Don't Forget Debt

A common way investors lose money is by buying shares of heavily indebted companies. This is particularly important now: As the economy appears to be heading into a recession of unknown severity and length, the capital markets are largely closed to all but the strongest companies. Debt can be a good thing -- in modest amounts, for the right companies, on the right terms. But as a general rule of thumb, prudent investors would be well served to think long and hard about a company's debt level before investing.

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By Whitney Tilson
October 16, 2001

A classic truism in baseball and football -- among other sports -- is that a good defense usually beats a good offense. The same is true in investing: Focus first on avoiding losses, and only then think about potential gains. Or, as Warren Buffett put it: "Rule #1: Never lose money. Rule #2: Never forget Rule #1."

While this is an extreme statement -- taken literally, one would only invest in U.S. Treasury notes -- I believe the point Buffett is really making is that the key to long-term investment success is avoiding significant, permanent losses, however infrequent.

Common ways investors incur such losses include investing in wildly overvalued stocks and buying shares of companies that are not -- and never become -- profitable. Another is to invest in heavily indebted companies. This is a particularly important topic now: As the economy appears to be heading into a recession of unknown severity and length, the capital markets are largely closed to all but the strongest companies. Corporate America, meanwhile, is burdened with its highest debt levels in roughly 40 years. That is a scary combination!

The data
According to a recent article in The Wall Street Journal and incorporating data from the Federal Reserve and Goldman Sachs, net corporate debt, after remaining steady at just above $2 trillion during the first half of the 1990s, has since doubled. Even with stock prices up substantially over this period, net debt now equals 42.5% of the total market value of stocks, a level not seen since the 1960s.

Of course, debt-to-market value is not a particularly meaningful number. What really matters is whether companies have the cash flow to cover the interest and principal payments on the debt. In this area, the news is grim as well. The ratio of net corporate debt to EBITDA (earnings before interest, taxes, depreciation and amortization is a common, though flawed, cash flow measure) has risen from roughly 2.25 in the mid-1990s to nearly 3.25 today. With earnings falling dramatically, I expect this ratio to continue to rise, resulting in financial distress at more and more companies.

Two examples
Venerable Polaroid, in the early 1970s a high-flying member of the Nifty Fifty, filed for bankruptcy last week, and trading in its stock was halted at $0.28 per share. A year ago the stock was at $14. Four years ago it exceeded $60. It's hard for me to believe investors buying this stock all the way into oblivion paid much attention to the company's debt.

I looked at the stock earlier this year in the $4 range and thought it would take a dramatic turn of events for Polaroid to begin generating enough free cash flow to cover its debt payments. If a company fails to do this, it will go bankrupt, the debt holders will own the company, and the equity (e.g., stock) holders will, in most cases, get nothing.

Speaking of increasingly indebted photography companies, let's look at Eastman Kodak (NYSE: EK). Legg Mason's Bill Miller, the only manager of a diversified mutual fund to beat the S&P 500 index in each of the past 10 years -- and someone I respect immensely -- is making a big mistake, I believe, in betting on a turnaround of this company.

Kodak, like Polaroid, is scrambling to compete in the area of digital photography, which is rapidly destroying the traditional film business. (I, for one, can't remember the last time I bought a roll of film.) Like Polaroid, I think Kodak has few competitive advantages in digital photography and is therefore destroying shareholder value by investing heavily in this space. How many carriage makers successfully became automobile manufacturers? (Two Fools debated Kodak's fortunes in an August feature.)

As sales and profits continue to tumble, Kodak foolishly continues to pay a big dividend and, in fact, recently increased it to more than 5% annually. The result is rapidly rising debt levels, as the following table shows:

Kodak's Net Debt 
Q4 97 $444 Q1 98 1,013 Q2 98 1,299 Q3 98 1,277 Q4 98 1,522 Q1 99 1,960 Q2 99 2,460 Q3 99 2,195 Q4 99 1,706 Q1 00 2,304 Q2 00 2,677 Q3 00 2,718 Q4 00 3,121 Q1 01 3,701 Q2 01 3,557
*Dollars in millions.

Kodak is nowhere near bankruptcy. Last quarter, the company had earnings from operations of $150 million, plenty to cover $58 million of interest payments. But the trends are ominous, as earnings from operations in the same quarter a year ago were $746 million vs. $42 million of interest payments, and the figures for the first quarter of this year were $262 million and $61 million, respectively.

The choice of debt vs. equity
When companies want to raise money, they can either issue equity -- usually via a secondary offering of stock -- or debt. It's critical for investors to understand the choices a company makes in this area. A company should generally choose debt when it has strong, stable cash flows and an undervalued stock, while issuing equity makes sense when the stock price is fully valued (if not overvalued), or when the company has little or no cash flow.

Thus, I don't fault Kodak for choosing to finance its deficits with debt rather than trying to sell stock when the price is depressed. Instead, my quibble is with how the company is allocating capital. Similarly, I think it was wise for Office Depot (NYSE: ODP), a stock I own, to take on more than $400 million of debt in 2000 when its stock was depressed, and use most of it to repurchase shares at a price of about $9 per share. (The stock is now at $15.25.) Brian Graney covered another example of clever use of debt in an April column.

At the other end of the spectrum, meanwhile, it was financially brilliant -- though perhaps cynical -- for tech and biotech companies to raise a mountain of cash during the bubble early last year, when their stocks were trading at extreme valuations. While investors foolish enough to pay such ridiculous prices have lost their shirts, the cash the companies raised is in many cases the only thing keeping them alive.'s bizarre capital allocation decisions
Given all of this, will someone please explain to me what (Nasdaq: AMZN) could possibly have been thinking when it issued debt during a period when its stock was trading at what I think anyone would agree was a rich valuation? (I know that much of the debt was on favorable terms, but debt is debt.) Consider this data:

        Capital Raised by    Capital Raised by
Year      Issuing Stock         Issuing Debt

1998 $14 million $248 million 1999 $64 million $1,075 million 2000 $45 million $693 million TOTAL $123 million $2,016 million

During a time when Amazon could have easily raised billions in equity by selling stock at highly attractive valuations, it instead took on massive debt -- that now totals $2.1 billion -- apparently without regard to the fact that the company has run huge cash flow deficits for most of its existence. What hubris!

To Amazon's credit, the company posted slightly positive operating cash flow of $2.5 million last quarter, but with so much debt, offset by only $609 million in cash, the future viability of this company is in doubt. Imagine how much better off the company would be today had it issued more shares rather than taking on debt.

Retailers and leases
I can't let any discussion of debt pass without at least mentioning a debt-like risk many companies, especially in the retail sector, assume: leases. Some retailers -- Costco (Nasdaq: COST), for one -- choose to own the land and buildings for most of their stores, and often take on debt to pay for this. Many other retailers (especially those based in malls, where it is impossible to own the land or building) instead sign long-term noncancelable leases with minimum rent commitments.

These lease obligations generally do not appear on the balance sheet but, like debt, are a claim against a company's assets and cash flows that supercede those of equity holders. This can mislead investors about the risks they are taking.

Abercrombie & Fitch (NYSE: ANF), for example, appears to have a pristine balance sheet, with $97 million in cash and no debt. Yet in the 10-K, one can see that the company has $655 million in noncancelable lease obligations. If its business takes a turn for the worse and cash flows turn negative, it still has to pay this amount. Leases aren't exactly the same as debt, since it's sometimes possible to renegotiate or terminate them -- and some may even have value that exceeds their cost -- but it is definitely a factor investors should consider.

Debt can be a good thing -- in modest amounts, for the right companies, on the right terms. But as a general rule of thumb, especially given today's economy and capital markets, prudent investors would be well served to think long and hard about a company's debt level before investing.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Office Depot at press time. Mr. Tilson appreciates your feedback at [email protected]. To read his previous columns for The Motley Fool and other writings, visit