“When you combine ignorance and leverage, you get some pretty interesting results.”- Warren Buffett
Leverage has many definitions and the quote above relates to the investors and speculators who bet more than they could afford on the housing bubble back in 2008. However, this saying can be applied to companies that use leverage in the form of borrowing, to borrow more that they can afford, gearing up balance sheets in an attempt to try and increase business performance.
Sometimes, this strategy can work well, especially when utility companies are concerned. On the other hand, this strategy can go terribly wrong and the business landscape is littered with corpses of firms that borrowed too much, increased their leverage to unsustainable levels, and then got hit hard when their business plans failed, income fell short of covering debt costs and a restructuring or even default soon followed.
How much is too much?
Well, according to various investing text books, notably the
Intelligent Investor
and
Security Analysis,
for debt to be considered safe and its repayments secure, the issuing company should be able to cover its interest payments at least two-and-a-half times by earnings, so, for this analysis, I shall be using that benchmark.
The culprits
Surprisingly, there are not that many companies that fail the above debt test, however, there are some and the results are listed below.
First up is grocery chain SUPERVALU INC. (NYSE:SVU), which has been working to bring down its debt during the past few years but earnings have fallen faster.
| Metric | 2010 | 2011 | 2012 |
|---|---|---|---|
| Financial costs | -$554 | -$514 | -$272 |
| EBITDA | $1,872 | $1,821 | $463 |
| Net debt | $6,579 | $6,099 | $2,817 |
| Interest cover | 3.4 | 3.5 | 1.7 |
| Net Debt to EBITDA | 3.5 | 3.4 | 6.1 |
Figures in $US million, except for ratios
During 2012, the company’s interest cover fell below the threshold of 2.5 times, which sends up a red flag about the company’s debt position.
However, taken over a three year time frame, debt and interest costs appear to be sustainable.
| Metric | Value |
|---|---|
| 3-yr Average Interest Costs | -$447 |
| 3-yr Average EBITDA | $1,385 |
| 3-yr average Net Debt | $5,160 |
| Interest cover | 3.1 |
| Net Debt to EBITDA | 3.7 |
Figures in $US million, except for ratios
The ability of SUPERVALU to sustain its debt depends on its ability to double its revenue this year. Having said that, Q1 revenue has already come in 50% lower than the same period last year, so the company and its investors could be sailing into dangerous waters.
Next up
Next up is Calpine Corporation (NYSE:CPN), an independent wholesale power producer that owns natural gas and geothermal power plants throughout the U.S.
| Metric | 2010 | 2011 | 2012 |
|---|---|---|---|
| Financial costs | -$206 | -$415 | -$541 |
| EBITDA | $1,277 | $1,243 | $1,126 |
| Net debt | $8,734 | $7,983 | $8,934 |
| Interest cover | 6.2 | 3.0 | 2.1 |
| Net Debt to EBITDA | 6.8 | 6.4 | 7.9 |
Figures in $US million, except for ratios
Calpine Corporation (NYSE:CPN) has been increasing its borrowing over the past three years but the company has not achieved earnings growth to the same degree. As a utility company, Calpine Corporation (NYSE:CPN) would be expected to have a slightly higher debt ratio and lower interest cover. However, a worrying trend at Calpine Corporation (NYSE:CPN) is the fact that while net debt has only grown 2% during the past three years, financing costs have exploded 162% — indicating a deterioration in the company’s credit rating.
Furthermore, the company’s rising interest costs have pushed down its interest cover, from more than six times during 2010 to twice last year. If this continues, the company will have a problem sustaining its debt.
And finally
Finally, nursing and care home provider Brookdale Senior Living, Inc. (NYSE:BKD). Brookdale Senior Living, Inc. (NYSE:BKD) is not a REIT, therefore the company is not entitled to preferential tax treatment and because of this, earnings are impacted.
| Metric | 2010 | 2011 | 2012 |
|---|---|---|---|
| Financial costs | -$142 | -$138 | -$146 |
| EBITDA | $382 | $401 | $369 |
| Net debt | $2,407 | $2,387 | $2,567 |
| Interest cover | 2.7 | 2.9 | 2.5 |
| Net Debt to EBITDA | 6.3 | 5.9 | 6.9 |
Figures in $US million, except for ratios
Brookdale Senior Living, Inc. (NYSE:BKD) has kept its net debt under control during the last three years and interest costs have remained relatively stagnant. Currently, after a poor 2012, Brookdale Senior Living, Inc. (NYSE:BKD) is only able to cover its interest costs with EBITDA 2.5 times, historically a low level. Indeed, as I have shown below, over the past three years, the company has, on average, been able to cover its interest costs around 2.7 times.
| Metric | Value |
|---|---|
| 3-yr Average Interest Costs | -$142 |
| 3-yr Average EBITDA | $384 |
| 3-yr average Net Debt | $2,454 |
| Interest cover | 2.7 |
| Net Debt to EBITDA | 6.4 |
Figures in $US million, except for ratios
Having said that, after a solid Q1 performance this year, Brookdale Senior Living, Inc. (NYSE:BKD) is in line to produce EBITDA of $432 million for the full year 2013, which should pull the company’s interest cover ratio back up to just under three times at 2.9.
Conclusion
The three companies above all exhibit worrying trends in debt. Personally, as an investor who likes to preserve his capital, I would stay away until the companies, or their management, commits to a debt reduction plan, or business improves to the stage where interest costs are not consuming such a large amount of earnings over a period of several years, not just a one off.
For a successful long-term investment, companies need to display that they are fiscally prudent and can maintain a consistent level of debt and easily cover interest costs; something none of the three companies above can do. Having said that, Brookdale Senior Living, Inc. (NYSE:BKD) does appear to be pulling itself back towards fiscal health, one to watch for now.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Supervalu. Rupert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article These Companies Are Finding It Hard to Handle Debt originally appeared on Fool.com is written by Rupert Hargreaves.
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