Corporate Debt
December 31, 2001
Money & Investing
Increase in Corporate Debt
Could Hurt U.S. Recovery
By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL
Heavy debts are hounding companies in almost every industry, from telecommunications to textiles. Could that be enough to keep the stock-market recovery at bay?
Because U.S. corporations are continuing to add to their debt, instead of cutting back, analysts have begun to sound the alarm. U.S. nonfinancial, nonfarm companies had racked up a record $4.9 trillion of debt as of the end of the third quarter, according to recently released figures from the Federal Reserve.
That was up 6.6% from the third quarter of 2000, even as the economy entered a recession, the stock market swooned and many companies saw their credit ratings slashed.
The fear among analysts is that the debt deluge will put a cap on corporate spending, cutting off what many economists see as a spark for an earnings turnaround next year. That could quickly put a damper on stocks, if earnings improvements that have now been predicted for months begin to look much further off.
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What is happening on the corporate level mirrors Americans' household budgets, which also are stretched to the breaking point with a record $7.5 trillion in debt, up 8.5% from the end of the third quarter in 2000. If consumers begin to reduce all this debt, it could put a crimp in consumer spending in 2002.
"It makes sense for the household and corporate sectors to reconsider how much debt they're piling on, because at some point it becomes too onerous," says Thomas McManus, chief strategist at Banc of America Securities. Mr. McManus predicts the Standard & Poor's 500 will rise just 4% or so in the next year, in part due to the heavy debts.
Last week, at least, investors bet that the worst is behind for the U.S. economy, and shifted into stocks. For the week, the Dow Jones Industrials rose 1%, or 101.65 points, to 10136.99. The Nasdaq Composite Index rose 2.1% or 41.43 points, to 1987.26, while the Standard & Poor's 500 climbed 1.4 % to 1161.02.
On Friday, the industrial average rose 0.1%, leaving it down about 6% on the year, while the Nasdaq rose 0.6% and is down about 19.5% for the year. The Standard & Poor's was 0.3% higher, and is off 12.1% this year.
Some attributed the gains to a view that this January will be another strong one for the market. But for stocks to sustain a long-term advance, a robust economic recovery must start soon. Many analysts are starting to say the heavy corporate and consumer debt loads could keep such a recovery relatively tame.
Of course, heavy debts aren't necessarily bad for the economy, or for stocks. The economy boomed in the late 1990s and the stock market soared, for example, even as U.S. debt reached record levels. Companies took on heavy debt to help finance spending on new factories and cutting-edge communications networks, among other things, though debt was also used to pay for a surge in share buybacks. In hindsight, the strategy helped create record earnings growth, though it also led to the overinvestment and inventory glut that is only now showing signs of abating.
Now, bulls argue that while consumers' assets have fallen 4% during the past two years, even as their debts surged 15%, the assets are still up sharply from the past decade, so the debts are manageable. Meanwhile, the value of assets owned by corporations has climbed 7% during the past two years, helping to at least partly offset the 15% rise in debt during the period, these analysts say.
"There's no question, debt is at record levels, but there's also no question there's been a huge run-up on the asset side," says Jeffrey Applegate, chief investment strategist at Lehman Brothers, who predicts a rise of about 15% for the S&P 500 in 2002. "So we're still in a better leverage position for companies than in 1991" at the end of the last recession, though many say the position of consumers is slightly worse compared with that period.
The bearish argument, of course, is now that the economy has slowed, debt has become much more of a burden. The loss of a big sales contract, or an industrywide slowdown, puts companies under more pressure than if they were facing smaller debts. Some investors argue that the value of the assets on some companies' books may be inflated, making their debts more of a problem, because they have yet to take big writedowns on such things as impaired goodwill. (Goodwill is an intangible asset created when one company pays a premium to buy another.)
In 2001, there were three times as many downgrades of corporate credit ratings as upgrades, according to Moody's Investors Service -- the fourth consecutive yearly drop in credit quality and the steepest decline in credit worth since 1991. That means that balance sheets are shakier, making it tougher for companies to weather the current slowdown, continue to service their debt and find financing to spur growth.
Global Crossing, for example, took on boatloads of debt to finance a high-speed communications network. But the debt expense caught up to the former highflier, and the company is working hard to restructure itself. Even AT&T has seen its heavy debts help force asset sales, such as the recent sale of Ma Bell's cable business.
"Companies took on additional debt and interest expense with diminished levels of debt protection, so they've taken on more risk with the recent drop in profitability," says John Lonski, chief economist at Moody's.
Another worrisome sign: The debt of U.S. companies stands at a record 48.1% of U.S. gross domestic product, up from a recent low of 36.8% in the final quarter of 1994. In fact, debt has been outrunning economic activity -- corporate debt rose 85% since 1994, while GDP increased 42% -- a troubling figure to many economists.
With the federal surplus possibly turning into a deficit, the U.S. government may again become a net borrower. That could create more competition for corporate borrowers, forcing interest rates higher.
As companies struggle to make payments on the heavy debts, some argue the debt will keep capital spending tame in the next year or so, hurting the economy and earnings.
The news isn't all bad. The pace of debt growth for corporations is slowing, as some companies begin to focus on the need to improve their balance sheets. The 6.6% growth during the past year is the slowest in four years. While 2001 will mark a record year for corporate-bond sales, a lot of that debt is either refinancing older debt, or replacing shorter-term financing amid difficulties in the short-term commercial paper market.
Economists predict debt growth will slow to less than 4% in 2002. Meanwhile, interest rates have fallen in recent years, so the costs of servicing the debt are lower than just a few years ago. If the economy begins to grow strongly in 2002, the debts probably won't be too much of a problem for most companies.
"The growth in debt is slowing, and we're in the early stages of a deleveraging, but many companies are just not generating enough in earnings to pay down their outstanding debt," Mr. Lonski says.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com2
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