Monday, February 15, 2010

When Debt Isn't Okay

Companies with lower risk can afford to take on more debt than the average company, as their low-risk nature allows them to service debt even when the going gets tough. In the finance industry, the term "low-risk" in this case usually equates to stable revenues and costs. But stable revenues and costs of the past cannot on their own constitute a sign that a company has low risk, for there are many oft-ignored elements that combine to form a company's risk.

Consider Cinram (CRW), producer of the DVDs and CDs on which music, movies and games are distributed. One would expect this to be a fairly steady industry (with the exception of the requirement to adopt new portable media technologies as they go mainstream) and the company has shown very steady revenues over the last few years. As a result, the company has loaded up on debt, both to lower the cost of capital and to fund acquisitions to increase its market reach and scale.

Unfortunately, despite the stable outlook for the industry and the company's stable history, there was a large risk embedded in this company that both creditors and the company's managers appear to have overlooked when they loaded up on debt a few years ago (and subsequently made the problem worse with share dividends and buybacks that further weakened the company's financial position): the concentration of its customers.

A large amount of business coming from just one customer represents a significant risk. Companies in this position should be wary of taking on too much debt, on the chance that the major customer has a change of heart. In Cinram's case, 28% of revenues came from Warner Brothers, who earlier this month had a change of mind about its DVD supplier. What you have now is a company with operating leverage suffering a large revenue cut, with debt obligations it can no longer afford. On the news of the loss of the major customer, the stock dropped 60%.

Since the first rule of value investing is "never lose money", situations like these must be avoided. While large amounts of debt can be okay for some companies, a superficial glance at the company's industry and operating history do not suffice in evaluating whether the company merits a low-risk moniker. Some additional revenue risks are considered here.

Disclosure: None

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