Low interest rates have incentivised borrowing in recent years. There has been little reason for companies to reduce their debt levels. Therefore, businesses in a range of sectors have leveraged up their balance sheets in order to improve shareholder returns. This has helped to boost profits and generated higher returns for investors.
However, a more hawkish monetary policy stance in the US and the threat of higher inflation across the globe mean higher levels of debt repayment could become a reality. A stronger dollar may also cause the cost of servicing debt to rise, meaning balance sheets must be deleveraged. This process may be unpopular among investors on the whole, since cash which could have been used for investment or for dividends may now be used to repay debt.
One stock which I think will benefit from a debt reduction plan is Tullow Oil (LON:TLW). Its balance sheet leverage has caused concern among investors, but it now has a clear path to reducing debt levels. Higher production, improving free cash flow and a more sustainable business model mean it now has the capacity to reduce gearing levels. In my view, this could act as a positive catalyst on its share price.
A new era of monetary policy
The investment world moves in cycles and it seems as though the world is entering a new one. Donald Trump’s plan to chase 4% GDP growth is likely to mean one thing in my opinion: higher inflation. To push GDP growth higher requires a more aggressive fiscal policy which is likely to include lower personal and business taxes, as well as higher spending on things such as defence and infrastructure.
According to comments made by Federal Reserve Bank of Philadelphia President Patrick Harker, the Fed does not want to be behind the curve. Given the 6-9 month time lags of interest rate changes, this indicates a sharper than expected increase in interest rates this year and next year, as policymakers seek to counter Trump’s potentially inflationary policies.
The effect of this on debt repayment could be significant. Not only will borrowing become more costly because of a higher interest rate, a stronger dollar will also make servicing debt more expensive for companies which borrow in dollars but trade internationally.
The effect of this on profitability and investor sentiment could be negative. That’s why I feel companies which either have low debt or a clear path to reduce current levels of debt could be worth owning.
The inherent uncertainty of resources companies came sharply into focus in 2014, when commodity prices fell dramatically. This caused investors to become more concerned with the balance sheet strength of Mining and Oil & Gas companies, since there was (and is) a realistic chance of sustained low prices.
This encouraged companies such as Glencore to put in place a plan of action through which to reduce debt and create a business which would have a better chance of survival in a commodity price rout. In the last year alone, Glencore’s share price has trebled and this is at least partly due to improving investor confidence in its financial position.
This leads me neatly onto Tullow Oil. Its net debt of $4.8 billion is 2.1 times larger than its net assets, which gives it a net debt to equity ratio of 213%. In my view, concerns about its long-term viability have held its share price back at a time when a number of sector peers have soared in response to a rising oil price.
Tullow Oil’s plan
This week’s results from Tullow Oil show it has a clear path to deleveraging its balance sheet. It has pivoted towards oil production and the completion of TEN in Ghana means its production will rise significantly this year. The effect of this on its free cash flow has already been dramatic, with positive free cash flow reported in Q4 2016. A reduction in capex should also help free cash flow in 2017, with the company set to use its free cash flow to primarily reduce debt.
Undoubtedly, many investors would prefer Tullow Oil to start paying out a dividend immediately or invest in more production growth. However, I think its strategy of paying down debt is a sensible one. The oil price may have gained support in the last year, but with the OPEC deal to cut production set to expire in mid-2017, I think the oil price could remain volatile. A new deal may be struck to allow a supply deficit to come into existence, but I feel that shoring up its balance sheet is a prudent step for Tullow Oil to take.
Tullow Oil’s prospective P/E using 2017 EPS is 23.5. This may seem high, but given its ramp-up in production and the potential for improved market sentiment as it executes its debt reduction strategy, I feel this could move higher. An EPS forecast of 20.8p in 2018 from 2017’s expected 11.9p also indicates the company has the potential to achieve a higher valuation in my view.
Further, I believe the rising oil price could provide a lift for the Oil & Gas sector. However, I think the biggest factor for Tullow Oil will be the deleveraging of its balance sheet. High gearing ratios could become problematic over the medium term, as a more restrictive monetary policy is put in place in the US and possibly across the developed world in response to higher inflation. This could cause investors to pivot towards companies with lower debt, or ones which at least have a clear path to debt reduction.
Tullow Oil’s strategy of increasing production and using its improving free cash flow to primarily pay down debt is a positive strategic move in my view. I think it will improve the long-term viability of the business, while also encouraging a higher valuation from investors. It may not be the most exhilarating use of the company’s new-found cash resources, but it could be the most effective means of delivering a rising share price in the long run.