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Now’s The Time For S&P 500 Companies Lever Up: Goldman

S&P 500 (INDEXSP:.INX) companies should enhance leverage to arrest their declining margins and return on equity, believes Goldman Sachs Group Inc (NYSE:GS).

Stuart Kaiser and team at Goldman Sachs think that by taking advantage of the prevailing low financing costs, S&P 500 companies should return asset / equity leverage to its 10-year average.

Leverage – an easy way to protect ROE

Goldman Sachs analysts have poured over 30 years of data and concluded that stocks with weaker balance sheets have steadily outperformed peers with safer balance sheets. Historically S&P 500 (INDEXSP:.INX) companies have increased debt (relative to sales, enterprise value and EBITDA) when ROE began to ease.

The following graph highlights the analysts’ view that ex-Financials companies have raised debt levels when ROE is declining.

ROW Lower Leverage Higher S&P 500

Goldman analysts point out leverage is the easiest path to protect ROE.

S&P 500 companies ripe to enhance leverage

Stuart Kaiser and team at Goldman Sachs have zeroed in on S&P 500 (INDEXSP:.INX) companies that have declining or below peer ROE and the highest capacity to add value, while at the same time maintaining an investment-grade credit rating. Goldman Sachs analysts have identified 34 companies with both the potential and the motivation to enhance leverage. The following are the 34 re-leveraging candidates:

Companies ripe for leverage

Goldman Sachs analysts believe companies that are earning lower ROE than their industry peers or those where ROE is showing declining trends are more likely to raise leverage. Furthermore, declining earnings growth could also motivate management to employ leverage to protect growth.

The analysts believe modest changes in leverage can have a meaningful impact on ROE.

Goldman Sachs analysts point out companies which have increased leverage in 2013 generally have large market capitalization, higher leverage, and lower expected growth than peers. The analysts have also identified 90 companies among the S&P 500 (INDEXSP:.INX) category who have increased leverage across each of three leverage metrics viz.: debt/enterprise value, debt/EBITDA and debt/assets.

The analysts make a point of noting that consumer staples and information technology account for over 30% of higher leverage companies. Focusing specific attention on individual stocks, the analysts point out Apple Inc. (NASDAQ:AAPL), Wal-Mart Stores, Inc. (NYSE:WMT), International Business Machines Corp. (NYSE:IBM), EMC Corporation (NYSE:EMC) and PepsiCo, Inc. (NYSE:PEP) are among the largest issuers of debt in the S&P 500.

Potential for large companies to leverage

Goldman Sachs analysts feel large companies would potentially enhance their leverage over the medium-term as earnings growth slows and ROE shows signs of declines. The analysts’ view is reinforced by the fact that a leveraged approach would be catalyzed by lower tax rates and favorable borrowing costs. For instance, Goldman Sachs analysts point out effective tax rates are only 28.6% against nearly 50% seen in 1975.

Goldman Sachs analysts anticipate each 0.1x increase in the asset/equity ratio would raise ROE by 30 bp and would have a 30 bp declining effect in EBIT margins. The following table elucidates the analysts’ views:

ROE sensitivity