One of the first things that investors look at when studying a company is the balance sheet. In particular, debt; companies that have high levels of debt relative to equity or EBITDA usually have high interest costs, which can constrict growth, income and shareholder returns.
In addition, high levels of debt can indicate that the company is on its last legs as a sudden cash call could be looming, resulting in a fire-sale of assets and almost no return for investors. There is also a risk to future earnings, as high interest costs can constrict the company’s ability to generate a positive net cash inflow. And, if the company wants additional borrowing to grow, then it may find itself having to pay even higher interest costs; or even worse, the company will be refused access to credit.
So, all in all, it would be wise for investors who wants to safeguard their cash to stay away from companies that have high levels of debt.
These companies look guilty
The good
| 2010 | 2011 | 2012 | |
|---|---|---|---|
| EBITDA | $44 | $13 | $34 |
| Finance Costs | -$52 | -$48 | -$35 |
| Net Debt | $464 | $536 | $570 |
| Net Debt to EBITDA | $11 | $41 | $17 |
Figures in millions of $ except for ratios
First up is construction-materials supplier, Texas Industries, Inc. (NYSE:TXI). Texas has been struggling to rebuild itself since the housing bubble burst, but debt keeps rising as interest costs are consuming all income. Indeed, the company is having to borrow just to run day-to-day operations, an unsustainable way to run a business.
Texas Industries, Inc. (NYSE:TXI) reported a loss per share of $1.37 last year and the company is working with a tiny operating margin of 1.2%. Moreover, Texas Industries, Inc. (NYSE:TXI) is only producing a 1.4% return on assets an extremely low rate of return for its investors. With these poor returns on assets and debt building rapidly, Texas Industries, Inc. (NYSE:TXI) is a company to avoid for now.
The bad
| 2010 | 2011 | 2012 | |
|---|---|---|---|
| EBITDA | $3 | $11 | $46 |
| Finance Costs | -$3 | -$22 | -$66 |
| Net Debt | $87 | $705 | $678 |
| Net Debt to EBITDA | $29 | $64 | $15 |
Figures in millions of $ except for ratios
Web.com Group Inc (NASDAQ:WWWW)’s net debt has been falling and earnings have been rising over the past three years, but the company is paying almost 200% more in interest than it was during 2011 — on a lower amount of debt. The issue here is that the company is deemed insecure by its creditors, therefore it is being asked to payout more in interest costs.
Still, the company is expected to report $2.40 per share in earnings this year, which, if achieved, will dig the company slightly out of its debt hole. Having said that, investors should be careful as Web.com Group Inc (NASDAQ:WWWW) has been issuing stock to bolster cash flow, so much so that the fully diluted number of shares in issue is now 84% more than what it was back in 2010.
Unless Web.com Group Inc (NASDAQ:WWWW) can get a handle on its debt without diluting shareholder equity further, the company is going to get stuck in a downward spiral of equity issuance to bolster cash flows and pay off creditors. This is a company to avoid until it can get its financial position in shape.
The ugly
| 2010 | 2011 | 2012 | |
|---|---|---|---|
| EBITDA | $323 | $185 | $105 |
| Finance Costs | -$174 | -$174 | -$172 |
| Net Debt | $2,121 | $2,097 | $1,655 |
| Net Debt to EBITDA | 6.6 | 11.3 | 15.7 |
Figures in millions of $ except for ratios
Cheniere Energy Partners LP (NYSEMKT:CQP) looks extremely toxic. The company reported a loss of $0.66 per share last year as interest costs consumed 170% of EBITDA. Furthermore, the company has a negative profit margin of -64% and a negative return on assets of -4.5%; the company actually has a gross profit margin of 78% but almost all of this profit is eroded by high interest costs.
Cheniere Energy Partners LP (NYSEMKT:CQP) is expected to produce EPS of $0.34 this year, putting it on a forward P/E ratio of 8.0, which is more expensive than almost all of its peers in the major oil and gas sector. Furthermore, EPS are expected to come in a $0.04 for 2014, placing Cheniere Energy Partners LP (NYSEMKT:CQP) on a forward P/E of 750. Additionally, investors are left with no margin of safety as the company trades at a price-to-book ratio of 5.7 and cash per share of only $1.45.
Surprisingly, even though debt has been falling, interest costs have remained constant, indicating that the company’s credit rating is deteriorating and Cheniere Energy Partners LP (NYSEMKT:CQP) is having to pay a higher rate of interest to borrow.
Foolish summary
Successful long-term investors only put their cash to work in companies that have a stable financial background. None of these three companies have a solid financial base, therefore it will be harder for them to grow and gain investor support. Overall, it is not possible to remove all risk from investing, however, it is possible to limit risk and the best way to do that is to only invest in companies that have a stable financial footing from the start.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Stocks Are Toxic for Your Portfolio originally appeared on Fool.com is written by Rupert Hargreaves.
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