Leveraged companies versus cash rich companies

[krishan]

Just thought I'd write a quick primer since some of the forum has invested in DSUP and you really need to understand leverage to understand how DSUP has performed recently and what could happen in the future.

EV is the total price of a company including cash/debt. The reason this can be a better foundation metric is because it more accurately portrays the value of a company independent of the capital structure. Assume two companies sell the same product. Company S has a 10M market cap, and company T has a 100M market cap. Is one bigger than the other? Depends on the debt levels at each company. If T has no debt and S has 500M in debt company S would be the larger company. It doesn't make sense to compare the companies on a market cap basis.

EV is paired most often with EBITDA for valuation purposes. EBITDA is the operating profitability of a company before interest, taxes, and non-cash charges depreciation/amortization. Two companies with 500M EV should have similar EBITDA generation capabilities. The fact that a lot of EBITDA will be used to pay interest/debt isn't necessarily relevant. Companies with lower EBITDA margins regardless of capital structure tend to be worse companies and be given lower EV/EBITDA multiples.

Leverage in this context is important because it magnifies the potential upside and potential downside. Cash

Company A has 10M shares at 10 bucks, the market cap is 100M. With 0 debt and cash, EV is also 100M.

Company B has 10M shares at 5 bucks with 50M in debt. Market cap is 50M but EV, the total cost of the company is 100M same as Company A.

Company C has 10M shares at 20 bucks with 100M in cash. 200M market cap but a 100M EV because you have to subtract the cash from the market cap to come up with true price of the company.

Assume all 3 companies generate 10M in EBITDA annually (10x EV/EBITDA multiple). Suddenly due to market demand, they are all able to do 20M in EBITDA. What happens to the stock price of each company assuming a consistent 10x multiple?

Company A will trade at 20$ for a 100% return on the $10 stock price.

Company B will trade at an EV of 200. The debt remains at 50M so the stock price rises from $5 to $15 a 200% gain.

Company C trades at an EV of 200 but because of the cash, the stock price doesn't move as much. Stock price moves from $20 to $30, a 50% gain.

On the flip side, if EBITDA contracts 50% the leverage hurts you the most.

Company A trades at $5 a 50% reduction in value.
Company B trades at $0. 100% loss of value, equity is wiped out.
Company C trades at $15, a 25% loss of value. The cash cushions the fall.

So DSUP is highly levered. ~100M MC and 330M in debt for a total EV of 430M. The stock price can drop from 14-8 or 8-5 without a large decrease in EV due to leverage. No downside protection with heavily leveraged companies.

I'm fast becoming a fan of cash rich companies. In particular cash rich companies whose stock is down dramatically. Because of the cash, stock price decreases can dramatically change the EV of a company making it significantly more attractive. CUTR is an example of this. If a leveraged company decreases in value it's not a huge change.

Just wanted to post some thoughts.

Krishan