Why Debt is So Dangerous
- Dec 08, 2004
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 “internet,” “new economy” and “broadband.” When I think back to the bear market, “accounting fraud,” “attorney general,” and “Wall Street greed” resonate the loudest. While these and similar phrases are the hallmark of every great bull and bear market, the term “debt” 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 it’s 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 CEO’s, 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.
Let’s 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 “supply” had outstripped “demand” 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. That’s 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.
Let’s 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 “covenants” 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 “depression,” 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 “things get better” 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 didn’t have and used to overpay for acquisitions they shouldn’t have made. Those are the facts. The result was the effect.
As we’ve 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.