Debt woes not as bad as they look
With the economy shrinking and credit markets in disrepair, many investors see debt as an unqualified evil. But businesses still see debt as a tool for everything from funding expansion to leveraging profit growth.
Issuing debt is cheaper and (until recently) easier than issuing stock. Used wisely, debt can boost returns and allow companies to make acquisitions or invest in growth initiatives.
There is some justification for investors’ worries, though the problems are not as bad as many think.
All nine of the nonfinancial sectors in the S&P 500 Index saw total debt rise in the 12 months ended September. Eight of the nine saw an increase in long-term debt as a percentage of total capital, and seven saw a decline in cash as a percentage of total debt. However, many sectors look fairly healthy relative to historical norms. Outside of the financial sector, long-term debt as a percentage of total capital has fallen over the last year.
Unfortunately, balance sheets can erode rapidly, and a prolonged economic downturn would make it more difficult for companies to cover debt payments out of operating profits.
The credit crunch has also made it more difficult for companies to borrow — a fact that can cause trouble even for companies not adding additional long-term debt. Nonfinancial companies in the S&P 500 Index combined to carry $2.72 trillion in debt in the September quarter, of which $578 million — or 21% — is classified as short-term, meaning that it is probably due within 12 months. All of that debt must be either paid off or refinanced in an unfriendly market.
Most short-term debt falls in two categories: short-term notes payable to banks and other creditors, and the portion of long-term debt due over the next year. Both of those types of debt come with their own problems:
Short-term notes. Many companies rely on banks or other creditors to obtain working capital. Such loans must be refinanced frequently, and in the current environment, new money may prove hard to obtain. A loss of short-term liquidity can be devastating. Short-term notes account for about 60% of all short-term debt.
Long-term debt. While most companies are covering their debt payments well enough, the trouble comes when long-term loans mature. In 2008, about 10% of S&P 500 companies’ long-term debt came due, and even more is slated to mature this year. In the current environment, many borrowers may have trouble refinancing that debt. Fortunately, a government push to loosen the lending market for consumers offers some hope that business lending will also pick up in the year ahead.
The amount of difficulty companies face in refinancing their debt depends on several factors.
• Debt level. Lenders may view companies that carry heavy debt as poor risks. High credit ratings have historically been a license to borrow. But, after meltdowns in the balance sheets of highly rated companies last year, skepticism abounds. In general, the Forecasts doesn’t like to see long-term debt represent much more than 50% of total capital. Capital is the combined book value of equity, long-term debt, preferred stock, and minority equity interests.
• Interest coverage. Our Quadrix® Financial Strength score considers three measurements of how easily a company can meet its debt payments — interest coverage (income excluding interest expense divided by interest expense), cash flow divided by interest expense, and cash flow divided by total debt. Especially recently, shares of companies weak in these areas have trended to underperform the average stock in many sectors.
• Cash position. Most companies have more debt than cash. But a large cash balance can change the picture. If a company has enough cash to pay off long-term debt, it does not matter if the debt-to-capital ratio is high.
• Existing credit lines. Do companies have sufficient credit to cover their needs without arranging new financing? This can be difficult to determine, as disclosure requirements are limited. Even if a company tells you it has a large credit line, it may not tell you how fast it is likely to draw down that credit. You don’t have to look far back (think Bear Stearns and Lehman Brothers) to find companies that claimed to be well-capitalized right before the bottom fell out.
In the following paragraphs, we discuss three attractive options.
Microsoft ($20; MSFT) broke from tradition twice in 2008. In January, it announced a willingness to take on significant long-term debt to help finance a $45 billion offer to buy Yahoo. This from a company that’s never had more than $1 million of long-term debt since 1989.
In September, Microsoft authorized up to $6 billion in debt financing and promptly issued $2 billion in short-term commercial paper. In support of the new program, Microsoft arranged for a $2 billion unsecured credit line, which was untapped at the end of September. Not that Microsoft needs the liquidity.
Cash exceeds $20 billion, comfortably covering current debt and the amount spent on dividend payments and stock repurchases in fiscal 2008 ended June. Microsoft, slated to release December-quarter earnings Jan. 22, is a Buy and a Long-Term Buy.
It has been a rough stretch for energy companies, but Chevron’s ($72; CVX) robust balance sheet should keep the company upright until it reaches calmer waters. The oil-price boom helped boost Chevron’s operating cash flow and cash holdings 36% in the nine months ended September. Chevron has enough cash to retire all its debt — with $4 billion to spare. The cash surplus could also fund continued stock repurchases. Chevron has lowered its share count at an annualized rate of more than 2% over the last three years. Moreover, Chevron has a $5 billion credit backstop available if needed.
In January, Chevron cited lower energy prices in warning that December-quarter earnings would be “significantly lower” than year-earlier results. However, the consensus already projected an 18% decline. Chevron also reported production slightly below guidance for the first two months of the quarter. Chevron is a Buy and a Long-Term Buy.
Western Digital ($13; WDC) is highly liquid and carries little debt. Operating cash flow has risen in 11 straight quarters, helping Western build up cash holdings to $1.22 billion, or $5.38 per share. Aggressive moves to cut costs during the downturn should help keep the balance sheet strong, though Western has enough cash to support research and other operating expenses for nearly two years.
For added protection, Western Digital obtained a $250 million credit line in February. Western Digital earns Quadrix Overall, Quality, and Value scores in the upper 90s. Western Digital is a Buy.