Companies do basically the same thing when they take out a loan and use it to pay themselves big dividends. It beats the alternative, which would be an owner selling some of its shares — getting cash but reducing its ownership stake and perhaps even losing control of the company.
The $700 million risk
There is, however, danger in this. Much like a homeowner who takes on too much debt when “taking cash out” of a subprime mortgage, a company that takes on too much debt to pay its owners a big dividend can be setting itself up for a fall.
Indeed, this may be happening at Beats. Reviewing the proposed issuance, Moody’s Corporation (NYSE:MCO) recently gave the debt a speculative B2-rating. Moody’s warned that Beats’ taking on debt to fund a dividend held particular risk because the company depends on just one “product offering” for its revenues, because it relies heavily upon its founders’ popularity to sell its product, and because “the sustainability of the company’s revenue and earnings growth” is questionable “given its very limited operating history and high business risk.”
In particular, the debt rater warns that “it is unclear whether or not Beats can refresh and relaunch its products successfully as they approach their life cycles in light of fierce competition.” Taking on debt to pay its owners dividends, rather than invest the cash in R&D and new product development, won’t help that situation.
On the other hand, if Beats does dig itself into a deep hole, it can always IPO… and hope investors will bail it out.
The article Dr. Dre’s Prescription: A Big Dividend Loan originally appeared on Fool.com and is written by Rich Smith.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
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