Wednesday, July 15, 2009

Scared Of Debt

If you're not the type of person that levers up his assets to the hilt (i.e. you would rather save up for a sizable downpayment for a car/house rather than borrow as much as you possibly can), you might apply that same mentality towards the businesses you own. Yet when it comes to stocks, many individuals who are not otherwise reckless with risk buy companies without regard for their levels of debt.

But while a company may look great from a net asset and earnings point of view, the company faces increased risk when it has levered itself up. Consider Thermadyne (THMD), a global supplier of cutting and welding products. Thermadyne trades for just $48 million, but its operating income in each of the last two fiscal years was above $40 million! Furthermore, its book value is $120 million.

The problem is, the company operates in a cyclical industry, meaning when a recession bites, it bites hard: revenue in the most recent quarter is down 35% from the same period last year and is at a level at which the company cannot make money. While revenues may eventually return to normal when the macroeconomic situation stabilizes, debt charges don't wait. The company is laden with $235 million in debt, for a debt to market equity ratio of almost 5!

To return to the personal asset example, this is akin to putting a 16% downpayment on a home (and taking on the rest as debt) when you don't have any income. You will likely find employment when the economic situation improves, but your creditors want their payments now!

Of course, this does not mean that Thermadyne does not make sense as an investment for those who specialize in such situations. It is cheap across several metrics, and a 2nd order analysis of its debt maturities reveals it has some time to repay much of its debt. But the fact that remains that high debt levels are akin to playing with fire. You may be able to get away with it for a while, but a Black Swan can leave you in a precarious position.

Disclosure: None

1 comment:

Travis said...

Great point about debt.

Most people don't think about it or for some reason think that debt doesn't affect businesses in the same way it affects our personal lives. Which ofcourse is not true.

My wife and I are almost debt free and amazingly as our debt goes down our income goes up.

Business work the same way.