Beware debt-laden stocks | Fin24
 
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Beware debt-laden stocks

Apr 06 2020 08:55
Simon Brown

Steers, one of Famous Brands outlets (Supplied)

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The Covid-19 global crisis is worsening and will continue to get worse for a while as countries scramble.

As I have written before, the impact is going to be significant as consumers are not out there spending, either out of caution or, in many parts of the world, because governments have banned people from going out.

This is going to be felt across pretty much every aspect of the economy and South Africa is in no way going to be spared.

At the time of writing this column, markets were down between 25% and 35% in 2020 while Brent crude oil is off over 60%.

I have seen several collapses of this scale before. But never this fast.Company earnings will be under pressure across the board and those with strong balance sheets and little or no debt will be able to trade through this crisis.

But those that have a lot of debt are going to find themselves under serious pressure.Investors need to take a hard look at the stocks they still own and especially the debt those stocks are carrying.

As a starting point, look at annual reports in order to dig into debt maturity details and debt covenants.

Interest is always being paid, but usually not the principal loan amount and the maturity is when that debt is due. Debt due many years out is not such an issue.

But debt due this year or next year could become a real problem as it is hard to pay off or roll over into new debt and, if rolled over, the terms may be more onerous, further straining the company and its balance sheet.

Covenants are the terms imposed by the lenders and if breached, the debt can be recalled. Typically, a covenant will be something like the net debt-to-equity ratio or net debt- to-ebitda (earnings before interest, tax, depreciation and amortisation).

Investors need to have a clear understanding of these covenants and whether they are at risk of being breached, because a breach could mean the company has to sell assets or raise capital to cover debt.

The option of selling assets right now is the worst possible idea; buyers will likely get spooked and those interested in buying will want to pay bottom-drawer prices.

This leaves a rights issue as an option, which entails having to issue new shares at these low share price levels.

But neither of these options is good for a company and, while it may not go bankrupt, either option will make getting back to normal a long and hard road.

You also need to look at the cash-flow statement to see what the free cash looks like and the company’s ability to service the debt interest.

Here you’ll look for the total interest amount payable every year and compare that with free cash, but remember that free cash will be under pressure as revenue and earnings drop.

Ideally, assume free cash will drop by at least 50%. If you find that stocks you hold have serious debt concerns, then you need to have a hard think.

Do you consider exiting the position? I know you’ll then be selling at greatly depressed prices, but things are still getting worse and the economic impact has yet to be quantified.

If you decide to hold rather than exit, expect a rough time, a lower share price and a rights issue at horrific levels. I am going through my portfolio and the one that stands out is Famous Brands*.

It is a consumer-facing company, which puts earnings under extreme pressure, and it has high levels of debt. I will likely exit but will see if I can get a better price. But, even as the share trades at decade-lows, more downside is likely.

*The writer owns shares in Famous Brands. 

This article originally appeared in the 2 April edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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