Personally, I am not a fan of debt. I like to invest in companies that have solid balance sheets with little or no debt, a strong cash position, and good current liquidity. That said, there is actually nothing wrong with a company using debt to improve shareholder returns, such as buybacks, takeovers and capital spending if the company controls its level of debt and more importantly, maintains its creditworthiness while ensuring interest costs stay low and controllable.
However, there are many companies that do not follow these simple rules, and as a result, the huge levels of debt and interest repayments put a strain on their cash flows, leading to further borrowing, and so, the downward spiral continues. Technically, these companies are called ‘zombies’, only just surviving and covering their interest costs, with no scope for growth or shareholder returns.
Three ugly looking income statements
These are three companies that exhibit such weak balance sheets and strangled cash flows where prospective investors should be careful before committing their cash.
| Metric | Dec-12 | Jan-12 | Jan-11 |
|---|---|---|---|
| Revenue | $2,417 | ||
| COGS | $2,171 | ||
| Gross Margin | 10% | ||
| Operating Expenses | $534 | ||
| Operating Income | -$288 | ||
| Interest Expense | $84 | $67 | $55 |
| Net Income (Excluding one-off items) | -$403 | ||
| One-off was $51 mil gain on share lending agreement |
Figures in millions of $US
Since the beginning of 2011, SunPower Corporation (NASDAQ:SPWR)’s interest costs have risen 53%. The company paid $84 million in interest during 2012, which is only covered three times by the company’s tiny gross profit margin. However, SunPower Corporation (NASDAQ:SPWR)’s operating expenses are so huge that the company is currently losing $403 million a year.
SunPower Corporation (NASDAQ:SPWR)’s rising interest costs have been fueled by a constant stream of debt and cash funded acquisitions, which have so far failed to make a return for the company.
Furthermore, as the company’s debt interest is growing at a CAGR of 24%, it is going to become more difficult for the company to turn a profit — a company to stay away from for now.
A struggling shipping company
Scorpio Tankers Inc. (NYSE:STNG) is suffering the same fate as the rest of the shipping industry. Falling revenue, rising costs, and overcapacity have driven down the company’s profit margin into the red. Meanwhile, Scorpio Tankers Inc. (NYSE:STNG)’s debt-fueled expansion has come back to haunt it, as while revenue has risen rapidly, its profits have all but disappeared.
| Metric | Dec-12 | Dec-11 | Dec-10 |
|---|---|---|---|
| Revenue | $115 | ||
| COGS | $132 | ||
| Gross Margin | -15% | ||
| Operating Expenses | $9 | ||
| Operating Income | -$26 | ||
| Interest Expense | $9 | $7 | $3 |
| Net Income (Excluding one-off items) | -$17 | ||
| One-off was $10 mil loss from asset sales |
Figures in millions of $US
Scorpio Tankers Inc. (NYSE:STNG)’s interest costs have risen at a CAGR of 73% during the past three years. Surprisingly, while interest costs have grown, net debt has remained almost constant, indicating that the company’s credit rating is falling and creditors are demanding more interest from the company
Meanwhile, the company’s operations are costing more to operate than they are generating in income. Indeed, Scorpio Tankers Inc. (NYSE:STNG) has not turned a profit since 2010 as the company’s operating costs and debt interest are rising faster than revenue and margins.
With debt interest rising while net debt remains constant, and the company’s costs exceeding revenue, Scorpio Tankers Inc. (NYSE:STNG) should be avoided.
The Hunger Games
Lastly, Lions Gate Entertainment Corp. (USA) (NYSE:LGF), apart from the one-off success of the Hunger Games, has been struggling during the past few years. The company has reported losses at least every year over the past five years.
| Metric | Dec-12 | Dec-11 | Dec-10 |
|---|---|---|---|
| Revenue | $1,600 | ||
| COGS | $907 | ||
| Gross Margin | 43% | ||
| Operating Expenses | $653 | ||
| Operating Income | $40 | ||
| Interest Expense | $78 | $55 | $58 |
| Net Income | -$39 |
Figures in millions of $US
Lions Gate Entertainment Corp. (USA) (NYSE:LGF) has a decent gross margin, but operating expenses consume almost all of it. Having said that, the company would have made a profit during 2012,2011, and 2010 if it were not for its rapidly rising interest costs.
Lions Gate Entertainment Corp. (USA) (NYSE:LGF)’s pre-tax income excluding interest costs was $31 million during 2010, $6 million during 2011, and $44 million during 2012. Including interest costs, the company actually reported a losses. Furthermore, during this period, net debt grew 110%.
So, despite the success of the Hunger Games, Lions Gate Entertainment Corp. (USA) (NYSE:LGF) does not appear to be a decent investment judging by its spiking debt and interest costs.
Conclusion
While these three companies may have borrowed cash in an attempt to boost shareholder value, their debt is now coming back to haunt them as interest costs strangle their income and shareholder value is erased. Until debt is paid down or income increases significantly, investors should stay away from Lions Gate Entertainment Corp. (USA) (NYSE:LGF), Scorpio Tankers Inc. (NYSE:STNG), and SunPower Corporation (NASDAQ:SPWR) and their constricting levels of debt.
The article 4 Companies That Are Being Strangled By Debt originally appeared on Fool.com is written by Rupert Hargreaves.
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