Why you must avoid over-indebted companies
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Associate Editor
David Stevenson Apr 09, 2009
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This recession has already put paid to swathes of the high street, with the demise of Woolworth's leaving some particularly big holes in the nation's shopping precincts.
And it won't stop here. Companies across all sectors that borrowed too much in the good times will find that refinancing that debt is nigh-on impossible now that cash is king again.
Even although half the nation's banks have been semi-nationalised, they're still currently unwilling to throw good money after bad. We should be grateful for that – after all, having a 'zombie' banking system is bad enough without it also propping up hundreds of 'living dead' businesses that really should be going bust.
But it also means investors need to be extremely wary of indebted companies. Even if a firm is making a profit, it's not necessarily safe from its creditors – and when that happens, it's the shareholders who get wiped out. Just look at the sorry tale of Robert Dyas…
How Dyas's shareholders were wiped out
If ever you want a lesson in how not to fund a business, just take a look at the recent history of hardware retailer Robert Dyas. Having survived two World Wars, the 1930s depression and a 1997 fire which wiped out its Croydon head office, Dyas then hit a problem it couldn't beat. It fell into the clutches of private equity (PE).
Change Capital Partners (CCP) acquired the firm in 2004 for £78m, the majority of which – in true PE style – was debt, including some £30m borrowed from Lloyds and Allied Irish Bank (AIB). That's a high-risk strategy even when things are going well. It's disastrous when they're not.
Five years ago, Dyas was making £10m a year, and servicing all that debt wasn't a problem. But as harder times have hit, those loans have become a heavy burden as cash has run low. Last year the company breached its banking covenants – i.e. it borrowed more than agreed. Annual profits have dropped to £4m, while debt remains in the region of £70m.
In other words, that debt has become a real millstone. So CCP asked its friendly Lloyds bank manager for help in restructuring the loans. Except that he wasn't very affable at all. Despite being partly on the public payroll, he refused to open up the cashpoint and increase the bank's exposure to Dyas, suggesting that CCP find a buyer for the company instead.
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So CCP threatened Lloyds with putting Dyas into administration – a form of insolvency. But while that might have meant some pain for Lloyds, it would also leave the buyout firm with zilch. And 1,250 employees would be joining the dole queues, which would no doubt make for some nasty headlines about asset-stripping private equity bosses.
In the end, the Dyas management team has bought CCP's entire stake for a reported £1m. Lloyds and AIB continue backing the business, so their stake is safe for now, but it's very bad news for CCP. Reports vary as to the losses, but Reuters reckons the PE firm has sunk more than £50m, in a mix of debt and shares, into the troubled hardware business. That'll now have to be written off.
A useful lesson for small investors
Dyas management has temporarily saved the company's skin, though for how long, no one knows. But the shareholder – CCP – has been wiped out. And that's a useful lesson for small investors to remember when they're hunting for stocks right now, because many cash-strapped firms could end up going the same way.
Half of the banks may be state-owned, but they've already made so many blunders, that they'll still pull the plug on firms where they see even bigger losses in the pipeline. And borrowing in the bond market is set to get harder, too. €565bn (£510bn) of rated corporate debt falls due by the end of next year, says Standard & Poor's, who are warning that it may prove "extremely difficult" for many European companies to roll their borrowings over.
Car makers have already "burned through" much of their cash reserves, leaving them "glaringly exposed to the downturn", says the ratings agency, while oil and gas, utility and telecom companies are all facing debt refinancing problems. S&P fears that lower-rated companies may be shut out of the credit markets altogether, particularly if the economic slump drags on into next year as it expects.
As The Telegraph's Ambrose Evans-Pritchard points out, this all "raises the risk of a default crisis on low-grade bonds". Moody's expects the non-payment rate among European "speculative grade" bond issuers – i.e. at the riskier end of the corporate scale – to soar more than ten-fold to over 21% by the end of 2009. That could mean a tsunami of corporate busts, with shareholders – as with Dyas – getting wiped out.
So the message for investors is very clear: be very wary of putting your money into firms with a mix of big debts, wobbly cash flows and dodgy credit ratings in the hope they'll somehow pull through.
How to tell if a non-financial business is in danger
How do you know if a non-financial business is in big danger? We swear by the Altman Z score, which monitors five key financial ratios to see if a business may be approaching the brink. You can learn more about it here: How Z scores can help you beat the slump. As for which stocks look worth buying on this measure, in this week's issue we choose five blue-chips that look as safe as you can get in this environment. Better yet, they're paying some pretty chunky dividends too. If you're not already a subscriber, get your first three issues of MoneyWeek magazine free here.
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