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Private Equity Repellent


Three weeks before Home Depot Inc. (HD) CEO Robert L. Nardelli resigned, Standard & Poor's (MHP) downgraded the company's credit rating, citing the retailer's "more aggressive" financial policy. In the past year Home Depot had taken on $5 billion in new debt and tapped two-thirds of its cash reserves to buy back shares and increase dividends. The moves were a sop to angry shareholders who had been pestering Home Depot to boost the stock price.

Nardelli, of course, won't be around to see how his maneuvers play out; he quit over pay issues. Yet Home Depot illustrates new thinking about corporate balance sheets. The underlying logic seems counterintuitive: By weakening the financial picture to return cash to shareholders, corporate managers can preempt shareholder challenges. At the same time, they make the balance sheet less enticing to voracious private equity firms. Leveraging up, the thinking goes, can kill two birds with one stone.

Many companies are buying in. Share buybacks and dividends, all the rage recently, are starting to outstrip profits. In 2006, for the first time since 1990, cash held by nonfinancial companies in the Standard & Poor's 500-stock index declined, according to S&P senior index analyst Howard Silverblatt. He pegs the drop at about 4%, based on preliminary data. Cash decreased "for a significant number of companies," he says, perhaps more than two-thirds.

The lurch toward debt isn't as dangerous as it sounds. Many experts say executives have made their balance sheets too solid over the years. According to a recent study by UBS (UBS) equity strategist David Bianco, companies in the S&P 500 could increase their debt to still-prudent levels in 2007, return excess cash to shareholders, and raise the index's value 3% to 5%.

Such thinking is showing up at a wide range of companies. At the Hershey Co. (HSY), spending on share repurchases exceeded free cash flow by $1billion over the past four years, estimates B. Craig Hutson, an analyst at Gimme Credit. S&P changed its outlook for Hershey's A+ rating to negative in October. Hershey declined to comment. Similarly, Computer Sciences Corp. (CSC) last year embarked on a $2 billion buyback campaign, partly with borrowed money, a move that prompted a downgrade from S&P to A-. And Expedia Inc. (EXPE) saw its rating threatened last month when S&P sized up its repurchase plan and changed its outlook to "negative." Both companies declined to comment.

Among "investment-grade" borrowers, cash as a percentage of total debt has decreased from 17.5% in January, 2005, to 12.5%, according to Gregory J. Peters, chief credit strategist at Morgan Stanley (MS). Yet that's still more than the historical average of 10%, says Peters, and merely leaves balance sheets "less pristine."

Bondholders hate the change; they're losing safety without getting higher returns. Then again, a willful shift toward leverage could be the lesser of two evils, the other being a leveraged buyout. LBOs pile on debt and often turn "investment-grade" bonds into junk.

At Home Depot, spokeswoman Paula Drake responded in an e-mail that "returning value to our shareholders is a top priority and the strength of our balance sheet enables the company to do so." That may well be. In other words, weaker is better, at least for now.

By David Henry


American Apparel's Future
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