Could Lower Gas Prices Push Highly-Leveraged EFH into Bankruptcy?
Saxo Bank | Mar 09, 2012 11:17AM ET
Leverage can be a wonderful thing when you have positive return streams. On the other hand, it can be poison if your return streams turn against you.
The masters of leverage may be private equity (PE) firms, and often it pays off, but the second largest private equity deal in history is turning into a nightmare for some of the US largest PE firms and Warren Buffett.
On October 10, 2007 the second largest PE deal (inflation adjusted, the RJR Nabisco deal still holds the top spot) became final when PE firms KKR, TPG Capital and Goldman Sachs Capital Partners bought Energy Future Holdings (EFH) known back then as TXU. The deal looked fantastic on the surface, and a year before the bankruptcy of Lehman Brothers and amid low interest rates no PE partners were worrying about levereage. There was only one problem. The company's prospects were tied to the price of natural gas, which is known for being volatile, unlike prices of cigarettes.
Another way to look at EFH's problems is by observing the ratio of its operating cash flows before interest and taxes to its interest paid, also called the cash flow interest coverage. As the chart above shows, EFH was more than able to handle its debt before the PE deal with a ratio between three and six. With a mountain of debt on the balance sheet and falling natural gas price, the ratio has declined to dangerously low 1.3 times, indicating that the company is only barely able to cover its interest payments. The problems get bigger when you include the needs for capital expenditures to maintain current electricity production capacity to serve its customers.
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How big an issue is this and will it get worse? EFH faces some tough problems as USD 31.8 billion worth of debt, according to Bloomberg data, will mature in 2012-2017. The debt will likely be refinanced at higher interest rates, since the credit rating of the company has deteriorated. But the biggest problem lies in the near term with natural gas prices poised to decline even further.
US natural gas at a ten year low
This week the price of spot month gas fell to another 10-year low at USD 2.27 per million British thermal units (mmBtu) and has now fallen by almost a quarter year-to-date. The reasons behind the continued selling are chronic oversupply from new sources like shale gas, plus winter temperatures much above normal. Due to this lower consumption during the peak months of winter, the available inventories in underground storage are almost 48 percent higher than the average over the last five years.
Worries have also been raised about how full storage facilities will be once we exit the withdrawal season and enter into the summer period of injection. Too-high inventories could force unwanted extra gas onto the market, which could put prices under further downside pressure.
It is would not be surprising to see even more depressed natural gas prices in 2012 and the big question is whether EFH can survive much longer on those low prices before they will have to restructure their business.
Buffet has written down EFH debt
A major casualty of the company's leverage and falling natural gas prices is Warren Buffett. As he writes in his 2011 shareholder letter, he spent USD 2 billion on several bond issues of EFH but has since written down the bonds by USD 1.4 billion with the remaining carrying value worth USD 878 million. In the letter Buffett even says it is likely that EFH's fortunes will not turn and the remaining carrying value will be wiped out. It will not be a complete loss of capital as he has already received USD 102 million in interest payments.
Conclusions
Leverage can be a friend and has been so for many PE firms. In the EFH deal it has turned out to be a disaster, showing why leverage is dangerous when return streams are not positive and stable (as it is with cigarette companies). Many companies do fine without debt, tech companies such as Apple and Microsoft, and have as a result lower business and investment risk. For the investor it is a lesson learned that overleveraged companies should be avoided, or at least be a small part of any portfolio.
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