The Debt Hangover from zero interest rates

Monday, Feb 26 2018 by

The recent travails of companies such as Carillion (LON:CLLN) and the AA (LON:AA.) have underlined the dangers of high levels of debt on corporate balance sheets.

The combination of zero interest rates and bond buying by central banks across the developed world has encouraged a certain number of companies to run up high levels of debt, which they then struggle to pay down or even service from cash flows.

While this may be most obvious in the US, where aggregate corporate net debt/EBITDA ratios have risen inexorably since the 2008 Financial Crisis to extremely elevated levels today (1.5x today according to Bloomberg, versus just 0.8x pre-crisis in 2007), this is also an issue with certain UK and European companies too.

A very high level of debt, combined with underlying problems with the business model was Carillion’s undoing. In the AA’s case, net debt level of £2.5 billion currently sits at 5 times the total value of the AA’s equity, and nearly 20 times the value of AA’s estimated net profit for this year (£127m).

As the Bank of England raises the UK base rate further, and long-term interest rates creep back up in line with the trend in US Treasury bonds, companies with such high debt loads could find themselves increasingly struggling to refinance these debts.

Debt plus structural decline: a dangerous mix

There are a number of sectors with structurally challenged business models: Retail is an obvious case in point, with high street shops threatened by changing consumer tastes and online retailers like Amazon. This has resulted in a number of bankruptcies at the likes of Toys R Us, BHS and Comet in the recent past.

Building contractor and engineering companies like Carillion (LON:CLLN) are clearly another, typically bidding for huge contracts which can at best, only generate very low profit margins for the company but which can result in substantial losses in the case of cost or time overruns.

Casual dining is a third sector under huge pressure from pressures on consumer spending and over-expansion, with a number of non-quoted restaurant chains running into difficulties and closing down including Byrons and Jamie’s Italian.

Focusing on profit margins and cash flows

At a time such as now when both short- and long-term interest rates are rising together with inflation, it becomes more important than ever to focus on companies that sustain high profitability (high operating margin, return on capital) and generate strong free cash flows, which can be used to reduce debt loads over time.

Ideally too, you want to select companies that can use a rising inflation environment to raise prices and thus potentially raise their own profitability. Often these are cyclical companies, who can benefit from a strong order book and a large element of fixed cost (giving a high degree of operational leverage) to boost profit margins.

What sectors to focus on currently?

From a cyclical and also structural perspective, companies mining and refining industrial metals such as copper, nickel and zinc are in a strong position to drive earnings and cash flows higher on the back of strong global industrial demand, following a six-year bear market for commodities to 2017.

In the UK stock market, global miners such as Glencore (LON:GLEN) and Rio Tinto (LON:RIO) have seen analyst earnings estimates rise sharply over the last few months on the back of a strong run-up in these industrial metals prices.

In the small-cap arena, Central Asia Metals (LON:CAML) and Griffin Mining (LON:GFM) are two miners that have sharply rising top-line growth translating into double-digit EPS growth, very high albeit cyclical operating profit margins, and double digit returns on capital employed (ROCE).

From industry and construction, Somero Enterprises Inc (LON:SOM) fits this bill as a manufacturer of laser-guided construction equipment for producing level concrete floors, with a 27% operating margin and a 55% ROCE over the last 12 months. Additionally, as a primarily US-focused company, Somero should be a prime beneficiary from the recent reduction in US headline corporation tax rate to 21%, a driver behind recent consensus earnings estimate upgrades.

Bottom line, I believe that the next year or two is a period where we will continue to see interest rates and thus debt financing costs drift higher, high profitability companies with strong balance sheets and the ability to raise prices can see rerating at the expense of highly indebted companies with challenged business models.  

From a quantitative screening point of view, I am thus looking for companies with consistently high return on capital (ROCE), some top-line sales growth and most importantly, net cash on the balance sheet or at least a steadily reducing net debt level.

What I feel is increasing a red flag from my own investing point of view, is a rising level of net debt combined with relatively low profitability (operating margin, ROCE).

Filed Under: Stock Screening,


My opinions only, not investment recommendations: Please Do Your Own Research

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Carillion plc is an integrated support services company. The Company operates through four business segments: Support services, Public Private Partnership projects, Middle East construction services and Construction services (excluding the Middle East). The Support Services segment includes its facilities management, facilities services, energy services, rail services, road maintenance services, utilities services, remote site accommodation services and consultancy businesses in the United Kingdom, Canada and the Middle East. The Public Private Partnership projects segment invests in Public Private Partnership projects in the United Kingdom and Canada. The Middle East construction services segment includes its building and civil engineering activities in the Middle East and North Africa. The Construction services segment includes its the United Kingdom building, civil engineering and developments businesses, together with those of its construction activities in Canada. more »

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AA plc is a United Kingdom-based roadside assistance company. Its segments include Roadside and Insurance. Roadside consists of two divisions; Roadside Assistance and Driving Services. The Roadside Assistance division helps stranded motorists at the roadside or at home utilizing a workforce of approximately 2,900 patrols attending on average around 10,000 breakdowns daily. The driving services division consists of its driving school and the British school of motoring and DriveTech. Its insurance segment comprises of insurance services, insurance underwriting and financial services division. The insurance services division consists of its insurance broker which sells motor and home policies, operating a diverse panel of underwriters. Its insurance underwriting underwrites motor and home insurance policies which originate from its insurance services segment. The financial services division provides competitively priced savings, loans, credit cards and mortgages. more »

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Rio Tinto plc is a mining and metals company. The Company's business is finding, mining and processing mineral resources. The Company's segments include Iron Ore, Aluminium, Copper & Diamonds, Energy & Minerals and Other Operations. The Company operates an iron ore business, supplying the global seaborne iron ore trade. Its Iron Ore product operations are located in the Pilbara region of Western Australia. The Aluminium business includes bauxite mines, alumina refineries and aluminum smelters. Its bauxite mines are located in Australia, Brazil and Guinea. The Copper & Diamonds segment has managed operations in Australia, Canada, Mongolia and the United States, and non-managed operations in Chile and Indonesia. The Energy & Minerals segment consists of mining, refining and marketing operations in over 10 countries, across six sectors: borates, coal, iron ore concentrate and pellets, salt, titanium dioxide and uranium. more »

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