Monday, November 15, 2010

Detrimental vs Non-Detrimental Debt

A company with a large debt load due within a short period of time can see its stock price take a hit, as investors perceive increased risk under such circumstances. But just because a debt load is high versus a company's current assets and ability to generate cash flow, does not mean the company is on the verge of bankruptcy.

Consider Genesis Land Corp (GDC), a residential real-estate developer in Alberta, Canada. The company has $46 million in debt due over the next few months, and it does not have the current assets to be able to cover that obligation. It is therefore reasonably within the realm of possibility that the company will be unable to cover the $46 million obligation with cash from operations.

But that doesn't signify the end of the company in this case. In other cases, such as those of Blockbuster, Rite-Aid, or TLC Vision, risk of default may be high. But for Genesis Land, the risk is not nearly as great, despite how the share price has reacted over the past few weeks and months.

To see this, it is important to consider the perspective of its lenders. They just want to get paid, quickly and easily. As a result, they have no interest in a drawn out and costly bankruptcy process; they would rather the company operate as a going concern so that it can sell its ample long-term assets in an orderly fashion to make the lenders whole. As a result, the likelihood of the company being able to refinance or alter the terms of its current debt to increase its maturity is very high. Companies without long-term assets are in a much more precarious situation.

Debt due within a short period of time can bankrupt a company. But sometimes a company's particular circumstances can make this a very remote possibility. Investors cognizant of the factors that contribute to a company's safety despite the presence of near-term debt maturities are in a position to capitalize on low share prices and thereby generate abnormal returns.

Disclosure: Author has a long position in shares of GDC

3 comments:

tscott said...

http://www.calgaryherald.com/business/Resale+market+slows/3822954/story.html

seems the market is falling, no surprise there but thought it was worth mentioning.

I am really impressed with the debt paydown even though some was due strategic land sales.

deanr83 said...

What are your thoughts on the new additions to the Board? They seem to be going in the right direction.

I think after tax NAV is still well above $6.

Saj Karsan said...

Hi dearnr,

Their credentials look good, but I don't really know enough to make a judgement either way.

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