Debt-free companies can have their virtues, but debt has an undeserved bad rap with individual investors. Too many investors see a large slug of debt and immediately assume there's a lot of risk to the business and its returns.
True, many companies are dangerously overleveraged, including General Motors (NYSE:GM) and recently bankrupt Delphi. In fact, the debt on GM's balance sheet only tells part of the story; it doesn't include the company's even more ominous unfunded health-care and pension obligations.
But there are plenty of companies with what I would call good debt. When used in moderation, it's far cheaper than issuing equity, which represents a claim on earnings for the life of the shares.
A couple of examples of companies with good debt are Motley Fool Stock Advisor selection Costco (NASDAQ:COST) and Outback Steakhouse (NYSE:OSI). Costco carries a long-term debt burden of $546.8 million, which is a manageable amount for a company with a $20.3 billion enterprise value. But what makes Costco's debt really good is how affordable it is for the company. All of the debt is financed below 5.5% interest; as of late August, the majority of it was financed at 3.5% or lower.
In an interesting twist, as of late August, Costco had $274 million of its debt in 20-year 3.5% zero-coupon bonds that have a bit less than 12 years remaining until maturity. With most bonds, companies must make interest payments annually or semiannually. Zero-coupon bonds are unique because no payments are made until the bond matures; instead, the company takes less money up front and pays all of the interest at maturity. Companies don't issue long-term zero-coupon bonds too often, because there often aren't many investors willing to take on the interest-rate risk. In Costco's case, the zero coupons were made sweeter because the holders can convert them into common shares at $22 per share. That's a great deal based on today's share price of $49, but when the bonds were issued in June 1997, shares traded hands at only $17.
Outback Steakhouse doesn't have zero-coupon bonds on its balance sheet, but does have about $110 million in total debt. Like Costco, this debt is financed at reasonable rates. For example, about 20% of Outback's debt is held by its Japanese subsidiary and is financed at rates under 1%. Costco's Japanese operations also carry debt at similarly low rates.
I'm not the first Fool, or even the second, to sing the praises of debt when it's used reasonably. Companies have many ways to finance their expansion, and using debt often makes a lot of sense. As an investor who's analyzing a company as a potential investment, your job is to determine whether the company is reasonably financed like Costco and Outback, or dangerously leveraged like Movie Gallery (NASDAQ:MOVI) and GM.
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Nathan Parmelee owns shares in Costco and Outback, but has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.
