Tick. Tick. Tick. Can you hear it? Some seemingly benign - perhaps even profitable - stock you own may well be a ticking time bomb set to go off in the future. Yet, there are no obvious hints right now. I've got four to show you, but there are a lot more out there.
Look for the Fuse
To spot one of these traps, you first have to spot the fuse. The fuse is debt. This is not debt that's being paid right now, but debt that's going to have to be repaid at some point in time in the future. Big debt. That kind of thing doesn't really show up in current or near-term (forward looking) valuation measures, however, which is why nothing seems amiss.
Not that I'm the Jack Bauer of the investment world, but check out these potential powder kegs.
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Ticking Time Bombs: Current Fundamentals
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Company
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TTM P/E
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Forward P/E
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Profit Margin
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Energy Transfer Equity
(NYSE:ETE)
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18.9
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12.0
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4.8%
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RSC Holdings
(NYSE:RRR)
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7.1
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8.2
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8.2%
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Western Union
(NYSE:WU)
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23.3
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17.8
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17.3%
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Crown Holdings
(NYSE:CCK)
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8.3
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14.0
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9.7%
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| Data as of Market close Friday August 29, 2008 |
All in all, not too bad in terms of the current fundamental snapshot, right? You could do a lot worse. The problem is that all of these companies have borrowed money - a lot of it - finance a growth initiative.
The capital is provided in one of two ways: either through bonds issued to bondholders, or a straight loan from a single source (perhaps a bank or business credit provider). Unlike issuing stock shares to raise capital, bonds or loans are contractual commitments. The creditors will demand payment. (For more read Bond Basics: Introduction.)
There's no inherent problem with the practice; we all know you have to spend money to make money. The problem is that if you borrow more than you get in return, somebody's going to be left holding the short end of the stick.
A simple debt-to-equity ratio can indicate just how leveraged a company is. The higher the ratio, the more committed the company is to future payments of interest and principal. Since the alternative is/was issuing equity (stock), a debt/equity ratio measures how much of a corporation's future income - and current assets if need be - are first reserved for someone other than common stock holders. In fact, typically shareholders are last in line.
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Ticking Time Bombs: Current Debt-to-Equity Ratio
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Company
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Debt/Equity Ratio
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Energy Transfer Equity
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569.7
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RSC Holdings
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148.2
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Western Union Co.
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132.1
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Crown Holdings
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18.7
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| Data as of most recent quarter |
For the record, a "normal" debt/equity ratio for a company with debt-based financing is usually no more than 50%, or 0.5. The numbers above are phenomenally higher than that. If these ratios were only temporary, or if the debt was fruitful, I might be able to forgive and forget. In all four cases, however, I see trouble ahead:
- Energy Transfer Equity primarily deals in natural gas and propane and operates through its subsidiary, Energy Transfer Partners (NYSE:ETP). It has $2.6 billion in debt coming due in 2011, and a total $3.6 billion coming due for several years after that. However, last quarter's sales were only $2.3 billion, and net income was only $120 million. (For more on what to look for when you see subsidiaries, check out Sneaky Subsidiary Tricks Can Cloud Financials.)
- RSC Holdings owes $2.7 billion, most of which is to be paid between 2001 and 2014. Problem? It earned $40 million last quarter, and that was better than the recent average.
- Western Union owes $3.3 billion, with $1 billion of it due in 2011. The company's only been earning a little over $200 million per quarter however.
- Crown Holdings is sitting on $3.8 billion in debt, which will be tough to ever pay off if quarterly earnings in the $100 million area persist. (For additional readings see Debt Reckoning and Evaluating A Company's Capital Structure.)
Disarmament Possible?
In all four cases there's the possibility that the company could crank up revenues and earnings to a level that would more than service or pay off the debt. If so, the self-destruct sequence will be deactivated and we'll all escape safely. Do the math though. These companies have a lot of ground to cover, and a short period of time to do it.
You could argue in favor of them simply issuing more debt when the time comes to take care of what's currently on the books, but that's a never-ending death spiral. It's like transferring a credit card balance to a different credit card. If you can't afford it now, why would you be able to afford it later?
These companies have to pay the piper sometime. And if they can't, shareholders will be the ones holding the live grenade.
