<THE RULE MAKER PORTFOLIO>
Debt: The Good, the Bad & the UGLY
Part 2 of 2
By Phil Weiss (TMF Grape)
TOWACO, NJ (September 1, 1999) -- Yesterday, we began the discussion of debt, covering an example of Coca-Cola's "good" debt, as well as some other debt concepts. Today, we'll share several examples of "bad" debt and then conclude with an example of debt's potentially ugly ramifications.
Bad Debt -- Shades of Gray
The region between good and UGLY debt is a gray area. The peril of debt is that companies often take it on with good intentions but then run into operational difficulties that cause their debt to become an arduous burden. Several examples come to mind.
In 1996, Disney (NYSE: DIS) acquired Capital Cities/ABC. Warren Buffett enthusiastically commented, "I do not have blanket enthusiasm about all deals. But this deal makes more sense to me than any deal I've seen, with the possible exception of Capital Cities and ABC." Oh well, nobody's right all the time. Since January 1996, Disney stock has appreciated only 31% during a time when the S&P 500 more than doubled.
To avoid diluting shareholders' equity, Disney used debt to make the acquisition and thereby quadrupled its debt from $3 billion to more than $12 billion. Today, every bit of that debt is still weighing down the company's balance sheet. This debt is doubly bad. First, it causes burdensome interest payments that immediately swallow more than 20% of Disney's earnings before interest and taxes (EBIT). Second, it has hampered the company's agility in making a decisive move into the Internet arena. Tom Gardner expanded on these and other woes in his May article, Mini Mouse.
Gillette (NYSE: G) is another company that seems to be walking the fine line of good versus bad debt. Between 1996 and 1998, debt was held in check at $2 billion. But in the past year, it has begun to balloon and now stands at more than $4 billion. Interest expense isn't yet causing a major dent in the bottom line (less than 5% of EBIT), but the trend is disturbing.
Even Rule Maker Gap (NYSE: GPS) is entering the gray region of debt. As discussed on August 13 and 16, Gap's debt is escalating quarter by quarter and now stands just shy of $1 billion, up from practically nothing in early 1996. Compared to Disney and Gillette, Gap's debt is minuscule, with interest expense that amounts to only 1% of EBIT. Nevertheless, Gap shows no signs of slowing its use of debt as it builds out its stores, so this will be an area to watch closely. While Gap's debt is nowhere near the danger point right now, the retail apparel business doesn't have the stability of Coke's beverage operations or Gillette's consumer staples. If the economy took a downward turn, Gap's debt could make hard times even worse.
One other company that I put in the no man's land that you'll find between good and bad debt is Lucent (NYSE: LU). When Lucent was first spun off from AT&T (NYSE: T) in April of 1996, it had cash of $448 million and interest-bearing debt of $172 million, a cash-to-debt ratio of 2.60. At the end of June of this year, it had cash of $1,495 million and debt of $6,792 million -- a ratio of 0.22. On a trailing 12-month basis, Lucent's interest expense is now just less than 5% of its EBIT. Like Gillette, this isn't a major hit to the bottom line, but the trend is alarming. While a lot of Lucent's debt was racked up during the time that it was prohibited from using its stock to make acquisitions, it's been almost a year since that restriction was lifted, and its debt continues to grow.
One advantage that Lucent has over the aforementioned companies is that it's in a rapidly growing industry. If growth were to slow down, then -- as with the Gap -- debt could make hard times harder.
Now, let's turn to the portion of tonight's report that's only suitable for mature audiences....
Too much debt can drown out earnings and suck the life out of a company. That's what happened with Starter, which declared bankruptcy under Chapter 11 in April of this year.
Starter makes athletic apparel. I created a spreadsheet with its quarterly data from March 1995 through September 1998 (financial statements for 12/31/98 were not filed with the SEC due to the bankruptcy filing). During this time, the company never had a cash-to-debt ratio above 0.14. Further, the seasonality of the business caused it to make money only during the third quarter of the year.
The problem was that in order to purchase the products that it needed to make money during that one quarter, it had to take on so much debt that it was unable to repay the money it borrowed. In 1995 and 1996, its interest expense was more than its pre-tax income. In 1997, Starter didn't even have a pre-tax operating profit. For practically three years, this company clung to the life-support of debt, but eventually the creditors came knocking. It's no wonder this company went bankrupt.
Here are a few of the numbers for this period:
Cash-to Operating Pre-tax Interest Debt Profit (loss) Income (loss) Expense ROIC 1997 0.003 (24,224) (31,393) 7,272 -14% 1996 0.070 8,333 3,132 5,647 4% 1995 0.140 7,243 2,288 5,259 4%
Pretty UGLY, wouldn't you say? The sad part is that I only knew about Starter because someone that I know owned shares of the company and still did when it went bankrupt. A while ago, he asked my opinion on the company, and I looked at the financials and told him if I owned it, I'd sell it. He held on for reasons that are common among people that continue to hold a stock they know is a loser. Wrong reasons that they are, most of us are familiar with the urge to get back to even, or the rationalization that the stock price is already so low that it couldn't go much lower, or the feeling that the stock is cheap, etc. Of course, since Starter went bankrupt, he ended up with nothing in the end. OUCH!
This is an example of why Philip Fisher, in his book Common Stocks & Uncommon Profits, said, "More money has probably been lost by investors holding a stock they did not really want until they could 'at least come out even' than any other single reason." The moral of the story is that there are no rules saying that a stock can't go down any more from where it is presently. It most DEFINITELY can.
In case reading about a bankrupt company like Starter wasn't enough to curdle your stomach, we'll check in on Rule Breaker Port short Trump Hotels & Casino Resorts Inc. (NYSE: DJT). Here are its numbers for 1998 and the first six months of this year:
($ millions) 1998 6 mo. 1999 Cash and cash equivalents $ 114,757 $105,089 Interest Bearing Debt $1,848,996 $1,854,404 Cash-to-debt 0.06 0.06 Operating Income $154,973 $66,024 Interest Expense $223,098 $110,907This one really doesn't look a whole lot better to me than Starter.
That's all for tonight. Do you have any other candidates for good, bad, or ugly debt? If you'd like to discuss them, or you have any other questions, please post to any of our message boards.
Phil Weiss, Fool
Matt Richey, contributing Fool
- Rule Maker Strategy Board
- Rule Maker Companies Board
- Rule Maker Beginners Board
- Rule Maker Ranker Spreadsheet (Excel 97, 68k)
- Rule Maker Ranker Spreadsheet (Excel 95, 41k)
- Rule Maker Essentials Spreadsheet (Excel 95 or 97, 53k)