An important lesson that has probably taken me too long to pick up is that corporations with leveraged balance sheets tend to have a management culture that will perpetuate those leveraged balance sheets even as conditions improve and profits increase.
The reason why I made the mistaken belief otherwise is because I try not to overweigh the natural ebbs and flows of the business cycle. Every day, there is information blasted at the investor.
If the price of coffee beans rises by 10%, what does that say about the future profit margins at Starbucks? If oil is up 15%, what does that say about Chevron? Doesn’t a $1.2 billion settlement impair the fair value of Wells Fargo? Each of these news items meet the definition of “material” but aren’t really determinative of whether those stocks will be great corporations to passively hold for the next decade.
My mistake has been extending this same deference to the ebbs and flows of the business cycle to the capital structures of corporations. If I saw a corporation carrying high debt coming out of a recession, I would make the assumption that the management team would try and get it down to the high end of moderate level. If the profits came in higher than usual, I would expect some of that excess cash to go towards alleviating the debt burdens.
But that’s not what happens. Instead, corporations with leveraged balance sheets have often treated the most favorable part of the business cycle as an opportunity to issue even more debt to engage in stock buybacks (i.e. the debt taken on by Sonic in 2006 to repurchase stock almost drove it to bankruptcy in 2009) or engage in acquisitions that required so much debt it couldn’t afford any near-term downtick in the business cycle (i.e. look at what eventually happened to shareholders of Baldwin-United when it bought corporations like Nifty Fifty member MGIC in the early 1980s).
Among the blue chip stocks I have studied, corporations with high debt tend to always have high debt, and corporations with strong balance sheets tend to keep them that way. The only exception I have encountered in my studies is the corporations that operate in the consumer sector like Kellogg, Campbell Soup, and Procter & Gamble that have struggled to grow revenues over the past fifteen years. They had light balance sheets in 2001, and changed the character of their balance sheet to either “moderate” or “high end of reasonable” depending on which one you’re discussing. Some of it is a consequence of low-interest debt availability that can be used to repurchase stock and make the earnings growth appear like business as usual.
The modification I have made is that I no longer expect corporations with high debt burdens to change the relationship between total debt levels and net profits over the long haul. If a beer company has 8x annual profits in current debt, ten years later it will probably be closer to 8x annual profits in debt than, say, 5x annual profits in debt. If the balance sheet improves, I’ll treat as a welcome surprise, but I won’t consider a stock that presumes substantial balance sheet improvement as a necessary condition for the investment working out.
Does this mean that corporations carrying high balance sheet debt shouldn’t be considered? No. But you should figure out what kind of earnings power those companies will have during a recession, and then compare that to the debt load. If the possibility of making the payments is iffy, then walk away.
Some firms, like IBM, Anheuser-Busch, and AT&T, have enormous debt loads and yet are owned by some of the most conservative pension fund managers and investors in the country. There is a rational basis for what they are doing. The stability of the net profits at those three firms has proven so resilient in recessions that the money from operations keeps rolling in to make the necessary debt payments. The cash flow is reliable enough to support a stressed balance sheet.
But an example of a corporation where debt levels would deter me from ever considering the stock is something like Sportsman’s Warehouse (SPWH), a Utah company that operates 57 stores dedicated to selling guns, ammunitions, fishing gear, canoes, outdooring cooking, tents, ATV accessories, and so on.
As a concept, Sportsman’s Warehouse seems intriguing. There are only 57 stores, and a P/E ratio of 13. Gun equipment and outdoor gear is often the kind of thing you need to see eye to eye and face to face; the Amazon and third-party risk factor isn’t as bad as what Dick’s Sporting Goods is starting to go through. If it could get up to 500 stores as end game, you could make a good ‘ole Peter Lynch ten-bagger because it doesn’t seem like the current P/E ratio would demand a headwind to future profits from P/E compression.
As reasonable as that thesis might sound in the abstract, that’s probably not going to happen because of Sportsman’s balance sheet. It makes $31 million in profits during a good year, and has $200 million in debt. None of the principal needs to be paid until after 2021, so it is conceivably possible that Sportsman’s could grow its profits by such a substantial rate over the next five years that the new earnings power will be enough to take care of the required debt payments.
That’s how I would have analyzed the problem a year or two ago. But it misses the mark because it ignores the management culture at Sportsman’s. In 2009, Sportsman’s went bankrupt because its profits turned into deep losses during the recession, and it had a crushing debt load. It needed to reorganize.
Seidler Equity Partners, which gobbled up more than half of it during bankruptcy and took it public again in May 2014, has been slowly divesting its stake (it is in the process of reducing its common stock position to 24.5% of the corporation). It’s understandable why. It is on a trajectory to repeat the exact same mistake again.
It was a solid corporation in the 2000s yet its vulnerability was that it couldn’t handle large debts during a recession. The earnings wouldn’t be there to service it. So it went bankrupt. Now, the same scene is playing out again. Profits have grown as economic conditions in the United States have improved, but the $31 million in profits isn’t going to be used to take a bite out of the $200+ million debt burden earlier than required. Heck, it only keeps $1.9 million in cash on hand in comparison to over $200 million in debt. That’s not how you ought to run any company, especially one susceptible to losses at the bottom of the business cycle.
The error in my logic was thinking that the earnings power improvements between 2016 and 2021 would be something worth measuring in reference to a $200 million debt obligation. Most likely, Sportsman’s will have a much higher debt burden in 2021. If it is making $100 million in annual profits then, it may very well carry $750 million in balance sheet debt. The problem is that another 2009 type of economy could turn those high profits into $150 million operating losses, and that doesn’t mix well with a $750 million debt burden.
If a corporation has high debt, low cash on hand, and is currently enjoying prosperous business conditions, it should not be assumed that management will alter the status quo and substantially improve the corporation’s balance sheet. For that reason, I only recommend that high debt corporations be considered as long-term investments if the cash flow is especially stable and can still service the debt during the projected profit levels at the low points in the business cycle. If a corporation is highly leveraged in prosperous economic conditions, and sustains losses or cash flows well below the debt requirements during a recession, stay far away. It’s an error to assume that a management team will moderate the debt burden during good times to prepare for a far-off downside.
I just haven’t seen this kind of change-of-heart shift towards prudence happen out in the wild; meanwhile, the case studies of overleveraged firms remaining overleveraged continues to mount.
Originally posted 2016-04-13 01:46:09.