The comparison between Wall Street and a “jungle” was never valid. If life in a state of nature can be described as “nasty, brutish and short”, nowhere is the Darwinian concept of “survival of the fittest” championed more. While consumption of small fish by a larger one seems an appropriate metaphor, it is trite and myopic enough to divert our attention from the truth: the concepts of mutual benefit and shared gain are more prominent than any vestiges of unilateral conquest.
In fact, if any allegory is especially applicable to characterizing “the Street”, it is the Biblical story of Jonah and the whale. Belief in miracles notwithstanding, “the Big Fish” swallowing a smaller creature is only part of the story. Jonah turns the crisis into an opportunity; he is “spat” out onto a beach, and begins preaching to the kingdom of Nineveh, changing their misbegotten ways.
Like the whale, the financial community must continue to grow to remain competitive. However, like Jonah, there is life after consumption. Despite its reputation for a “bottom line” mentality, Wall Street creates mutual benefits by sharing risk. When individuals with similar tolerances for risk pool their resources, the potential return rises, or the chance for an unacceptable outcome decreases, or both; the embodiment of this concept is the inherent limited liability of the corporation itself. This “symbiosis” is the product not of some hierarchical structure that eliminates competition, but a mathematical process that combines risk and return in the most efficient manner possible.
The following story relates a scenario that is quite characteristic of competition between modern corporations. One company’s risk- seeking marketing strategy narrows its focus to a point where its cash-flow is compromised. Another company whose revenue stream is more diversified, seeks risk in its manner of funding, and ends up borrowing money to take over the first company. This tension between two types of risk – one that affects revenues and one that affects funding – forms the crux of all capital structure decisions. Leverage is merely the measured manipulation of these risks, while an optimal capital structure points to their successful use. In effect, corporate share prices will maximize when these two risks are perfectly reconciled.
Like the proverbial “whale”, larger corporations can swallow-up smaller ones because they have a wider array of options when combining risk. Less risk in their revenue stream allows them to take more risk in other areas – especially in their sources of funding. On the other hand, any miscalculation in either risk by a smaller “Jonah– type” company will have a far-reaching impact because of the relative size of the firm. Ultimately, larger, “predator” companies can exploit an imbalance between risks in smaller companies usually a matter of timing.
Curtin Matheson Scientific was a quality distributor of scientific products for over twenty-five years. After the famed statistician, Dr W. Edwards Deming, reported on the precision quality control of Japanese firms, Curtin Matheson’s executives became disciples of Philip Crosby, one of the early and premier adherents of the concept of quality leadership.
A booming market in health care products in the middle 1980s produced high profits and some pricing power, and Curtin Matheson shifted its focus away from industrial laboratory equipment and toward the burgeoning diagnostic testing field. The marketing initiative was steadfast: the firm would attempt to carve out a niche for itself based on a high level of service and fastidious product knowledge. Selling to the rapidly consolidating HMOs (health maintenance organizations) would ensure cost effectiveness and high profitability.
By the time a recession hit in the early 1990’s, however, competition had altered the health care landscape. A shift to higher volume and lower prices necessitated the closing of distribution centers and the consolidation of customer service. Cut-backs became even more rampant when fears of nationalized health care gripped the industry. Price control would revert to a government entity and sales reps would be competing for contracts that would yield almost nothing. Curtin Matheson Scientific became vulnerable in the one area on which they concentrated - health care
Health care product distribution has two characteristics that make it especially attractive for acquisition by larger firms. Although profit margins had been shrinking, significant cash-flow was channeled through very high revenues; the price of the inventory was buffeted by technological scarcity - blood analyzers that sold for $200,000, for example. Moreover, the demand for health care products is steady enough to cushion other risk taking ventures; even in a downturn, revenues are stable.
Fisher Scientific was an old nemesis of Curtin Matheson. When Curtin Matheson began concentrating on the health care market, Fisher moved in the opposite direction, focusing on specialty chemicals and industrial products - a move that limited their exposure to an industry with declining margins. By the middle 1990s, Fisher spotted an opportunity; the floundering Curtin Matheson was ripe for a takeover. Fisher garnered a loan from a Canadian bank and paid Curtin Matheson’s English holding company, Fisons’, approximately 350 million dollars. Management became jittery about losing the company they had so adeptly built, even as a tell tale sign quashed any rumors about maintaining the Curtin Matheson Scientific (“CMS”) brand integrity: the Fisher logo began appearing on every product, from sharps containers to beakers and test tubes.
Fisher Scientific International was listed on the New York Stock Exchange, but they were not a “big” player on Wall Street. Their stock sold for about eleven dollars a share, which was considered paltry in the hyper-inflated market of the late 90s; there was nothing “romantic” about specialty chemicals and analysts maintained a low key coverage on the company. However, Fisher had a solid reputation in the scientific community. In fact, the firm had been around since the late industrial revolution of the 1800’s, building profitable vendor relationships that had produced a long track record of consistent sales.
The integration of Curtin Matheson into Fisher went smoothly. As an interested participant, I could not help but notice some oddities. Although we laughed at how rapidly Fisher put their brand name on “our” products, there seemed to be some disconnect between sales and operations. While the two entities were closely integrated in Curtin Matheson, emphasizing an emotional, “Japanese-like” commitment and unity between team mates, the Fisher approach was very clinical, like brokering a commodity, which of course, health care products had become. The main operations center was in Pittsburgh, but all executive decisions were conveyed from a small town on the coast of New Hampshire, called Hampton. The dichotomies posed more questions than they did answers.
In fact, Fisher Scientific was rapidly becoming a strategically-run financial powerhouse that expertly negotiated risk. By the onset of the new millennium, the firm was extremely well-diversified, carrying over 250,000 items. Fisher had divisions in safety, health care, chemicals, electronics and even had a supply center for radioactive material at the Los Alamos nuclear facility in New Mexico. Curtin Matheson was just one acquisition that fueled this diversification, albeit the largest at the time. By having at least one division that would react favorably to a changing economy at any one time, the risk of Fisher’s cash-flows were decreased, and its revenue base was maintained. While most high- tech companies were struggling with revenues of approximately $250,000 per employee by the year 2000, Fisher had a stream of about $340,000 in a field that was not particularly capital intensive - distribution.
Although revenues were high, Fisher could not generate the type of internal funding that supported both existing operations and a program of diversified growth simultaneously; margins were just too low. The funding for acquisitions came from debt a lot of it. By early 2001, Fisher carried negative equity. Stock was never issued for purchases, and retained earnings were insubstantial. On the other hand, the various integrations of acquisitions were expensive even as Fisher’s long-term debt to capital rate approached eighty-five percent.
Cash-flow, however, remained very high, even during the recession that began in 2001. Creditors took one look at the size and variation of Fisher’s revenue stream and gave them the “green light”. The firm responded by renewing loans at lower interest rates, courtesy of the Federal Reserve. Equity was kept to a minimum.
Ultimately, when acquisitions began to pay off, the stock soared, but it did not move on the basis of sales or profits. The stock barely moved at all in fact, except for a single situation: when any news or rumor of an acquisition occurred, the stock would jump out of its usual stable dormancy and take off like a rocket. Since some small acquisition occurred at least twice a year, the stock was a good addition to any portfolio; its only volatility was self generating. In the mean time, Fisher began to pare down its debt and issue equity, causing the stock to soar even higher. They bought biotech suppliers in Sweden and test equipment companies in the United States. By 2006, they had merged with ThermoElectron, a company that had no long-term debt whatsoever. They ended up calling themselves, “Thermo-Fisher Scientific” (TMO). And inevitably, they also had the last laugh- they seemed poised to start the whole “process” over again.
In a nutshell, the story of Fisher Scientific provides a valuable lesson in managing capital structure. Fisher had two types of risk that were in potential conflict: business risk sometimes called economic risk or “operating risk”, and financial risk. Business risk is the variation in revenue, costs and operating income that stems from the type of industry; some industries react to inflation, recessions, foreign competition, and other economic factors differently than others. On the other hand, financial risk is almost entirely selfgenerated, and stems from the variation in net income from the decision to use debt. In essence, financial risk is expressed as the potential for defaulting on interest payments and principal. It works together with business risk through the variability of operating income; an adequate and steady operating income can keep financial risk very low because there is less probability of default.
Fisher Scientific treated its operating cash-flows like a portfolio, adding and dropping product lines that would make it less risky. Even as margins declined, its return on equity (ROE) increased because it never funded with its own money. By financing with debt, but simultaneously decreasing the risk of its operating income, Fisher configured the risk-return tradeoff in its favor. Alternatively, the decision by Curtin Matheson to focus on health care to the exclusion of other divisions made the company a takeover prospect. With few barriers of entry, the industry invited intense competition; margins declined, and the company was left with a riskier and depleted cash-flow.
Companies like Fisher Scientific are quite ordinary. They never have the type of sensational results that makes them the darlings of speculators. They rarely make the evening news. And yet - here was a company whose stock was selling at $11 a share in 1997 only to rise to a peak of $77 eight years later. In that period, it was only about half as volatile as the rest of the market.
One misconception that students and investors share alike is that a business is suppose to “maximize” profits: the “bottom line” mentality is almost an endemic archetype and yet rarely occurs in economic behavior. Imagine a cash flow for Company A of 60, 70, 65, 90, and 110. Now compare it to the cash flow of Company B: 60, 60, 65, 75, and 75. Which would you prefer? Most people would pick the first because the chance of getting a high number is greater. However, the flow from Company B is much steadier and by several mathematical gauges of risk has a better risk-return characteristic than Company A’s. In fact, the difference is small, but may be compelling enough for investors to choose Company B as an investment. While the average in Company A is much greater than in “B” (79 vs. 67), the risk is far greater also.
Capital structuralism is not about directly maximizing profits through programs like a new marketing campaign or “zero base budgeting” or the implementation of new technology; it takes a far more subtle approach. It chooses a course of action from several alternatives that balances the risk of different types of funding with returns that exceed their cost. Thus, the goal of minimizing the cost of capital is implemented through the capital budgeting process; the cost of the mixture of debt to equity will determine the plausibility of each project because of the necessity of exceeding capital outlays with returns. The lower is the cost of capital, the greater the number of projects that will be potentially profitable.
Risk and return are so intertwined that it is proper to refer to them as a statistical “distribution” with two parameters, rather than as separate categories. As an example, consider an equity issue, the marketing of more shares of stock to raise additional funds. The characteristics of risk and return for such an issue are much different at the beginning of a recovery than at the end of a bull market - for both the issuing company and the investor. Although the investor is not encouraged to “time” investments over the short term, some awareness of the correlation between sector performance and the business cycle is essential. Capital structure is dependent on the relationship between interest rates and the equity market, which are dependent on the state of the economy. Therefore, time is a unifying factor between risk and return and encourages their interdependence. The investor is left in a precarious position. On the one hand, he or she is encouraged not to time the market because it is not successfully done over a long period. On the other hand, time is the essential component in all risk-return distributions - from investment horizons to the choice of which investments to make. By identifying and investing in firms who repeatedly move toward their optimal capital structures, capital structuralism resolves some of this conflict.
What about variation? Random fluctuation is the bane of any analyst. No matter how precisely one measures the deviations in past performance, current and future behavior of an investment seems to defy formulation. While Wall Street prizes certainty, long-term viability is never certain. The market keeps changing and the response to world events is embedded in corporate gains and losses. Capital structuralism is flexible enough to encompass change because it never defines optimality as a rigid set of conditions. Each industry has a particular response to economic factors that produces a different optimum level of proportional debt and equity. Some industries have better risk-return characteristics without any debt at all. Others can compete with firms that have two or three times its profit margins simply because they know how to use debt judiciously. Since capital structure is dependent on the business cycle, it responds to societal trends, demographic changes and political risks better than the various “systems” that have made their way into the investment literature. In effect, capital structure reflects the reasons why a certain entity is in business in the first place: to grow and make a profit.
Ultimately, our analysis attempts to put a dollar price on risk. While the market responds to information instantaneously, we attempt to measure its content before it becomes meaningful. We can define cost in three different ways, all of which are used to evaluate risk:
• 1) The Nominal Cost- This is the “up front”, accounting cost of an action which will be
reported in financial statements
• 2) The “Real” Cost - This is the cost of an action with economic conditions factored in.
If my net income is $100 and the inflation rate is five percent, then my “real” net
income is probably only $95. If I have tax “look backs” of $20 figured into that $100,
then my effective tax rate was reduced and I will have to make a much greater net
income in the next year.
• 3) The Risk Adjusted Cost - If I keep all of my money in a checking account when the
market is rising by fifteen percent a year, I will be penalized for not putting more
money into the market. The risk adjusted cost is the comparative cost of taking one
action over another, creating either a gain (opportunity gain) or a loss (opportunity
loss). It is most related to what can be termed, “the going market price”. In capital
structure, this risk adjusted, “opportunity cost” is more important than any other because it looks at an array of alternatives and chooses a course of action that attempts
to create the largest possible opportunity gain. Therefore, many of the costs we incur in capital structure are not representative of a physical asset and passed on from a previous owner, but are the result of a choice of actions with which we have comparative information. The integrative approach of this text is to position the analyst, the investor and the financial manager from the same viewpoint: he or she gauges the risk of operating cash flows and balances that observation with the choice of alternative sources of capital, repeatedly making comparisons between the industry, the sector, and the greater economy. Under the premise that capital structure is the interface between comparative accounting and the macro economy, the student receives an overview of corporate finance through the attempted reconciliation of risk and return. In effect, the difference between student, investor, analyst and manager is clouded because each perspective is directed by the need to seek and discover optimality. The text requires some familiarity with statistics and computer spreadsheets but not an extensive background in either. There is a chapter dedicated to statistics, and most spreadsheets have step by step instructions. The flow of the text is as follows:
• 1. Theoretical Background: Capital structure theory is examined through previous
research with an emphasis on integrating the evaluation of risk and return.
• 2. Model Building: A mathematical conception of capital structure is built through
computer models and the adaptation of existing formulas. Each of the spreadsheet
models has been used to evaluate corporate behavior.
• 3. Correlation Studies: Examination of the relationships between stock price and
capital structure variables gives insight into the behavior of some major corporations.
While no definitive conclusions are drawn, tendencies that support capital structure
theory are examined using the Spearman rank correlation.
• 4. Case Studies: Application of capital structure analysis to Kimberly-Clark and
ConocoPhillips, as well as Microsoft and Chevron display the effectiveness of the
techniques. One of the great philosophers of the early twentieth century, William James, might have appreciated the personal computer revolution. He who championed “the cash value of ideas” and the philosophy of pragmatism might have found solace in a machine that tested the viability of theory. While we often lack the political framework to implement ideas, at least “the information age” has made them available, which is certainly “half the battle”. For students, the author hopes that this book will unify financial thought into a comprehensible “whole” and encourage the actualization of “just theory”. For investors, the author hopes that this book will help them see beyond the superficiality of conventional wisdom with the knowledge that the cash value of any idea is almost always found in its underlying structure. Finally, for the executive, the imperative is placed on innovative thinking: a time-tested solution is the outgrowth of a new perspective. (Back to Table of Contents)