Can High Levels of Corporate Debt Predict Fraud?
- Mar 09, 2006
- admin
- Investing
Of all the lessons taken from the great bull and bear market of
the past ten years, corporate debt is perhaps the most overlooked.
When I think back to the bull market, the terms that come to mind
are ìinternet,î ìnew economyî and ìbroadband.î When I think back
to the bear market, ìaccounting fraud,î ìattorney general,î and
ìWall Street greedî resonate the loudest.
While these and similar phrases are the hallmark of every great
bull and bear market, the term ìdebtî is noticeably absent from
the lexicon. This is a problem.
The fact of the matter is that Worldcom, Adelphia, Enron and
Qwest all had something in common beside allegations of fraud-they
each struggled with huge debt loads. Some of them played with their
cash flow statements to appear financially stronger to shareholders
and creditors (Worldcom) while others tried to hide it entirely (Enron).
But irrespective of the specific situation, these actions beg the
following question: Can investors protect themselves from fraud
by avoiding companies with large debt loads?
I think itís a question worth exploring.
We know that the economy moves in cycles. We have periods of
expansion followed by periods of contraction. During an expansion
(especially a strong one like we recently witnessed) business can
be very good.
As a result, sales and profits soar and stock prices reflect that.
It also becomes very easy to borrow money.
During times like this, many CEOís, in a sign of hubris and
inexperience, believe that they should acquire their competitors.
Acquisitions in and of themselves are the not necessarily the
problem. The problem is the price you pay and how you finance
the deal.
Letís take Worldcom (MCI) as a simplified but revealing example.
They sell long-distance, local and internet services to both
businesses and consumers.
At the height of the telecom boom Worldcom made many acquisitions.
During this time the average price of a T-1 line (the broadband service
they sell to their business customers) was approximately $10,000/month.
Therefore, the price they paid for each company they bought was
based on revenue of $10,000/month for services like a T-1 line.
Within five years prices had dropped over 95%, to less than
$500/month.
Bad Business Environment
Let me explain why. Competitors saw Worldcom charging clients
$10,000/month for a T-1 line. And as internet demand exploded they
all realized this was a game they had to become involved in–so
they all began to build new fiber optic networks.
The problem is that they overbuilt. At the height of the boom
ìsupplyî had outstripped ìdemandî by a 100-1 margin. What would
you do if you just built a multi-billion dollar fiber network and
you had to pay for it? You would drop prices until you filled it.
Thatís what they all did.
At this point you may be thinking to yourself that nobody could
have foreseen such a dramatic decline in prices. While hindsight
certainly gives me specific details today, history itself had
provided specific clues yesterday. In other words, every single
new industry throughout the history of time is littered with
examples like this.
Letís briefly look at the airline industry.
In 1960, it was easy to forecast that growth in air travel was
going to explode. Blowing away estimates, air travel increased by
more than 1000% by 1970. But the cumulative loss for the airline
industry during the same period was over $200 million dollars.
How, you ask, is it possible for business to lose money in an
industry that grew 1000% within 10 years? Dozens of competitors
each rushed in to build terminals, reservation systems and lease
airlines.
By the end of the decade there was simply too much investment;
demand had to catch up to supply. The shakeout was
intense-competitors dropped prices to win business and many of the
weaker companies folded. Any manager who took the time to read
about the airline industry (or computers, automotive,
railroad etc) would have known this.
Too Much Debt
Now back to the problem with debt. When companies borrow money from
lenders, lenders install ìcovenantsî into the loan agreement to
protect themselves.
Perhaps the most popular covenant states that a company must cover
the interest payment by a certain multiple. For example, if a company
has an interest payment of $1000/year it must have earnings
before interest, taxes and depreciation of five times that amount,
or $5,000/year (similar to a consumer having an income requirement
to obtain a home mortgage.)
If the company cannot maintain the agreed upon covenant than the
bondholders can take action to protect their loan. The action they
take can be as benign as formally forgiving the breach or as severe
as taking control of the company. Lenders will take the action that
reflects the danger to their interest and principal payments.
In 2000, the Federal Reserve decided to make money more expensive
by raising interest rates. This in turn slowed down business spending
which slowed down consumer spending.
By 2001 we were in a recession (some believe the telecommunications
industry experienced a ìdepression,î a fact that I tend to agree with).
While the depth of contraction is debatable, what is not is the
condition Worldcom was in when this happened- a mountain of debt
in an industry where prices, sales and profits were declining
rapidly. This is akin to the position a salesperson would be in if
he ran out and bought three new homes and five new cars after
having one good commission month.
Tying it all Together
How do the allegations of fraud tie into all of this?
Some colleagues of mine argue that a huge amount of corporate debt can
affect senior management the same way that it would affect an
individual who has lost a job.
The desire to mislead or hide the truth until ìthings get betterî
can be very strong, especially with a CEO who has a strong
identification with the company. Others suggest that since some of the
alleged fraud was perpetrated before the recession that it was simply
a function of management with bad character.
Human nature being what it is both scenarios have merit.
But as independent investors we are not paid to psychoanalyze
people; we have to make decisions based solely on the facts and an
understanding of history. And the fact is that Worldcom was a
terrible investment despite allegations of fraud.
First, they operated in a hypercompetitive industry with declining
prices.
Second, they borrowed money they didnít have and used to overpay
for acquisitions they shouldnít have made.
Those are the facts. The result was the effect.
As weíve discussed, a simple reading of business history would have
provided many of the clues one needs; just as Worldcoms recent history
will do the same for you in the future.
–By Dylan P. Jovine