COMMENT: Leverage a la Russe

COMMENT: Leverage a la Russe
Gazprom's HQ.
By Mark Adomanis in Philadelphia May 20, 2016

Despite the often feverish denunciations that leverage sometimes receives (over the past several years, the German finance ministry has been particularly vociferous in its criticisms of debt-fueled economic growth), like most things in the business world it is not inherently bad or good. Stripped of the negative connotations that are often associated with the word “debt”, leverage is simply a tool, a method of financing that, like any other method, has a distinct set of positives and negatives.  

Some highly leveraged companies, like the American pizza-maker Dominos, are among the most profitable and successful in their industry. For these companies, leverage not only serves to boost equity returns, it also functions as an effective check on management, keeping the company disciplined in its spending, and realistic in the development of its financial projections and execution of its strategy. Much like Cortez burning his ships after arrival in the New World, leverage, and the recurring fixed charges it creates, can keep a company well motivated.

But, of course, in other instances leverage can be extremely dangerous, even fatal. If a company borrows heavily but invests the money wastefully (by creating products no one wants to buy, or by paying excessively large premiums to acquire other companies), it can rapidly run into distress if not outright insolvency. For bad companies, debt can often serve to amplify pre-existing problems.

For many reasons, state-owned companies ought to be more conservative than others in their approach to leverage. There is a spectrum, of course (the Norwegian oil firm Statoil isn’t particularly comparable to Rosoboronexport), but in general state-owned firms tend not to be terribly profitable. And it’s not exactly a secret why: publicly owned firms, almost by definition, have purposes other than simple profit maximization. They therefore, in general, possess cost structures that are inefficient in comparison to most of their privately owned peers. This lack of efficiency is important not for moral reasons, but because it makes debt service significantly more difficult than it would be for a comparable non-state-owned firm. Financing costs are met only after a company has paid its suppliers, employees and operating costs. The more cash these costs eat up, and among state-owned firms they tend to eat up quite a lot of cash, the less there is left to pay back any borrowings.

From a public policy perspective there’s another, and arguably far more significant, issue with leverage: the taxpayers are the ones left holding the bag.

For a “normal” publicly traded company, because equity claims are always junior to debt claims, the shareholders are the ones who lose out if the company over-levers and things go sour (with the normal result that, in bankruptcy, the old equity holders are wiped out and the creditors are given equity in the new, restructured and recapitalized firm). But with state-owned firms that’s just not the case: the likelihood of a such a firm going into bankruptcy proceedings or, in an even more extreme example, being liquated at an auction is virtually nil. The state simply won’t allow such an event to occur in any but the most apocalyptic of circumstances.

Instead, the government will inevitably (in one form or another) inject resources in a quantity sufficient to resolve the financial distress facing the firm. Maybe that comes through a “voluntary” agreement with creditors (states can make for very good negotiators!) or maybe it comes through a direct infusion of equity via the finance ministry or the central bank, but in either case the taxpayers are the ones who ultimately foot the bill. These bailout-related costs can sometimes be camouflaged, or at least rather difficult to understand. For example, the “costs” of a forced debt write-down might not be immediately apparent and could come via credit tightness or systematically higher costs of debt for other, private firms.

But in Russia the costs of financial distress for any state-owned firm would be very obvious indeed: the banks which would stand to suffer the brunt of any kind of debt restructuring are also owned by the Russian state. These banks would immediately have to book enormous losses if Gazprom, or another similarly sized state firm, was ever allowed to renege on its debt.

I hope the above is sufficient to convince you both that leverage is important, and that it is particularly important when it comes to state-owned firms who are, for a host of reasons, quite ill-suited to carry heavy debt burdens.

So what has happened in Russia? Has there been a meaningful change in how its “state champions” are financed? 

Geared up

In order to get a rough idea of what the state sector's leverage situation is like, I aggregated the IFRS financial statements of one mid-sized and three behemoth state-owned firms: Bashneft, Rosneft, Gazprom and Russian Railways. I then compared the long- and short-term debt burdens of these companies to their adjusted Ebitda, a common proxy for cash flow.

Due to the differing ways in which these companies present their financial results, several adjustments were necessary so that a truly comparable basis could be presented. This was particularly true of Gazprom, which lumps its foreign exchange losses and gains in with its other financing costs (most firms, for purposes of clarity, tend to separate and clearly label any gains or losses that result from exchange rate movements). 

The general picture that emerges is one of a rapid increase in leverage relative to income: from 2011-2015, debt grew from about 1.0 times Ebitda to more than 2.3x. It is worth noting that that level of indebtedness is not extraordinary; many companies in both developed and emerging markets can comfortably service debt burdens of anywhere between 2.5x and 4.0x Ebitda. It’s also worth noting the debt taken on by the firms mentioned above does not appear, at least at first glance, to be particularly expensive: even in 2015, with elevated levels of indebtedness, net interest payments were only about 7% of Ebitda. That’s considerable, but it’s a far cry from what “distressed” firms typically experience.

What is genuinely worrisome, however, is the trajectory of “Russia Inc.’s” debt profile: at a period of time when the overall growth rate of Russia’s economy was noticeably slowing, state-owned companies were rapidly increasing their levels of net debt. That process, it should be clear, cannot continue indefinitely: sooner or later firms that increase their debt burdens without generating corresponding increases in cash flow will run into trouble. If the authorities want to avoid a full-scale financial crisis, the levering-up that has taken place over the past four years will have to come to a halt. That will likely mean significant pain throughout the Russian state-owned sector, which, as best as I can tell, has used debt to forestall long-overdue restructuring and reform.

Much of what gets written about Russia in the Western press is significantly off the mark: there were widespread concerns about a foreign debt crisis even as the Russian corporate sector was rapidly paying down its dollar- and euro-denominated borrowings. The real debt crisis isn’t foreign but domestic – state-owned Russian companies that have borrowed from state-owned Russian banks with little to show for it.

Mark Adomanis is a Wharton MBA student by day, Russian analyst by night. Follow him on @MarkAdomanis