Low margins and high debts are a lethal mix

Warren Buffett’s first rule of investing is “don’t lose money” and it is very good advice. Even the best investors lose money from time to time, but avoiding losses should be every investor’s top priority. This is because they are very hard to recover from and can wreak havoc with a portfolio’s long-term returns.

The gut-wrenching feeling of being a holder of a share that suffers a calamitous fall in price is a humbling and sobering experience. Yet, in very many cases the danger signs were there to see before the company and its share price came a cropper. Too often, the lure of a low share price and seemingly cheap share price suckers people in, often with disastrous results.

2018 has seen some notable share price blow-ups that have been covered extensively in the financial press. A selection of unfortunate companies and their share price falls in 2018 to date are shown in the table below.

2018 blow-ups

Source: SharePad

Hindsight is a wonderful thing, but the companies shown have two main danger signs in common: They have very low profit margins and lots of debt or hidden debts. These two characteristics often lead to trouble for investors sooner or later.

What operating margins tell you

I’ve often been asked what is the most valuable financial ratio an investor can calculate. I am a big fan of return on capital employed (ROCE) but in terms of an expression of business quality and safety, operating margin is hard to beat.

A company’s operating margin tells you what proportion of its revenues is turned into operating profits. It’s easily calculated from a company’s income statement by taking its operating profit and dividing it by its revenue or turnover.

Generally speaking, the higher the profit margin, the better. High profit margins are often seen as a sign of an outstanding business that can provide a good or service that very few competitors can copy. Sometimes high profit margins are a warning sign that a company is charging its customers too much, which will eventually attract competition or regulation that will reduce them. Funeral provider Dignity (DTY) is a good example of this.

Low profit margins usually paint a less favourable picture of a company’s health. That said, companies such as internet retailer Amazon (US:AMZN) or clothing company Asos (ASC) use low profit margins as a competitive strategy in order to grow their revenues at a rapid pace. What constitutes a low margin business is a matter of opinion. My view is that a business with a margin of less than 10 per cent is a low-margin one. A very low-margin business is one with margins of less than 5 per cent.

In most cases, low profit margins are a sign of a company operating against lots of competition and/or one facing a lot of difficulties. Profit margins can be seen as a buffer between the amount of money received from selling goods and services and the costs involved in producing them.

The smaller the buffer, the bigger the risk to the investor. This is because that thin buffer can disappear completely if trading conditions deteriorate and profits turn to losses.

Turning to the list of companies whose shares have had a terrible 2018, we can see that they are all very low-margin businesses and have been for some time. Companies such as Carpetright (CPR) and Flybe (FLYB) are actually losing money, whereas all but McColl’s (MCLS) have lower margins than four years’ previously.

Low operating margin

Source: Company reports

With the best will in the world, it is difficult to see how these companies could have been seen as very high quality ones that deserved high stock market valuations. Their low profit margins tell you why this can’t be so.

The last thing that you really want to see with a very low-margin business – one with a low buffer of safety – is a business that is saddled with high debts and hidden debts.

Debts, hidden debts and their dangers

Debt is the big enemy of any shareholder of a company. The reason why is very simple. A company’s lenders have to be paid before shareholders are entitled to a penny of its profits or the proceeds of its assets if the business is liquidated. The more debt a company has, the larger the share of a company’s profits or cash flows is allocated to it.

If a low-margin business sees a deterioration in profitability, the worst-case scenario is that there is no profit or cash flow left for shareholders after the debt has been serviced and insolvency becomes a possibility.

It is important to point out what investors should consider a company’s debt to be. It is not just the borrowings that are seen on the face of a company’s balance sheet – other liabilities such as pension fund deficits are debts in all but name. Deficits have to be made good with cash payments into the fund. This is cash that cannot be paid to shareholders.

You can find a company’s pension fund position on its balance sheet. Some pension funds are in surplus, but for matters of prudence I do not see it as something that is normally distributable to shareholders or to be used to reduce other debts.

Then there is the often ignored hidden debts in the form of operating leases that are not disclosed on a company’s balance sheet. This will change from 2019 onwards.

Operating leases are liabilities that should be treated as debt. This has long been a controversial subject and subject to many years of debate. Operating leases arise when a company enters into an agreement to rent assets such as properties or plant and machinery. High-street retailers tend to enter into long-term rental agreements rather than own their stores, while airline companies tend to rent their aircraft.

The obligations to pay rents – often for many years into the future – are essentially debt-like liabilities but have not been treated as such in a company’s accounts due to the view that the risks and rewards of ownership of the asset being rented rest with the lessor – the landlord or aircraft owner – rather than the lessee. Instead, the annual rent is expensed in the income statement against revenues and reduces a company’s profits.

Hidden debts

Source: Company reports

Until the debt equivalent liabilities of rented assets is stated on the face of company balance sheets from 2019, it is possible to estimate the value of them by using numbers in a company’s annual report.

You can usually find the annual operating lease expense in the operating profit note in the accounts. If you can’t find it there then it should be found in the note detailing the minimum future operating lease obligations towards the back of the accounts.

For years, credit rating agencies such as Moody’s or S&P have estimated the equivalent debt value of operating leases by multiplying the annual operating lease by a factor between six and eight. I tend to multiply it by seven. So if a company has an operating lease expense of £100m, the estimated equivalent debt is £700m. Some companies will helpfully give you the estimated lease debt number in their annual report.

The other debt-like liability to be considered is if the company has any preferred equity and preference shares. Dividends on preference shares have to be paid before ordinary shareholders can be paid a dividend, just like interest on borrowings.

To calculate a company’s real level of effective debt you calculate the sum of the following:

Net debt + pension fund deficit + lease debt + preferred equity

We can see that companies such as Carpetright have much higher levels of debt than is shown on its balance sheet. Also, Debenhams (DEB), Thomas Cook (TCG) and Flybe have massive off-balance-sheet debts that have brought them lots of problems as their thin profit margins have fallen or disappeared. Low profit margins and high debts are a lethal mix.

Calculation of fixed charge cover and interest cover

When looking at any company with big rental and interest expenses one of the most useful ratios you can calculate is known as fixed charge cover. You need three numbers from a company’s annual report in order to calculate it:

• Operating profit
• Operating lease expense
• Net interest expense

Fixed charged cover

Source: Company reports

Operating leases and interest are known as fixed charges that have to be paid. To calculate the income to pay those fixed charges you need to add back the operating lease expense to operating profit (as this has been expensed to calculate operating profit in the first place).

Fixed charge cover = (operating profit + operating lease expense)/(operating lease + net interest)

As a rough rule of thumb, a fixed charge cover of 1.3 times or less is something to be concerned about. Based on the figures from its most recent annual reports, you can see why Carpetright has had to radically restructure its business by raising fresh equity, cutting costs and reducing its rent bill and why Flybe had to put itself up for sale, as neither could cover their fixed charges. Debenhams and arguably Thomas Cook are in the danger zone.

Problems with Interserve’s (IRV) energy from waste business has pushed up debt and put pressure on its profits in 2018. This has pushed its fixed charge cover down to dangerous levels and is responsible for the collapse in its share price. Its debt as a percentage of its enterprise value (market cap plus adjusted net debt) is now 98 per cent, indicating that there is little equity value left.

Other companies in the danger zone

Using a very simple screen, a number of other companies – in addition to those mentioned above – are clearly in the danger zone based on the following criteria:

• Fixed charge cover of less than 1.3 times
• Forecast operating profit margin of less than 5 per cent
• Debt to market capitalisation (incl pension deficit but excluding lease debt) of more than 100 per cent, which is a classic sign of distress for non-financial, non-property and non-network utility companies

Danger list

Source: SharePad