Dear Porter & Company readers,

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Good investing,

Porter & Company

In 1964, Rollins Broadcasting bought Orkin, the country’s leading pest control services company.

What happened next was, at the time, the greatest creation of wealth in American corporate history.

Even today, almost 60 years later, the deal for Orkin remains one of Wall Street’s greatest secrets. It was the very first leveraged buyout.

Rollins purchased one of America’s best businesses – with zero money down.

At the time of the deal, Orkin was earning about $3 million a year on sales of close to $40 million. Rollins Broadcasting, which was a pioneer in African American radio stations (it owned ten stations) and African American-focused cosmetics, was earning about half a million dollars on sales of $8 million. Rollins’ radio stations provided some of the most important programming in the country to Black audiences, including virtually every leader of the rapidly growing civil rights movement. It was a brilliant business strategy: the company’s radio revenues were growing 40% a year faster than the industry’s average.

Otto Orkin (“Orkin the Rat Man”) started his business in 1901, selling rat poison door- to-door from a horse-drawn wagon. A Latvian immigrant, Orkin was a hard worker. He launched his company when he was 14 years old. But his family members, sadly, were worthless. One son, “Fat Bill,” hired someone to kill his wife and ended up in jail. And Otto’s new – much younger – wife wanted him to sell the company for cash that she could spend — never mind that Otto himself was approaching 80 years old at this point.

Rollins Broadcasting founders Wayne and John Rollins had experience in radio, car dealerships, and billboards. Approached by the bankers selling Orkin, they made a careful study (hiring McKinsey consultants) of the pest-control market. What they saw in Orkin was a very poorly managed business that had wonderful economics: Customers generally signed long-term pest control management contracts that produced high-margin, repeat revenue.

The Rollins brothers knew the company would grow rapidly – if they simply used their radio stations to advertise and expand the business into larger markets.

But… where were they going to get the money to buy Orkin?

The Orkins and their bankers and lawyers weren’t dumb: they were asking $62.4 million, which was 20 times earnings for the business. The amount was more than 100 times what Rollins Broadcasting was earning at the time.

BORROWING $62.4 MILLION – WITH NO MONEY DOWN

During the summer of 1964, the Rollins brothers took their business plan to Wall Street, seeking loans. None of the major banks were willing to finance the deal, which entailed making a high-risk, long-term loan to a company that had almost no collateral.

Life insurance companies, on the other hand, understood that the collateral underlying the loans was the company being acquired and, with its long and successful operating history and high cash margins, the loans were safe. Prudential Insurance Company was willing to finance the deal and agreed to lend $40 million at 5.75% interest. Equitable Life and Chase Manhattan then decided they’d join the financing, lending $10 million.

But the lending syndicate offer was predicated on the Rollins brothers having skin in the game too. They had to come up with at least $10 million on their own. Where did they get the money? From the Orkin family! The final amount of cash ($2.4 million) came from the company’s own treasury.

The Rollinses structured the deal so that none of these debts encumbered any of Rollins Broadcasting’s core assets, the radio stations. The loans were tied only to Orkin’s revenue streams. They borrowed $60 million to finance the deal – but they didn’t put up any of their own money, and none of the collateral.

No one had ever done this type of deal in America before… and the results were shocking.

In early 1964, shares of Rollins were trading around $12. By mid-June, when the letter of intent to buy Orkin was signed, the shares jumped up to $16. By the time the deal closed, in September, the stock was trading at $50. A year later, with Rollins Broadcasting revenues up 363% in a year – without any new shares being issued – the stock price was over $150.

Investors in Rollins made almost 1,000% in a year.

This deal would soon become the basis for an entirely new industry – private equity. Companies staffed with lawyers and bankers would raise huge new funds to purchase companies, like Orkin, that had good economics and room for national or international expansion.

The business model frequently works very well.  And today, private equity firms like KKR, Blackstone, Carlyle, Apollo, Cerberus and others anchor a $6 trillion global industry.

But…that entire industry was almost destroyed by the 1970s inflationary environment and the accompanying soaring interest rates. Even Rollins – which, by now, owned a whole portfolio of solid pest control businesses – almost didn’t survive. By 1974, shares of Rollins hit $2.

And more recently… in 2020, American corporate debt hit a new, all-time high relative to GDP.

As inflation continues to send interest rates higher, the debt of corporate America is going to cause serious problems. Credit analysts predict that up to 40% of the lowest-rated corporate borrowers will default. But all companies, even investment-grade credits, will suffer.

A particular concern during the last decade has been companies using debt to “fake” growth.

Declining businesses that can’t grow their revenues and earnings have been adding large amounts of debt to their balance sheets. Then, they use the money to buy back their own stock (which reduces share count, and artificially boosts earnings per share).

It seems obvious to us that buying your own stock won’t help you market your products or services, invent new or better products, or lead you to innovative breakthroughs… in other words, the things that companies should be doing to grow.

Instead, these new, higher debt loads will ultimately send these dying companies to their graves.

AS INTEREST RATES RISE, THE “FAKE” GROWERS WILL FAIL

Consider the case of iconic American motorcycle manufacturer, Harley Davidson (NYSE: HOG, $35.31). The company’s earnings peaked at just over $1 billion back in 2006 – and since then have dropped by 35% to $650 million last year. But you wouldn’t know it from just looking at earnings per share – which hit a new record high in 2022.

That’s because the management of Harley Davidson has attempted to mask the decline of the core business with debt. Starting in 2005, just as earnings were peaking, management shifted their focus from engineering motorcycles, to engineering Harley’s share price.

Starting with a previously pristine net cash position in 2004, the company subsequently accumulated over $5 billion in net new borrowings. That debt went into repurchasing stock, cutting Harley’s outstanding share count from 294 million in 2004 to 144 million today. The chart below shows the result of this financial maneuvering, effectively swapping debt for equity on Harley’s balance sheet:

Now, the company finds itself leveraged up with net debt exceeding 5 times annual operating income. And over the next three years, the company faces nearly $3 billion in debt maturities, including nearly $1 billion next year alone. Refinancing those bonds – at much higher rates – will spike the company’s interest costs. Meanwhile, factor in a potential hit to demand from a recession… and this HOG could get taken out to pasture.

Harley is a good example, because it’s an iconic American brand which, on the surface, appears to be thriving in terms of earnings per share. But under the surface, the company is extremely vulnerable to potential one-two punch of higher interest rates and falling consumer demand.

And Harley is just one of countless examples. The last decade of rock-bottom financing costs spawned a horde of “zombie companies” – the walking dead of corporate America. Now, these companies face the potentially lethal combination of sharply rising financing costs and a coming hit to consumer demand, that could push them over the edge.

We’ve identified a list of several other stocks whose core businesses are in secular decline, and which have aggressively taken on debt to fund share buybacks, placing them in very tenuous positions:

Keep these names on your list of stocks to avoid in the coming recession.

THE BEST WAY TO SNAG DISTRESSED DEBT GAINS THIS TIME AROUND…

Is America, as a whole, in trouble? Yes, and we think the coming bear market will be especially painful for corporate bonds and highly indebted corporations.

But don’t forget: bear markets bring outstanding opportunities for investors who are prepared… the markets rain gold every now and then. We’re watching the bond market the same way a wolf looks at an old bull moose. He’s dangerous. But he’s gonna die. And when he does, we’re going to get an incredible meal.

Buying corporate debt that’s distressed (when it’s trading at a discount to par), and where the underlying business is sound, is – by far – the best investment opportunity we’ve ever seen in our careers.

In the past we’ve recommended things like a Rite Aid convertible bond that generated total returns in excess of 700%, while paying out double-digit annual coupons. And there are dozens of examples of bonds we’ve recommended that generated total returns far more than average stock market returns, and that also paid high coupons and offered far less risk than stocks.

At Porter & Co. we are watching the corporate credit markets carefully. We believe that defaults will continue to rise, refinancings will be become progressively more difficult and expensive, and, periodically, panics will erupt, giving us opportunities to make outstanding investments – like once-in-a- decade kind of stuff.

We expect to launch a new, distressed debt-focused advisory next year to capitalize.

In the meantime, there’s one fixed-income investment we have already begun to research. It’s a way to invest (indirectly) in Bitcoin, through a fixed income security that offers potential total returns of 1,000%+ and pays a handsome coupon (currently almost 8%).

Look for details in our subscriber-only issue that will be out next Friday (if you’re not a subscriber to The Big Secret on Wall Street, and you’d like to be, click here).

P.S. What happened after the elderly Orkin sold his company? His family members began fighting over the money as Otto descended into senility. Otto’s young wife was offered $5 million – but that wasn’t enough for her, so she sued. The case dragged on for years, and legal fees consumed her wealth. She had to sell her home, and eventually even her wedding ring. Finally, destitute, she lived on food stamps. Meanwhile, Otto – the enormously successful immigrant-turned entrepreneur multi-millionaire – died in poverty, and estranged from his children.