Let's see what the capital structure of two well-known companies -- cell phone maker Motorola and offshore driller GlobalSantaFe -- and why private equity and merger activity is likely to continue bidding up drillers.

Most private equity deals seek to optimize the target company’s capital structure, or the appropriate mix of debt and equity claims.

Debt holders have a priority claim on the company’s assets, while equity holders have a residual claim. If things go wrong, debt holders are first in line at bankruptcy court, but their exposure to the good times is basically limited to a fixed stream of payments. Equity holders are left with nothing if the company a) goes bankrupt and b) there’s nothing left after creditors liquidate what’s left of the assets in an attempt to recoup as much of their principal as possible. But equity holders enjoy all the extra cash flow when business is booming.

When used appropriately, debt, or “leverage,” can greatly enhance shareholder returns. Private equity, aka “leveraged buyout,” funds generally look for businesses with solid competitive positions that consistently generate cash. Private equity deals are heating up into a craze because the supply of cheap credit appears to have no limit (until all of a sudden, everyone discovers that there is, in fact, a limit).

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Private equity funds first pool together their capital. Then they leverage their buying power by layering debt on top of their capital. This allows them to buy much larger businesses -- and streams of future cash flow -- than they otherwise could buy outright with their limited funds. Returning to the concept of capital structure, the debt holders get paid a fixed 5-6% per year and the equity holders have a claim on the rest, whether it ends up being a total loss or a stream of cash that’s even larger than they anticipated.

Motorola’s Levering Shareholders’ Exposure to Creative Destruction

Motorola’s recent disappointments have been numerous. A glut of cell phones is building in the supply chain and the fallout is not going to be pretty. Wireless carriers are giving them away with minimal contract commitments. The title of this article on Bloomberg yesterday says it all: “Motorola’s Zander ‘Running Out of Scapegoats’ as Profit Fades”:

“Earnings and revenue this year will be ‘substantially’ below its forecasts because of plunging mobile phone prices, Schaumburg, Ill.-based Motorola said yesterday. Zander, who already is cutting 3,500 jobs, said the company will overhaul marketing and product design to make its prices competitive without sacrificing earnings.

“The world’s second biggest maker of mobile phones also named a new president and detailed a plan to step up its share buyback program amid a proxy fight with shareholder Carl Icahn.

“Instead of sparking optimism, the news set off criticism of Zander’s choice for the promotion and a product plan that investors said didn’t show enough concern for bigger rival Nokia Oyj’s recent advances in the market.”

Bloomberg then describes Motorola’s big management shake-up in the wake of this ugly news:

“Motorola’s choice for its new president and chief operating officer, Greg Brown, who runs the networks and enterprise unit that sells networking devices to companies and government agencies, also drew fire.

“‘There’s not a single senior Motorola executive that had more predictions go wrong,’ said Albert Lin, an analyst at American Technology Research in San Francisco, of Brown. He rates the shares ‘neutral’ and said he doesn’t own them.

“Motorola also said Chief Financial Officer David Devonshire will retire. Director Thomas Meredith will be acting CFO.

“Motorola expects a loss of 7-9 cents a share, its first loss since 2004, on revenue of $9.2-9.3 billion this quarter. Motorola didn’t provide new full-year figures.

“‘I never would have thought that they would go into a money-losing situation,’ Lin said.”

Lin “never would have thought that they would go into a money-losing situation.” This statement is puzzling because it’s not that hard to imagine a situation where Motorola goes into the red. Short product cycles and high R&D spending requirements can combine to produce red ink very quickly when business sours.

In recent months, Motorola shareholders had gotten excited about the leveraged recapitalization efforts of Carl Icahn. Mr. Icahn has been branded with the title “corporate raider,” yet his tactics have a record of creating value for shareholders when management and the board of directors slack off on this responsibility.

The recent cell phone boom left Motorola with plenty of excess cash that Icahn believes it doesn’t need. Since Motorola’s business doesn’t entail managing a multibillion-dollar bond portfolio, Icahn is pressuring the company to disburse all excess cash to shareholders through share buybacks (allowing for enough of a cash cushion to fund operations through the rapidly approaching down cycle).

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