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 (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.

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 (LUV -0.54%), which flies with a modest debt load, and Spirit Airlines (SAVE -2.90%), 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.

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.