Join our community of smart investors

Debt health check

As borrowing conditions become more favourable, investors need to keep an eye on companies' debt profiles and other liabilities. Bradley Gerrard explains how and where to probe
September 23, 2016

Sterling corporate bond yields have fallen to record lows, providing UK plc with an attractive opportunity to increase leverage or refinance existing borrowings at a lower rate.

The number of corporate bonds being issued by UK companies has fallen in the past couple of years after a splurge of borrowing to lock in lower rates. But that quickly changed in August when the Bank of England announced it would be entering the fray by purchasing UK corporate bonds as part of its wider quantitative easing programme. That week, UK corporates issued £1.78bn of bonds, according to Dealogic, which was the largest week of issuance since 2014.

So with the cost of borrowing becoming broadly less punitive and a new major purchaser in the market, it's increasingly important for investors to understand the debt profile of a company. It's not only worth considering why the money is being raised, but which metrics can best help you understand how strenuous a company is finding servicing its debt pile and whether certain types of businesses are always better able to weather high levels of borrowing.

While it might cost companies less to borrow money now, increased borrowing, even at lower rates, will affect a company's balance sheet and could lead to increased pressure on the amount of free cash that could be distributed to shareholders.

 

 

Key metrics

Most fund managers use the net debt to cash profits (earnings before interest, tax, depreciation and amortisation, or Ebitda) ratio to help them establish the size of a company's borrowing in relation to what it earns. This should not be used in isolation by investors, though, as it could ignore factors such as property assets, which can be used as security against borrowings. A company could have a high leverage ratio, but still be favoured by fund managers if it has assets it can easily sell or is considered defensive due to its reliance on small, repeatable purchases by its customers.

For instance, data from S&P Capital IQ shows Market Tech Holdings (MKT), the Camden-based property developer, has a net debt/Ebitda ratio of 20.9 times. This is the highest out of all London-listed companies, excluding investment trusts, above £100m. But in June, the company reported a 12.4 per cent rise in the like-for-like value of its property portfolio and all of its debt is now at a fixed interest rate, which is useful considering that the amount it charges in rent is likely to rise. The company also has a fairly low total debt/total assets ratio of 0.32 times, showing that the value of its assets is greater than the size of its borrowings.

Perhaps more worrying is insurance and breakdown company AA (AA.). Using the net debt/Ebitda metric, its high ratio of 8.72 times is made worse by the fact it boasts a total debt/total assets ratio of 1.6 times, the worst of all the companies in our data set from S&P Capital IQ. The group has recently made inroads into reducing the huge debt on its balance sheet by raising £199m and issuing £735m in new bonds in July, allowing it to retire its most expensive debt and reduce annual financing costs by more than £45m. While this resulted in a one-off £85m cost, it meant the group's net debt was down by £158m - although outstanding borrowings remain a huge £2.8bn. This should improve its interest cover - which is how many times its operating profit (ebit) covers its interest expense - a ratio also favoured by fund managers and analysts.

 

Key debt metrics
CompanyMarket capNet debt/cash profits (ebitda)Ebit/interest expenseTotal debt/Total assets
Market Tech Holdings770.820.90.6950.326
AFI Development103.819.30.6870.406
Capital & Counties Properties2,342.3018.71.680.152
Helical325.716.51.680.57
Kaz Minerals843.214.55.080.843
KSK Power Ventur142.913.20.5970.767
CLS Holdings643.210.51.990.459
Grainger922.410.11.640.657
Tullow Oil1,935.208.88-0.385
AA1,816.508.721.411.63
Enterprise Inns441.77.721.770.582
Punch Taverns238.57.641.280.669
Marston's815.87.621.930.581
United Utilities6,665.507.242.340.586
Stobart Group534.46.95-0.103
Shire43,650.106.94170.095
St Modwen632.86.933.610.319
Premier Oil311.806.736.360.493
Raven Russia248.86.591.410.639
Sophos Group1,188.606.390.3470.303
Source: S&P Capital IQ, data excludes investment trusts

 

A ratio of 1.5 times is usually the lowest investors like to see. Anything below this means a business could struggle to keep up with its debt repayments. According to data compiled for Investors Chronicle by S&P Capital IQ, companies with a ratio at or below 1.5 times include Tesco (TSCO), Speedy Hire (SPD), Punch Taverns (PUB), The Gym (GYM), Hostelworld (HSW), Glencore (GLEN) and Premier Foods (PFD). And AA is there too.

The latter ratio could be particularly useful to watch because, while the interest rate environment might be benign, companies can quickly become overstretched if trading begins to suffer. Many of the UK's listed pub companies, which were perceived as safe debtors due to their reliance on small, repeatable purchases, found themselves overleveraged prior to the financial crisis when the economic environment moved aggressively against them, and their dwindling earnings quickly led to rights issues to help them service their debt.

 

 

New burden?

Generally, businesses that rely on repeatable purchases, such as supermarkets or consumer staples companies, or have dependable income, such as utilities, are better able to withstand higher levels of borrowing. But even this rule is not a hard and fast one and should be monitored by investors.

"A few years ago, if you'd have asked who could stomach leverage I would have said [a company] like Tesco, as it's a food retailer with defensive qualities because it relies on small-ticket purchases," says Iain Wells, a fund manager at Kames Capital. "But that goes to show it is important to really pay attention to the environment, and changes to it, that these companies are operating in."

The supermarket plunged to a £6.3bn pre-tax loss in 2015 and new chief executive Dave Lewis has since been selling businesses here and abroad to help improve its financial standing.

This means investors need to make sure that, even if a company or a sector has historically been comfortable with high levels of leverage, this remains the case as the economic climate alters.

Richard Marwood, fund manager at Royal London Asset Management (RLAM), says that, while the repeatable and dependable business models of utilities meant high levels of gearing were acceptable, there was a potential issue in the long term.

"There's an argument they can withstand a lot of debt, but the absolute amount of debt is very large," he says. "That's been fine in a 20-year bull market for bonds, but if rates rise and bond investors demand higher rates of return that could be problematic. It could be harder to deal with the absolute level of debt."

Mr Wells says he would be "more cautious" around cyclical areas. "The obligation to pay interest does not go away even if times get tough," he said. "A really good example - and I still think it is an area that is overleveraged - is the resources area.

"Miners, oil stocks, and exploration and production companies have been cutting dividends, selling assets and some have had rights issues. This was all because they were too acquisitive and, if you are generous, it was difficult to foresee the phenomenal collapse in commodity prices. That happened overnight, but the debt stays while profit evaporates."

Mr Marwood highlights the recent problems at Cobham (COB) and Sepura (SEPU, both of which have links to the energy sector. Cobham had to undergo a £500m rights issue in April to help it avoid breaching bank covenants after its debt pile swelled as profits dropped. Sepura has also recently completed a £65m rights issue to help get banks off its back as profits slid. Both had used debt to help fund acquisitions and offer examples of deals being pursued at the wrong point in the cycle.

Mr Marwood adds that investors should be wary of companies with high operational leverage as it means they are "very susceptible to demand and price weakness, which is very cyclical".

 

'Hidden' debt

An important factor investors should be aware of is that leases and pension deficits, which are also types of debt, are often disclosed separately from the net debt figure. Disclosure of lease requirements is improving ahead of mandatory publication from 2019 due to new International Accounting Standards Board rules. But it is important to identify these figures in a company's results when assessing its debt, especially in segments of the market such as retail or airline stocks. Estimates suggest $3 trillion will be added to global liabilities as a result of the 2019 changes.

Many retailers are grappling with the shift to online shopping, the growth of which makes the largely fixed costs of running bricks-and-mortar stores proportionally more expensive. Managing leases is incredibly important as shorter ones offer greater flexibility but are likely to cost more, while longer, cheaper agreements could tie a company to a store estate for longer than necessary. Understanding the lease profile of a retailer could be a key factor in determining winners and losers in the coming years.

Likewise with airlines, net debt figures here could rise considerably once leases of planes are included, so understanding the ratio of planes owned versus leased could also help investors pick a less indebted company.

The other elephant in the room, which is trampling across the market as we speak, is the issue of pension deficits. Record low levels of interest rates are good for companies wishing to borrow money, but they also have the impact of deepening pension deficits by virtue of depressing gilt yields. Gilts are a go-to asset for pension funds and lower yields make it harder for schemes to match assets to their liabilities. There are fears that plastics manufacturer Carclo (CAR), which said it might now be unlikely to pay its final dividend due to the stresses upon its pension scheme from low bond yields, could be a precursor to similar moves by other companies.

"At the moment [the issue of pension deficits] is going up the risk spectrum because deficits are blowing out," Schroders analyst Harry Jack says.

"Cash contributions are only going up. It's something we have always paid attention to and if you are being more detailed you can look at the assumptions made on the liability side. These vary between companies - some are more aggressive to flatter the deficit, ie make it smaller."

High-profile investor Neil Woodford has said company pension schemes may need to rethink their asset allocation strategies and consider upping exposure once again to equities. He said concerns about pension deficits had, at the margin, "reduced the level of conviction that we have in stocks such as Royal Mail, BT and BAE Systems".

"The presence of a substantial pension deficit is therefore a consideration for investors and could put further pressure on the cash available for distribution via dividends, particularly in an environment where the balance between deficit reduction and shareholder returns is being called into question," he added.

And to hammer home how important the issue is, the latest 'Pension Risk Survey' by consultancy Mercer showed pension deficits among FTSE 350 companies ballooned in August as bond yields fell following the latest opening of the monetary taps by the Bank of England.

Despite a £20bn increase in assets held by pension funds to £737bn over the month, pension liabilities among FTSE 350 companies rose by £70bn to £936bn, leaving a record collective accounting deficit of £189bn. Mercer's data covers around 50 per cent of FTSE 350 companies.

The message here is that investors cannot ignore pension deficits.

 

 

Skewed incentives

A potentially questionable use of debt is share buybacks. With rates where they are, management teams facing a mixed global economic outlook will look for ways to jab some life into their company's share price. Share buybacks reduce the amount of shares in issue and thus augment the amount of earnings per share. This is not necessarily a bad thing for investors, but there are a few things to consider.

Share buybacks cannot continue ad infinitum. They have to come to an end and, when they do, what's left? Potentially an indebted company that hasn't been investing in its business, thus endangering decent organic growth. A rule of thumb for share buybacks comes from the Sage of Omaha, Warren Buffett. His view is that it's acceptable for strong companies to buy their shares back when the price is well below their 'intrinsic value' - ie less than the value of assets held, also known as price to book. Broadly speaking, if the shares are trading below 1x price to book, it suggests an opportunity has opened up to buy exposure to a company's assets at a discount.

James Sullivan, founder of Coram Asset Management, said the key point here was the intrinsic value analysis. "Arguably companies have been overpaying for their own stock, beyond the parameters of 'fair value' in order to find an equilibrium between supply and demand, thus maintaining their rating and to demonstrate share price stability."

"A cynic may suggest there is a temptation to return too much cash, damaging balance sheets and restricting growth opportunities, due to the short-term 'sugar rush' impact a buyback can have on a share price in a world that increasingly demands immediate results."

So debt-funded buybacks are not necessarily always bad, but some understanding of the existing debt position of the company in question is necessary to make this judgment.

Schroders' Harry Jack says he would tolerate a company raising debt to fund its dividend or a share buyback only if it had low levels of gearing and there weren't better uses for the cash, such as capital expenditure or acquisitions.

"But if the company is indebted and cannot fund its ordinary dividend through cash generation then we are much less comfortable as that is clearly not a sustainable strategy," he said.

"Even scrip dividends should raise a red flag and suggest the dividend might be too much of a stretch for the company. I would say a company with an ordinary dividend yield of more than 5 per cent suggests the market is starting to question the sustainability of that policy. Investors then need to assess if the market is being excessively pessimistic or not."

And as Coram's Mr Sullivan points out, endless investment in a business doesn't always end well.

"When one looks at the Japanese corporate cycle in the early 1990s, and the excessive investment, which in part led to the collapse of corporate Japan, one would perhaps be encouraged by the current buyback vogue."

This suggests investors have to make a judgment about what value they place on the share buyback versus investment in the business.

As Simon Henry, chief financial officer at Royal Dutch Shell, has been reported as saying: "The longevity of the firm is what matters… executives need to hold their nerve against short-term pressure so that they can invest for the long run."

Mr Sullivan adds that shareholders may well drive policy and the cycle would shift again from "increasing short-term return on equity to investment and merger and acquisitions, hopefully before we hit a 'research and development cliff'".

Investors may also want to check whether management long-term incentive plans are linked to EPS growth and, if they are, question whether management should be rewarded simply for buying back its own stock.

 

Tricks of the trade

Some management teams may 'dive for the line' when it comes to announcing their net debt via a process of 'window dressing'. Nearly all companies do this to some extent, however some are more aggressive than others, according to Mr Jack at Schroders.

Debt positions can be flattered by ensuring you collect as much as is owed to you from your customers, running down your inventory and delaying payments to creditors ahead of key reporting dates.

"The result is that your cash position looks its healthiest at these points in time, but that masks a much lower position than is typical for the rest of the year," says Mr Jack. "When done aggressively, without additional disclosure, it can be very misleading and make the company appear less indebted that it is. It also has ramifications for the company's customers, suppliers and other stakeholders who are getting squeezed hard."

Serco (SRP) has made improvements in the intra-year movement of its net debt figure, as the chart below shows, a demonstration of better cash management.

 

Investors can check how indebted a company really is with a simple calculation, though, according to Mr Jack. He said a company may disclose a certain level of debt at its year-end, but if investors find the interest charge in the profit-and-loss account and find the average cost of debt, these two figures can be divided to show the true level of debt. For example, a company reports debt of £1bn at its year-end but has an interest charge of £80m and an average cost of debt of 5 per cent. £80m/5 per cent = £1.6bn.

Mr Jack says both Serco and Tesco have made big improvements to both disclosure and practices aimed at smoothing out the intra-year cash profile which "paints a fairer picture to investors while treating other stakeholders less aggressively".

A good example of solid disclosure comes from Mears (MER). The company reported net debt of £14.1m as at 30 June 2016 but highlighted that a "far more important metric" was the group's daily net debt balances because these provided a better indication of working capital management throughout the period. The average net debt over the six months was actually £75m (from £69.0m in 2015), which management said was "pleasing given the group incurred outflows of £16.1m in respect of acquisitions over the past 12 months".

end box out

 

Debt management

It is also important to make sure a company is managing the time profile of its debt. Companies that have a large proportion of debt due in the same month or in quick succession could cause themselves problems. RLAM's Mr Marwood says he prefers to see companies raise debt with lots of different maturities.

"Investors need to be careful that a company's debt is spread over time and that it doesn't have too much maturing too soon," he says.

Not only that, but investors have to question whether they are comfortable with the length of debt a company they invest in has issued.

Mark Wharrier, manager of the BlackRock UK Income Fund, says he would be "relaxed" if something he views as defensive, such as Unilever (ULVR) issued a 20- or 30-year bond because "the business will be around then and it is not that cyclical".

But he'd be more cautious with a more economically sensitive business issuing long-term debt because earnings can fluctuate more aggressively. He highlighted Cobham as a company that has had, in his view, debt that was too long-dated and did not provide the flexibility shorter-term borrowing would. "If it's a cyclical business you want more flexibility on the balance sheet," he added.

Mr Jack says it's important to take note of a company's borrowing headroom. This might simply be sensible business planning, but if the amount it is allowed to borrow from creditors is well above its reported net debt figure it either means the company borrows intra-year or could become more highly geared at short notice.

Essentially, understanding the demands on a company's cash are key and can help investors make the right decisions about which stock to back.

BlackRock's Mr Wharrier says analysing debt when picking stocks is "absolutely critical" as it is imperative to understand what strains there are from debt and other capital commitments.