Singapore Investing: Just How Leveraged is Starhub?

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Starhub is well-known among retail investors for its high dividend yield. However, its brand name and dividends belie the extent of credit risk. Here is our attempt at wrapping our heads around Starhub’s degree of leverage.

Starhub’s ROE is 249%

To first get a sense of how leveraged Starhub is, one can look to its insanely high return on equity (ROE). Typically, ROE of above 20% is considered impressive. Starhub’s 249% in its last financial is way above the curve and in 2011, its ROE was 1396%. How does ROE related to the degree of leverage? The answer lies in the Dupont analysis which breaks down ROE into 3 constituents:

ROE = Profit Margin x Asset Turnover x Leverage

Simply put, the higher the leverage employed by a company, the higher the ROE will be, assuming profit margin and asset turnover remains constant. The crucial thing is that the degree of leverage employed is a conscious decision made by the management of a company. There is no talent required in changing a company’s capital structure. A company’s capital structure can be easily changed – either by borrowing more and increasing debt, or issuing new shares to increase the equity base. The implication is that 2 companies with similar profit margins and asset turnovers can have very different ROEs; it all depends on the choice made by management regarding the company’s capital structure. In Starhub’s case, the choice is pretty clear.

‘A more holistic approach in measuring Starhub’s debt’

Starhub debt to equity is 13.3x; this means that for every dollar of initial capital, Starhub borrows $13.3. A ‘normal’ high debt to equity is about 2-3x. Starhub’s debt to equity is by far the highest we have seen. I did not go to their recent AGM as I am not a shareholder. However, according to the good fellows at fifthperson, the management said that “a more holistic approach to measure StarHub’s debt position is to compare its net debt against its EBITDA which is less than 1!”

We disagree. While debt to equity is by no means a perfect indicator, we do not believe that comparing net debt against EBITDA is any more holistic. EBITDA does not include important expenses such as interest and depreciation. Depreciation, while itself a non-cash expense, has implicit relations with capital expenditure which is a very real source of cash outflow. EBITDA also does not include dividends and this is important since Starhub is known as a high dividend yielding stock. In a nutshell, a net debt/EBITDA of less than 1 means that Starhub can theoretically pay off all its debt in 1 year. But it may also mean cutting dividends, not being able to afford the interest on the debt, and not being able to reinvest in equipment.

Our version of a holistic approach

Let us first look at the relation between depreciation and capital expenditure (purchase of property, plant and equipment).

(SGD m) 2010 2011 2012 2013 2014
Depreciation Expenses 259.5 277.8 272.5 269.5 271.2
Purchase of PPE 272.1 246.5 272.7 302.8 321.6

Depreciation is an accounting concept invented to represent the cost of upkeeping assets against wear and tear. We can see that depreciation mirrors capital expenditure fairly closely. In Starhub’s case, depreciation clearly cannot be ignored. As a capital-intensive and asset-heavy business, capital expenditure is vital to the continued provision of services.

Secondly, EBITDA is often used as a proxy to cash flow.

(SGD m) 2010 2011 2012 2013 2014
EBITDA 601.8 676.0 719.8 743.0 747.9
Operating Cash Flow 669.6 696.2 689.5 594.7 564.9

We can see that this is fairly true, but why use a proxy when you can evaluate the real thing? We now piece together the entire puzzle by subtracting capital expenditure and dividends from operating cash flow to find the available cash flow.

(SGD m) 2010 2011 2012 2013 2014
Operating Cash Flow 669.6 696.2 689.5 594.7 564.9
Purchase of PPE 272.1 246.5 272.7 302.8 321.6
Dividends Paid 343.1 343.3 343.4 344.2 345.2
Available Cash Flow 54.4 106.4 73.4 -52.3 -11.9

Based on the 5-year historicals, it is clear that Starhub has very little cash remaining after reinvesting in equipment and paying off dividends. The available cash flow above is from a perspective of a dividend investor who would like to see his dividends maintained. Of course, in reality, payments to creditors take precedence over equity owners. Starhub has the following debt obligations:

(SGD m) 2010 2011 2012 2013 2014
Total Debt 669.6 696.2 689.5 594.7 654.9
Finance Expenses 26.6 18.4 15.9 19.2 22.5

All in all, the negative ‘free’ cash flow in the last 2 years indicate that Starhub did not generate enough cash from its operations for the reinvestment of equipment and payment of dividends, much less the payment of interests and principal. Even when it has enough for the payment of interests (from 2010 to 2012), there isn’t much cash left for the repayment of principal.

Final words

Our analysis indicates that Starhub is indeed very highly leveraged. As a company in a relatively stable industry, it may be one of the luxuries that it can afford. Nevertheless, we believe that investors should be fully aware of the risks involved in investing. Net debt/EBITDA of less than 1 may seem low, but it omits critical considerations which makes it out of touch with reality. Be wary when management resort to touting such measures.

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