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How to avoid the dangers of debt

As the UK emerges from lockdown, share prices are beginning to recover. But the burden of a big debt pile means that some companies may have rerated too strongly.
How to avoid the dangers of debt
  • Weak balance sheets should be a major red flag for stockpickers
  • SSP and WH Smith provide a lesson in overoptimistic recoveries

As a general (if not golden) rule, investors should tread carefully around businesses classed as having “a weak balance sheet”. In the stock market rebound from the initial Covid shock in Q1 2020, this rule may have been overlooked and the share prices of many financially weaker companies have climbed steeply, some perhaps too steeply. 

Many share prices are back to, or even well above, pre-Covid levels despite radical changes for many industries and individual companies. This is hard to square when a business model is unchanged, with trading likely to resume only at prior levels (at best) and where the financial position has been significantly weakened. This suggests there could be overstating of potential and understating of risk.    

 

What is a weak balance sheet?

As in personal finance, company financial weakness is primarily about debt, but there are other substantial financial commitments that can become a stumbling block, limiting or threatening the ability to function. 

Examples might include bonds or preference shares, pension fund deficits, deferred consideration for past acquisitions, heavy replacement capital expenditure, large cost commitments deferred by Covid measures, changes in credit rating score (Moody’s or S&P) or large historic tax bills from better times. 

The presence of debt per se, even if high, is not automatically a red flag for investors. For a fast-growing company making high returns, debt is unlikely to be an issue. Debt only becomes a problem when a company can't easily repay it using trading cash flow or is unable to renew facilities and must resort to issuing shares or selling assets.

But surely with ultra-low interest rates, debt is less of a problem than historically? Most commercial debt interest rates are set against a benchmark such as gilt yields or Libor (the London Inter-Bank Offered Rate). Before the 2007 financial crisis, these benchmarks were at roughly 5 per cent, meaning loan interest of 7-8 per cent. Today, these benchmarks are below 1 per cent so loans may only cost 2-4 per cent in interest. Clearly, servicing debt is more manageable than in the past. 

The problem with debt is not its cost but the constant need to replace, renew or extend it. Even long-term debt agreements might only run for five years and shorter for more indebted businesses. When trading is weak or debt has risen, companies required to reschedule their repayments are likely to find it harder to secure similar maturities. 

Weaker balance sheets also result in more onerous covenants – conditions created by lenders which if breached risk default or having harsher terms imposed. Covid has caused a perfect storm of falling profits and rising debt so covenants, a long-dormant issue, are back in focus. Emergence from Covid does not mean covenant risks disappear and many businesses may find that they breach as they recommence investing and bearing costs that had been deferred. 

If actions are not taken to reverse a weak balance sheet, day-to-day problems – including cost pressures and shortages, poorer trade terms, forced asset sales, missed investment opportunities or lower dividends – could begin a negative cascade that may lead to insolvency or liquidation as creditors attempt to recoup loans that can’t be repaid. In the extreme, a company might also face a ‘debt-for-equity swap’. Here, a large number of new shares are issued to creditors giving them ownership of the business and diluting existing shareholders, often to zero. 

These are worst-case outcomes, but even seemingly viable, profitable businesses can suffer this fate if overwhelmed by debt they cannot repay by other means. 

 

Climbing back

During the UK’s many lockdowns, most businesses have been shielded from financial pressures by legislation or co-operations with counterparties. Many items of expenditure have only been deferred rather than cancelled and will begin to fall due. Rent arrears can be pursued, deferred taxes (VAT and PAYE) become payable, previously government-funded salaries end and creditors previously muzzled can now pursue payment, most likely starting with riskier debtors. 

Investors should not be blindsided on debt issues by resumption of trading. Some businesses see pent-up demand during a crisis and rebound fast, while for others lost business is lost forever.

Selling cars, new homes or luxury items likely only saw sales deferred while utilities ploughed on almost unaffected. Many businesses shifted sales online, but others such as restaurants or pubs simply dried up. Trading will recommence but probably below pre-crisis level with no scope for catch-up. 

 

Tapping shareholders 

So why not just issue more shares to lower debt? Issuing shares only to repay debt can be a poor use of equity and is likely to destroy shareholder value even though it does reduce risk. Issuing shares to raise capital for investment is always preferable. An acquisition might generate a 15 per cent return on capital employed (ROCE) whereas with just repaying debt, ROCE only equals the debt cost, say 3-5 per cent – this is below the cost of capital and is how value is destroyed. In the table below we compare the impact of using equity to repay debt and to acquire earnings – the latter case is positive because value is created. 

Impact of clearing debt or acquiring earning with an equity issue
  

£100m equity

£100m equity

 

Base case

repays debt

buys earnings

Debt

100.0m

0.0m

100.0m

Interest

4.0m

0.0m

4.0m

    

EBIT

20.0m

20.0m

35.0m

Pre-tax profit

16.0m

20.0m

31.0m

Profit after tax

13.0m

16.2m

25.1m

Dividend

6.5m

11.7m

11.7m

Retained profit

6.5m

4.5m

13.4m

    

Shares in issue

40.0m

72.0m

72.0m

EPS

32.4p

22.5p

34.9p

DPS

16.2p

16.2p

16.2p

    

Share price

389p

338p

523p

PE ratio

12.0x

15.0x

15.0x

Source: Investors Chronicle. Both scenarios assume a £100m share issue at a 20% discount

 

Spotting risk: Why you should be wary of WH Smith and SSP

Coming back to our original proposition on debt and share price rebound, we sought to determine if markets could be overlooking debt issues. We screened the FTSE 350 index to compare share price recovery, net-debt-to-Ebitda ratio and debt-to-equity ratio. The most affected stocks are shown in the table below. 

Ticker

Name

Gearing [1]

Debt to EBITDA [1]

Price Chg 12mths

SSPG

SSP Group Plc

1568%

600.2x

45%

EVR

Evraz PLC

406%

1.4x

105%

SMWH

WH Smith PLC

383%

7.6x

54%

PAG

Paragon Banking Group PLC

373%

124.0x

50%

ICP

Intermediate Capital Group plc

286%

7.9x

68%

NXT

Next plc

276%

2.7x

50%

FGP

FirstGroup plc

275%

3.5x

47%

RTN

Restaurant Group plc

264%

15.2x

88%

OSB

OSB Group PLC

251%

140.6x

76%

WOSG

Watches of Switzerland Group PLC

218%

3.5x

212%

VMUK

Virgin Money UK Plc

208%

247.0x

101%

LLOY

Lloyds Banking Group plc

196%

47.3x

48%

WIZZ

Wizz Air Holdings Plc

182%

138.7x

46%

BT.A

BT Group plc

156%

2.5x

73%

ENOG

Energean Plc

139%

123.1x

53%

AHT

Ashtead Group plc

128%

1.8x

91%

AO

AO World Plc

123%

5.1x

61%

Source: Factset  [1] as at last full year balance sheet and before recent equity issuance

We have picked two stocks for closer examination: WH Smith and SSP. They are high on our list, both have come to the market recently to raise money and they have similarities in their key business drivers.

 

Similar, but not so similar

WH Smith

  

SSP

 

Q1 2020 Share price high

2654p

 

Q1 2020 High

567p

Q2 2020 low

701p

 

Q2 2020 low

125p

Price today

1691p

 

Price today

301p

Fall to 2020 price low

78%

 

Fall to 2020 price low

71%

Bounce from 2020 low

141%

 

Bounce from 2020 low

141%

     

Gearing [1]

487%

 

Gearing [1]

1568%

Debt to EBITDA [1]

6.2x

 

Debt to EBITDA [1]

602.0x

Source: Factset  [1] as at last full year balance sheet and before recent equity issuance

Both businesses derive the bulk of profits (in normal times) from sales at travel hubs including stations and airports). WH Smith roughly 66 per cent and SSP closer to 100 per cent, the former as newsagents and the latter through food & beverage sales. Both have been hit badly by the slump in travel, with profits collapsing into heavy losses, negative cash flow, rising debt and both have ‘lost forever’ sales due to Covid with little scope for pent-up demand. Ostensibly, SSP appears much weaker on our measures and seemingly more risky, but this is not necessarily so. 

While both have come to the market for new money, SSP raised equity while WH Smith issued a convertible bond. A share issue clears debt and boosts the balance sheet (but is dilutive) while a convertible is just another form of debt that might convert into equity and possibly bring the same benefits. If the WH Smith share price has recovered enough by 2026, the bond converts into shares but if not it will have to be refinanced as debt, making this a deferral rather than a fix. 

Both companies should begin to see business momentum improve as travel restrictions lift, but SSP feels more dynamic. First, WH Smith has a large high-street business which exhibits poor growth prospects and will drag on overall growth. Second, food and beverages is a faster-growing area of travel retail and one in which there is much greater scope to use technology to cut expensive labour costs (app ordering for example). Third, SSP has more exposure to fast-recovering US domestic air travel, although WH Smith has entered this market via recent step-change acquisitions. Those purchases now, however, look pricey and risk dragging on returns. Fourth, SSP has sizeable exposure to the EU, another area where more rapid travel recovery is expected while WHSmith's presence here is small. Fifth, SSP is a beneficiary of the drift to no-frills flying as flyers must now eat before or take food on board. Books and newspaper sales are, by comparison, low-growth, possibly even negative as the use of digital media grows. Finally, SSP enjoys a high level of turnover-related rather than fixed rents, tying cost increases more closely to the pace of recovery. 

WH Smith also warned recently that it risks breaching its debt covenants in 2022. While nothing destructive is likely to arise from this, it does give lenders the upper hand in setting future debt terms and pricing. SSP, by contrast, is really only subject to liquidity covenants on its debt and has plenty of headroom after its rights issue. 

Both businesses face the same slow climb back and it is likely to be 2024 before revenue levels recover even to 2019 levels: pre-Covid, underlying travel market growth was forecast at circa 5 per cent compound annual growth in this period. So it’s right that both share prices remain below Q1 2020 levels. However, SSP has only recovered less than half its share price fall while the less dynamic, riskier WH Smith had clawed back nearer two-thirds (before slipping 5 per cent last week). On a snapshot view of the current financials, this might look right, but when considering debt outlook and trading prospects, the balance of risk and reward seems a little about-face: WH Smith does not justify having staged a better share price recovery. Looking at a snapshot of debt can be helpful and a useful place to start when assessing investment potential, but it can also be misleading.