Debt: The Good, the Bad & the UGLY
Part 1 of 2

By Phil Weiss (TMF Grape)

TOWACO, NJ (August 31, 1999) -- Is debt always a bad thing for a company, even a Rule Maker, to have? Surprisingly, I think the answer to this question is no. Over the next two nights, I'm going to talk about interest bearing debt -- what it is, and why companies need it sometimes -- then I'm going to go through some examples of companies that I think have what I'll call "good" debt, "bad" debt, and "UGLY" debt.

Good Debt

Before I get down to talking more about some debt-related concepts, I'm going to tell you about a current Rule Maker that I think has "good" debt -- Coca-Cola (NYSE: KO). I know, I know. Many of you are asking how a company with a cash-to-debt ratio of 0.38 can have good debt. After all, the latter number misses our stated guideline of 1.5 by a wide margin.

However, there are a couple of reasons that I feel Coke's debt is good. The first of these is that the company has clearly stated its goals to utilize Economic Value Added (EVA) by maximizing return on capital and minimizing cost of capital. For the uninitiated, EVA is essentially a means of comparing the cost of capital to the operating profits generated by the business. EVA is something that has been discussed by Dale Wettlaufer over in the Boring Portfolio on a number of occasions.

I also decided to look at the returns being generated by Coke by doing some simplified calculations of its return on invested capital (ROIC). I calculated ROIC using the following equation and a 35 percent tax rate:

      Net after-tax operating earnings
ROIC= --------------------------------
         (shareholder's equity +
          interest-bearing debt) 

It's really not as complex as it looks. You've heard the phrase, "It takes money to make money." Well, if Coke takes $1 to go out and make money, ROIC tells us how much money the company made on top of the $1 it used.

Here are the results:
Coca-Cola ROIC ($ millions)
          Income from       Invested
         Continuing Ops.    Capital      ROIC
1998        4,967            13,552       24%
1997        5,001            11,149       29%
1996        3,915            10,638       24%
As you can see, Coke's beverage operations are highly profitable. In 1998, for each dollar the company invested in its business, it earned 24 cents. Not bad. These returns on capital are much higher than the company's weighted-average after-tax cost of capital, which management currently estimates as approximately 11%. That means each dollar used in the business has an average annual cost of 11 cents. Quick math -- for each dollar invested, 24 cents earned minus a cost of 11 cents equals an economic profit of 13 cents. That's EVA in a nutshell.

The key to understanding EVA is that a low cost of capital is just as important as a high return on capital. In other words, Coke's managers realize that decreasing the current 11 cents that each dollar costs is just as beneficial as increasing the current 24 cents earned. Either one will increase the economic profit above the current 13 cents.

Therefore, an important part of Coca-Cola's financial strategy is to keep its cost of capital as low as possible. According to Notes 5 and 6 of Coke's 1998 annual report, the weighted average interest rate paid on its short-term debt was less than 6% in both 1997 and 1998. The rate of interest paid on its long-term obligations ranges between 5.75% and 7.875%. Both of those figures are substantially less than Coke's ROIC. It seems to me that Coke is following through on its goal of utilizing EVA to maximize its returns.

Okay. I've gone ahead and said that debt can be good. Before I get to the bad and the UGLY, I thought that it would be worthwhile to talk about some debt-related concepts.

Debt Concepts

In its simplest form, debt is an obligation to pay someone else money. The repayment terms for debt can be fixed, meaning that, for example, monthly payments are required like your home mortgage. Also, the interest rate can be either fixed or floating (it changes at some regular interval). Debt can also be secured, meaning that the lender has the right to receive certain property in the event that the loan is not repaid (again like a home mortgage), or unsecured.

There are also certain liquidation rights or preferences granted to those that loan money. If a company is unable to pay off its debts, it is likely that it will declare bankruptcy. The two most common kinds of bankruptcy are called Chapter 7 and Chapter 11.

Chapter 7 is a proceeding designed to liquidate the debtor's property, pay off its creditors to the extent possible and discharge the debtor from his or her other debts.

Chapter 11 bankruptcy takes place when a debtor realizes that it will become insolvent or will be unable to pay off its debts as they mature. Such a debtor can petition the court for reorganization under Chapter 11 of the Bankruptcy Code. The debtor business is normally able to continue its operations under court supervision until some plan of reorganization is approved by two-thirds of its creditors.

In the event of a liquidation or reorganization due to bankruptcy, there are certain liquidation preferences given to debt holders. Secured creditors come first. Then come unsecured creditors. If there's not enough money to pay the unsecured creditors, then as a general rule, they get a pro rata distribution of the company's assets.

If you're a shareholder in a company that declares or enters bankruptcy, then you end up with nothing. The reason for this is because the secured and unsecured creditors receive payment first. Since a company in bankruptcy proceedings has liabilities that are greater than its assets, there's nothing left over for the shareholders at the end of the day.

Okay, that gives a brief description of what debt is and what can potentially go wrong if a company can't pay off its obligations. Now, let's explore why companies borrow money.

Why Companies Borrow Money

When a company needs more cash than it currently has available in its war chest, there are really two ways that it can get it. It can either issue new shares of stock in a public offering (called a "secondary offering"), or it can borrow money. There are advantages and disadvantages to each.

The primary advantage of issuing new shares instead of borrowing money is that it doesn't have any ongoing obligation to pay out cash to its equity investors. The disadvantage is that if you're already a shareholder in a company that then decides to issue new shares, then your ownership interest in the company will be diluted by the issuance of the new shares.

Borrowing, whether in the form of loans from a bank or bonds from the public market, also has its pros and cons. The primary advantage of borrowing money is that debt costs less than equity. Here's why: Since a company has no obligation to repay its investors the way it has to repay those that loan it money, an equity investment is assumed to have a higher level of risk. As a result, an equity investor expects to receive a higher rate of return on his or her equity investment than a lender would. In addition, the interest paid on debt is tax deductible, which further reduces the cost of debt.

Well, that's about enough for now. Tomorrow, we'll resume with a look at several examples of companies that fall in the gray area of bad debt, as well as one truly disgusting, UGLY example of debt.

We covered a lot of ground today. If you have any questions about EVA, ROIC, debt, or anything else, drop a note in either the Rule Maker Beginners or Strategy message folders.

Phil Weiss, Fool