Friday May 30, 02:17 PM
Steer Clear Of Dangerous Debt
By Padraig O'Hannelly
In the current credit environment, it's not just consumers and mortgage holders who need to worry about debt, businesses are feeling the pain, too.
Property management company Erinaceous had many problems, but it ultimately folded after
breaching the terms of its banking agreements late last year. Thistle Mining (LSE: TMG.L - news) , a smaller company that I wrote about in August, was subsequently taken over by its bondholders.
That's the risk with highly-geared businesses: if a company can't meet its obligations to its creditors, either the business collapses or the creditors gain control. At best, shareholders have their investments mildly diluted in a rights issue, but in many cases they effectively lose everything.
Debts alone are not the problem. If cash-flow and profits are very predictable, as is often the case with utilities for example, then it can make sense to borrow heavily. But when financial risk is combined with an uncertain business outlook, the alarm bells should start to ring.
Johnston Press (LSE: JPR.L - news) (LSE: JPR) was a recent example of this.
The local newspaper group depends heavily on income from advertising, which in turn is very sensitive to the economy, and it's in competition with internet advertising. Even though revenues were not particularly predictable, the company had taken on huge debts to fund acquisitions. When sales fell, it had to announce a £212m rights issue to shore up the balance sheet. The problem is that this may not be enough, and I think there's a danger that further funding will be required in the future.
I fear similar problems at Yell (LSE: YELL), which produces directories such as the Yellow Pages. It, too, depends on advertising, and its balance sheet is heaving with debt.
Another company that I'd view cautiously at the moment is the retailer Debenhams (LSE: DEB.L - news) (LSE: DEB). Debts are roughly double the company's market capitalisation, and interest is covered less than three times by earnings. If retail spending declines, this could cause problems.
Property companies are also prone to these sorts of issues, as they invariably gear up their investments by securing loans on their property portfolios. The value of these loans in relation to the portfolio -- the loan-to-value ratio -- is a key measurement. If the property value falls, the LTV (LTVCQ.PK - news) rises, and may breach the terms agreed with the lenders.
Earlier this month, retail property company Capital & Regional (LSE: CAL) said that one of its funds was approaching its LTV limit, and it may have to sell off some properties. The shares are down 30% since the announcement, and have lost more than 80% since early last year.
Obviously there's more to all these companies than just their debts, but I'd need to see some very convincing arguments to allay my fears regarding their debts.
More: What Not To Buy: Low Interest Cover
If you're worried about the risk of investing in just one company -- especially if it's burdened with lots of debt -- why not invest in the whole market instead? Index trackers are a cheap and easy way to invest in all the shares in the FTSE 100.
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