# Shares are already leveraged



## Zaxon (19 June 2018)

Most companies have debt that they use to grow their business faster than if they had to save up the cash. So essentially, when you're buying shares, you're mostly buying an already leveraged asset.  If you then take out a LOC or margin loan, you're leveraging and already leveraged asset.

Does anyone else think about it from this point of view?


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## galumay (19 June 2018)

Yep. I never use leverage and I only buy part ownership of businesses with very low leverage. When the **** hits the fan, debt is the wrecking ball.


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## Zaxon (20 June 2018)

galumay said:


> Yep. I never use leverage and I only buy part ownership of businesses with very low leverage. When the **** hits the fan, debt is the wrecking ball.




I feel the same way.  The 1929 crash, the 2007/2008 GFC (and most other historical crashes) all stemmed from speculating with high amounts of leverage.


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## So_Cynical (20 June 2018)

Zaxon said:


> Most companies have debt that they use to grow their business faster than if they had to save up the cash. So essentially, when you're buying shares, you're mostly buying an already leveraged asset.  If you then take out a LOC or margin loan, you're leveraging and already leveraged asset.
> 
> Does anyone else think about it from this point of view?




I haven't looked at it that way but have to agree that it make sense, some of my favourite stocks have no debt, i personally have none.


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## Value Collector (20 June 2018)

Zaxon said:


> Most companies have debt that they use to grow their business faster than if they had to save up the cash.




Debt is not necessarily about "growing faster", it can be used to raise the return on equity for the share holders (eg the owners of the equity), and provide low risk returns for others investors (debt holders).

When the debt is supplied by longterm bonds etc, if can be a way of developing a capital structure that allows a capital intensive business to be funded by a wide arrange of people with different risk and reward profiles.

For example,

Say we need to build a big Wind Farm thats going to cost $200 Million dollars, and we need investors.

Conservative forecasts might tell us the project will deliver a 9% return over the 30 year life of the asset, that specific return and risk profile only appeals to a specific sector of investors, but we can appeal to a much wider group if we structure the capital using a few different types of debt and equity.

To provide the $200 Million, we could seek.

$60 Million from Share holders
$30 Million Bank debt @ 7% interest
$50 million from Junior Bonds @ 5% interest
$60 million from Senior Bonds @3.5% interest

So over all we have our $200 Million and it will earn 9.5%

But,

Share Holders earns 20% If all goes well, but are the first to lose capital if it goes bad.
Bank Debt      earns 7%   But have the share holders capital as a protection Buffer
Junior Bond.   earns 5%   But Have share holders capital and Bank debt as a protection buffer
Senior Bond   earns 3.5% But won't lose anything until all the other investors have lost.



> So essentially, when you're buying shares, you're mostly buying an already leveraged asset. If you then take out a LOC or margin loan, you're leveraging and already leveraged asset.




Yes, you are.

essentially you are doing what I described above on a personal level.

You could take that shareholders position that you think will earn 20% if all goes well, and fund it with debt at 6%,

So if you put in 30% of the funds and borrowed 70%, you will increase your return from the 20% per year to 52% per year (if all goes well).





> Does anyone else think about it from this point of view?




Nothing wrong with it, its just every time you bring in debt you are expanding your total possible return, but also your total possible loss, you have to be aware of that extra risk.

Without debt the most you can lose is 100%, but with debt you can lose 300% of your money.

You just have to think of debt as bringing in another investor, who is going to give any profits over a set interest rate to you, however for that they are using your capital to provided insurance on their position.


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## luutzu (20 June 2018)

Value Collector said:


> Debt is not necessarily about "growing faster", it can be used to raise the return on equity for the share holders (eg the owners of the equity), and provide low risk returns for others investors (debt holders).
> 
> When the debt is supplied by longterm bonds etc, if can be a way of developing a capital structure that allows a capital intensive business to be funded by a wide arrange of people with different risk and reward profiles.
> 
> ...




I always thought that lenders would also lose everything (in practical terms) if their debtors goes down the tube. So why lend when you'd only lend to the safe ones; and safe ones making higher return mean you ought to in on that boat that earn a higher return... practically the same risk anyway.

But I guess it make sense what you're saying there. Those large managed funds can say that them lending as well as owning assets... a more balanced portfolio with different risk profile. A safer place to park the cash short term.


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## Value Collector (20 June 2018)

luutzu said:


> I always thought that lenders would also lose everything (in practical terms) if their debtors goes down the tube. So why lend when you'd only lend to the safe ones; and safe ones making higher return mean you ought to in on that boat that earn a higher return... practically the same risk anyway.




there is two ways the Debt holders have higher safety.

1, debt holders have priority to Income -if the project ends up earning less than forecast, the company can cancel dividends for years giving no income to share holders, but still having enough income to pay the bond interest, 

2, In the case of liquidation or reorganisation - Shareholders will be the first to lose capital, the bond holders have first claim on any cash that comes from asset sales until all their capital and interest is repaid, the share holders can also be completely wiped out while the bond holders may have their debt transferred to the surviving entity after reorganisation.


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## luutzu (20 June 2018)

Value Collector said:


> there is two ways the Debt holders have higher safety.
> 
> 1, debt holders have priority to Income -if the project ends up earning less than forecast, the company can cancel dividends for years giving no income to share holders, but still having enough income to pay the bond interest,
> 
> 2, In the case of liquidation or reorganisation - Shareholders will be the first to lose capital, the bond holders have first claim on any cash that comes from asset sales until all their capital and interest is repaid, the share holders can also be completely wiped out while the bond holders may have their debt transferred to the surviving entity after reorganisation.




Yea I guess at a certain level for a certain rate of return, debt is sensible. 

Though I find that no matter what the debt ratio says, often, when a company goes into administration, lenders would be lucky to get 10 cents on a dollar back.


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## Value Collector (20 June 2018)

luutzu said:


> Yea I guess at a certain level for a certain rate of return, debt is sensible.
> 
> Though I find that no matter what the debt ratio says, often, when a company goes into administration, lenders would be lucky to get 10 cents on a dollar back.




It depends on the types of assets owned by the company, and the lenders should be factoring all that into their risk reward calculations.

Use Real estate as an example.

If you want to buy a house, the bank will lend you money, But they will want you to put up a "deposit" of 20% or so.

Think of that "deposit", as your equity.

If the house was worth $500K - you put in $100K of equity and the bank puts in $400K of debt.

If the deal goes south and the house must be sold, you have to lose all your $100K equity before the bank begins to lose, Your equity is their protection.

Its the same at companies, Share holders are "equity" holders, a share holders position can go to Zero while the bond holders are still are ok, any assets at the company will be sold or reorganised to the benefit of the bondholders until they receive 100% before any goes to the share holders.


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## galumay (20 June 2018)

For all that, I still want to invest in unleveraged, or very low leverage businesses and I never use leverage myself. The short of it is my potential returns suffer somewhat, but my primary goal of protecting capital is fulfilled!


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## Knobby22 (20 June 2018)

galumay said:


> For all that, I still want to invest in unleveraged, or very low leverage businesses and I never use leverage myself. The short of it is my potential returns suffer somewhat, but my primary goal of protecting capital is fulfilled!



Then you can't invest in Transurban. A very good company that makes toll roads. I think it depends on how the debt is used and how much risk it creates. I generally prefer low or no debt except in infrastructure companies.


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## Value Collector (21 June 2018)

galumay said:


> For all that, I still want to invest in unleveraged, or very low leverage businesses and I never use leverage myself. The short of it is my potential returns suffer somewhat, but my primary goal of protecting capital is fulfilled!




That’s totally understandable, some companies are suited to having debt as part of their capital structure though, even Warren Buffett who always talks about the danger of leverage is willing to use leverage in his energy utility and railroad businesses.

Eg, companies holding stable long term assets that can sources cheap long term financing.

But yeah some companies do not suit it at all.

————————

There are cases where companies I own have done capital raisings to get money for projects, where I would have preferred them to use debt.

It’s easier to get rid of debt holders than it is shareholders, so it can be better to use debt holders for a while than bring in more shareholders to dilute you.


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## Zaxon (21 June 2018)

Value Collector said:


> even Warren Buffett who always talks about the danger of leverage is willing to use leverage in his energy utility and railroad businesses.




The only thing I'll add to that is that Buffett lets the managers of his companies make their own decisions.  So it's quite possible to find his wholly owned companies making decisions that he wouldn't do himself.  Perhaps debt is an example of that.


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## Value Collector (21 June 2018)

Zaxon said:


> The only thing I'll add to that is that Buffett lets the managers of his companies make their own decisions.  So it's quite possible to find his wholly owned companies making decisions that he wouldn't do himself.  Perhaps debt is an example of that.




No, He thinks debt in the large Infrastructure business is good, he has said it many times, Even Ben Graham (Warrens Mentor), Points out in both his books that large utilities are basically special cases when it comes to debt, due to the long terms and low interests available to them, and the regulated contracted income that generally raises with interest rates.

He also threw around the Idea of $10 Billion of debt to finance Precision cast parts when he bought it for $35 Billion, even though he had ample cash, I am not sure if he went ahead with it.


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## Value Collector (21 June 2018)

luutzu said:


> Yea I guess at a certain level for a certain rate of return, debt is sensible.
> 
> Though I find that no matter what the debt ratio says, often, when a company goes into administration, lenders would be lucky to get 10 cents on a dollar back.




Also, the financing that I broke down in my made up example of the wind farm, is pretty much how APA work, due to their financing strategy of using long term low rate bonds, Share holders equity is throwing off operating cashflow of about 24%.

And where you have said you have been worried about them doing capital raising, those injections of capital have just been to provide more share holders equity, so they can do more projects on the same finance terms.

eg, they raise $30 of equity so they can borrow $70 and then go and build another $100 of new infrastructure.


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## Value Collector (21 June 2018)

galumay said:


> For all that, I still want to invest in unleveraged, or very low leverage businesses and I never use leverage myself. The short of it is my potential returns suffer somewhat, but my primary goal of protecting capital is fulfilled!




Take a look at APA, they have delivered total share holder returns of about 20% pa, for over 15 years.

delivering a great mix of capital growth and dividends, in the 18 years I have held they have gone up in value by 500%, and currently deliver a 27% dividend based on my original entry price, a nice quiet achiever in my portfolio,


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## luutzu (21 June 2018)

Value Collector said:


> No, He thinks debt in the large Infrastructure business is good, he has said it many times, Even Ben Graham (Warrens Mentor), Points out in both his books that large utilities are basically special cases when it comes to debt, due to the long terms and low interests available to them, and the regulated contracted income that generally raises with interest rates.
> 
> He also threw around the Idea of $10 Billion of debt to finance Precision cast parts when he bought it for $35 Billion, even though he had ample cash, I am not sure if he went ahead with it.




Debt financing, like everything else, is reasonable and acceptable if the business does not depend on it to survive. So if the business is capital intensive but its income and cash streams are stable and predictable... and if it can borrow for at or below its rate of return etc., then of course it should use other people's cheap bargain.

But that doesn't mean that if the business is a utility or large infrastructure that debt level doesn't really matter. 

But then seeing how APA is being pursued for the equivalent of some $23B enterprise value... I guess nowadays if you're big enough some idiot will take you over. Maybe they use a different calculus than just the financial ones... But depending on such gold knights shouldn't be a business model.


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## luutzu (21 June 2018)

Value Collector said:


> Also, the financing that I broke down in my made up example of the wind farm, is pretty much how APA work, due to their financing strategy of using long term low rate bonds, Share holders equity is throwing off operating cashflow of about 24%.
> 
> And where you have said you have been worried about them doing capital raising, those injections of capital have just been to provide more share holders equity, so they can do more projects on the same finance terms.
> 
> eg, they raise $30 of equity so they can borrow $70 and then go and build another $100 of new infrastructure.




Na. 

APA is just a ponzi. 

I've studied BNSF... I reckon I can figured out a highly capital intensive business that's also doing well; to one that just raises equity to borrow more. 

Not saying that you didn't figure that out. Just that maybe your judgment is impaired seeing how you're among the earlier investors in that ponzi. 

I wouldn't complain either if I jumped in early.


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## luutzu (21 June 2018)

Value Collector said:


> Take a look at APA, they have delivered total share holder returns of about 20% pa, for over 15 years.
> 
> delivering a great mix of capital growth and dividends, in the 18 years I have held they have gone up in value by 500%, and currently deliver a 27% dividend based on my original entry price, a nice quiet achiever in my portfolio,




Total shareholders return were calculated by APA as share price appreciation plus dividends, yes?

In APA's case that measure is quite misleading.


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## Value Collector (21 June 2018)

luutzu said:


> APA is just a ponzi.
> .




Nope, Just a well managed and well financed company holding cash generating assets critical to the Australian economy.



> Total shareholders return were calculated by APA as share price appreciation plus dividends, yes?
> 
> In APA's case that measure is quite misleading.




How is that misleading? Total share holder returns are a function of share price and dividends, are hey not?

It's a pretty standard calculation, to show the performance of a company or index had you held the investment over a given time and reinvested all the dividends etc.

Commsec calculates if for you for any company.


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## Value Collector (21 June 2018)

luutzu said:


> Debt financing, like everything else, is reasonable and acceptable if the business does not depend on it to survive. So if the business is capital intensive but its income and cash streams are stable and predictable... and if it can borrow for at or below its rate of return etc., then of course it should use other people's cheap bargain.




APA's weighted interest rate is 5.56%, and their debt long dated, Some of it is 60 year bonds, that don't mature until the year 2072.

Yes, the year 2072, that means I am 36 years old Today and the Notes don't expire until after I turn 90.

Hell, with bonds with that type of expiry, its just as stable as share holders equity.

They have no issue with their debt, and all infrastructure they have bought or developed earns much higher rate than the 5.56% interest they pay, and they have heaps of operating cashflow.

the only reason they have done capital raising is to expand, they pay pretty decent dividends, so to take advantage of growth opportunities they have brought in fresh capital rather than cut dividends, but share holders equity is less than $3.90 per share, so a capital raising at $8 is good for exisiting share holders.


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## luutzu (21 June 2018)

Value Collector said:


> Nope, Just a well managed and well financed company holding cash generating assets critical to the Australian economy.
> 
> 
> 
> ...




Well financed that's for sure. And lucky too. But the takeover will either be blocked or the Chinese will walk away once they take a closer look. 

Share price gains can be due to many reasons. One of them being momentum. If a company get higher enough on that Index, money is going to pour into it. If it manages to use that high position and market sentiment, raise more cash... the bank will lend more due to higher equity... then its asset value increase; market price on a "stable" dividend paying giant should at least be priced at asset value... acording to some thinkers... so its share price goes up. Then on and on until it either come crashing down or some rich idiot with a grand strategy come on over with pallets of cash.

From memory, I don't think APA's net operating cash or profit was big enough to pay its interests and dividends. 

When a company cannot pay both, one of them have to be cut. Can't cut back on the lenders... and here, they didn't cut on the shareholders either. Sooo.... raise and borrow for "growth".


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## Value Collector (21 June 2018)

luutzu said:


> Well financed that's for sure. And lucky too. But the takeover will either be blocked or the Chinese will walk away once they take a closer look.




I actually hope they get denied, I don't want to sell


> Share price gains can be due to many reasons. One of them being momentum. If a company get higher enough on that Index, money is going to pour into it.




The share price has risen as the dividend has increased, the equity has increased, and the company has gone from operating a few isolated point to point pipelines to develop an interconnected grid/web of pipelines that link every market on the east coast, as well as a bunch of other investments.



> From memory, I don't think APA's net operating cash or profit was big enough to pay its interests and dividends.




You are just plan wrong on that one,

last year, they had $ 1,470 Million of EBITDA,

They only had interest costs of $513 Million, leaving operating cashflow of more than $950 Million from which they paid $501 Million in dividends.



> When a company cannot pay both, one of them have to be cut. Can't cut back on the lenders... and here, they didn't cut on the shareholders either. Sooo.... raise and borrow for "growth".




They can easily pay Both interest and dividends from EBITDA, and still have over $400 Million per year to  clear debt if they decided they didn't want to grow anymore, and $400 Million per year would be more than enough to clear the debt as it matured.

if they cut the dividend they would have over $900 Million of cashflow per year to clear debt with.

You need to look at the numbers again, it sounds like you mis read something some where.


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## luutzu (21 June 2018)

Value Collector said:


> I actually hope they get denied, I don't want to sell
> 
> 
> The share price has risen as the dividend has increased, the equity has increased, and the company has gone from operating a few isolated point to point pipelines to develop an interconnected grid/web of pipelines that link every market on the east coast, as well as a bunch of other investments.
> ...




Enron was pretty widespread and held a lot of important and strategic stuff too. 

But alright, I'll take another look later just to prove you wrong. 


Didn't Buffett say that EBITDA is funny accounting where management assumes there's no Interest, Tax or Depreciation? Just that in the real world, there are all those things?


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## Value Collector (21 June 2018)

luutzu said:


> Didn't Buffett say that EBITDA is funny accounting where management assumes there's no Interest, Tax or Depreciation?




Yeah, But you just have to be aware of the D & A part of it, which for APA I understand well and they are minimal. (True D & A anyway, they do get some accelerated Deprecation for tax purposes) 





> But alright, I'll take another look later just to prove you wrong.




I will just let APA, prove you wrong over the next 10 years (another reason I don't want the take over to succeed haha)

I am not a nit wit, I understand a thing or two about companies and finance, and I have spent 18 years watching and learning about everything APA has been doing, So in situations like this I tend to do better by backing my own judgment, So to be honest will be ending the discussion on APA with you Here.


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## gaius (22 June 2018)

Zaxon said:


> Most companies have debt that they use to grow their business faster than if they had to save up the cash. So essentially, when you're buying shares, you're mostly buying an already leveraged asset.  If you then take out a LOC or margin loan, you're leveraging and already leveraged asset.
> 
> Does anyone else think about it from this point of view?




That's the point, isn't it. That's exactly where the profit is coming from - Leverage! What's the point of issuing shares if not for leverage? What's the point of investing in shares if not for leverage? This is exactly how money had been made - borrow and buy, borrow more and buy more.


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## Zaxon (22 June 2018)

gaius said:


> That's the point, isn't it. That's exactly where the profit is coming from - Leverage! What's the point of issuing shares if not for leverage? What's the point of investing in shares if not for leverage? This is exactly how money had been made - borrow and buy, borrow more and buy more.




True.  But in a down market, too much leverage can wipe you out.  And if you're taking out a margin loan on a company that already is internally geared, you could argue that this just compounds the problem.


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## galumay (22 June 2018)

Value Collector said:


> Take a look at APA..




Thanks VC, I am sure its a great business that I have missed because of my dislike of debt and leverage. Well done for unpicking the business and understanding it well enough to make a great investment.


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## gaius (22 June 2018)

Zaxon said:


> True.  But in a down market, too much leverage can wipe you out.  And if you're taking out a margin loan on a company that already is internally geared, you could argue that this just compounds the problem.




There won't be a down market. It is a problem that will never happen. Not even a global trade war could stop ASX from rising to fresh 10-year high. There are so much money in the system that people simply can't stop buying.


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## galumay (23 June 2018)

gaius said:


> It is a problem that will never happen.




So its "different this time"?


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## gaius (23 June 2018)

galumay said:


> So its "different this time"?




Let's say I wouldn't lose any sleep worry about if the next ice age would come tomorrow.

The market could go down 1% or 2% now and then, 10% at most. Believe it or not, people will rush back in before 10% correction. The fact is, no one really believe that there is any genuine reason for a significant downturn. Those who think the market will go down are really just looking for buy opportunity. They are all buyers on the side. How could there possibly be a down market?


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## luutzu (23 June 2018)

Value Collector said:


> Yeah, But you just have to be aware of the D & A part of it, which for APA I understand well and they are minimal. (True D & A anyway, they do get some accelerated Deprecation for tax purposes)
> 
> 
> I will just let APA, prove you wrong over the next 10 years (another reason I don't want the take over to succeed haha)
> ...




I know you're quite a capable guy. Just no one's perfect. And it's silly to fault an investment decision that had return so well all these years... or is it?

But of course man, always stick to your judgement.


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## galumay (24 June 2018)

gaius said:


> How could there possibly be a down market?




Is that a serious question?!

I guess this is the consequence of a generation who as investors have never seen a market crash. Trust me, know one sees it coming and its never caused by what people are expecting.


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## gaius (28 June 2018)

galumay said:


> Is that a serious question?!
> 
> I guess this is the consequence of a generation who as investors have never seen a market crash. Trust me, know one sees it coming and its never caused by what people are expecting.




Seriously, global trade war barely moved ASX200, I'm sure the market is waiting for a jump.


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## galumay (29 June 2018)

*Sigh* *whack*


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## Value Hunter (9 February 2020)

I think with leverage (and risk taking in general) it should depend partly on your age and financial situation. I think most young people should take on some investment related debt while they try to establish an asset base, given how high cost of living and house prices is these days and how low wages growth is, its really the only way to get ahead for many young people. Then once their asset base starts to slowly build up they can gradually deleverage over time.

I have taken this approach myself. I started off with very high levels of investment related debts and have gradually brought down my gearing ratio over a number of years through injecting more of my own cash into new investments and through the growth of existing investments (without taking on any additional borrowings). In the coming year I will sell some assets at an overall profit to further reduce my gearing levels.

Ideally retired people should have zero debts or at least that is my thinking.


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## ducati916 (10 February 2020)

Value Collector said:


> I actually hope they get denied, I don't want to sell
> 
> 
> The share price has risen as the dividend has increased, the equity has increased, and the company has gone from operating a few isolated point to point pipelines to develop an interconnected grid/web of pipelines that link every market on the east coast, as well as a bunch of other investments.
> ...





So the post above is about 8 months ago.

The 2019 financials for APA disclose:

Working capital needs to be financed. (Current Assets < Current Liabilities); and
Financing is required to meet expenses of Interest, CapEx and Dividends (combined costs).

They (Company) also seem to be making a push (expansion) into US (Houston).

Raises (some) questions.

jog on
duc


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