Headlines sure look great, don’t they?
“S&P 500 reaches 1,900 for the first time!”
“The Dow Jones posts a new all-time high!”
“GDP is expected to reach 3% in 2014.”
Upbeat as these statistics are, they mask some serious dangers lurking just beneath the surface. Five years of ultra-low interest rates have encouraged excessive borrowing by companies that are losing money and excessive lending by firms that are taking on way too much risk.
Here are just three examples of stocks that are warning us of corporate America’s addiction to cheap money.
Excessive Debt in a Slowing Industry
When considering which businesses to invest in and which to avoid, don’t simply look at the obvious annual revenues and cash flow — also look at the company’s equity balances. If net equity is negative, the company could be in trouble.
Homeowners are all too familiar with negative equity. It simply means their house is worth less than their mortgage.
How serious is that? Well, it led to the greatest housing market implosion in 80 years.
Many investors are surprised to learn that companies can have negative equity, too. Despite growing sales, revenues, and income, companies can have negative equity if their total debt is greater than their total assets. And we saw what that did to the housing market.
Cablevision Systems Corporation (NYSE: CVC) is one such company that is drowning in debt. Its revenues and cash flow are actually very good. In the trailing 12 months, the mid cap generated $6.3 billion in revenues, which is 138% of its $4.56 billion market cap. And revenue is growing at 4.3% year-over-year, with plenty of income from a cash flow of $1.41 billion.
But here’s the problem: The company’s debt of $9.77 billion is more than twice its market cap. The company’s liabilities of $11.86 billion are almost twice its total assets of $6.59 billion, producing a net shareholder equity of negative $5.28 billion.
At $17.04 a share, its book value per share is -$19.74. Instead of getting $17.04 worth of equity for each share they hold, shareholders actually own $19.74 worth of debt.
Further compounding the problem of excessive debt is the stagnation of its related industry. The cable TV space looks dangerous for the smaller players, with a merger between Time Warner Cable and Comcast, as well as Google’s expansion into fiber-optic TV, threatening to steal market share away from little guys like Cablevision.
So even if excessive debt is not a problem in a growing industry, in an industry facing major upheaval — with major players jockeying for position and mega caps coming in to gobble up market share — it is unlikely Cablevision can simply grow its way out of its debt problem.
Excessive Debt in an Expanding Industry
But what if the industry a company belongs to is performing well? Wouldn’t it be alright to invest in a company with a high debt ratio on the expectation that it will grow itself out of it?
There is that possibility, which makes such investments a little more difficult to call.
Take Navistar International Corporation (NYSE: NAV), for instance — manufacturer and retailer of commercial and military trucks, school and commercial buses, and diesel engines.
The industry it sells to — transportation — has been on fire since the economic recovery began in 2009. Where the Dow Jones Industry Average of 30 blue chip stocks has gained some 102% since then, the Dow Jones Transportation Average of 20 transportation companies has soared 158%.
So you might think any business that caters to transportation companies will do just fine…
Until you look at Navistar’s books. Although the mid cap generated $10.35 billion in revenues over the past 12 months, which is a fantastic 367% of its $2.82 billion market cap, its quarterly revenue growth year-over-year shrank 16.3%.
Its debt of $4.86 billion represents 172% of its market cap, with high operating losses of -7.95%. As a result, despite such high gross revenues, its EBITDA (earnings before interest, taxes, depreciation, and amortization) is a negative $543 million, with net income available to common equity of negative $992 million.
The company is taking value away from shareholders, not adding to it.
That its peers are faring so much better shows there is something wrong at NAV. By comparison, BAE Systems (OTC: BAESY) and Paccar Inc. (NASDAQ: PCAR) posted EBITDAs of +14.4% and +9.7% of their market caps, respectively, while NAV’s EBITDA was -19.3% of its market cap.
Again, debt seems to be the issue. Where NAV’s debt is 1.72 times its market cap, its two competitors’ debt is just 0.22 times and 0.38 times their market caps, respectively.
As Cablevision’s and Navistar’s troubles with profitability under heavy debt show, negative equity is something investors want to be wary of. Even if subscription-based businesses like Cablevision generate steady cash flow that can cover interest payments today, what will happen when interest rates start to rise in a few quarters?
Higher financing costs are precisely what destroyed millions of homeowners when they could no longer afford their mortgages as rates rose. Rising rates will likely seriously damage companies like Cablevision and Navistar that are taking on way too much debt.
Low Interest Rates Lead to Risky Lending
The raising of interest raises an interesting question: From where do companies with negative equity keep getting their loans? Isn’t it risky to lend to companies that are underwater like that?
It is. One reason it’s so risky is because there are no assets left to use as collateral for new loans. Unsecured debt comes at a very high interest rate and is very attractive to private equity lenders and BDCs (Business Development Corporations), who are always on the lookout for high yield.
Prospect Capital Corporation (NASDAQ: PSEC) is one such BDC that lends to companies that have difficulty getting loans. For the increased risk, Prospect Capital and other BDCs charge higher interest rates, which they pass on to their shareholders as high dividends. PSEC’s dividend is currently a whopping 13.4% per year.
But what will happen to lenders like PSEC when interest rates start to rise? Pretty much the same thing that happened to banks like Lehman Brothers when mortgage rates rose a few years back: As home mortgages failed, so did the banks that held them.
Just as ultra-low interest rates in the early 2000s pushed the banks into taking on riskier and riskier mortgages in their quest for yield, so too are today’s low interest rates pushing lenders like PSEC into issuing riskier and riskier corporate loans. And they use a great deal of leverage, which PSEC may be trying to hide.
PSEC’s stock tumbled as much as 14% over the past few days on some sour earnings news — it was revealed the Securities and Exchange Commission wants the company to restate several quarters of earnings. The problem lies in the way the company spreads the loans it makes across multiple holding companies.
To put is very simply, PSEC has created a number of holding companies that it fully owns and funds with cash. These holding companies take the money that PSEC gives them and, in turn, lend it to other companies.
But PSEC counts the loans it makes to its fully owned holding companies under the same category as loans made to outside companies. In effect, PSEC treats its fully owned holding companies like external companies — which they are not.
“[PSEC] does not consolidate its wholly owned entities, and further asserts to be able to count as interest income loans owed effectively to itself [made to its holding companies]. Prospect Capital Management then collects incentive fees based on interest paid on such loans,” explains Lawrence Zack Galler of Seeking Alpha.
So while the left hand loans the right hand money, the right hand pays the left hand interest, which PSEC counts as income, and for which it earns fees. The only problem is that PSEC owns both hands and is simply conducting some of its business with itself.
Hence the SEC’s demand that PSEC consolidate its businesses, which the company is appealing.
Why appeal? Because “if consolidated, this and other senior instruments would likely count against the BDC statutory leverage limit,” answers Galler.
In other words, Prospect Capital may have overstepped the leverage limit imposed on Business Development Corporations, which would require it to exit some of its loans, thereby reducing its income and stock price.
Even if PSEC comes out of this unscathed, investing in firms that lend to companies who have difficulty securing loans does not justify its high dividend yield.
If the end companies are having a hard time getting loans at these ultra-low rates, imagine how many of them will fail when rates start to rise? It is just like sub-prime lending in the housing market.
Investors Beware
Investors who don’t want to lose their shirts when financing conditions change should be careful not to wade too far into murky waters looking for high yield.
The same dangers lurk beneath the surface now as did six and seven years ago, just before the housing market imploded. A good many companies that are treading water today will be washed out to sea when all this easy money disappears — both borrowers and lenders alike.
Until next time,
Joseph Cafariello for Wealth Daily
