead of repatriating overseas cash and $100 million a year from the tax deductibility of interest expense.

But this isn't what has me so excited about the news. What has me so bullish is the message this deal sends and how it shatters the old myth of dangerous debt.

Times Change -- And Management Needs To Change With Them
I'm going to sound old, but not too long ago -- say, 30 years ago -- the cost of debt was prohibitively expensive for many companies.

The safest bonds around, the 10-year Treasury note, hit a rate close to 16% in the 1980s, and companies had to look to equity financing for their capital needs. After all, it doesn't make sense to pay double-digit rates on bonds when you could pay investors 10% or less to take an equity position in your company.

As rates continued to fall, the optimal funding mix of debt and equity started to change. Companies could issue bonds cheaply, write off some of the interest against their taxes, and not have to dilute ownership by selling more shares.

But a holdover to the days of expensive bonds still remains, and it's making some companies terribly inefficient. Many of the old-timers on the boards of directors and in management still consider it a source of pride that they can run a company with no long-term debt. They argue that the required interest payments limit operational flexibility and that their cash flow more than pays for capital needs.

But that's the old way of thinking.

After the tax benefit for interest, Apple will be paying an average of 1.4% across the different maturities it issued. That's less than the rate of inflation, which has been running at 2.4% over the past decade, and much less than the cost of equity financing, which is between 4.7% and 8.5% for the general market.

Even companies with shaky fundamentals are able to issue less than investment-grade debt, appropriately called junk bonds, at rates around 5%.

Paying interest on a loan at less than the rate of inflation is like getting free money.

An example: Say you take out a loan of $1 million with 2% interest paid annually and the principal amount repaid after 10 years. You'll pay $200,000 in interest, but with 2.4% annual inflation, the $1 million you repay in 10 years would only be worth close to $784,329 today. You actually made $15,671 by taking the loan.

Inflation is lower now, but it could grow much higher if the world's central bankers keep the printing presses going. With rates on investment-grade debt at or below long-term inflation, it is irresponsible for management not to take advantage of the fixed-income market. In addition to being able to pay back the debt with money worth less than it's worth today, the company also sees its earnings improve through the tax-deductibility of interest expenses.

As the old school of thought becomes more accepted as the dinosaur -- as it is by an increasing number of directors and executives -- you are going to see more companies coming to the debt market, increasing their dividend and buying back stock. Companies with no debt, stable sales growth and a positive return on assets may soon take Apple's lead and issue debt to return money to shareholders.

These Companies Are Prime Candidates To Borrow

Finding companies with strong sales growth and a positive return on assets could help you get in front of the announcements and pick up shares before the pop. These companies should have no problem meeting the debt payments and will probably see higher margins on that cheap money.

I've run a screen and looked through the financials of three companies that could be strong candidates for this new debt outlook. They should each be able to obtain an A rating from Standard & Poor's, which S&P defines as "Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances." The current yield for this rating is 2.88%, higher than Apple's but still putting the after-tax rate of 2.16% below that of inflation.

Fastenal (Nasdaq: FAST) is a $14.3 billion seller of industrial and construction supplies. The company pays a dividend yield of 1.6% and has $160 million in cash on its balance sheet. Sales have grown an average of 9.5% over the past five years, including 13.5% last year on the rebound in housing.

If Fastenal were to increase its debt-equity ratio from zero to 15%, well under the 48% average for industry peers, then it could issue about $275 million in debt. That would be enough to buy back 5.7 million shares or increase the dividend by 18 cents over five years, which would boost the dividend yield to 2.1%. Further, the company would see its earnings improve through the $2 million tax deduction on interest expense.

ARM Holdings (Nasdaq: ARMH)
is a $22.7 billion semiconductor company with a dividend yield of 0.5% and $882 million in cash on its balance sheet. Sales have grown an average of 15.9% over the past five years and increased 17.4% last year.

If ARM were to increase its debt-equity ratio to 7.7%, in line with the average for industry peers, then it could issue about $165 million in debt. That would be enough to buy back 3.4 million shares or increase the dividend by 7 cents over five years, which would raise the dividend yield to 0.6%. Further, the company would see its earnings improve through the $1.2 million tax deduction on interest expense.

Qualcomm (Nasdaq: QCOM) is a $110 billion maker of digital communication products (and it happens to count Apple among its customers). The company pays a dividend yield of 2.2% and has $13.5 billion in cash on its balance sheet. Sales have grown an average of 17.2% over the past five years and jumped 27.8% last year on the surging smartphone market.

If Qualcomm were to increase its debt-equity ratio to 10%, just under the 11.5% average for industry peers, it could issue about $3.7 billion in debt. That would be enough to buy back 58 million shares or increase the dividend by 43 cents over five years, which would bump the dividend yield to 2.9%. Further, the company would see its earnings improve through the $26.8 million tax deduction on interest expense.

Risks to Consider: For many companies, the current environment of low interest rates and the benefits of issuing debt are factors in just one decision among a number of others to be made. The questions of which companies will issue debt and how well their shares will perform will be affected by many other decisions and the broader economy. While the decision to issue debt and return cash to shareholders should have a positive effect on the three prospects named here, investors need to look at the whole picture before buying.

Action to Take --> Companies with stable cash flows and a positive outlook would be irresponsible not to tap historically low rates to lower their cost of capital and return money to shareholders. More companies are poised to follow Apple's lead and issue debt this year, which should put more money in investors' pockets.

Note: Projections for debt issuance were determined by increasing debt-equity ratio (long-term debt/stockholders' equity) to stated goal. Issuance was then divided by stock price for share buyback estimate or divided by shares outstanding for increase to dividend. The increased dividend is divided by five years to ensure sustainability. The debt-to-equity ratio across the market is 32%. Typically, utilities finance more than half of the company; by comparison, tech firms usually finance less than 10%.

P.S. -- If these companies were to tap the debt markets in this fashion, their stocks would be perfect for what we call the "Dividend Trifecta" strategy. Simply put, it's a three-part approach to dividends that multiplies the effectiveness of every dollar you invest. The plan is specifically engineered for people who want to retire sooner or those who would like a steady stream of extra income. Go here to learn more.

Joseph Hogue owns shares of AAPL.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.