Beware the Dark Passenger of Too Much Debt

Dexter Morgan, star of tv's "Dexter," has an unusual problem, particularly for a member of the Miami Police Department: the urge to kill. While Dexter tries to constructively channel this personality disorder -- his "dark passenger" -- by only murdering serial killers who would otherwise escape justice, it inevitably creates problems. Similarly, a company can suffer from its own "dark passenger" -- a compulsion to take on excessive debt, which can place the company in mortal danger.

The Dark Passenger overwhelms Dexter's thoughts and steers his actions. The same is true for a company that borrows more than it should. As Dan Caplinger of the Motley Fool wrote:

At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.

This "distraction of debt" places a lien on the cash flow. That prevents companies from competing with rivals who have cleaner balance sheets. Just as Dexter can never fully control "The Dark Passenger," heavily-indebted companies have to dedicate much of the cash earned to paying off creditors. Rivals without debt issues can expand, improve operations, and price products to drive competitors into bankruptcy. In some industries where the cash flow is stable, such as utilities, a high debt load is not crippling. But in others, with low margins, it can be fatal.

There is an excellent example of this taking place in the supermarket sector. Supervalu (NYSE: SVU  ) has a debt-to-equity ratio of 98.25, with the average for the supermarket industry being just 1.11. That means it required almost $100 in borrowing to produce each dollar in equity for Supervalu. Much of that was piled on to finance the acquisition of Albertson's, a rival supermarket chain. What makes this even worse for Supervalu is that many of the best-run companies with the strongest capital structures, also sell groceries and other similar items.

Metric

Supervalu

Wal-Mart (NYSE: WMT  )

Target (NYSE: TGT  )

Family Dollar Stores (NYSE: FDO  )

Industry Average

Debt-to-Equity Ratio:

98.25

0.78

1.16

0.41

1.11

Net Margin:

(0.03)

0.04

0.04

0.05

0.02

Pre-Tax Margin

(3.10)

5.50

6.20

7.30

2.20

Source: Motley Fool Caps

Can't fly away from a debt burden
The same holds true for Republic Airways (Nasdaq: RJET  ) . With a high debt-to-equity ratio, Republic Airways must directly compete against Southwest Airlines (NYSE: LUV  ) , which flies with a modest debt load, and Spirit Airlines (Nasdaq: SAVE  ) , which takes off with no debt. Unburdened by a "dark passenger' of debt, both Spirit Airlines and Southwest Airlines have performed much better than Republic Airways.

Company:

Republic Airways

Southwest Airlines

Spirit Airlines

Industry Average

Debt-to-Equity Ratio:

4.75

0.48

0.00

1.14

Net Profit Margin:

(0.04)

0.02

0.09

0.05

Source: Motely Fool Caps 

Taking on debt to buy another's problems is never a good idea
Just as Dexter sometimes is confronted by danger -- and even death -- as a result of the "Dark Passenger" compulsion, both Supervalu and Republic Airways are threatened by borrowing heavily. Both larded up the balance sheet with debt as the result of counterproductive acquisitions. Ironically, when companies are looking to purchase another entity, one of the biggest deal-breakers is excessive debt on the balance sheet of the target.

Like so many others, Supervalu, with its purchase of Albertson's supermarket chain, and Republic Airways, with the acquisition of Frontier Airlines, foolishly took on massive debt to buy a rival. That rarely works out for the best. Anand Chokkavelu of the Motley Fool wrote about this in The 100 Things I've Learned in Investing:

Mergers and acquisitions are overrated. Somewhere between 50% and 85% of mergers fail to boost value. The frequency of achieving promised synergies should be filed somewhere between unicorns and no-hitters.

Due to its heavy debt load, it is virtually impossible for Supervalu to recover without going into bankruptcy. That process will allow the company to cleanse its balance sheet of the debt burden, while wiping out the shareholders, who have already suffered greatly, because the stock price is down more than 70% for the year. Republic Airways is desperately trying to shed itself of Frontier Airlines so that its share price will rebound. There is little, if any, chance now of a takeover bid for Republic Airways (under $5), or Supervalu (under $2), to rescue the shareholders, even with the stock price so low.

The Dark Passenger, like excessive leverage, controls the destiny of a company, with a happy ending rarely in the script. Investors should avoid companies with too much debt, because it's a force that could kills a portfolio.

Rather than have their portfolios suffer from a "dark passenger" of too much debt, investors can profit from our increasingly global economy. This can be as easy as investing in your own backyard. Our free report, 3 American Companies Set to Dominate the World, shows you how. Click here to get your free copy before it's gone.

Jonathan Yates has no positions in the stocks mentioned above. The Motley Fool owns shares of Supervalu. Motley Fool newsletter services recommend Family Dollar Stores, Southwest Airlines, Supervalu, and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 26, 2012, at 11:34 PM, honcharella wrote:

    Frontier was not a rival of RJET. It was a move by an egomaniac hellbent on proving he could run a "stand alone" airline. Problem is it sucked on the teat of the profitable model of business (the fee for departure side). Bryan Bedford has trashed shareholder value in the abortion called "Frontier". Don't forget he also purchased Midwest airlines at the same time. Who are they again? ZERO RETURN there, ZERO.

    The "dark passenger" here is actually the CEO and his thoughts of airline super-stardom. The debt was his means to an end and that end is the entire failure of RJET if they are unable to sell a "bridge" to some fool.

  • Report this Comment On October 28, 2012, at 2:05 PM, datruthdog wrote:

    This author knows nothing about airlines and his views should be dismissed. He ignores off balance sheet obligations (i.e. leases) which are nothing more than debt that, because of accounting, don't appear as "debt" on the balance sheet. So ALL of his conclusions are wrong. Mr. Yates, learn something about the industries you write on or stop writing. That's pure incompetence. Frontier and RJET were not rivals; not even close.

  • Report this Comment On October 30, 2012, at 3:19 PM, jyates13 wrote:

    As the author of the article, I agree with what honcharella wrote about the ill-advised acquistions made by Republic, including Midway.

    As for the comments by datruthdog, in all the articles and books I have read that discussed the subject, every one advised against airlines with excessive debt like that of Republic. I have yet to read anything that considers the 4.75 debt-to-equity ratio of Republic being an asset. As to my conclusions being wrong, I believe that the high short float for Republic and low share price proves them to be right.

  • Report this Comment On October 31, 2012, at 12:18 PM, datruthdog wrote:

    Mr. Yates, you are again missing the point entirely. All airlines are highly leveraged either on balance sheet or off balance sheet (question for you: do you know what that means?). So to single out RJET for too much balance sheet debt is misguided. Single out the entire industry if you must. It's good to read books but it's much better to study industries that you are going to pretend to advise on. Don't take it personal, just do your work before you opine on and industry you don't know much about. Trying to be artful and cute in your writings does not make up for a lack of understanding or work.

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