Has LU have a bad debt?
Debt: The Good, The Bad & The UGLY
Part 2 of 2
By Phil Weiss (TMFGrape) and Matt Richey (TMFVerve)
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TOWACO, NJ (September 1, 1999) -- Yesterday, we began the
discussion of debt, covering an example of Coca-Cola's "good"
debt, as well as some other debt concepts. Today, we'll share
several examples of "bad" debt and then conclude with an example
of debt's potentially ugly ramifications.
Bad Debt -- Shades of Gray
The region between good and UGLY debt is a gray area. The peril
of debt is that companies often take it on with good intentions
but then run into operational difficulties that cause their debt
to become an arduous burden. Several examples come to mind.
In 1996, Disney (NYSE: DIS) acquired Capital Cities/ABC. Warren
Buffett enthusiastically commented, "I do not have blanket
enthusiasm about all deals. But this deal makes more sense to me
than any deal I've seen, with the possible exception of Capital
Cities and ABC." Oh well, nobody's right all the time. Since
January 1996, Disney stock has appreciated only 31% during a
time when the S&P 500 more than doubled.
To avoid diluting shareholders' equity, Disney used debt to make
the acquisition and thereby quadrupled its debt from $3 billion
to more than $12 billion. Today, every bit of that debt is still
weighing down the company's balance sheet. This debt is doubly
bad. First, it causes burdensome interest payments that
immediately swallow more than 20% of Disney's earnings before
interest and taxes (EBIT). Second, it has hampered the company's
agility in making a decisive move into the Internet arena. Tom
Gardner expanded on these and other woes in his May article,
Mini Mouse.
fool.com
Gillette (NYSE: G) is another company that seems to be walking
the fine line of good versus bad debt. Between 1996 and 1998,
debt was held in check at $2 billion. But in the past year, it
has begun to balloon and now stands at more than $4 billion.
Interest expense isn't yet causing a major dent in the bottom
line (less than 5% of EBIT), but the trend is disturbing.
Even Rule Maker Gap (NYSE: GPS) is entering the gray region of
debt. As discussed on August 13 and 16, Gap's debt is escalating
quarter by quarter and now stands just shy of $1 billion, up
from practically nothing in early 1996. Compared to Disney and
Gillette, Gap's debt is minuscule, with interest expense that
amounts to only 1% of EBIT. Nevertheless, Gap shows no signs of
slowing its use of debt as it builds out its stores, so this
will be an area to watch closely. While Gap's debt is nowhere
near the danger point right now, the retail apparel business
doesn't have the stability of Coke's beverage operations or
Gillette's consumer staples. If the economy took a downward
turn, Gap's debt could make hard times even worse.
One other company that I put in the no man's land that you'll
find between good and bad debt is Lucent (NYSE: LU). When Lucent
was first spun off from AT&T (NYSE: T) in April of 1996, it had
cash of $448 million and interest-bearing debt of $172 million,
a cash-to-debt ratio of 2.60. At the end of June of this year,
it had cash of $1,495 million and debt of $6,792 million -- a
ratio of 0.22. On a trailing 12-month basis, Lucent's interest
expense is now just less than 5% of its EBIT. Like Gillette,
this isn't a major hit to the bottom line, but the trend is
alarming. While a lot of Lucent's debt was racked up during the
time that it was prohibited from using its stock to make
acquisitions, it's been almost a year since that restriction was
lifted, and its debt continues to grow.
One advantage that Lucent has over the aforementioned companies
is that it's in a rapidly growing industry. If growth were to
slow down, then -- as with the Gap -- debt could make hard times
harder.
Now, let's turn to the portion of tonight's report that's only
suitable for mature audiences....
UGLY Debt
Too much debt can drown out earnings and suck the life out of a
company. That's what happened with Starter, which declared
bankruptcy under Chapter 11 in April of this year.
Starter makes athletic apparel. I created a spreadsheet with its
quarterly data from March 1995 through September 1998 (financial
statements for 12/31/98 were not filed with the SEC due to the
bankruptcy filing). During this time, the company never had a
cash-to-debt ratio above 0.14. Further, the seasonality of the
business caused it to make money only during the third quarter
of the year.
The problem was that in order to purchase the products that it
needed to make money during that one quarter, it had to take on
so much debt that it was unable to repay the money it borrowed.
In 1995 and 1996, its interest expense was more than its pre-tax
income. In 1997, Starter didn't even have a pre-tax operating
profit. For practically three years, this company clung to the
life-support of debt, but eventually the creditors came
knocking. It's no wonder this company went bankrupt.
Here are a few of the numbers for this period:
Cash-to Operating Pre-tax Interest
Debt Profit (loss) Income (loss) Expense ROIC
1997 0.003 (24,224) (31,393) 7,272 -14%
1996 0.070 8,333 3,132 5,647 4%
1995 0.140 7,243 2,288 5,259 4%
Pretty UGLY, wouldn't you say? The sad part is that I only knew
about Starter because someone that I know owned shares of the
company and still did when it went bankrupt. A while ago, he
asked my opinion on the company, and I looked at the financials
and told him if I owned it, I'd sell it. He held on for reasons
that are common among people that continue to hold a stock they
know is a loser. Wrong reasons that they are, most of us are
familiar with the urge to get back to even, or the
rationalization that the stock price is already so low that it
couldn't go much lower, or the feeling that the stock is cheap,
etc. Of course, since Starter went bankrupt, he ended up with
nothing in the end. OUCH!
This is an example of why Philip Fisher, in his book Common
Stocks & Uncommon Profits, said, "More money has probably been
lost by investors holding a stock they did not really want until
they could 'at least come out even' than any other single
reason." The moral of the story is that there are no rules
saying that a stock can't go down any more from where it is
presently. It most DEFINITELY can.
In case reading about a bankrupt company like Starter wasn't
enough to curdle your stomach, we'll check in on Rule Breaker
Port short Trump Hotels & Casino Resorts Inc. (NYSE: DJT). Here
are its numbers for 1998 and the first six months of this year:
($ millions)
1998 6 mo. 1999
Cash and cash equivalents $ 114,757 $105,089
Interest Bearing Debt $1,848,996 $1,854,404
Cash-to-debt 0.06 0.06
Operating Income $154,973 $66,024
Interest Expense $223,098 $110,907
This one really doesn't look a whole lot better to me than
Starter.
That's all for tonight. Do you have any other candidates for
good, bad, or ugly debt? If you'd like to discuss them, or you
have any other questions, please post to any of our message
boards.
Phil Weiss, Fool
Matt Richey, contributing Fool
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